Distressed Debt Investors Club Update

Over the past few weeks I have received a number of emails on the status of the Distressed Debt Investors Club. And because I have not provided an update here for sometime, I thought I would take a few minutes to talk about the amazing success of the site.

As noted before, we have capped the limit of users to 250, with an unlimited number of guests. Currently, nearly half the member spots have been filled with well over 1000 guests logging onto the site. For reference, we are receiving 5-15 applications a week for full membership and admitting 2-4 of those same applications (this number has been declining as the number of available spots decreases). For those that are interested, I would encourage you to join as a guest member to see the quality of ideas on the site (when asked for idea synopsis / text just write in guest) For more information on applying, please read the FAQ.

In terms of ideas, we have well over 100 ideas fully written up on the site. The diversity of ideas is simply amazing. For example, in the past week we had a member write-up a long thesis on Visteon's equity and the same week another member wrote-up a short thesis on Visteon's equity and bonds. Ideas range from full blown Chapter 11 distressed, to stressed high yield investments, to event-driven equity longs, and finally to equity shorts. While I have not fully run the numbers, I would estimate that 90% of the ideas presented to the site have generated positive absolute returns.

One of the main reasons I set out to develop the site was to develop a platform where smart, dedicated analysts and portfolio managers could share ideas with one another to develop a culture of alpha generating security selection where all incentives were aligned. By joining, members have access to a plethora of actionable ideas and research, while at the same time adding to the collection of ideas through the application process. I have always been wary of sell side and desk analyst recommendations as you do not know if a broker or dealer is talking up an idea to move inventory. Here, each member realizes that XYZ member pitching ABC credit probably has a position, and thus can better judge the situation at hand. Further, because ideas are rated by the community of analysts and portfolio managers on the site, and each member's idea recommendation history can be easily pulled up, it is in every member's best interest to submit their best ideas on the site to avoid being labeled someone simply out to talk his or her book.

Finally, and what I have been most surprised about, is the success of our message board where members discuss ideas more informally and talk about general macroeconomic and thematic concepts (for example, there is a recent thread on the China real estate bubble and how to play it). We also have a job board which I am fully ramping in the next few months with the help of some outside partners.

Overall, I have to say the success of the site has fully exceeded my expectations. We continue to add features to the site and have a number of interesting developments in the pipeline. If you have any questions, please feel free to email me (hunter [at] distressed-debt-investing [dot] com). I hope to see you on the site soon.

The Kelly Formula and Event-Driven Investing

The Kelly Formula, and its application to investing has been discussed by Charlie Munger, Monish Pabrai, and other legends in the value investing community. A few months ago, we presented commentary from Peter Lupoff, founder of Tiburon Capital Management. We saw some of his new commentary on the Kelly Formula and Event-Driven Investing and he allowed me to share it on the site. Enjoy.

Edge/Odds – The Kelly Formula and Maximizing Returns

Professional money managers, particularly in our strategies (event-driven, deep value and the like) seek to distinguish themselves with the construction of portfolios spiced with unique calls where they perceive that they have an “edge.” It is what should differentiate us from the market, or beta, and from each other in attracting capital. However, it is my view that very few managers spend any time attempting to define the appropriate sizing of positions to mitigate downside and maximize returns. We at Tiburon use our own proprietary variation on what is known as “The Kelly Formula.” It is part of every decision to put a position in our portfolio. While the Kelly Formula has some well-known advocates in the investing world, such as Warren Buffett, Charlie Munger and Bill Gross, Kelly requires some meaningful modification in order to be an effective investment sizing tool. We will discuss here, the Kelly Formula, its flaws and modifications we make at Tiburon in order to use it effectively to optimize position sizing.

John Kelly and an Edge

John Kelly, a scientist who worked at Bell Labs in the 1950’s, is best known for formulating what has become known as the “Kelly Formula” or “Kelly Criterion.”[1] It is an algorithm for maximizing winnings in bets. Kelly’s early work was based on sizing bets when the gambler had an “edge.” The issue was in what circumstances would a gambler have an “edge” in games of chance? Dancing around the matter of morality, Kelly’s examples were mostly rigged horse races and game shows. Privately he’d mentioned the logical application to investing as well. By analogy, some had suggested that the “edge” necessary to effectively use Kelly to size investments was inside information.[2] However, we would argue its justifiable use predicated on the real edge we and others obtain due to our unique investment process and accurate interpretation of information available in the public domain.

The Kelly Formula Explained

For simple bets with two outcomes, one involving losing the entire amount bet, and the other involving winning the bet amount multiplied by the payoff odds, the Kelly bet is:

where:

f* is the fraction of the current bankroll to wager;

b is the net odds received on the wager (that is, odds are usually quoted as "b to 1")

p is the probability of winning;

q is the probability of losing, which is 1 - p.

For example, you have $1,000 and are offered 2-1 on coin flips – you win $2 if it comes up heads; you’ll lose $1 if it comes up tails. With a 50% chance of winning (p = 0.50, q = 0.50), you receive 2-to-1 odds on a winning bet (b = 2), then you should bet 25% of the bankroll at each opportunity (f* = 0.25), in order to maximize the long-run growth rate of the bankroll.

If the edge is negative the formula gives a negative result, indicating that the gambler should take the other side of the bet.

Why Kelly Needs Modification to Apply to Investments

Distinctions between Games and Investments

Kelly assumes sequential bets that are independent.[3] That may be a good model for some gambling games, but generally does not apply in investing. The roll of dice is not influenced by the price of oil, the outbreak of war, the failure of financial systems, but securities prices are. Kelly requires lack of correlation between bets – this is a difficult task when applied to a portfolio. A game of Poker starts with a hand dealt and ends with players displaying cards. The game then starts anew. Investing professionally usually means there’s a portfolio. Even if a portfolio is concentrated, there are a variety of “bets.” Considering the bets one at a time, let’s say Kelly says to bet 10% of wealth on each, which means the investor's entire wealth is at risk. That risks ruin, especially if the payoffs of the bets are correlated. If, as an investor, you put on 10 positions in this way, there would need to be zero correlation in order for Kelly to be effective (where correlation is defined as a dependent statistical relationship). Further, the portfolio has these 10 bets on simultaneously. The sequential nature of Kelly is more applicable to gambling games than to investing.

