Exit Facilities in Bankruptcy

When a company is in the process of planning its bankruptcy exit, discussions on how the company will raise capital to fund administrative and DIP claims (among many others) begin to be heard in the market. Will the company do a bond offering? What about a rights offering? All this will be stipulated in a company's disclosure statement and bankruptcy plan.

One thing for certain though: Debtors want to raise the cheapest, least restrictive debt that its creditors will allow. And we are seeing a lot of that in the high yield and leveraged loan primary markets: Smurfit Stone, Six Flags, and Reader's Digest are a few of the more topical examples.

What is interesting to me: How cheap these financings are actually coming to market. Now I know bankruptcy is to be a cathartic process...but can one really justify an exit term loan with only incurrence based covenants? Or term loans with 7-8% rate when the DIP came at 13%?

This is all well and good for the debtors. They get cheap financing, with lenient covenants (to say the least), that is generally locked in for at least a 5 year term. The problem though: A lot of time potential lenders are looking at the disclosure statement's projections and taking them at face value. Let's look at Reader's Digest's projections (from their disclosure statement):

Now, if you can't read that, here is what you need to know:

Cash EBITDA grows from FY 2011 $184.3M to $198.8M in FY2014. Maybe I am mistaken (and I haven't read the roadshow or offering docs on this particular new deal), but I think potential bond investors in the new RDA deal (or any exit deal for that matter) may be using this cash flow to ascertain leverage metrics and free cash flow potential through the life of the new bond issue.

This disclaimer comes with the projections:

THE PROJECTIONS HAVE BEEN PREPARED EXCLUSIVELY BY THE DEBTORS, WITH ASSISTANCE OF ALIXPARTNERS. THESE PROJECTIONS, WHILE PRESENTED WITH NUMERICAL SPECIFICITY, ARE NECESSARILY BASED ON A VARIETY OF ESTIMATES AND ASSUMPTIONS WHICH, THOUGH CONSIDERED REASONABLE BY MANAGEMENT AT THE TIME AND TO THE BEST OF THEIR KNOWLEDGE, MAY NOT BE REALIZED, AND ARE INHERENTLY SUBJECT TO SIGNIFICANT BUSINESS, ECONOMIC AND COMPETITIVE UNCERTAINTIES AND CONTINGENCIES, MANY OF WHICH ARE BEYOND THE DEBTORS’ CONTROL. THE DEBTORS CAUTION THAT NO REPRESENTATIONS CAN BE MADE AS TO THE REORGANIZED DEBTORS’ ABILITY TO ACHIEVE THE PROJECTED RESULTS. SOME ASSUMPTIONS INEVITABLY WILL NOT MATERIALIZE, AND EVENTS AND CIRCUMSTANCES OCCURRING SUBSEQUENT TO THE DATE ON WHICH THESE PROJECTIONS WERE PREPARED MAY BE DIFFERENT FROM THOSE ASSUMED OR MAY BE UNANTICIPATED, AND THUS MAY AFFECT FINANCIAL RESULTS IN A MATERIAL AND POSSIBLY ADVERSE MANNER. THE PROJECTIONS, THEREFORE, MAY NOT BE RELIED UPON AS A GUARANTY OR OTHER ASSURANCE OF THE ACTUAL RESULTS THAT WILL OCCUR.

And yes it is in "All Caps" in the disclosure statement. And what about the Management Equity Plan:

Management Equity Plan. The Plan provides that the New Board will grant equity awards in the form of restricted stock, options and/or warrants for 7.5% of the New Common Stock (on a fully diluted basis) to continuing employees and directors of the Reorganized Debtors; provided that such equity grants will not include more than 2.5% in the form of restricted New Common Stock.

Now the specifications on what/when/how these options will be awarded has yet to be determined. But remember, we like to think about incentives here...what would be the incentives for showing an optimistic plan? (Note: I have no idea if RDA's cash flow will grow over the foreseeable future...I am just using them as an example).

Bottom line: It helps with emergence. It is much easier raising capital for a company that is growing versus a company that is not. Therefore, if projections do not turn out to be as rosy as defined in the disclosure statement, who gets hurt: The new lenders of course. Management has their equity (probably more than they owned PRIOR to the bankruptcy) and the company is out of bankruptcy. But if events begin to unfold that do not mesh with what was projected, someone is left holding the bag.

So when you are seeing all these new exit facilities come to market (and I am hearing there are A LOT in the pipeline), remember these disclosure statement projections can sometimes be clouded by the various players incentives in the bankruptcy case. Go over the assumptions with a fine toothed comb and run scenarios where you think management's assumptions on gross margins, or subscribers, or unit costs are different from your own: On that basis, and that basis alone should you be lending you and your investor's hard earned capital to companies emerging from bankruptcy.

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Distressed Debt Hedge Fund Manager Commentary

A few months ago, we interviewed hedge fund manager Peter Lupoff, who is the founder of Tiburon Capital Management. Peter is thoughtful in his analysis and in my opinion, one of the best emerging event-driven hedge fund managers out there right now. Given where valuations are in both the credit and equity markets, allocating capital to those managers that can profit in both up and down markets (versus being long beta) seem like a winning strategy to me.

