Corporate Restructure Conference

Earlier in the week, we had note from Wharton's Restructuring Conference. We continue with Part 2 of the restructuring conference with more notes and commentary:

One of the two morning sessions was a case study panel that discussed the Charter Communications restructuring. The panel included most of the key parties involved in this historic case, which was the largest pre-arranged bankruptcy filing ever.

Panelists:

Cyrus Pardiwala of PricewaterhouseCoopers as moderator (no role in Charter)

Richard Cieri of Kirkland Ellis – Debtors’ counsel

Gregory Doody – Executive Vice President and General Counsel, Charter Communications

Alan Kornberg of Paul, Weiss, Rifkind, Wharton and Garrison LLP – Bondholder Committee Counsel

James Millstein – Senior Restructuring Advisor, U.S. Department of Treasury (Formerly Lazard financial advisor to Charter)

Eric Zinterhofer – Senior Partner, Apollo Management

Mr. Millstein walked the audience through how Charter’s “Byzantine” cap structure came into existence through a multitude of bond issues. For those unfamiliar to Charter, the company had one of the most convoluted corporate structures known to man. Although the Charter operations were generating cash, the company’s highly leveraged balance sheet required access to the high yield bond market to refinance maturities. With the complete shutdown of the new issue market in 4Q08, Charter’s auditors refused to issue a going concern opinion. This is what precipitated the restructuring.

At this point (December 12, 2008) the restructuring advisors began approaching bondholders regarding a debt restructuring. Most bondholders were shocked by the announcement because the company had the cash to continue making interest payments and assumed the runway was much longer. Once bondholders got past the initial shock, they (mostly) agreed that avoiding a freefall bankruptcy was a must. Both the company and creditors feared an “Adelphia-like bankruptcy” that would destroy a lot of value via a protracted valuation fight.

On January 15, 2009 the company announced that two of its subsidiaries did not make their scheduled interest payments. Mr. Millstein referred to this as “the hammer” to get more bondholders to the table during the 30-day grace period. It was around this time that the “cram up” idea was hatched. For those unfamiliar, the cram up was a new twist on reorganizations last year whereby senior debt is reinstated if all events of default can be cured prior to emergence. In fact, Mr. Cieri noted that the original idea came from a consumer bankruptcy case where an individual reinstated his car loan.

The bank debt reinstatement was the crucial part of the Charter case because the firm had several billion dollars of senior secured bank debt with a LIBOR+250 interest rate, which they guessed was anywhere from 500 to 700 bps cheap to where a new loan could get done. Obviously, JP Morgan—the agent bank—opposed being reinstated, although Mr. Millstein had a funny anecdote about how they at first didn’t even understand what the company was attempting to do. Were Charter unable to reinstate the bank debt, there would have been a much longer bankruptcy case that would have destroyed value and “killed” many of the junior creditors. This fight eventually resulted in a 19-day hearing where JP Morgan’s attorneys argued that Charter was violating a covenant in the credit agreement that prevented any group from owning more than Paul Allen. The attorneys argued that the bondholders committee amounted to a “13-d group” and thus violated the covenant. Backing up a bit, a huge part of the plan was Apollo putting up $1.6 billion for an equity investment. The company’s lawyers argued that the ad hoc committee did not constitute a group under rule 13-d because they purchased their bonds at different times, different prices and for different reasons.

Ultimately, Judge Peck sided with the company in an 82-page opinion that the panel agreed would be the lasting legacy of the case. { Judge Peck’s opinion } Mr. Kornberg made some interesting observations about how the JP attorneys essentially shot themselves in the collective foot by stating from the outset of the case that they were out to get their clients higher interest payments. He believes that judges have little sympathy for unimpaired creditors when junior creditors are a) taking a haircut and b) putting in new money.

Restructuring Conference

Distressed Debt Investing attended the Wharton Restructuring Conference this past Friday in Philadelphia. As usual the conference featured an outstanding lineup of leading distressed investing world players including hedge fund managers, bankruptcy attorneys and restructuring advisors. We note that the conference is an exceptional value at $125, a fraction of the cost of most non-sell-side industry events. We will do a series of posts over the coming week with the highlights of the conference.

http://whartonrestructuringconference.org/index.html

The morning keynote speaker was Bennett Rosenthal, Senior Partner, Ares Management LLC.