Gambling game results are statistical whereas investments have an idiosyncratic nature. Winning and losing in games of chance leave no room for second guessing or changes in assumptions based on qualitative matters. Security prices are impacted not only by market recognition of intrinsic value and exogenous macro events, but by the behaviors of rational interested parties and irrational uninformed ones.[4] Determining “edge” when considering investments is most often qualitative and based on the analyst or portfolio manager’s personal perspective.

In the Long Run We All Die

The Kelly Formula works out "in the long run" (that is, it is an asymptotic property). Kelly considers long-term wealth solely. This is one of the reasons that value investors discuss using the Kelly Formula to size investments. However, for many us, the near term matters as well. Sizing trades using Kelly leads to highly volatile short-term outcomes regardless of what might happen in the long run.

Do Not Bet Thy Whole Wad

One of the most unrealistic assumptions of the Kelly Formula’s application to investments is that wealth is both the goal and the limit to what one can bet. Most people cannot bet their entire fortune. As a manager with absolute return criteria, we still afford our investors with quarterly liquidity. How do we reconcile sizing positions fully with the prospect of loss (no matter what edge we might have) and/or volatility in market value when the sources of capital are varied and with short term liquidity rights? So clearly Kelly, if applied to investments, has relevance regarding personal investment choices, less so with professional investment managers, particularly when the sources of capital also value liquidity. One last comment here: the answer isn’t locking up investor capital for long periods. Look at 2008. Many deep value investors lost copious amounts of money as they sized up positions based on a sense of edge (over odds or not). My point is why not seek to make money over the long term while not losing money in the short term?

A natural assumption is that taking more risk increases the probability of both very good and very bad outcomes. One of the most important ideas in Kelly is that betting more than the Kelly amount decreases the probability of very good results, while still increasing the probability of very bad results. Since in reality we seldom know the precise probabilities and payoffs, and since over betting is worse than under betting, it makes sense to err on the side of caution and bet less than the Kelly amount.

The Tiburon/Kelly Formula Variance

The Kelly Formula is an essential tool we use to size positions that enter our portfolio. However, as noted above, there are a number of flaws in the strict adherence to Kelly. Just to innumerate them once more succinctly:

• Kelly applies to sequential bets with, therefore, no correlation. Professionally run pools of capital are done so in a portfolio with underlying “bets” influenced by macro factors, markets and each other. There is some inherent correlation.
• Gambling games are won and lost in ways that can be statistically derived. Movement and terminal value of investments have idiosyncratic properties.
• Determining the “edge” in gambling is quantitative and precise. Determining the “edge” in investments is most often qualitative and based on personal perspective, and therefore hard to define precisely.
• Professionally run investment pools rarely have the ability to place highly concentrated bets with no care for short term volatility, while seeking long term absolute returns. In the real world, there are competing objectives.

While Marty Whitman, my old mentor, has said, “Diversification is a surrogate, and usually a damn poor surrogate, for knowledge, control, and price consciousness,” we deal, in part, with the varying goals of performance, liquidity for our investors and longevity as a manager by diversifying across approximately 40-50 positions. This amount of line items is small enough to have an “edge” in each investment, know them intimately and yet still moderate volatility.

We do correlation analysis on the portfolio to identify correlation between positions and between the portfolio broadly, and markets, interest rates, commodity prices, etc. We wring out correlation among the investments in portfolio via hedges that mitigate risk exogenous to the thesis of each investment.

Getting a handle on “edge,” we create “base,” “best,” and “worst” case scenarios, probability weight them, of course, after processing via our Five Prong Methodology.

Tiburon Variance A - Sizing

Our variation of the Kelly Formula solves two issues we have with Kelly when applying his methodology to portfolio allocation: 1. Tiburon risk rules and investment prudence limits us to 10% at market in any given position, and; 2. We won’t invest in a situation where we don’t see at least 40% potential upside. If we weight 40-50 portfolio positions by the traditional Kelly Formula, it would suggest that we use approximately 6x leverage. Therefore, we common size[5] the Kelly derived sizing recommendation. This enables us to assemble and appropriately size our portfolio without leverage.

Moderating the Kelly derived position size has some interesting mathematical properties. It cuts our risk of temporary loss (i.e., volatility) by a large amount while reducing our return expectation only a little. A 50% of Kelly bet, for example, gives a large margin of safety in the risk estimate. If you are off by a factor of two on your risk of loss estimate, a full Kelly bet will reduce your return expectation to zero. But a half Kelly bet will leave you with 2/3 of the return expectation.

With the full Kelly bet, your probability of temporary loss is a linear function of the amount of loss. For example, you stand a 90% chance of losing 10%, an 80% chance of losing 20%, a 50% chance of losing 50%, etc. Not many investors are comfortable with the prospect of a 50% probability of losing 50% of their money. With a reduced Kelly bet, your probability of temporary loss is a quadratic function of the amount of loss. For example, at half the Kelly bet you stand an 81% chance of losing 10%, a 64% chance of losing 20%, a 25% chance of losing 50%, etc.

Your expected gain with the half Kelly bet is reduced by 25%. For example, if your expected gain is 40% with the full Kelly, it is 30% with the half Kelly, and if your expected gain is 10% with the full Kelly, it is 7.5% with the half Kelly.

Tiburon Variance B – Beta Correlation

Every new trade is evaluated for its correlation to the rest of the portfolio. For the Kelly Formula to be effective in sizing positions, positions need to have little to no correlation to each other. Tiburon evaluates sizing trades as a function of the correlation between the new investment and the existing portfolio. The beta of the portfolio to the market and macro events is another matter, reviewed and potentially hedged as part of portfolio considerations and does not weigh on the sizing of the prospective new investment.