Peter sent me a letter he recently penned to investors regarding "Confirmation Bias" in analyzing investment opportunities. In the past, we have constantly hammered the point that searching out opinions that go CONTRARY to your perceived notions is a key ingredient for success in producing out sized risk adjusted returns. The letter is a fantastic read. I hope you enjoy:

Tiburon Capital Management

Shark Bites Volume 1 Article 1 November, 2009

Risk: Confirmation Bias and the Onset of Blindness as We Develop “Clarity”

As we know, there are known knowns. There are things we know we know. We also know There are known unknowns. That is to say We know there are some things We do not know. But there are also unknown unknowns, The ones we don't know We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Who knew that Donald Rumsfeld was such an adept Risk Manager? The point is well taken. With regard to our investments, as you likely know, every trade idea at Tiburon is looked at through the lens of our Five Pronged Methodology. This is the linchpin, in our view, of a scalable business, creating peer-beating returns with low downside deviation. Nonetheless, every trade idea has risk exogenous to the trade. That is, there are at least two critical, broad risks to consider: 1) There are the risks we contemplate and that we seek and receive compensation for as part of the risk/reward assessment. For us, this is the risk of the occurrence of our foreseen Revaluation Catalyst(s) – that/those event(s) that will move securities we may be long or short, in a step-function change to fair value. 2) There are those risks we identify to be outside of the trade thesis, i.e., exogenous to the trade thesis. Tiburon professionals and risk management (internal and external) will conceive the most correlated and effective hedges to wring this risk out. However, as Donald Rumsfeld would point out, we’ve then contemplated, probability weighted and where effective and desirable, hedged out the known risks - what about the risks we don’t know that we don’t know?

The Dangers of Bogus Math and Observances that Seem “Empirical”

Not only are there risks we don’t know we don’t know, but we routinely gather data deemed empirical that reinforce our beliefs, eventually blinding us to, or lessening our sense of the probabilities of risk. I will pull another reference out in demonstrating this concept of risks we don’t know that we don’t know (at the risk of angering some of my quant and academic friends).

An acquaintance of mine, Nassim Taleb, the writer of “The Black Swan” puts it this way:

I start with my old crusade against "quants" (people like me who do mathematical work in finance), economists, and bank risk managers, my prime perpetrators of iatrogenic risks (the healer killing the patient). Why iatrogenic risks? Because, not only have economists been unable to prove that their models work, but no one managed to prove that the use of a model that does not work is neutral, that it does not increase blind risk taking, hence the accumulation of hidden risks.

The More Clarity the Less Vision

Investment professionals will spend endless hours tinkering with models, listening to company conference calls, doing channel checks, meeting management, competitors, etc. Few, however can ring Confirmation Bias out of their work. Like the turkey, actively chronicling its daily access to housing and food from altruistic humans, most investment professionals have a tendency to develop an impartial view and then actively seek data that support their supposition. Confirmation Bias, the human trait of seeking and interpreting evidence that is partial to existing beliefs, expectation and hypothesis, is a risk of human bias that can only be wrung out of portfolio, in my view, with a rigorous and agnostic investment methodology and risk culture that actively engages in objective scenario analysis. A recent Wall Street Journal article quoted a vast psychological study that concluded that people were twice as likely to seek information that confirms what they already believe as they are to consider evidence that would question those beliefs. Do we not have some covenantal obligation to investors as a fiduciary to wring out this risk as well?

A Third Eye for More Clarity of Vision?

Absent stepping to the challenge of projecting all downside scenarios that can be concocted, we too, would be in the business of simply putting on trades and then earnestly capturing all the data that supports the trade thesis. As part of the way we think about risk at the research level, we imagine a bad outcome for the trade and then attempt to list the most compelling reasons for the trade’s failure. This is a form of projected forensics, for lack of a better way to describe it.

The Deception of a Reinforcing Market Price and the Wall Street Feedback Loop

So here we are again in late 2009 with rising asset prices, providing investors with confirmation that everything is fine and the pundits that reassure that doomsday scenarists are always early. At Tiburon, our take is “who cares”? I don’t mean to be flip on this point. Yes, we do care and work vigorously to cultivate our dynamic world view. Aren’t we supposed to make money in all markets? The point is that the portfolio is granularly conceived at the trade level. Risks exogenous are managed at the trade level. If this is done, we’ve done as well as most professional investors do. However, taking our blinders off as we systematically build the case for the investment allows us to see all data with impartiality. Defining the compelling reasons why we are wrong is part of this process. The point is to make good decisions – not to achieve consensus or arm ourselves with data to rationalize mistakes. We often talk about how conviction level about our Revaluation Catalyst shapes position sizing. This is true, but greater conviction does not create a greater probability of being right absent correcting the very human Confirmation Bias.

Peter M. Lupoff November, 2009 Tiburon Capital Management, LLC

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DDIC: Guests Admitted

I wanted to give a heads up that all guests that have requested access to the Distressed Debt Investors Club should now have access. If you do not remember your password, please visit: Distressed Debt Investors Club Forgotten Password. If you are still having problems, please contact me.

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Distressed Debt Ideas for 2010 - General Motors

One of few things I like about dealers in the investment grade, high yield and distressed debt space, is that each year, around this time, the various desk and publishing analysts from the different investment banks put out lists of buy and sells in the corporate debt space. These events are always well attended and can sometimes provide a fruitful ground for generated distressed debt investment ideas for the new year.

Over the next few weeks, in tandem with some work I am doing on a few new websites / blogs, and of course the Distressed Debt Investors Club, I will be discussing a number of these ideas in detail. Given that the HY / Distressed market has backed up in the past week and half, I think we are not going to miss any rip-roaring opportunities...(maybe Visteon on a court decision?).