His bio from the conference website:

“Bennett Rosenthal is a Senior Partner in the Ares Private Equity Group and sits on the Executive Committee of Ares Management. Mr. Rosenthal is the Chairman of Ares Capital Corporation. Mr. Rosenthal joined Ares in 1998 from Merrill Lynch & Co. where he served as a Managing Director in the Global Leveraged Finance Group and was responsible for originating, structuring, and negotiating many leveraged loan and high yield financings. Mr. Rosenthal was also a senior member of Merrill Lynch’s Leveraged Transaction Commitment Committee. His transaction experience is both acquisition and non-acquisition related across a broad range of industries including retail, telecommunications, media, healthcare, financial services and consumer products. “

Mr. Bennett gave an overview of Ares, described their investment strategies and shared his thoughts on the various markets in which they transact. Below are some of his thoughts in bullet format.

• Ares is a $33 billion LA based firm
• They have 3 groups: Private Equity, Liquid/Capital Markets, Private Debt
• 20 industry analysts, which provides them significant depth in every sector, this also helps generate private transactions
• Recent volatility of emotions has made it difficult to invest
• The early ’09 “bottom” was misleading because it was a small window of time that was hard to take advantage of; very few transactions
• Still see a great opportunity for liquid markets to generate excess returns, but it won’t be a beta driven rally like 2009
• Going forward it will be about credit selection
• In the leveraged loan market 30% of loans trade below 90% of par, excess return will come from refis and covenant repricings
• CLOs are back but w/ less leverage
• Seeing good opps in the 2^nd lien market
• HY spreads of +600 still offer “great opportunities”
• Senior secured credit at L+300 is great value
• The largest opportunity is senior secured bonds of refinanced leveraged loans at double digit yields
• $1 Trillion of maturities in the next 4 yrs
• Last year the “loan to own” investors were paid to wait, this is no longer the case
• LBOs – they are getting propped 6x deals again
• Ares has a business development corp (“BDC”) – there they are moving down into mezzanine loans from senior secured
• PE biz has four pillars: Rescue, Distressed for control, LBO, Growth equity
• They view distressed for control as an auction w/ few bidders
• Not a turnaround firm, they don’t want to replace management
• “Mission in life” is finding good companies w/ bad balance sheets
• They always try to buy the fulcrum security and get a seat at the table
• Simmons was a signature transaction for them, perfect example of how restructuring advisors can drive a transaction
• He noted the advantage of having deep pockets at the trough. Most other buyers—financial and strategic—are too scared or too tight on cash to buy things
• Always look for the security that trades at the multiple they believe the business is worth and then have the cash to pay off the people above them

Stay tuned later in the week for part 2 of the Wharton Restructuring Conference

Distressed Debt Case Study

A few readers asked me if I would walk them through an analysis of a distressed debt investment case study on the blog. Well - this weekend, someone sent me Icahn Capital's 4th Quarter Investor letter (no - I will not post it...have you seen the lawyers that guy has?). In it, he talked about his position in Realogy - which is a well publicized position of Carl Icahn's fund. I have yet to look at Realogy, and thought I would walk readers through the process of getting up to speed on a credit in real time. This will be part 1 of a 3 part series.

First, of all, for all those interested in following along, here is Realogy's Investor Relations website.

Generally speaking, the first thing that I do when looking at a credit (after having a simple understanding of what the business does) is understand the company's history, both operationally, but more importantly financially - I try to answer the question: "How did the company end up with the capital structure that I am looking at today?" Was it an LBO? Was there a dividend to the sponsor? Were there exchange offers? Etc Etc. In this, I start to formulate an assessment of the players involved - and as we have discussed constantly on this blog, it is imperative that one understands the incentives of the various parties to get a better sense of the likely outcomes - whether that be "going-concern", restructuring, etc.

In Realogy's case, there is a long-history. Realogy was spun out of Cendant in 2006. Then Apollo (through: Apollo Management VI, L.P.) acquired Realogy in 2007 through an LBO. In 2009, the company issued a $650M in second lien term loans. The "Financial Obligations" section of Realogy's 2009 10K is quite lengthy - The bottom line:

So total debt of ~$7B (including securitized debt) with about $730M available under its revolver.