Therefore, the Tiburon/Kelly Formula Variance is:

For any investment reviewed, subject to the trade’s correlation to the Portfolio being less than 1[6],

where:

· Ts is Tiburon position sizing;

· Ts cannot exceed 10% of Tiburon portfolio at market;

b is the net odds received on the wager (that is, odds are usually quoted as "b to 1")

p is the probability of winning;

q is the probability of losing, which is 1 – p;

? is the summation of Kelly allocations across our portfolio.

For any investment professional building a portfolio, they first need to identify positions that meet their criteria and are part and parcel of their investment strategies. Given this, sizing the position is a function of the manager’s edge in the trade and the odds of the favorable outcome. At Tiburon, every trade idea passes through our Five Pronged Methodology. As a function of this work, we probability weight the outcomes. As every trade idea requires a Revaluation Catalyst, and sizing is in part, a function of our conviction level about the catalyst (or the odds of its occurrence and impact on securities price), sizing naturally become edge/odds. We use the Tiburon/Kelly Formula Variance to, as best possible, accurately size positions to maximize profitability while minimizing downside.

Peter M. Lupoff March, 2010 Tiburon Capital Management, LLC

[1] See “A New Interpretation of Information Rate” J.L. Kelly, March 21, 1956 (ATT) http://www.racing.saratoga.ny.us/kelly.pdf

[2] Claude Shannon, Kelly’s Bell Labs mentor and collaborator. See “Fortune’s Formula”, William Poundstone, Hill & Wang 2005.

[3] In probability theory, independent means that the occurrence of one event makes others no more or less probable.

[4] See discussion of Tiburon’s Five Pronged Methodology – “Rational Actors Assessment.” http://www.distressed-debt-investing.com/2009/09/exclusive-interview-with-hedge-fund.html

[5] Common sizing is the expression of items as percentages rather than as dollar amounts.

[6] Tiburon may reduce ß via hedges to meet these criteria.

Hedge Fund Commentary

Every now and then I stumble upon a letter from an investment advisor/hedge fund that I enjoy reading and decide to share with readers. This letter below, from Downtown Associates has some great words of wisdom. My favorite:

We will not “chase” performance – when stocks are expensive the ensuing returns are likely to be subpar. Instead we prefer to hold cash, remain liquid and wait for attractive opportunities. Why should today’s opportunity set be the only one we consider when tomorrow’s is likely to be more fertile? By remaining disciplined in our purchase decisions, we seek to maximize future returns while limiting our downside risk (the possibility of a permanent loss of investment capital).

We prefer the risk of lost opportunity to the risk of lost capital.

Enjoy! And if you have any letter or commentary you think I would find interesting to share with our readers, please email me at hunter [at] distressed-debt-investing [dot] com

DTAII 033110 Quarterly Letter (3)

Back from the Dead: The CLO Revival

Last week it was reported that Symphony Asset Management is launching a $500M CLO. To give you some historical context of CLO issuance, please see the chart below from an 2009 LSTA conference:

This would be the second CLO launch of the year. Combined with the $525M CLO placed by Fraser Sullivan earlier in the year, and this $500M Symphony deal, CLO issuance will reach the $1 billion dollar mark, with more deals expected in the second half of the year. Compared to the chart above, that $1 billion dollars looks awfully minuscule.

According to various news reports, this CLO will purchase new deals, and given the current state of the primary market, will have a substantial amount of supply to choose from. The AAA tranche will be $317M in size, $113M to a Class B tranche (rated Ba2 from Moody's) and $70M in equity notes. In addition, it is reported that the AAA tranche will be held by one investor.

Given the $70M of equity versus the $430M of debt, this deal will be slightly more than 6.1x levered versus 2006 and 2007 structures which were 12-13x levered. While I have not heard hard data on the potential for equity returns in the structure, it is rumored that they will somewhere in the low-mid teens which is slightly less from what equity investors were told they would earn in the go-go years (2004-2007).

From looking at my runs, the Fraser Sullivan deal priced their AAA tranche at L + 190. Here is a chart of AAA and AA CLO liability spreads (again from LSTA)

If you were to show the most recent data, these levels would be even tighter. While investors have varying preferences for investing in legacy CLO liabilities or new CLO liabilities, it is readily apparent that the market is in far better shape than it was at this time last year.

Assuming investors can place the subordinated tranches of these structures, it seems likely that we will see more of these structures announced throughout the year. There has been substantial consolidation in CLO manager land which further bolsters the case that CLO liability investors will become comfortable with the less levered, more modest 2010 CLO vintages. And given that AAA liabilities are pricing near L+200 vs L+40 in 2007, investors are surely being paid a premium to play in these structures.

What this means for buy-side investors? More competition in the primary leveraged loan market where most deals today are already well oversubscribed. Also - more capital available for refinancing troubled borrowers or busted LBOs. The last thing this market needs is more capital - unfortunately, I think that is exactly what we are about to get.

Advanced Distressed Debt Concept: Reinstatement

Grant, a member of the Distressed Debt Investors Club, pens a piece on the advanced distressed debt concept of pre-petition debt reinstatement. Enjoy!

Some companies currently experiencing financial distress raised large amounts of debt capital on significantly easier terms during the last decade’s “credit bubble” than they could obtain today.

Consequently, debtors currently contemplating or undergoing restructurings sometimes seek to keep existing pieces of debt in place rather than (a) replacing that debt with a new, more expensive facility with potentially tighter covenants or (b) giving concessions to existing creditors who now hold a below-market instrument. “Reinstatement”, or keeping pre-petition financing in place, is contemplated under the Title 11 of the US Code (the “BRC”). Per BRC §1124, for debt to be reinstated it must be unimpaired, meaning the debtor must cure its defaults (with the exception of certain technical defaults such as “ipso facto” clauses declaring the debtor’s bankruptcy to be a default in se) and restore the creditor’s legal, equitable and contractual rights prior to default.