Admittedly, I am neither long nor short any of the names I am going to be discussing (Sandbag much?). Rather, what I am trying to accomplish is to help the reader understand some of the intricacies involved in analysis ranging from investment grade to distressed debt. We are going to start with a favorite of many in the space: General Motors.

General Motors filed for bankruptcy protection in June 2009. After much public debate/discussion, GM (hereafter referred to as "Motors Liquidation Company"), sold the majority of its assets to the new GM in a 363 sale. As noted above, there was much debate in this sale, as the U.S. Treasury funded the purchase and became new GM's largest shareholder.

The pre-petition bonds of Motor's Liquidation currently trade in the market in the high 20s context. Like we have discussed in previous posts, one now needs to figure out the asset and liability structure of the corporation in question. In other words: What are the assets and liabilities of Motors Liquidation?

The most meaningful asset of Motor's Liquidation (really the only asset) is an equity and warrant stake in new GM ("Newco"). We need to somehow value that which we will get to in a second. The liabilities of Motor's Liquidation are where things get a little trickier...

The unsecured claims pool in large complex cases, like Enron, is a very difficult number to pin down. For example, in GM, here are some of the liabilities that an analyst needs to estimate:

1. The exact amount of claim from the pre-petition unsecured bond debt...including accrued interest per tranche.
2. Monies owed to affiliates
3. Accounts payable
4. Accrued expenses
5. Environment reserves
6. Union obligations
7. Worker's comp obligations
8. Litigation and other product liabilities
9. And other which is a catch-all for everything else (for example: dealer rejection claims).

If you ask two different desk analysts on the street to quantify these numbers, they will give you different answers on each line item. Further, most of these liabilities are subject to compromise, meaning an unsecured creditor might file a claim, and that claim could be rejected. In November, Motor's Liquidation filed a monthly operating report that tried to nail these numbers down. You can see that file here: GM November 2009 MOR. There is also some very specific nuances with double dip claims at two finance Co's of GM. In all likelihood, that number presented in the MOR will be different as claims come and go.

Since we know we now need to compare assets versus liabilities, and our one asset is the equity in NewCo, we need to figure out how much NewCo is worth. For that, we can either use the experts valuation model, or model the company ourselves. From the people I have talked to across the Street, analysts are making assumptions on the SAAR in the outer years, GM's eventual market share of that SAAR, GM's variable profit/vehicle, GM's fixed costs, and then estimating the cash flow of GM's overseas operations. They then apply a multiple to these cash flows, back out the debt, and get the equity value of the equity.

Remember, Motors Liquidation has both an equity stake and a warrant stake in NewCo. After exercising these options, it looks like Motors Liquidation will own a little more than 23% of NewCo (thank you tax payer!). Therefore if you think new GM's equity is worth, $10B, Motors Liquidation would have an asset value of 2.3B. If there were then $35B of claims, all else being equal, those claims would be worth a little more than 6 cents on the dollar.

Let's be a little more realistic. I built a quick little model using the aforementioned variables, and came up with $8B of North American EBITDA in 2012 and $3B of overseas EBITDA in 2012. Capitalizing these numbers 5x and 6x respectively, gives me a valuation of $58B. Backing out the post-petition debt and preferred stock of NewCo of approximately $29B, leaves me an equity value of $29B. But wait...there' more. Lots more.

The cash balance at GM is massive right now. At 9/30/2009 that cash balance was $42B. Assuming a standard burn of $10-12B, leaves us with ~ $30B in cash. Let's add that back to our $29B to give us an equity value of a little less than $60B. Owning 23% of that beast, gives you a valuation of assets to Motors Liquidation of ~$13.8B.

And how does this compare to our claims pool? Let's be conservative, take the MOR number noted above, add in the double dip claims, and then add another billion of allowed claims to get to $35B. Given that ~$28B is claims from these old GM notes we are discussing means that as a % of the claim pool, approximately 80% is related to the notes. Then if our value of the equity is $13.8B, 80% is going to the notes, or $11B. $11B divided by the $28B in bond claims give you a value of approximately 40 cents on the dollar.

Now there are so many variables that can change this number DRAMATICALLY. For example, we could of used a 4x cash flow number for North American EBITDA. We could of used a much lower SAAR number. We could of used a much higher market share number. And even if we ARE getting 40 cent on the dollar, we have no idea when we will be getting distributions. What if it take 5 years? That would be a return in the 11-12% range which would definitely not compensate us for the risks involved.

This is definitely a complicated case. Everyone likes to talk about it. And its definitely a 8 or 9 foot poll if you are using Warren Buffet parlay. It shows you some of the little steps that one goes through in this type of analysis. Hopefully in the future, we will be able to update the analysis with more clarity on our numbers, and feel more comfortable about our distressed debt valuation.

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Wisdom from Seth Klarman - Part 9

We continue our long-running Seth Klarman series where we analyze Baupost's annual shareholder letters with the second half of the 2008 annual letter.

"Baupost build numerous new positions as the markets fell in 2008. While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up, and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better."

A problem that many value investors complain about is buying too early. In distressed debt, transaction volumes at the bottom are nil at best. Even worse, some dealers will quote incredibly wide markets which can make buying an exercise in futility...for example: would you buy a bond when a dealer quoted you 10-30 ... you can buy at 30 or sell at 10...This was seen quite often in the months following Lehman brother's bankruptcy.

