Lehman Brothers Bankruptcy

A number of years ago, when I knew nothing about distressed, my portfolio manager sat me down and said, "Our friends at XYZ hedge fund [name redacted] are telling me these Enron bonds are interesting - start working through it." Over the next 6 months I cut my teeth (hard) on figuring out how much bond holders would receive and what return that translated to. It was one of the best exercises that I've ever been put through as an analyst.

In my opinion, the best situations for distressed debt investors to make out-sized returns are when the bankruptcy filing is unexpected. I remember when Solutia filed in 2003 and Parmalat soon after. In both situations, no one had any idea what to make of the situation. Uncertainty creates opportunity. Chaos as it were. In that vein, of every situation I've encountered in my professional career, Lehman, and its various 'flavors' has been one of the most complex.

On a daily basis I am receiving over 200 trader runs on various Lehman instruments. The most liquid of these instruments are the LBHI bonds, or Lehman Brothers' holding company. In addition, you have runs on "LBSF", "LBCS", "LCPI", "LBIE", "LBT", "LBCC", "LOTC", LBHI Euro, LBHI Yen etc etc. While these instruments are more illiquid, each may hold the possibility of a solid risk adjusted return.

Earlier in July, a diverse group of creditors agreed to a settlement that will (more than likely) enable Lehman to exit Chapter 11. Similar to Enron, this settlement resolves around a partial substantive consolidation (80/20) split. This settlement was agreed upon by a "Who's Who" of hedge funds and prop desks (dubbed the PSA Creditors):

Angelo, Gordon & Co., L.P.

Barclays Bank PLC

Barclays Bank S.A.

BNP Paribas

Canyon Capital Advisors LLC

CarVal Investors UK Limited

Contrarian Capital Management LLC

Credit Suisse International

Credit Suisse Loan Funding LLC

Credit Suisse Securities (Europe) Limited

Cyrus Capital Partners, L.P.

Davidson Kempner Capital Management LLC

DB Energy Trading LLC

Deutsche Bank AG

Elliott Management Corporation (also Elliott Associates, L.P.

Elliott International, L.P. The Liverpool Limited Partnership)

Fir Tree, Inc.

GLG Ore Hill LLC

Goldentree Asset Management, LP

Goldman Sachs Bank USA

Goldman Sachs International

Hayman Capital Master Fund, L.P.

King Street Capital Management GP, L.L.C.

Knighthead Capital Management, L.L.C.

Morgan Stanley & Co. International PLC

Morgan Stanley Capital Group Inc.

Morgan Stanley Capital Services LLC

Mount Kellett Master Fund II, L.P.

Oak Tree Capital Management, L.P.

Och-Ziff Capital Management Group LLC

Paulson & Co. Inc.

Silver Point Capital, L.P.

Societe Generale

Societe Generale Asset Management Banque

Societe Generale Bank and Trust

Taconic Capital Advisors L.P.

The Baupost Group, L.L.C.

The Royal Bank of Scotland plc

Varde Partners, L.P.

York Capital Management Global Advisors, LLC

This group of creditors held over $100 billion (!) of claims against Lehman Brothers.

While the value proposition was definitely there when the LBHI bonds were trading in the teens, another aspect of this case was that A LOT of capital could be put to work with very little correlation to the market with very little downside. And that is still probably the case.

Like in all bankruptcies, the disclosure statement here lays out contemplated recoveries for the various creditor constituencies. And like most bankruptcy cases, these recoveries cannot be relied upon to make actual trading decisions. For instance, LBHI Senior Bonds are contemplated to recover 21.1% whereas in the market as of this afternoon the bonds were trading (depending on the specific bond) between 26 - 26.5%. While in "dollar value" that may not look like a lot, in reality it's a ~25% difference. Why the disparity?

• As in most cases with financial assets as collateral for creditors, there is a perception that there has been a sense of conservatism and that, over time, these assets throw off cash that increases recoveries to creditors
• The fact that no one really knows the recovery on foreign inter company receivables. We do know that the recovery of inter company receivables from foreign affiliates, at less than 10% is far below similar (domestic for instance) recoveries contemplated in the disclosure statement - It's also a HUGE number where a 1% bump means $500M more recovered for LBHI
• Litigation awards that could go any which way

These are just a few factors. In addition, returns to investors depend dramatically on when cash actually gets paid out. The fact that the plan / disclosure statement is on the docket means the likelihood of more timely distributions increases. It will be a sad day when this case finally comes to a close (I believe it accounts for something like 70% of all trade claims).