In situations where junior creditors and/or equity holders attempt to impose reinstatement on a senior class, some professionals use the descriptive term “cram up” to distinguish this procedure from the process under which a class is forced to accept a plan in a “cram down” under BRC §1129(b)(2).

Reinstatement and “cram-up” were hot topics in the closely-followed, intensively litigated Chapter 11 bankruptcy of Charter Communications, et al (“Charter”). In late 2008, Charter engaged a Lazard team to engage in intensive pre-bankruptcy planning and negotiations with creditors to avoid a “free-fall” bankruptcy. The ensuing pre-negotiated plan (the “Plan”) included complex arrangements designed to keep $11.8B Charter senior debt unimpaired, and reinstated on Plan confirmation. Importantly, the senior creditors did not participate in the pre-bankruptcy negotiations. Not surprisingly, therefore, the senior creditors objected vociferously to the “cram-up” element of the Plan. While the senior creditors were “paid everything that they are owed under the existing facility and have even received default interest during the [Charter] bankruptcy cases”, they “openly admit that their goal here is to obtain an increased interest rate that reflects what would be charged for a new loan in the current market for syndicated commercial loans.” The senior lenders therefore objected to the Plan and challenged reinstatement by calling attention to a number of alleged defaults under the credit agreement.

On November 17, 2009, Judge James M. Peck rendered a landmark decision ordering the reinstatement of the senior debt. His full opinion can be found here: http://www.kccllc.net/documents/0911435/0911435091117000000000001.pdf.

For those seeking full understanding of the Charter reinstatement, a careful read of Judge Peck’s opinion will prove not only essential but also pleasant: he delivers his conclusions in plain, well-written English. The rest of this article will attempt to summarize his key findings:

One tenet of the senior creditors’ argument revolved around a specific covenant in the credit agreement, Section 8(g)(v), regarding the debtor’s “prospective” ability to pay its debts as they came due. Judge Peck rejected the senior creditors’ argument that (a) Section 8(g)(v) was “forward looking” and (b) Charter defaulted when drawing down an additional $250M under the senior credit facility because it relied on good faith on financial advisors to calculate “surplus”(essentially a valuation test) in making the drawdown. The Judge therefore repudiated the senior creditors’ allegation of a default under Section 8(g)(v) of the credit agreement.

The senior creditors also alleged the Plan caused a change of control, which also would have triggered a default. Judge Peck noted the change of control issue was a “challenging problem” for reinstatement, but ruled against the senior creditors and determined no change of control would occur on confirmation of the Plan. Prior to bankruptcy, Charter had been backed by billionaire Paul Allen. The credit agreement’s definition of “change of control” incorporated the condition that no change of control would occur if Allen held a voting percentage of at least 35%. The Plan incorporated some clever structuring with Allen. Allen would receive nothing for his pre-petition equity; but would receive $375M to retain his voting participation at 35%. Lazard and Charter designed this arrangement specifically to avoid a change of control for two reasons: to (a) effect reinstatement of senior debt and (b) preserve tax benefits. Interestingly, Judge Peck found Charter received an estimated net present value of (a) $3.5B from reinstatement of the senior debt vs. replacing the senior debt with a new facility at market rates, plus (b) $1.14B of tax savings from the preservation of NOLs. Effectively the Plan contemplates the capture by Allen and Charter of billions in value at the expense of the senior creditors and the IRS. Nevertheless, Judge Peck ruled that Charter’s arrangement with Allen did not constitute a breach of the change of control provision, principally because the provision contemplated voting control as opposed to economic control. Judge Peck furthermore rejected the senior creditors’ argument that three bondholders (Apollo, Crestview and Oaktree) working together were a “group” under Section 13(d) of the Securities Exchange Act because the three bondholders did not have an explicit agreement to act as such. Therefore the actions of these bondholders, in Judge Peck’s opinion, did not trip the change of control provision.

The senior creditors also argued that the bankruptcy of some of the holding companies within the Charter structure triggered a cross-default, and acceleration, of a borrowing entity that did not itself enter bankruptcy. The senior creditors argued that this default was not an “ipso facto” clause because it dealt with the cross default of a different entity that went bankrupt in the structure and not the borrowing entity itself. Judge Peck also rejected this argument, ruling Charter to be an “integrated enterprise” and citing documents and behavior patterns that indicate the senior creditors consistently treated the separate entities within Charter as such. Accordingly, Judge Peck ruled the cross-default and acceleration covenant indeed to be an invalid “ipso facto” clause.

Again, the above is a short summary of Judge Peck’s conclusions, and reading his opinion is a great window onto how a bankruptcy judge analyzes issues. With the dollars and principles involved, this matter involved fierce litigation: the first couple pages of the opinion list myriad professionals at some of America’s most prominent corporate and bankruptcy law firms. For the distressed debt investment professional, careful consideration of how courts will rule on reinstatement issues can have drastic implications in assessing value, especially if credit markets do not return to the frothy levels of a few years ago and debtors fight to keep below-market debt instruments in place post-emergence.

Advanced Distressed Debt Concept: The J Factor

When analyzing a distressed debt investment, it always helps to remember that the presiding judge on a case will be the final arbiter on a number of decisions that may sway the direction of a case and consequently, recovery and return to distressed debt investors. For example, today in Tribune's bankruptcy, the bankruptcy judge extended the exclusivity period of the debtor, shutting down the ad-hoc lenders plans of filing its own plan of reorganization.

The J Factor is the judge's role in a case. While lawyers pore over briefs and orders of past rulings of judges to get a sense where they may stand on a certain issue, one can never be quite sure which side of the fence the court may fall on. Take the example of Trump's bankruptcy.

Yesterday the court ruled, in a 121 page document (embedded below), that the Ad Hoc Committee/Debtor plan will be confirmed versus the Icahn/Beal Bank plan. The document is a fascinating read.

Trump Judge Ruling

The judge first lays out an overview of the case, presents the competing plans in plain language, and then methodically tests whether both plans are confirmable in relation to the bankruptcy code especially in light of the contested elements of each plan (i.e. Beal / Icahn contested that the Ad Hoc Plan may not meet XYZ requirement of the code). Significant legal discourse and case law is presented which is learning tool for all those interested in interpretations of the code.