"Most of our new investments in 2008 were in deeply discounted senior corporate and residential mortgage debt. Debt instruments, because they occupy a senior position in a corporate capital structure and pay interest and principal on a contractual basis, are typically considered less risky than equities. For this reason, when corporate debt become troubled and the possibility of default rises, holders often overreact. When the promise to timely pay interest and principal is on the verge of being broken, many will urgently sell either from fear or due to restrictions in their investment charters. Enormous legal and process complexity create great uncertainty, which adds to the pressure to sell. Prices often overshoot to the downside, creating an attractive risk-return proposition, especially for those able to analytically deal with complexity.

Beyond favorable pricing, distressed debt involves multiple catalysts for the realization of underlying value. If a troubled company is able to recover, whether through operational turnaround, asset sales, or capital infusions, the contractual repayment of principal is a catalyst of full value realization. Alternatively, if the company fails to recovery, reorganization through the Chapter 11 bankruptcy process, whereby a company satisfies claims in the order of their legal hierarchy, can itself result in value realization. In bankruptcy, senior debt holders often receive cash, new debt, equity or some combination thereof, in return for their defaulted securities. Being first in line for recoveries from the corporate estate can confer a valuable margin of safety."

Many smart value investors were looking at Senior Secured debt in November and December 2008. For example, a company like Dollar General saw its bank debt trade to the mid 70s. This effectively created the company at 2x EBITDA through the senior secured bank debt. Equity Comps of the other hand, were trading 6-7x EBITDA - and with dollar general you were also getting a nice coupon stream equating to a size able IRR if the valuation discrepancy collapsed...which it did and investors earned ~40% return with minimal downside risks.

Even for those companies that filed, the ability to cease paying interest to creditors may create a windfall of cash to be distributed in reorganization. Further, we are always looking for value with a catalyst at Distressed Debt Investing, and bankruptcy is by far our favorite catalyst.

On thinking about declining security price:

"Many of the distressed debt investments we bought in 2008 declined further after our initial purchases, inducing us to buy more, as we often do, after thoroughly checking and rechecking our analysis and assumptions. Although most investors find it painful to have positions decline in price after purchase, we remained focused on the silver lining: the ability to building large positions at increasingly favorable prices. In many ways, this temporary market decline represents delayed gratification. When we buy a four-year bond with a 5% coupon at $70.7 to yield 15% to maturity and the price drops immediately to $60.0 where it now yields 20%, we have a 15.1% mark-market loss, but (assuming no new fundamental developments) now hold an even more attractively priced investment while experiencing an even better buying opportunity. A rise in the market's required yield to 25% would cause a further 14.6% price decline. Clearly, if our initial analysis was correct, these temporary price declines, as significant as they are, will be far more than offset by the eventual profitable recoveries."

An investor has to realize that a decline in price does not always equate to a decline in value. And when price declines significantly beyond the value of a business, a buying opportunity may arise.

On the government stimulus plan:

"When the government prints money to solve a problem, the result is almost always inflation. The history of paper money, back by nothing except a government's promise to pay, is that it will be debauched. Politicians are good at spending money that is not theirs; they can please all, antagonize none, by going on a spending spree while asking no one to pick up the tab. But the bill will come due and taxpayers are ultimately on the hook. National wealth cannot be created by a printing press but only be education, hard work, saving, and investment. "

Continuing...

"Over the next several years, inflation seems inevitable, along with much higher interest rates, which will surely impact the value of most investments. We have put hedges in place that we hope will protect our portfolio should such risks materialize."

I wonder what hedges he is talking about? Maybe buying calls on interest rates? But is he playing the long end or the short end of the curve? My concern in high yield, where I have been spending a lot of my time, is that even if you get your credit calls right and you find an improving story, if the curve widens 200+ basis points, you will show mediocre return.

"...James Montier, Societe Generale's market strategist, recently pointed out that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the consistent response was a focus on process, not outcome. The same ought to be true for investors.

According to Montier, during periods of poor investment performance, the pressure builds to change the process to enable immediate gratification. But, so long as the process is sound, this would be a big mistake. It is so easy for one's investment process to break down. When an investment manager focuses on what a client will think rather what they themselves thing, the process is bad. When an investment manager worries about their firm's viability, about possible redemptions, about avoiding loss to the exclusion of finding legitimate opportunities, the process fails. When the manager's time horizon become overly short-term, the process is compromised. ..."

How many of us are guilty of this? You have to maintain the discipline that the Graham and Dodd approach to investing is sound and not delve into the unfamiliar when your returns lag the market. You will never be right 100% of the time. Maybe this is why Joel Greenblatt's formula works so well over the long term - people lose the discipline to keep up with it out of sheer need for immediate gratification.

Klarman then goes on to talk about the investing process at Baupost. The relevant quote I think most pertinent:

"Once we decide to invest, the work continues. Are their new developments? What additional information should we seek? Are their affordable hedges that can limit our risk? If the price falls should we increase our position? If a price rises, at what point should we start to sell and at what point should we wholly liquidate our position? If dealing with a private real estate investment, should we raise or lower rents, reposition or spruce up the asset, refinance, or offer the property for sale?

Perhaps most crucial to the success of this process is intellectual honest. Have the facts changed? Was our original judgement wrong? Are their better investment to hold? If we made a mistake, we need to recognize it and learn from it."