Knowing the capital structure, I then go look to see where the various debt instruments are trading (as of Feb 21st, 2010) based on my messages in Bloomberg and TRACE. Starting from the top:

Term Loan: 89-90

Delayed Draw Term Loan: 88 - 89

Second Lien Loans: 109.5-110.5

10.5% Fixed Rate Senior Notes due 2014: 84-85

11% Toggle Notes: 83 - 84.5

12.375% Senior Sub Notes: 69.5 - 70.5

Now, I shouldn't have to tell you, but those Subs are quite yieldy: Using the YTC function in Bloomberg: Yield to worst at the offer side is 22.3%. The Term Loan - obviously not as yieldy if you look at it on a straight yield to maturity...but what if the term loan gets refinanced early with the opening of the loan market, or what if the company exchanges them into new higher yielding securities, or the company goes into reorganization and the term loan is the fulcrum. We cannot dismiss a security simply because its yield to worst is single digits - we have to evaluate each security on a risk/reward basis under various scenarios.

After I get a general sense of the capital structure, I look back as far as possible in the financials. Unfortunately, given that Realogy was a part of Cendant, it may be a little harder to figure out what this company has earned historically. Luckily though, the prospectus from the bond deals/S1 issued in 2007 offer a little help.

For example, we can see that in 2005, Realogy earned a little more than $1.038B before tax on a little more than $3.5B of allocatable equity - or a 30% return on equity. EBITDA that year was $1,167.

This year on the other hand - I calculate Realogy's EBITDA at around $465M (the company then adjusts this EBITDA for its covenant calculation, which we will discuss in a future post) Obviously, the weakness of the real estate market has had its effects on this company. But the question becomes: is this a temporary problem (i.e. cyclical) or a secular problem. If it's a temporary problem (I think it is), what is the ordinary run-rate cash flows of this business and when will normality return to the business - if it is not expected to return for a long-long time, then market prices will reflect that. But if you have an opinion that things might turn around sooner, then you may be compelled to buy these securities.

Let's look a little closer at the 4th quarter and 2009 results: 4th Quarter: Revenue up 11% y/y. EBITDA for the quarter was $89M ($104M before restructuring) - up $70M y/y. The company ended the year with $219M of readily available cash. For the year, revenue was down 17% to $3.9B with $427M of EBITDA before restructuring vs $411M last year. That translates to an EBITDA margin of 11%. In 2004 though, EBITDA margins were 21.5%.

Importantly - on the recent earnings release:

"As of December 31, 2009, the Company’s senior secured leverage ratio was 4.66 to 1, which is below the 5.0 to 1 maximum ratio required to be in compliance with our Credit Agreement. The senior secured leverage ratio is determined by taking Realogy’s senior secured net debt of $2.89 billion at December 31, 2009 and dividing it by the Company’s Adjusted EBITDA of $619 million for the 12 months ended December 31, 2009."

So with the covenant compliance, and the aforementioned cash, it looks like liquidity is solid for this company. Seeing this, I started to do a little digging in the most recent 10K and found this gem:

"On February 15, 2010, Apollo advised the Company that, through one of its affiliates, it owns approximately $995 million in aggregate principal amount of Unsecured Notes."

That's a big number if you also consider that Apollo put up a substantial amount of capital in the initial LBO. At this point, I am at least interested in this situation - If the company can get back to a 2003 run-rate revenue and conservative EBITDA margin of 15%, this company would be doing a little more than $800M of EBITDA or 6.8x levered through 10.5% Senior Notes. Is this favorable to the valuation that Apollo paid for the company of 10.7x (11.6x if you include contingent liabilities?). Maybe - but we need to do more work. We need to dig into the business drivers, more detail on who the players are in this case, covenant / credit agreement analysis, etc. Lots more work to be done - but at least we have a beginning framework for analyzing Realogy's debt.

New blog added to the Distressed Debt Investing family

A few months ago, I sent out a request for a co-blogger on a new venture I was working on. I am pleased to announce our Merger Arbitrage blog has been launched with the help of Edward, a merger arbitrage and special situations analyst. Similar to our "How to Get a Hedge Fund Job" blog, we will post our thoughts on risk arbitrage and merger arbitrage less frequently than we do on this forum. We hope you enjoy and any thoughts / comments are appreciated.

