Advanced Distressed Debt Lesson #4

It has been a few months since we had our last advanced distressed debt lesson. More the previous editions, here you go: Advanced Distressed Debt Lesson #1, Advanced Distressed Debt Lesson #2, Advanced Distressed Debt Lesson #3 (needs a follow-up post).

A friend asked me my opinion of something Whitney Tilson said in his most recent email regarding GGP. Here is the relevant text.

"Hovde’s most serious mistake is misunderstanding (or misrepresenting) what will likely happen to GGP’s unsecured debt. Hovde assumes that it either remains outstanding (throughout its presentation, Hovde calculates GGP’s leverage and interest payments assuming that the debt remains outstanding, which is the main reason its analysis differs from Pershing’s and ours – see page 63, for example) or that it converts to equity, which will result in “significant dilution” (page 72). Hovde makes explicit this assumption when it claims that Pershing “does not use consistent assumptions” regarding what happens to the unsecured debt on page 35 of its report.

Hovde doesn’t appear to understand bankruptcy law and what will likely happen to the unsecured debt. There is almost no chance that it will remain outstanding: it will either be refinanced or, more likely, be converted into equity (this is what Pershing assumes – there is no inconsistency). But here’s the key: it will NOT BE DILUTIVE because it will convert AT FAIR VALUE, as determined by the bankruptcy judge. Of course, if the judge determines that fair value is $1/share, then it would be massively dilutive, but that’s not going to happen. The judge has a great deal of discretion in determining fair value, but will certainly take into consideration the current stock price, comps and the price of any equity offering(s) GGP might do.

For example, as soon as GGP exits bankruptcy and its stock is relisted (it currently trades on the pink sheets, which means most institutional investors can’t own it), it will be a must-own stock for every REIT fund (a big catalyst Hovde misses). To meet this demand and pay down some debt, GGP might issue equity – and the negotiated price at which this stock is sold would likely weigh heavily on the judge’s determination of fair value (and would not be dilutive). Of course, if someone like Simon were to buy GGP at, say, $20, the debt would convert at this price – and again, it wouldn’t be dilutive."

This in response to Hovde's response to Pershing Square's response to Hovde's short thesis on GGP. What a mouthful! And like a lot of financial bloggers out there, I love the back and forth. And why not jump into the fray and learn something here? For all those following along at home, I have embedded Hovde's presentation below.

There has been a number of press reports recently about Brookfield Properties buying GGP's unsecured debt. Here is a WSJ article that also mentions Simon Properties buying GGP's debt. Now, who knows what instrument either enterprise is buying. It could be the Rouse bonds or it could be GGP's unsecured term loan on the GGPLP LLC side.

We know from the original Rouse proxy (when GGP acquired Rouse in 2004), that there was indeed a bidding war for Rouse's assets. Read the background of the merger here: Rouse and GGP background of merger. So it is likely that yes, assuming that Company A or Company B in the merger agreement were Simon or Brookfield, people indeed have interest in Rouse. Why would Brookfield or Simon buy the unsecured debt of GGP or Rouse? Well, they could be making an investment thinking the bonds are undervalued and will be taken out at par+accrued.

Or they could be positioning themselves to have a nice big seat at the table.

Let's talk about incentives for just a little bit, because it is crucially important to any analysis of a possible distressed debt investment. Rational players want to maximize their return on capital given like amounts of risk. They would much rather have a 100% return than a 10% return on the same amount of capital. Who wouldn't? An example that has been discussed on this blog in the past is Six Flags. The HoldCo note holders want to maximize their return, and not get rail-roaded by the Op-Co note holders plan, so they propose their own plan, backstopping an equity rights offering taking out the opco note holders, reinstating the bank debt, and getting the vast majority of the equity. Likewise, the op-co holders want the equity (they believe they are creating it cheap), have offered a plan to take out the bank debt, de-lever the company with a rights-offering, get the majority of the equity and give a sliver of the equity to the holdco.

Similar to what is going on in the Trump bankruptcy between Carl Icahn/Beal Bank and the Ad-hoc Committee / Donald Trump. Both parties want the equity. Owning the equity of levered company in an economic recovery can be lucrative (see: DTG stock). Both have submitted plans, objected to one another plans, maybe a compromise is made, votes are cast, votes are tabulated, judge approves, plan confirmed, and off we go.