Two takeaways for me here: 1) They do not liquidate a position all at once but will ease out of it as the price rises 2) They believe it just as important to monitor investments as it is to find new ones. A weakness of mine is wanting to look at new situations because the more information I get the better.

He closes out the letter with a section entitled: "The Value of Not Being Sure" ... I will not reprint the whole section, but will strip out what I think is my favorite paragraph of the entire letter:

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security's price begins to reflect full value, because we are never sure that our thesis will be precisely correct. While we typically concentrate our investment in the most compelling situations measured by reward compared to risk, we know that we can never be full certain, so we diversify. And, in the end, out uncertainty prods us to work harder and to be endlessly vigilant."

Fantastic. This concludes our reviews of Seth Klarman's shareholder letters (we will not review the 2009 letter for another 12 months). What I will do is continue the series, analyzing some of the Seth Klarman videos I have my hands on, as well as take a look at Baupost's portfolio when their various 13Fs come out.

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Distressed Debt Book Review - The Predictioneer's Game

As many of you know, I have written about how important it is to look at incentives when predicting what may happen, or what the probability something may happen, in certain distressed debt and high yield investing situations. It is my belief, that generally speaking, people act in their own best interest. Whether it be a management team that sides with a certain creditor plan because their upside will be greater, or a group of creditors that may block a debt exchange to trigger the default provision in a credit default swap, it is vitally important to look who is getting what spoil when deciding how to allocate your own capital. Few books discuss the implication for motivated self interests and how one can use those same self interests to make decisions about the future. I just finished reading one...and frankly...It was fascinating...

The Predictioneer's Game by Bruce Bueno de Mesquita talks about the use of game theory to predict the future course of events. If you have not heard of the Bueno de Mesquita, there have been a number of articles written about him in the past. He run's a consulting business (who's number one client apparently is the CIA) which predicts the unfolding of future evens using game theory. From the Book Description:

Bruce Bueno de Mesquita is a master of game theory, which is a fancy label for a simple idea: People compete, and they always do what they think is in their own best interest. Bueno de Mesquita uses game theory and its insights into human behavior to predict and even engineer political, financial, and personal events. His forecasts, which have been employed by everyone from the CIA to major business firms, have an amazing 90 percent accuracy rate, and in this dazzling and revelatory book he shares his startling methods and lets you play along in a range of high-stakes negotiations and conflicts.

For me, the political discussion in the book was interesting. But as noted above, I care more about how rational (maybe sometimes irrational) actors act in the finance world and how I can profit from these opportunities. Many of us have read about Game Theory, or learned about it in our Econ classes far too long ago - this bring a real world, tangible discussion to the mix which merits everyone's attention.

After reading this book will you be able to lay claim on a 90% hit ratio on prediction on which company is getting acquired or which company is next going to file...No. Definitely not. But it will begin to show you, that when you break things down, predicting how certain situations or cases will play out can become blindingly obvious.

The book is a fast, quick read. There is some promotional aspect to the book (he runs a consulting business and hence wants to show off his predicting abilities). Nonetheless, I think this text is an essential addition to the enterprising investor's library.

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Wisdom from Seth Klarman - Part 8

This is our 8th edition of Wisdom from Seth Klarman. In this edition, we will analyze the 2008 Baupost Annual letter. This, like other parts of the Seth Klarman series, will be split into two posts.

If anyone ever asks you why the "Great Recession" transpired:

"The implosion of the subprime mortgage market in 2007 let to losses that ultimately precipitated a collapse of financial institutions and markets and nearly the system itself. The 2008 financial market sell-off accelerated into a panic after September's Lehman Brothers bankruptcy filing, as no one could figure out who was, or would remain solvent. Selling by financial institutions, desperate to rein in their balance sheets, put sustained pressure on securities prices. Strategies that relied on leverage were the first to fail as the downdraft triggered margin calls. Dismal investment performance drove redemptions from equity and debt funds alike, necessitating further selling, and thereby creating a downward spiral that overwhelmed investment fundamentals. With the exception of mispricings that have ensued, this is actually value heaven; it just feels like value hell."

Incredible right? You can take that one to the bank.

"In today's unforgiving environment, buying anything has become so punishing that few (we are one of the few) want to do it any more. Numerous competitors have gone into hibernation or become extinct, victims of the market selloff, investor redemptions, or margin calls. Even those with capital, unsure of their staying power, seem unwilling to invest it. Holding cash, which would have been a far better idea had people thought of it when prices were at their highs, is now in vogue."

It is so interesting to me. So many of the great investors (Klarman, Buffett, Icahn) all espouse the benefits of holding cash. Many investors (whether that be of the advisory or even the corporate side) look up to these people. But nonetheless, so few are committed to holding cash as a strategic asset. Whether it be the "institutional imperative" to always be fully invested or the fact that it is difficult to defend to stakeholders being only 50-60% long when the market is going up, it seems like so few people feel comfortable holding excess cash. Think of all the corporations that bought back stock in 2006 and 2007, only to see their stock prices down 50-80% ... think of deploying all that capital at early 2009 levels - now that is a smart capital allocation choice.