After opining on each point and contention of each plan, the judge offers an opinion on the ability of the plan to be confirmed subject to modificatoins. For example, for the AHC/Debtor Plan:

I conclude that the AHC/Debtor Plan meets the requirements of section 1129(a) and (b), and is confirmable, subject to the following modifications:

(A) The plan provision releasing Trump from the Trump Personal Guaranty must be deleted from the plan.

(B) The plan provision releasing the Second Lien Noteholders from liability for any alleged violations of the Intercreditor Agreement must be deleted from the plan.

(C) The plan provision offering the Backstop Parties indemnification must be clarified and limited, per the discussion supra.

(D) The AHC, the Backstop Parties and the Indenture Trustee must apply under section 503(b) for reimbursement of fees and expenses as substantial contributors to the case.

(E) The New Term Loan must be modified to afford the First Lien Lenders a 12% rate of interest, and an 1111(b) premium.

(F) The plan is confirmable subject to approval of DIP financing.

and for the Icahn/Beal Bank Plan:

I conclude that the Beal/Icahn Plan meets the requirements of section 1129(a) and (b), and is confirmable, subject to the following modifications:

(A) The plan provision for exculpation must be modified to provide for acts or omissions constituting gross negligence, willful misconduct or fraud.

(B) The plan provision providing for a severance payment to certain employees must be stricken.

(C) The plan provision placing a cap on administrative and priority expenses, and requiring acceptance of post-confirmation claims determinations of the bankruptcy court by the proponents, must be stricken.

(D) The plan provision cancelling the Indenture dated May 20, 2005, applies only to the debtors’ obligations, and does not affect the relationship between the Indenture Trustee and the Noteholders and guarantors.

(E) The bar date for filing administrative claims must be extended to thirty (30) days after the date of confirmation.

So net/net, both plans are confirmable subject to the modifications listed above. Now, the judge must decide which plan will be confirmed. She does this by weighting the preference of creditors, the feasibility of the plan, and the treatment of creditors and equity security holders. For example, in regards to treatment of creditors:

As to the treatment of creditors, both plans provide for a full recovery to First Lien Lenders, one through conversion of the debt to equity, and the other through deferred cash payments at present value. But the two plans differ markedly otherwise, particularly as to the treatment of Second Lien Noteholders. Except for providing a pro rata share of $500,000 to the Convenience Class, the Beal/Icahn Plan provides no distribution to any other stakeholders in the case. In contrast, the AHC/Debtor Plan provides for a nominal recovery of cash, subscription rights and liquid stock to the Second Lien Noteholders and General Unsecured Creditors. More importantly, the plan provides, to a large number of the Second Lien Noteholders, (approximately 61% of the Noteholders), the opportunity to receive the only value that is left in the case after satisfaction of the First Lien Lenders’ claims. That value is the potential future benefit of the reorganization, if the reorganization succeeds. The Ad Hoc Committee is making a substantial payment of $225 million for the opportunity to participate in the future upside potential of the debtors, which would otherwise inure to the exclusive benefit of the First Lien Lenders. The treatment of creditors favors the AHC/Debtor Plan in this regard.

She states though in her ruling that the "most significant element in choosing between two confirmable plans is the statutory direction to the court to 'consider the preference of creditors and equity security holders in determining which plan to confirm'" - The preference is reflected in the voting results.

In the end: The largest creditor group in this case were the second lien note holders who voted overwhelming in favor of the AHC/Debtor Plan and against the Beal Bank/Icahn Plan:

The end result of the voting is that an overwhelmingly number of creditors voted in favor of the AHC/Debtor Plan and against the Beal/Icahn Plan. Of course, it must be recalled that both the AHC members and the Icahn parties obviously support their own plans. But the significant support for the AHC/Debtor Plan by the largest creditor constituency, coupled with the treatment of creditors and feasibility considerations noted above, compels the conclusion that the AHC/Debtor Plan, as modified, should be confirmed. Confirmation of the AHC/Debtor Plan will allow the debtor to shed approximately $1.4 billion in secured debt, to pay the First Lien Lenders in full, and to offer to creditors the opportunity to participate in the upside potential of the debtors.

So with that, and the revised changes above, it looks like the Ad Hoc Plan will go through. If a different judge had presided over the case, maybe a different outcome would have occurred. I have not yet heard what Icahn/Beal will try to again swing the needle in their favor (if anything). If the current plan gets approved, Avenue Capital, and a number of distressed hedge funds (holders of the second lien and participants in the rights offering), along with the Donald will be the new owners of Trump. We will be sure to follow the post-reorg equity (if its trade-able) upon emergence.

Distressed Debt Concessions and Settlements

A pivotal aspect of distressed debt investing is the negotiations among opposing (read: warring) creditor factions. Senior creditors may want one thing, but subordinated bond holders want another. Sometimes people throw the "cram down" rule as a gauntlet in negotiations when in fact they may not even have the necessary stipulations as required by 1129 of the bankruptcy code to cram down a dissenting creditor class. Many of these negotiations are worked out behind the scenes - when evaluating an investment in a bankrupt creditor, it is prudent to play out all likely scenarios to see where ultimate recovery will come out.

Some of the more interesting cases are when a single creditor class has differing views about how a settlement or concession may play out. This is important, because under the code, from the US Courts website:

Under section 1126(c) of the Bankruptcy Code, an entire class of claims is deemed to accept a plan if the plan is accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in the class.

This exact situation is playing out in Tribune's bankruptcy proceedings. Some background: Last week, Tribune announced it had come to an agreement between Centerbridge, J.P. Morgan and certain other senior secured lenders that would enable the company to file a plan and possibly emerge from bankruptcy. Under the settlement, Centerbridge and other pre-LBO senior debt holders would receive 7.4% of the cash, debt, and equity of the reorganized debtor's distributable enterprise value. The catalyst for this settlement was Centerbridge and other creditor's assertion that the LBO was effectively a fraudulent conveyance. On the news, the bank debt traded up a couple of points. To note, in the marketplace, a settlement was widely expected and in my opinion the bank debt traded up due to the 7.4% distribution being slightly lower than the 10% thrown in the market running up to the announcement.