Trouble is, valuation is always subject to disagreement. As noted in a previous post on this blog (Now you too can value GGP's equity), small changes in cap rates have enormous effects on the valuation of GGP's common stock. I can argue just as well that cap rates should be 6%, as I can that they should be 9%. In the very fun case back in 2007, Nellson Nutraceutical, had 4 different valuation experts representing the company, and three different creditors group (each with their own). These valuation experts did what we all do: They applied assumptions to discounted cash flow analysis along with using multiples applied to different metrics and came up with a value for Nellson. The debtor's valuation of its own business was ~$75M higher than the other valuation business - why? It is my belief, that the equity sponsor wanted to be in the money. Higher valuation accretes value to lower claimants...i.e. stockholders.

Valuation is rarely litigated in the court. More often, different creditor or equity constituents will offer submit a plan of re-org and disclosure statement that has an implicit valuation based on testimony/work of a valuation expert. For example, from an earlier disclosure statement from the Trump bankruptcy:

"Solely for purposes of providing a distribution for Allowed Second Lien Note Secured Claims and Allowed General Unsecured Claims as set forth in the Plan, and in order to avoid a lengthy and expensive litigation process in these cases, the Plan Proponents refer to the valuation analysis prepared by the Ad Hoc Committee in connection with the AHC Plan (the “AHC Valuation Analysis”), which estimates the range of reorganization value of the Debtors to be approximately $464 million to $534 million (with a midpoint value of $499 million) as of September 17, 2009"

What is interesting: in the Trump case, Icahn and Beal Bank use the valuation proposed by the Ad-Hoc equity committee. The difference lies in who gets what via the plan. And how well they argue their case. For example, Icahn/Beal may say that the plan proposed by the Ad-Hoc committee may put too much debt on the company or maybe the fees proposed are too high etc etc. In one hand, the subscription/rights offering winds up in Icahn/Beal's hands, in the other, in the hands of the Ad-Hoc committee...the winner gets control of the company.

So what does this all mean for GGP? Unsecured debt sometimes is not converted at fair value. If it were converted at fair value, why would distressed debt investing even exist? Why would I buy a distressed piece of paper that I think is fully valued? And using prevailing security prices to determine where a judge may/may not confirm a plan is foolish. See: Delphi's bonds and equity circa Jan 1, 2007. Security prices do changes when different plans are filed. See: Visteon in the last few weeks...Term Loan skyrockets, bonds get hammered. Why? Because current plan proposes the vast majority of the equity goes to the Term Loan lender. No doubt this will be fought.

So why would Simon or Brookfield be buying unsecured debt? Like I said, to get a seat at the table. Let's take a hypothetical example here. Shall we? And as noted in previous posts, I have no position one way or the other, and am just laying out an instructive scenario that may or may not occur in the future.

Let's say the rumors are true. Brookfield and Simon have bought $1 billion of GGP unsecured debt. And let's say specifically they bought $1 billion of the Rouse bonds. They do not want to overburden their investment grade ratings, so they want Rouse to emerge with less debt. So they offer to backstop a $1.5 billion dollar rights offering, and cancel their bonds for, lets say 75%, of the equity at Rouse. Remember, you cannot look at GGP as one consolidated entity ... you have to bifurcate between Rouse and GGPLP LLC.

What did they do here? They spent (call it) 80 cents on the dollar for the Rouse bonds (so $800m spent) and put up an additional $1.5B to retire the remaining Rouse bonds they do not own. They spent $2.3B of value to acquire 75% of Rouse's equity.

How much did GGP's stock holder get from this transaction - They are left with 25% of Rouse. And that affects valuation greatly.

Could this happen? Maybe. Simon and Brookfield want to buy this asset on the cheap, NOT at fair value. Once exclusivity is done, they could propose their own plan (i.e. backstopping a rights offering to buy Rouse), arguing that the Debtor (Rouse in this case) would be woefully over-levered upon emergence. If the equity holders do not like it, then they should do an equity offering to take them out...$2.7B of claims ($2.44B of face at 110%...par+accrued)...versus a current market cap of $3.6B. You do the math.

In the bull case of course, which is also just as likely, every piece of debt gets reinstated (or unsecured bonds across the cap structure get refinanced by committed bond financing, and the judge does not think the company overly levered), operating results shoot to the moon, equity holders see their stock go to $40 and some acquirer top-ticks it. Pershing looks like a miracle worker and Hovde ends up flat out wrong. Look to Pilgrim's Pride as an example of an acquisition a Chapter 11 company where equity holders kept their interest, but got diluted (current ownership now 36%), where the stock could be really cheap (trading at 4.0x EV) and could surely take off...it definitely can happen.

Remember distressed debt valuation is only one piece of the puzzle - figuring out which plan will get confirmed and what / how much of the pie they are getting is really where the money is made in this business.

General Growth Properties - 2 - Hovde