Profiting from Short Duration Opportunities

When I first started on the buy side, investing in high yield and distressed debt, my boss gave me a book on Michael Milken (Fall From Grace for all those that are interested). In the book, there is a passage, and I am not quoting directly here, on Milken's take on corporate insolvency. Essentially, his take was: It is very hard for a company to file for bankruptcy.

There are really only a few reasons for a company to file for bankruptcy: 1) They run out of cash 2) There is an "unforgiven" covenant default 3) They are trying to eliminate a legacy liability 4) They can't refinance maturing debt and enter in some sort of pre-pack/exchange/etc. In my experience, I have seen very few companies truly run out of cash, have seen very little "pressure" from lenders of covenant defaults (MGM Studios has been in forbearance for nearly a year now), and legacy liability filings get smaller every year.

With that said, a lot of bankruptcies are the result of an over leveraged balance sheet that cannot refinance maturing debt (or cannot conceive of a situation where in the future they WILL be able to refinance said debt). Over levered balance sheets are the result of boom cycles of past, where senior and sub lenders would lever corporations at 80% of inflated LTVs. Gaming historically trades at 8x cash flow, but in 2006 it traded for 14x cash flow, so people levered the entities to 12x. An obvious mismatch of normalized cash flow generation and run-rate leverage.

With that in mind, why do default rates peak and then (generally) decline significantly within 12-18 months of the peak? Because the capital markets open up and corporations can get in front of maturing debt. And with that, there are lots of opportunities to make very high cash on cash returns, if you can use this dynamic to your advantage.

For instance, a few months ago, we posted a DDIC entry on Tembec. At the time, the debt was trading at 86, with two years until maturity. Last week, Tembec announced a refinancing of the debt (http://ca.news.finance.yahoo.com/s/17082010/30/link-f-cnw-tembec-announces-closing-senior-secured-notes-offering-achieves.html). 14 points, on 86 of invested capital in five months...I am sure I don't have to tell you but those are nice returns.

The question the naturally becomes: How do you know which debtors will be able to refinance existing debt versus the debtors that will be blocked from the capital markets? This is where the art comes in but I want to try to give readers a flavor of how I approach these situations?

First, what is the health of the industry? Are there other similar companies doing equity or debt deals? If so, what were the leverage on those deals? Ratings? Spread? Weak covenants? Why covenants? A struggling debtor has a better chance of raising debt capital with tight covenants. It sometimes even gets the deal across the proverbial "goal line." The debtors most assuredly hate this, but nevertheless, the debt is refinanced and they get breathing room.

Second, who holds the debt? Who holds the equity? If there is a large equity holder, there may be a reverse inquiry to also do a debt deal. This gives the equity a long runway to turn its operations around or just wait for the recession to subside. Is the debt held by hedge funds? CLOs? How would you find this out? By developing relationships with your sales coverage and other buy side investors.

Third, the company itself. Is there a story to the EBITDA decline? Did the whole industry decline? Melting ice cube or a cyclical? Is leverage at least reasonable under the new structure? Could sub debt be more easily refinanced into senior debt and if so, will outstanding covenants allow it? A company that is 6x levered with 1 turn of bank leverage and 5 turns of senior leverage may find that doing a 3x and 3x deal respectively may make it easier to raise capital (assuming senior lenders are on board). What is the company's market cap? Could they raise equity? Converts? Remember, bankers are talking to these companies all the time - giving them intel on the various markets - the bankers want them to do a deal for the fees, and the company wants to do a deal to survive (even if management can make more in a bankruptcy via management compensation plans).

Fourth, and really a natural extension to the third point above, what do covenants allow? Will the company be tripped up by tight debt incurrence baskets? Is the current debt outstanding guaranteed by all the subsidiaries? If not, maybe the company could get a guaranteed deal done easier. As noted above, would investors be more "approachable" if the covenants were tighter? If the deal was secured? Etc.

With all this in mind, you still want to focus on the downside. Let's say you are wrong and the company does file: What will be your worst case recovery? If its a zero, stay away - I tend to only do these situations high up in the capital structure. Remember - always focus on the downside.

Is this post a recommendation to get long a lot of short dated paper? No - but I will say that a lot of my time has been spent on these sort of situations - especially given where the curve is and how investors are not getting compensated whatsoever (in terms of total return) for moving further out the curve.