"It is easy for the volatility of one's thinking to match the volatility of prevailing conditions. Time horizons have shorted even more than usual, to the point where the market's 4:00 p.m. close seems to many like a long-term commitment. To maintain a truly long-term view, investors must be willing to experience short-term losses; without the possibility of near-term pain, there can be no long-term gain. The ability to remain an investor (and not become a day-trader or bystander) confers an almost unprecedented advantage in this environment. The investor's problem is that this perspective will seem a curse rather than a blessing until the selloff ends and some semblance of stability is restored."

I remember the "dark days" of late 2008, when literally a bond would be quoted down 20 or 30 points on no news. Nothing. Everyone always blamed Lehman's prop desk from blowing out a position. But really - there were no buyers. So few of us were pounding the table saying things like: "Listen - I know the markets are trading like the world is coming to an end - But if I can create HCA through the bank debt at at 2x EBITDA, the upside-downside on that trade is out of this world and one we may never see again in our life times."

"Warren Buffett has said - and other have endlessly repeated - that you can't tell who is swimming naked until after the tide goes out. This turns out to be only partially true. The tide has receded, and most portfolios are down. But not all declines are equal. Some investors have lost money and locked in those losses by going to cash. Some have made investments in failed or failing banks, brokers, and homebuilders, or toxic subprime mortgage securities; these losses are largely permanent and irreversible. But the investment baby has been thrown out with the bathwater, and some who invested wisely aren't naked, it just seems that way. Buying early on the way down looks a great deal like being wrong, but it isn't. It turns out you won't be able to accurately tell who's been swimming naked until after the time comes back in.

As Benjamin Graham and David Dodd taught us, the financial markets are manic and best thought of as an erratic counterparty with whom to transact, rather than as an arbiter of the immediate accuracy of one's investment judgement. There are days when the market will likely overpay for what you own, and other days when it will offer you securities at a great discount from underlying value. If you look to 'Mr. Market' for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of his emotional extremes, then you are very likely to succeed over time. If you see stocks as blips on a ticker tape, you will be led astray. But if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations."

There folks, are two of the greatest paragraphs on investing that I have ever read. Klarman has written extensively on the problem of "catching a falling knife" in investing...i.e value investors tend to buy early. But in the end, we have to stick by two truths: 1) None of us can consistently call the bottom 2) Buying a dollar for 50 cent as opposed to buying a dollar at 30 cents, is still better than buying a dollar for 90 cents. If we come from a position of strength (with cash and with capital that will not flee at every rocking of the boat), and practice the tenets of value investing, we should come out on top.

"Most investments - illiquid private transactions, but also publicly traded stocks and bonds - are like roach motels, easier to get into that out of. When you make an investment you give up liquidity and valuation certainty of holding cash. You do so, presumably, to earn a higher return while accepting the risks of diminished liquidity, price volatility, and fundamental value impairment. To be successful, you must maintain the thought process articulated by Graham. When a seemingly attractive investment suddenly retreats in market price in the absence of adverse fundamental development, you must have the psychological makeup t see it as more, not less attractive. If you have either investment constraints or flighty capital which makes it impossible for you to favor an investment more after its price falls, then you shouldn't be investing at all."

Theoretically this is fantastic. But most of us do not have a 25+ year track record to lock investors in. I have a theory on the best way to accomplish this and am working on some practical applications for it - more detail in the future.

Later in the week, will discuss more of the 2008 Baupost annual letter. It really provides some fantastic investing lessons.

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Distressed Debt Investing on Linked In

I set up a Distressed Debt Investing Group on Linked In. I will post interesting distressed debt articles I come across throughout the week on the group website and hope to foster some community discussion and networking opportunities.

If you would like to join, please visit this link:

Distressed Debt Investing on Linked In.

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2009 - What a Year for Distressed Debt!

What a year for distressed debt. By every metric known to the credit investing community, 2009 was a blockbuster year:

• CCC index up over 100%
• Year-to-date inflows of HY funds over $20B
• LSTA Leveraged Loan Index up 52%
• Pilgrims Pride Sub Notes: up 105 points to 111 (yes, you read that right)
• Spansion Senior Notes: up 101 points to 108
• Bon-Ton Senior Notes: up 80 points to 92
• Post-re org stocks, like Dana or Solutia, that were widely held by various distressed funds up 5-10x from their lows.

And it continues - ResCap bonds are up 20 points in the last few days.

What I think is the most telling statistic: CDS Auction Settlement Prices and where bonds are trading today...

As a quick primer: When there is a credit default swap (CDS) outstanding on an entity, and a default occurs, Markit will run an auction to determine the settlement price for an outstanding CDS contract. If you have bought protection on an entity, you will be paid par less the settlement price (i.e. if the settlement price is 10, you would receive 90 points on your notional). And if you are a seller of protection, you would pay up those same points.

Now, why do I think this is important? I believe filing of bankruptcy causes certain lenders and investors in high yield and leveraged loans to sell their holdings for "uneconomic" reasons. In other words, forced selling. This may be anything from CLOs that need to empty some baskets to insurance companies that bought paper at par in the primary, and cannot own defaulted securities. In that, I would think that while the event of bankruptcy may not be the "low" on a particular security, many times it will be an event that forces some sellers out and provides a catalyst for future capital appreciation.