Two hedge fund letters worth reading

I am a big fan of reading hedge fund letters, especially those written by Julian Robertson's Tiger Cubs. Dealbreaker published Lee Ainslie's Maverick Capital 2009 Annual letter last week which can be found here: Maverick Capital 2009 Annual Letter.

In addition, you can read David Einhorn's Greenlight Capital 2009 Annual letter (another investor I truly look upto) here: Greenlight Capital 2009 Annual Letter.

Warren Buffett Investing

Here at Distressed Debt Investing, we devour anything we can find related to Warren Buffett to gain into the "Warren Buffett Investing" mind. I do not know if this document has been lingering around the web and I just did not notice, but a friend sent me a letter WEB sent former Treasury Secretary Hank Paulson on his plan to solve the mortgage crisis back in 2008.

If I were not too busy, I would definitely start a Warren Buffett blog - focused on his earlier years - nonetheless, the letter below is quite interesting and is just another piece of the puzzle in trying to craft how WEB thinks about different investing decisions.

buffett-paulson12112009

The Debt Market

Over the last week or so, I have received a number of emails from readers asking my thoughts on the current debt market. Most of these questions really refer to the state of the primary debt market so I will focus on that for this post specifically. The secondary is a whole other issue, but for now, let's try to dig in and see what is happening in the primary debt market.

Before we begin, we need to segment the market into three baskets. These baskets are quite broad obviously, but for the time being will serve us fine:

1. The high yield bond market
2. The investment grade bond market
3. The levered loan market

We participate in all three markets. Last week, AMG reported their mutual fund flows for the week ended February 10th. Here are the relevant statistics:

High Yield

• Outflow of $984M this week
• YTD inflow of $2,246M

Bank Loans

• Inflow of $195M this week
• YTD inflow of $1,691M

Investment Grade

• Inflow of $692M this week
• YTD inflow of $24,070M

So, the only real outflow was the weekly data for high yield. And empirical that's how it feels in the market right now. We have seen a lot of new deals being postponed or pulled in the high yield market. And the high yield deals that did get done are definitely trading weaker. For example, Freescale issued a 10.125% bond last week, which priced at par. On the 9th of February, after the deal was closed, I saw a market of 100.75/101 (i.e. the dealer will buy from you at 100.75 and sell to you at 101). The last run I saw on Friday was 98.625/98.875.

Now, that might not seem a lot to readers, but most new issues were trading at least a point or two above the break up through January. That, in tandem, with quite a few new issues being pulled (Songa, Bombardier, etc) spells some trouble for the high yield market. You also have exogenous events like Travelport pulling their IPO which sent bonds down 6 or 8 points depending on the tranche, and you get even more skiddish.

Why is this occurring? I couldn't give you a specific reason but my guess is that investors are ratcheting up risk premiums in light of what is going on with the PIIGS. Higher credit spreads are needed when everything is riskier right?

Investment grade is another story. To me, it seems like the IG market, despite the index nearly trading back to par (the IG13's got as low as the mid 70s in January) still feels pretty strong. Obviously PIIGS risks have sent spreads leaking higher, but new issue's are still trading quite strongly. Kraft did a big deal last week (had to relaunch it 5 bps back) and priced the 16s at 190 over. They went out on Friday wrapped around 178. And yes, maybe Kraft issued well wide to get a strong syndication, but quite a few of the new issue high grade companies are trading well through new issue prices.

I'd have to say the same for senior secured bank debt. SSCC's new term loan is trading above OID. Six Flag's exit facility is trading a little bit weaker, but not materially. Some of the smaller new issues in the bank debt market are trading quite well. From everyone I talk to in the street, CLO's still have money to put to work with so much paper being refinanced into the senior secured bond market and their reinvestment windows not expiring until 2012-2014 depending on the vintage.