This is where things get interesting. I have embedded the full response below.

Tribune AdHoc Lender Response

The ad-hoc lenders, which I listed in a previous post, and include some pretty big names in distressed debt are saying: "Nope. This won't do." And because they represent 42% of the bank debt, people should listen. From reading the document, it is readily apparent their main issue is that there are far too many releases being granted in exchange for nothing. Further, the bank group, via their post-re org equity interests, would fully indemnify Sam Zell, Tribune's directors and officers, the bank debt arrangers, etc. Everyone wins except the bank debt holders.

The ad-hoc lenders are asking the court to end exclusivity so that they themselves may file their own plan of reorganization (this will be their third attempt). Their plan looks to either shut down Centerbridge's claims of fraudulent conveyance by filing a "subsidiary only plan" (see above document for explanation). They also consider setting up a litigation trust among other actions which may allow the company to exit bankruptcy quicker as the company could emerge from bankruptcy and the litigation trust could deal with causes of action relating to the LBO.

After the close today, Tribune filed its own plan. We will find out soon enough where the direction of the case is headed because also filed tonight on the docket is the Amended Agenda of Matters Scheduled for Hearing on April 13th, 2010 at 10:00AM (tomorrow). Item 14: Debtors' Motion for an Order Pursuant to 11 U.S.C. 1121 (d) Further Extending Debtors' Exclusivity Period ... Responses Received: The above docket I have embedded.

We do not know which way the judge will rule in this one. If the ad-hoc group holds itself together (I am sure J.P. Morgan will be working the lines to work people over to their side), I do not see how the current plan gets confirmed. I have to think either settlement gets renegotiated. We will see though. Will be an interesting day in court.

Distressed Debt Fund Commentary

A few months ago, we took some time out to profile Third Avenue's Focused Credit Fund. We were particularly impressed with some of the commentary coming out of the manager's letter.

As a side note, if you work at Third Avenue, can you please shoot me an email (hunter [at] distressed-debt-investing [dot] com). Have a question.

We thought we would check in and see if Third Avenue's managers had released more commentary, and we were please what we found their 2010 First Quarter Report (yes - I know this came out at the end of January...don't shoot the messenger).

What I found interesting reading through the various manager's commentaries were the fact that the value funds had invested in a few of the distressed situations which they worked with the credit team to identify. For example, Curtis Jensen in the small cap value fund notes:

Energy XXI Senior Notes represent the Fund’s second debt investment in a U.S. Gulf of Mexico-focused oil and gas producer. Securities valuations of Gulf of Mexico (“GOM”) energy companies like Energy XXI had been decimated in late 2008 following the disruption brought on by Hurricanes Ike and Gustav. The dramatic collapse in commodity prices during that period further pressured the industry’s operating results and, in many cases, led to dramatic accounting-based asset impairments. Energy XXI’s production levels, for example, fell more than 26% in the first quarter following the hurricanes and GAAP accounting resulted in a $580 million impairment of the company’s oil and gas reserves. The opportunity in Energy XXI Notes surfaced at the end of last year while the company was in the midst of a debt exchange offer designed to address a capital structure ill prepared for these sorts of adverse developments. We believed that the company’s “troubles” – both financial and operational – were temporary and fixable, that our capital, as creditors, was well protected and the investment had a number of ways to win:

• the proposed exchange offer and a coincident private financing included a credit-enhancing common stock offer that also extended the company’s debt maturities;

• production that had been interrupted because of the hurricanes would return, in time, along with additional production pending completion on more recent projects, bolstering both cash flow and reserves; the company was due to collect the proceeds of a substantial insurance settlement, further enhancing corporate liquidity;

• our multi-pronged valuation work, which relied on asset-based production and cash flow metrics, suggested our downside was well protected (i.e., the probability of a loss of capital seemed remote) while the Notes, trading at a price of around 81% of face value at the time of acquisition, provided an equitylike return of more than 17% and a current yield of approximately 12%;

• creditors like the Fund could get further comfort from the relatively strong covenants within the terms of the Notes and those in the company’s bank credit facility;

• While unnecessary for a successful investment, the company’s exposure to a potentially large exploratory success would further enhance overall corporate value;

• finally, other facts, taken together, strongly suggested to us that management was intent on improving the balance sheet. These clues included i) the company’s most recent proxy statement that requested a sizable expansion of the company’s authorized share capital, signaling a potential future equity raise; ii) new “change of control” language within the new notes indenture that seemed to contemplate the impact of an expanded equity base; iii) the fact that the company itself had repurchased $126 million face amount of Notes at a cost of $94 million1, suggesting a proactive approach toward enhancing the corporation’s financial flexibility; and iv) comments on the company’s recent conference calls and presentations committing to “debt reduction” and “further strengthening of the balance sheet.”

While subsequent events at the company largely support our thesis (a thesis developed with our colleagues on the Third Avenue credit team), the investment continues to face a number of hard-to-handicap risks, chief among them: i) operational risk (hurricane season starts in June!); ii) political risk (uncertainty related to how the Obama administration might change the industry tax regime or rules on access to reserves); and iii) deal risk (the possibility that significant new leverage is introduced as the result of either a debt-financed acquisition or a takeover of the company by a highly leveraged acquirer).

Readers active in the distressed debt market will know Energy XII was a hot topic. And given where those notes are trading right now, the investment looked like it paid off.

Let's move on to the credit team's commentary. And as discussed in previous posts here: Lots of capital is flowing to the distressed space: The Credit Fund's assets grew from $280M to $545M at the end the quarter. Their performance slightly lagged the Barclays HY Index and CSFB Leveraged Loan Index due to a position in Blockbuster's Senior Secured Notes (a hotly discussed topic on the Distressed Debt Investors Club site) and high cash balances.