Let's look at the data. Using Markit's incredible site, which details date and settlement price for various auctions both in CDS and LCDS land (I am going to solely discuss CDS this time around), I can get a sense for where a security is trading when a default occurs. There are some limitations to this of course (i.e. the bond may not of been trading exactly where the auction price went off for hedging or unique reasons), but it will be pretty close. I have listed the company name, auction date, auction settlement price, and the year end bond price (ball parked according to dealer runs and TRACE) for the on-the-run bond in the capital structure. Going in chronological order from Markit's site (note - I have not included all bonds on the list, specifically predominantly European issuers, CIT [too recent], and a few other bonds [most are up dramatically as well]):

Yes. You read that right as well.

379% percent return average return. (306% if you exclude the Tribune bonds).

Will this strategy work in the coming year? I think it will, but I doubt to the tune of 2009. 2009 was such a great year for distressed debt and debt investing, but the math alone makes it hard to justify another return like this. Here's to hoping its one-half, or even a quarter, or even a tenth of 2009's return...

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Distressed Debt Research - Tronox

Every few months, I am going to take a recent submission from the Distressed Debt Investors Club and post it to the blog. This week, Tronox, a distressed debt situation authored by member jnahas, will be presented. This allows readers to see the quality / type of ideas being posted to the site which will help you decide if you would like to apply as a member or a guest. Currently, there are over 200 guest membership requests for the site - I have not approved them yet as we add some new and exciting functionality - member requests are being processed as they come in (we are up to 75 high caliber members posting a number of ideas each week). I will write an "Inside Look" post on the DDIC later on in the week for all that are curious.

One quick point before posting this case: The Distressed Debt Investors Club allows users to upload attachments (Excel, PDFs, etc) to add to one's ideas. The author of the idea below attached a phenomenal Excel file to the write-up which goes through each point / comment in crucial detail. If you would like to see that Excel, well you are just going to have to apply as current members have access to it.

Tronox

Situation Type: Distressed/Bankruptcy

Investment Idea Synopsis

• Recommend purchase of 9.5% Senior Unsecured Notes (Ticker: TRX) at 75 and subscribing to rights offering at $10.40 per share a 40% discount to implied market value.
• Recommend purchase of L+700 bp (2% LIBOR Floor) DIP/Exit Facility at approximately 96(W/OID) at syndication.

With a strong management team, reduced debt burden and settlement of legacy liabilties Tronox represents an attractive investment opportunity. Tronox's projections are conservative and they should be able to achieve $145mm of EBITDAR in 2010. They have expsoure to fast growing markets in Asia through Australian JV and 40% of their volume is on long-term multi-year contracts with blue chip customers. At current trading levels you are creating the post-reorg equity at 6.5x 2010 projected EBITDAR of $130mm. Plan EV will likely be struck around this valuation as well, approximately $850mm. At exit the company will have $450mm of secured debt and net debt of $390mm and have 3x net leverage. In estimating potential returns, Tronox is best looked at as a distressed LBO, with the equity being created through the bond. No multiple expansion is need to generate a 30% IRR under relatively conservative assumptions for free cash flow with every dollar of debt paydown increasing equity value. The following analysis is base on the bonds having 80% pro forma ownership post-reorg. It would not be unlikely to see a sale to Huntsman in the future, albeit at a much higher valuation.

Investment Idea Write-Up

Tronox was spun off from Kerr-McGee Corporation in 2006. At the time of the spin-off, the Company was burdened with substantial legacy liabilities that are not related to its operating TiO2 or Electrolytic businesses. Legacy liability costs have consumed substantial cash flow, resulting in an inability to continue to service Tronox’s debt. Due to the continued impact from legacy liabilities, exacerbated by credit market conditions and the resulting tight liquidity situation, certain of Tronox’s U.S. businesses and foreign affiliates filed for protection under Chapter 11 of the United States Code on January 12, 2009

The Chapter 11 filing does not include any of Tronox’s foreign operating subsidiaries. Tronox was set to sell the majority of its assets in a 363 sale to Huntsman for $415mm. An ad hoc bondholder group of the 9.5% Senior Unsecured Noteholders has proposed a plan of reorganization in conjunction with Goldman Sachs as replacement DIP and exit lender and the support of the Debtor. In, addition the EPA, a major other unsecured creditor, has reached an agreement to take $115mm cash and 88% of litigation proceeds against Anadarko Petroleum (purchased Kerr-McGee). The $115mm will be funded by a $105mm rights offering backstopped by the bondholder group and open to unsecured creditors who are accredited investors. On December 22, Huntsman dropped its motion to enforce the 363 Sale Bid Procedures and the debtor is committed to moving towards confirmation of the ad hoc bondholder plan. The timeline assumes approval of a replacement DIP facility(converts to exit facility) by 12/31/2009; 4/30/2010 approval of the Disclosure statement; 6/30/2010 plan cofirmation.

Company Brief Overview

Tronox Incorporated (TRXAQ or the Company) is the fourth largest producer of titanium dioxide (TiO2) pigments (93% of sales) in the world. Titanium dioxide is used in a range of products for its ability to impart whiteness, brightness and opacity. The pigment product is used in coatings for residential and commercial paint, industrial, automotive, specialty market, plastics such as polyolefins, PVC, engineered plastics, and paper and specialty products such as inks, food, cosmetics. The Company also produces electrolytic and other chemicals (7% of sales) used in batteries, pulp and paper, and pharmaceuticals, semiconductors, high-performance fibers, specialty ceramics, and epoxies.

− Sales by Geography: United States 53%, Australia 18%, Germany 18%, and the Netherlands 12%.

− Sales by Segment: Pigments 93% and Electrolytic/Other Chemicals 7%.