So net/net? Investors are asking for more risk premium and are allocating more capital to safer asset classes (high grade and levered loans) at the expense of riskier assets like high yield. One could also argue that high yield had such a monstrous run that something had to give. Most of the people I talk to were de-risking going into the end of the year and even through January. I do not have a sense whether the street is long/short right now - everyone is playing their cards pretty close to the vest. Obviously IG is the home run trade if the curve tightens from here as investors seek the safety of the U.S. treasury relative to risk assets. Unless of course credit spreads widen significantly on a double-dip recession. Like I noted in a previous post, I wouldn't want to ratchet up the risk at this point in the cycle - lots of us made money in 2009, and want to conserve our investors capital when better, more juicy opportunities arise, possibly in the 3rd or 4th quarter of this year.

Bankruptcy Investing and Restructuring

Grant, a member of the Distressed Debt Investors Club and guest contributor at Distressed Debt Investing writes an interesting piece on tax considerations in restructuring. Enjoy.

Some Key Tax Issues in Restructuring

Tax considerations can have a material impact on the value of a distressed business. The following contains a brief introduction to three important issues that investors in distressed securities might consider when estimating the impact of tax consequences on returns.

Modifications and Exchanges of Debt

While generally modifications of debt do not have tax consequences and exchanges can, the IRS may determine a modification to be effectively an exchange. Even altering an instrument’s interest rate by as little as 25 basis points, or by over 5% of the original yield, can trigger the IRS to treat a modification as an exchange. Internal Revenue Code (“IRC”) §108(e)(11) states cancellation of debt (“COD”) income on an exchange equals the difference between (a) the adjusted issue price of the old debt minus (b) the adjusted issue price of the new debt. Market price is the relevant metric for public debt instruments. For private debt instruments, the stated principal amount is used, unless the instrument does not yield adequate stated interest. In that case, the IRS discounts by the applicable federal rate as per IRC §1274.

Debt Discharge and COD Income

While debt discharge normally creates a taxable gain under IRC §61, IRC §108 allows exclusion of COD income from gross income under any of the following four conditions:

Occurs in a Bankruptcy Code (“BRC”) case

Occurs when taxpayer is insolvent

Is qualified farm indebtedness

Is qualified real property indebtedness1

The amount of excludable COD income is capped at the amount of the debtor’s insolvency, determined by the value of assets and liabilities immediately before discharge. Consider an out-of-court restructuring for a debtor with the following characteristics:

Debt outstanding: $20M

Market value of assets: $10M

Debt discharged: $12M

This debtor meets condition (2) and is insolvent by $10M: accordingly, $10M of the discharge is excludable. However, $12M of debt has been discharged, so the debtor will owe tax on $2M of COD income ($12M - $10M).

For debt discharged that is excluded (the $10M in the above example):

The debtor may make a IRC §108(b)(5) election, which allows the debtor to reduce its basis in depreciable assets by the amount of the excluded debt discharge. This reduction cannot exceed the debtor’s basis in depreciable property during the first tax year after the discharge (no negative basis).

If the debtor does not make the IRC §108(b)(5) election, there is a “waterfall” of tax attributes that must be reduced in the following order:

Net Operating Losses (“NOL”s)

General Business Credits

Alternative Minimum Tax (“AMT”) Credits

Capital Loss Carryovers

Basis of Assets

Passive Activity Loss and Credits

Foreign Tax Credits

(2), (3), (6) and (7) above are reduced by 33⅓ cents per dollar of debt discharged, while (1), (4) and (5) are reduced dollar-for-dollar.

NOLs and Section 382

Under IRC §172(b), NOL can be carried back two prior taxable years and carried forward twenty. IRC §382 limits NOL utilization by a company that has undergone an ownership change: the maximum deduction is the value of the loss corporation's equity times the IRS “long term tax exempt rate”. Consider the following example:

Value of loss corporation’s equity: $100M

Value of loss corporation’s NOL: $10M

Long term tax exempt rate: 5%

The use of the NOL by an acquirer is limited to $5M per annum (5% * $100M). Additional time-based limitations apply if the loss corporation’s NOL is greater than 25% of the loss corporation’s equity. NOL treatment is particularly pertinent in bankruptcy, as the debtor may have made significant prior losses, and may undergo a change of control as a result of restructuring.