On the market's returns in the quarter:

Market returns were led by CCC-rated issues which returned nearly two times the index return in the most recent quarter. This included a number of higher-risk Finance company bonds. The Finance sector had the highest return in the high-yield index for the quarter, with a return of 9.25%. For many of the Finance sector bonds that performed well, Fund Management determined there was not adequate information or transparency available on specific companies to be able to obtain a high enough conviction level that there would be minimal downside risk. These bonds included AIG, ILFC, Rescap, Aiful, Takefuji, as well as several hybrid/perpetual preferre stocks of U.S. and European banks.

On the market pullback we discussed in February:

We view this market pullback, which has continued into February, as constructive and a good opportunity for us as investors. As we have said in the past, “Trees don’t grow to the sky” and this is especially true in the credit markets. It seems that investors are finally paying attention to thefundamentals and capital structure of specific companies since the rally in the credit markets began in March 2009. In general, during this rally, the riskiest securities benefitted the most. Returns on CCC-rated high-yield bonds exceeded 100% in 2009, despite the fact that many of these companies have over-leveraged balance sheets and their cash flows from operations have declined meaningfully.

Risk appetites for these types of companies appear to be diminishing. Companies that report disappointing earnings or have uncertain outlooks have seen their security prices decline recently. This is the type of market we favor and believe we can excel in – it is what we call a “Credit Picker’s” market. We believe that investors should be invested with a manager that focuses on credit selection and carefully measures the upside potential versus downside risk of each security, as opposed to investing with a manager that just buys the riskiest securities in hopes that they will increase.

Apparently they were also caught off guard on how fast the market snapped back in March. I tend to agree - that this is the kind of market where the wheat is separated from the chaff. Especially given how volatile the market feels when you are trading it (i.e. in the morning you will not be able to buy a bond, bad news comes out, and then you would not be able to sell the bond in the afternoon). Credit selection is so important in a market like this.

From reading their commentary, they believe that returns for the next few years should be moderately positive but investors should not look to 2009 as a barometer for returns going forward. And as noted in previous posts on this blog, the refinancing wall of 2012-2014, despite being worked down in past months, still is a monstrous number to the tune of $600-$700B.

The manager, Jeff Gary, then goes on to talk about some individual investments. This is a very good read and I suggest you go read it. The one I will post here is again on Energy XXI to give the reader more perspective on the investment:

Energy XXI (“EXXI”) is an independent oil and natural gas exploration and production company with operations focused in the U.S. Gulf Coast and the Gulf of Mexico. (This credit is also discussed in the Third Avenue Small-Cap Value Fund shareholders’ letter, which you can refer to for additional information.)

Due to hurricanes which disrupted production in the Gulf of Mexico and the collapse in commodity prices, EXXI ran into liquidity issues. During the fourth quarter, EXXI attempted to do a debt exchange whereby it would exchange approximately 50% of its $625 million 10% Senior Notes for new 16% second lien secured notes at a price of 80% of par. Additionally, EXXI planned to retire the $125 million in 10% bonds the company had purchased to reduce its overall debt load.

Based on our proprietary research, we determined that EXXI’s oil reserves more than covered the value of its debt at par and the 10% notes were trading in the low 80 dollar price range. When we discussed the rationale for the debt exchange with management, they said there were two key reasons. First, it would reduce slightly its overall debt. Second, they wanted to modify the “Change of Control” provision in the new 16% second lien notes so it would be different than the 10% Notes. A “Change of Control” provision is standard in high-yield bonds and provides that if a company is bought out by another company, then the bondholders can force the company to repurchase their bonds at a price of 101% of par.

EXXI wanted the flexibility to be able to issue more than 50% of their outstanding common stock in a new acquisition deal. This would have triggered a “Change of Control” in the 10% notes. This led us to conclude that management wanted to do an acquisition funded with almost all equity, in order to substantially reduce its ratio of debt to equity. If this happened it would positively impact the bonds. We purchased the 10% senior notes and agreed to the debt exchange. Following the debt exchange, the combination of the new notes traded at a higher price than our cost basis.

In November 2009, EXXI announced that it was purchasing interests in oil properties from Mitsui & Co. for $283 million. These are interests in oil fields that EXXI already owns and operates. They were able to negotiate a favorable purchase price and will incur almost no additional operating costs. EXXI then completed an equity and convertible bond offering to fund the entire transaction.

EXXI owns interests in two deepwater exploration fields being drilled and operated by McMoran. Our analysis attributed no value to these fields, since there was no discovery yet but they were drilling the wells and had incurred costs. In January, EXXI and McMoran announced favorable findings for one of these wells. The stock now has a market capitalization of $1 billion and the 10% and 16% notes we own now trade at par and 115% of par, respectively.

Spectacular analysis.

And finally, in a footnote, there is commentary on the fund's top 10 largest issuers as of January 31st:

The following is a list of Third Avenue Focused Credit Fund’s 10 largest issuers and the percentage of the total net assets each represented, as of January 31, 2010: Swift Transportation, 4.2%; Energy XXI Gulf Coast, Inc., 3.8%; CIT Group, Inc., 3.0%; TXU Corp., 2.9%; Lyondell Chemical Co., 2.9%; Pinnacle Foods Finance LLC, 2.8%; First Data Corp., 2.7%; FMG Finance Ltd., 2.7%; Georgia Gulf Corp., 2.5%; and Culligan International Co., 2.3%.

I know most of these names well and will try to write up a snippet about each in the coming weeks. I will note, that a lot of these names have run substantially since Jan 31st.

Overall, very strong distressed debt commentary out of the Third Avenue's Credit Team.

Falling Levels of Distressed Debt

As I have noted in previous posts, the opportunity set for distressed debt has fallen immaculately over the past 12 months. Two charts from Bloomberg confirm this.

