Notes from NYSSA's Distressed Investors Market Panel

Last week, NYSSA held a Distressed Investors Market Panel where a number of market participants discussed the current climate and trends in the distressed market. Distressed Debt Investing was there taking notes which we've copied below. Enjoy!

NYSSA Distressed Debt Panel - Notes

NYSSA held its Distressed Debt Investors Market Panel on July 19, 2011 at its headquarters near Times Square in NYC. The Distressed Debt Investors Club was a media sponsor, and its writers helped organize and were present at the event. The event was well received by the audience of 85, mainly credit analysts.

The moderator was Joshua Nahas, Principal at Wolf Capital Advisors. The panelists included

• David Jackson, Senior Analyst at $6 billion AUM PENN Capital Management
• Varun Bedi who leads transaction origination, structuring, and execution activities for Tenex Capital Management, an investment fund focused on operationally intensive opportunities and special situations
• Andrew Milgram, the managing partner at a distressed and special situations hedge fund, Marblegate Asset Management
• Derrick Pitts, managing director in the Financial Restructuring Group at Houlihan Lokey
• Justin Smith, Senior Covenant Analyst at Xtract where he oversees the review and analysis of complex debt documents.

The panelists covered a broad range of topics such as what were the lessons learned from the previous credit cycle and the financial crisis we underwent, how deep are we in the credit bubble currently, where is value in distressed markets today, and how bad could the maturity wall prove to be.

Andrew Milgram started out asserting that one of the main lessons to be learned for distressed investors (and buy-side in general) from the financial crisis was to avoid stark mismatches between the underlying investments and fund structures which exacerbated the losses and forced selling when redemptions started dramatically. Times were extremely tough for everyone, but disciplined investors won whereas the ones who “owned two of everything” suffered most of the losses. Andrew also mentioned that mid-market bank debt is a disaster waiting to happen since some lenders have kicked the can down the road as some of the restructuring in the last cycle was done poorly and left some of the underlying problems intact. This will be the one of the roots for the next distressed cycle.

Derek Pitts suggested that from his advisory perch he could see that there was so much velocity in the transactions that the value of due-diligence was often times neglected, and investors didn’t really know what they owned. For example, the second lien holders often did not bother to have intercreditor agreements, let alone go through and understand them prior to restructurings.

Justin Smith echoed similar observations and lamented that things seem to have reverted back to usual in that understanding the credit documents thoroughly is again taking a backseat. Investors seem to have learned the lessons much less than the issuers and their private equity sponsors in that the new credit documents now seem to build in flexibility for issuers and sponsors, and things like “equity cures” have become rather standard. He would advice the investors to understand and appreciate the risks from the outset.

From a middle market private equity fund perspective, Varun Bedi said that despite the fact that some of the smarter and bigger PE funds (such as Apollo and Blackstone) joined the hedge fund managers in buying distressed debt of their portfolio companies at attractive levels so that they could continue controlling their assets and not fight the hedge funds over them, not all the PE shops (especially the ones that do not have much liquidity/money that is locked up) can make the switch without running into trouble. The smaller PE shops should continue to focus on retaining their edge in terms of operating skills, which are hard to acquire in short term. On the operational side the opportunities came for his fund since history repeated itself - in previous upmarket small to mid cap firms tried to grow using debt and their managements started focusing solely on maximizing equity values. This worked well for 20-30% of the firms, but for the rest just as working capital requirements and cash burn increased, liquidity dried up and the firms got into trouble. Firms don’t seem to have learned the lessons and this will again provide opportunity in the mid-market.

Next up, the panelists were asked on their views on the macro fundamental outlook given what’s gone on with quantitative easing (QE1 and 2), equity markets essentially getting back to flat after spending $2T, etc. Dave Jackson mentioned that due to Fed interventions there has been misallocation of financial resources and there will be unintended consequences due to that. He observed that the long term interest rates are rising for the first time in 30 years, and investors need to be aware of that new environment when they make decisions and keep in mind the open question, what will happen when the Fed exits the marketplace. The hands of the Fed are somewhat tied now if there is a next liquidity crisis due to another sizeable credit shock. Andrew mentioned that the period of late 70s, early 80s is pretty instructive as the risk of policy mistakes is very high both in US and Europe currently. Many parts of Europe clearly need restructuring. Derek added that these dislocations we had in the past couple of years will take a decade or more to resolve themselves fundamentally work themselves fully through the system. During this period there will be some pockets of opportunities (outside of housing, general employment, etc), and people will flock to those creating mini-bubbles in those pockets eventually. The economy will continue to give out a lot of mixed signals, and investors will need to be very careful in pocking their spots.

On the topic of middle market distressed, it was mentioned that most firms do not have much differentiation and pricing power. Varun replied that enough though the space is getting crowded, his fund is still able to find good deals based on enticing prices in the <$500mm revenue companies. The price on a deal makes it worth it for them to take on companies facing severe operational issues. They specialize in getting the companies in the very low percentiles into middle percentiles; do not focus on revenue growth which is very hard to come by in today’s environment, but on EEBITDA margin expansion. They essentially are in a “relentless pursuit of mediocrity,” as this formula has provided good returns for them. Starting last August 2010, banks started letting go of (rather than just amend, extend, and pretend) the operationally weaker companies on their portfolios since they are healthier now and also are scared of Fed coming in and auditing their books, so banks have been selling what would we “non-passable” credits.

