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.