− Sales by End-markets: Coatings 70%, Plastics 21% and Paper and Specialty 9%.

− TiO2 Market Share: DuPont 22%, Cristal (owned by Saudi National Industrialization Company), 14%, Tronox 12%, Kronos 10%, Huntsman 10% Other 32%

With a strong management team, reduced debt burden and settlement of legacy liabilties Tronox representsan attractive investment opportunity. Tronox's projections are conservative and they should be able to achieve $145mm of EBITDAR in 2010. They have expsoure to fast growing markets in Asia through Australian JV and 40% of their volume is on long-term multi-year contracts with blue chip customers. At current trading levels you are creating the post-reorg equity at 6.5x 2010 projected EBITDAR of $130mm. Plan EV will likely be struck around this valuation as well, approximately $850mm. At exit the company will have $450mm of secured debt and net debt of $390mm and have 3x net leverage. In estimating potential returns Tronox is best looked at as a distressed LBO, with the equity being created through the bond. Nomultiple expansion is need to generate a 30% IRR under relatively conservative assumptions for free cash flow and every dollar of debt paydown increasing equity value. The following analysis is base on the bonds having 80% pro forma ownership post-reorg. It would not be unlikely to see a sale to Huntsman in the future, albeit at a much higher valuation.

Recovery

Adjusted for particpation in the rights-offering you are fully covered if you purchase the bonds at 75 with 2009P EBITDAR of $126mm at a 6.5x multiple and maintain significant upside.

Comps

Huntsman, which was bidding for Tronox has 6.5x leverage and trades at 8.2x 2010E EBITDA and Kronos trades at 50x LTM EBITDA and 12.2x 2008 (Sr Sec Notes due 2013 yields 15%). Dupont (albeit far more diversified), the largest TiO2 producer with 20% of the market trades at 8.1x. Solutia, a post-reorg chemical name with 50% of its revenues tied to automotive and 3.5x levered trades at 7x 2009 and 6.3x 2010. Tronox should trade at a premium to Solutia.

Plan Summary

− Reorganized Business: Reorganized Tronox will emerge from chapter 11 as the owner and operator of the headquarters facility at Oklahoma City, Oklahoma and the titanium dioxide facilities at Hamilton, Mississippi and Botlek, Netherlands. Reorganized Tronox also will own and operate the electrolytic chemical facility at Henderson, Nevada (but Reorganized Tronox will not be responsible for environmental remediation at that site related to legacy contamination) and will hold Tronox’s interests in BMI, Landwell and the Tiwest Joint Venture in Australia. Reorganized Tronox will be funded by the Replacement DIP Facility, which will convert to exit financing on the Effective Date.

− Recoveries for the Government/Environmental Settlement: In full satisfaction of all claims filed by the United States and its instrumentalities, and state, local or municipal governmental entities and in settlement of all civil obligations arising under environmental laws related to Tronox’s legacy environmental liabilities, these governmental entities will receive, collectively, $115 million in cash, 88% of Tronox’s interest in the Anadarko Litigation and certain other consideration. These amounts will be used to fund custodial trusts that will conduct remediation at sites presently owned by Tronox and satisfy remediation obligations at sites that are not owned by Tronox but at which Tronox may be liable for certain remediation costs. Under the Plan, reorganized Tronox will emerge from chapter 11 free and clear of such liabilities to the maximum extent provided under the law and all such claims shall be discharged.

− Recoveries for Tort Claimants: Tort Claimants, who include, among others, holders of claims for personal injury and property damages arising from or related to environmental contamination, chemical, asbestos, benzene, creosote and other exposure, collectively will receive $7 million in cash, 12% of Tronox’s interest in the Anadarko Litigation and proceeds of applicable insurance policies.

− Rights Offering: Holders of allowed general unsecured claims that are “accredited investors”, as that term is defined in Rule 501 of Regulation D of the rules and regulations promulgated under the Securities Act of 1933, will have the opportunity to participate in a $105 million rights offering that will be backstopped by the Bondholders. Participants in the rights offering will receive 70% of the equity in Reorganized Tronox.

− Recoveries for Holders of General Unsecured Claims: Holders of allowed general unsecured claims will receive their pro rata share of the GUC Pool, which will be funded with 30% of the equity in Reorganized Tronox.

− Recoveries for Holders of Private Party CERCLA Claims: Recoveries for claims of private parties under CERCLA and similar state statutes will be divided equally between participation in the GUC Pool and the Tort Claims Pool.

− Anadarko Litigation: Interests in the Anadarko Litigation will be transferred to a litigation trust for the benefit of the government entities and those claimants sharing in the Tort Claims Pool. This trust will be administered by a trustee to be appointed by Tronox and the United States, in consultation with the representatives for the Tort Claimants and other governmental entities.

- Recovery for Existing DIP and Prepetition Lenders/Lender Litigation: The Existing DIP Facility and Prepetition Facilities will be paid in full in cash with the proceeds of the Replacement DIP Facility. While the Term Sheet preserves the suit of the Creditors’ Committee currently pending against the Prepetition Lenders (Adv. Proc. No. 09-01388), Tronox, the Creditors’ Committee and the Prepetition Lenders have reached an agreement to resolve that suit. Such resolution will include a release of the Prepetition Lenders from the claims underlying that suit. The parties intend to seek the Court’s approval of that settlement once it is documented

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