The first, is the number of distressed bonds traded. From Bloomberg: "This represents the number of distressed bonds traded during the previous day's market. Distressed is defined as any bond that trades at greater than 1000 basis points over the benchmark Treasury."

Here is the 1-year chart:

And the same chart since the index begins (1/17/2008):

The other index we can look at on Bloomberg is a similar chart, but instead this one tracks issuers, not issues. So for example, if one credit had 30 issues (read: Lehman Brother Holdings), the above charts would count each of those issues. From Bloomberg again: "This represents the number of issuers whose distressed bonds traded during the previous day's market. Distressed is defined as any bond that trades at greater than 1000 basis points over the benchmark treasury."

Here is the 1 year chart:

And the chart since the index began (same date as above):

Both these charts tell the same story: The opportunity set has gotten a lot weaker.

None of the four charts above pull in distressed bank debt. Empirically, from my seat on the desk, it is not as bad as the charts above indicate, but it is still horrible compared to late 2008, early 2009. What has contributed to this: Lots of capital chasing returns in the space combined with an improving economy. In bank debt land, you also have an issue of CLO's not wanting to sell any sub par exposure to realize overcollaterization hits and hence you have something I like to call: "An irrational holder."

All is not lost though, in the past week there has been some pretty major decisions in distressed debt land (one of the reasons for the lack of posts), which has provided some interesting opportunities for investors. We are going to explore these over the coming week and hopefully learn something from each of the decisions.

Who is playing what Distressed Debt Deal?

In the distressed debt world, it is helpful to know who you are up against and who's side you are playing for in a particular deal. But how do you find this information out? Let's use Tribune as an example.

For reference, here is a link to Tribune's Claim Agent site: Tribune's Claims Agent

Tribune has been a favorite of the event driven / distressed hedge fund space for over 2 years now. Let's say you are interested in investing in the bank debt but want to get up to speed by talking to other investors you may know that already hold the position.

I goto the docket, and start poking through filings that could shed some light. You are looking for things like "Statement of Representation" which is just a fancy way to say XYZ legal firm is representing ABC Creditor. In Tribune, the first thing that pops up when searching starting with the most recent documents is Docket #3927.

It reads:

...3. HBD and YCST represent a number of individual creditors in connection with holdings of indebtedness governed by the Credit Agreement, dated as of May 17, 2007 (as amended, the “Credit Agreement”), by and among Tribune, each lender from time to time party thereto, and certain financial institutions as administrative agent, syndication agent, codocumentation agents, and joint lead arrangers and joint bookrunners.

4. The names and addresses of the creditors currently represented by HBD and YCST (collectively, the “Lenders”) are identified on Exhibit A, attached hereto. The aggregate principal amount of claims held by the Lenders against the Debtors currently totals approximately $3.8 billion.

In the above text, HBD and YCST stand for two legal firms: James O. Johnston, on behalf of Hennigan Bennett & Dorman LLP (“HBD”), and M. Blake Cleary, on behalf of Young, Conaway, Stargatt & Taylor, LLP (“YCST”).

And read that again - The creditors listed hold $3.8B of the claims. That is a big number. The file continues by listing the lender (with addresses). Here are some the names on the list.

Anchorage Advisors, L.L.C.

Avenue Investments, LP

Avenue Special Situations Fund IV, L.P.

Avenue - CDP Global Opportunities Fund, L.P. (US)

Avenue International Master, LP (Master)

Avenue Special Situations Fund V, L.P.

Canyon Capital Advisors, LLC

CFIP Master Fund, Ltd. c/o Chicago Fundamental Investment Partners, LLC

Contrarian Funds LLC

A Number of Franklin Templeton affiliated funds

GoldenTree Asset Management, LP

Goldman Sachs Loan Partners

Greywolf Capital Partners II LP

KKR Financial CLO 2005-1, Ltd.

KKR Financial CLO 2006-1, Ltd.

KKR Financial CLO 2007-1, Ltd.

Oregon Public Employees Retirement Fund

KKR Financial Holdings III, LLC

KKR Strategic Capital Holdings I, L.P.

Knighthead Master Fund, L.P.

Latigo Master Fund Ltd.

LP MA1, Ltd.

SEG LP MA2, L.P.

SEG Latigo Master Fund Ltd.

Luxor Capital Group, LP

Marathon Asset Management, LP

Newstart Factors, Inc.

Oaktree Capital Management, L.P.

Onex Credit Partners

Scoggin Capital Management LP II

Scoggin International Fund LTD.

Scoggin Worldwide Distressed Fund, LTD

Taconic Market Dislocation Fund II LP

Taconic Market Dislocation Master Fund II LP

Taconic Capital Partners 1.5 LP

Taconic Opportunity Fund LP

Värde Investment Partners, L.P.

Viking Global Equities LP

Viking Global Equities II LP

VGE III Portfolio Ltd.

Waterstone Market Neutral Master Fund, Ltd

Waterstone Market Neutral Mac51 Fund, Ltd

York Capital Management, L.P.

So just eyeballing it: Avenue, Canyon, Contrarian, Franklin Templeton, Goldentree, Knighthead, Luxor, Oaktree, Onex, Scoggin, Taconic, Viking, and York are in the mix. That is a strong list of solid hedge fund names.

Unfortunately, these filings don't tell you where these assets were being bought. But if you know someone at one of these places, you could make a call, get a summary of the situation, and you are off to races.

Distressed Debt Investing Turns 1

In April 2009, I thought it would be an interesting exercise to bring together some of my thoughts on distressed debt investing, the hedge fund world, value investing, and whatever else I may be thinking at the time in a blog format. And after 1 year, I could not be happier with our successes:

1. 350,000 page views on this site, and another 100,000 on my ancillary sites
2. Over 2500 RSS Subscribers
3. The Distressed Debt Investor Club was launched and in my opinion is a fantastic success that continues to get a steady stream of member and guest applications

I am very grateful for all the help I receive from guest writers, as well as our readers who have made this all possible. In the coming months we have some big plans for our various sites. Here is to hoping a second year of successes!