There is a “bankruptcy exception” under IRC §382(l)(5): if historical shareholders and creditors2 of a loss corporation in bankruptcy own more than 50% of the loss corporation’s equity after the reorganization, the loss limitation on NOL usage does not apply. However:

Per IRC §382(l)(5)(B), NOLs will be reduced by any interest deducted by the debtor over the three past taxable years plus interest deducted in the current year on any debt converted into equity. However, if the debtor makes an election under IRC §382(l)(6), the IRC §382 limitation on NOL usage is calculated using the equity value of the debtor after the conversion of debt to equity. Making this election can make sense for a debtor which has converted a large amount of debt to equity, as more NOLs may be preserved after making this election than under the bankruptcy exception.

IRC §382(l)(5)(B) mandates that a second ownership change within two years of the ownership change resulting from bankruptcy will trigger the elimination of any NOL carryforwards that arose before the ownership change that resulted from bankruptcy.

Tax issues can have a major present and future cash flow impact on a company undergoing restructuring, with attendant value implications that a distressed investor ought to consider. Fortunately, most disclosure statements now include detailed explanations of a plan’s expected tax consequences. The CIT Group, Inc. bankruptcy provides one recent example of the management of tax concerns during a particularly complicated proceeding.

Perry Capital's 2010 Letter

A few months ago, we discussed Perry Capital's 2nd quarter 2009 Letter to Investors. Last week, while our dear friend, Jay, from Market Folly, posted their 2010 Letter to Investors. I would embed it below, but as usual Jay's blogging skills far surpass mine. Some take-aways from the letter:

• Their largest positions were in "low priced senior corporate credit in challenged industries such as auto finance and residential real estate." This is very similar to the approach of Marty Whitman's team at Third Avenue and frankly my approach as well. As the letter continues to point out, the up-side / down-side in that trade is very good when you are buying the most senior bank debt in the 60s/70s.
• Talks about the ownership of Delphi which has been written up on the DDIC (one of the highest rated ideas on the site).
• Perry has initiated a position in General Motor's bonds which we discussed late in January.
• CIT, a post I know I have promised people (I'll eventually get to it), was profitable for pretty much every hedge fund under the sun in the 4th quarter.
• The letter goes on to talk about the excessive debt situation in the corporate, commercial, and sovereign markets. I could not agree more.
• And, along with some other funds, are suing Porsche for the VOW/PAH3 arbitrage debacle.
• And it looks like they have a nice, big position, in Europe credit derivatives. Shorting sovereigns much? By the way, I love that trade - Klarman has spoken in the past how Baupost has bought protection on sovereign debt because the upside / downside is remarkable.

We hope to bring you more hedge fund letters and commentary in the near future at Distressed Debt Investing. We look forward to it.

Was that a top in the high yield market?

On January 27th, I wrote a post in the Distressed Debt Investors Club Forum (available to members only) entitled: "Top?" in which I commented that if the Ryerson's discount note offering, that was used to fund a dividend to Platinum equity, priced to yield a little over 16% was not excessive, then I really do not know what is.

Members of the DDIC have known I have been bearish for the last few months. When new issue market is a storming, I go a-running. We have played probably 15% of the deals that have come to both the high yield and leveraged loan markets in the past three months. Now admittedly, when the market started to open up in June, some issuers were bringing reasonably priced deals to the market with reasonable covenant packages.

Then things got ugly.

But, as investors, we are the only ones to blame. You can't blame the issuers: They want to lock-in long term financing that is anything but restrictive. You can't blame the bankers: They want to lock in their risk less fees. And you can never blame the sponsors: They are the ones that will suck high yield and leveraged loan investors dry if they get the chance.

In November / December, new issues were breaking two or three points above new-issue price. And then everyone was playing the flip. And order books continued to swell - and larger funds (including index funds) had to pad their orders to get the allocation they wanted / felt like they deserved. And the order books swelled some more. Vicious cycle. And as a high yield investor, you look at these new issues trading at 105 or 106 and say: "Where did I/we go wrong here"?

So, I have continued to focus my attention back to distressed / stressed high yield and other ancillary opportunities where the upside/downside is better suited than buying a poorly structured, deeply subordinated high yield bond. In addition, I have really laid into my shorts over the past few weeks. Wouldn't mind a correction to hit the reset button on all these easy money made over the last five or six months.