Derek said that the number of liquid distressed opportunities is low, and that the banks are still holding on the some questionable assets. Investors are in turn, putting more money in their existing situations so that they can be in a better position to make their investment thesis play out by solidifying their seat on the table. Investors are looking for strategic advice from restructuring advisors to help them play out their thesis and communicate more with the issuers and sponsors, rather than just advice on troubleshooting or saving principal they might feel is at risk.

On the health of banks, Dave Jackson thinks that loan growth will be the source of future earnings generation at banks. He did not think that CMBS is going to be a big source of losses at banks as it is different from RMBS due to 75% LTV requirements which are much stricter than in the housing market. One would need to see very high loss frequencies, otherwise commercial real estate loans would not prove to be as bad as some in the market are thinking. Banks’ balance sheets are getting better if only because they are increasing earnings through reserve releases. Dave thinks that banks will get more selective going forward in terms of what they sell. Derek mentioned that only the mez lenders in commercial real estate space might be in trouble while most other tranches would be fine.

Other Miscellaneous topics:

• Justin felt that the weakened covenant packages in the current cycle have increased but they are not the norm across the board. He mentioned that “the companies fail to realize that the capital structure today is not the capital structure of tomorrow.” General theme, however, he is seeing is of “flexibility”
• Companies and sponsors are building flexibility in the documents; Key for investors is to understand that flexibility and risks associated with that.
• On the topic of whether bankruptcy judges might be more circumspect in approving DIP cases in the next distressed cycle since DIP lenders made a lot of money (in some cases 3x in 6 months) despite the judges being told that company had very little chance of survival absent the DIP financing, the panel felt that judges won’t be comfortable ruling against companies’ assessment of its situation and if DIP availability is the best available financing in the market at the time, they would stop those financing from happening. Essentially, the feeling was that the judges can’t rule against the type of last ditch financing the market dictates.
• In terms of Fraudulent Conveyance, Justin brought up the recent case of Dynegy which he felt was very interesting. Dynegy’s situation looks like a case of FD but the documents might prove otherwise. He pointed that the unresolved question there is whether there will be substantive consolidation? The panel felt that regardless of the fairness of the TOUSA decision in which United States District Court for the Southern District of Florida quashed the Bankruptcy Court’s previous decision, the market views the decision as welcome as it took away some of the uncertainty.
• For an inflation hedge, Andrew likes to be involves with companies that are price makers more than price takers. Dave likes leverage loans as they provide collateral, priority, and very importantly interest rate protection.

Next was the question of Wall of Maturity - is it real, or has it just been moved out a couple/few years? Andrew said that it is essential to decompose the pieces constituting that wall. Big pieces (such as TXU, etc) will restructure themselves most likely, but the smaller pieces might face trouble. One big determinant he cited was potentially reducing demand from CLOs which is the next 2-3 quarters are slated to get into their “harvesting” period, and thus will likely be sellers. He felt that the lowest quality credits will be the worst impacted. In the high yield market, he is generally concerned about the demand for the paper. Derek felt that the wall has flattened towards the out years but meaningful maturities remain in the next 2-5 years. He also felt that if the yields become attractive enough, innovation in the financial markets would ensure that a 2.0 version of CLOs would emerge. He further felt that the companies that are unable to extend/refinance in this cycle would be better dead than alive, especially in the middle market. He believes that the wall is not unsolvable absent any sovereign default issues. Others felt that we are in year 2-3 of bad issuers coming to market, and this could continue for another couple of years as the overall % of these issuances is still low but increasing. The timing of the inflection point will depend on when maturities of these type of credits abound.

When quizzed on what they saw as the current opportunity set, panelists had varied views which reflected their vantage points. Varun likes trucking (along with other “crappy” industries) due to fragmented market where improvements in operational efficiency can set a company apart and increase EBITDA margins. He also likes health services industry due to fragmented and mismanaged nature of the industry. He will only invest in health services situations where he can fix things up while fighting deflation. Dave tries to find companies that have some “taint” but where he feels that the companies will be able to restructure. An on-the-run situation he recommends Central European Distillation Corp – he expects to earn 16-19% IRR by 2012.

Andrew likes the middle market space as it is highly disaggregated. He sees potential value in shipping industry players, second tier market commercial real estate which the banks could potentially look to get off their balance sheets, and gaming (which he described as “the gift that keeps on giving.”) Derek also is seeing activity in gaming, shipping, and mezzanine type CMBS structures. In addition, he advocates looking at the municipal space which obviously needs much localized knowledge. Within municipals, he suggests looking at revenue bonds (sewers, stadium, parking garages, etc).

The panelists obviously covered a lot of ground during the event. It was good to get differing perspectives from distressed hedge fund, private equity, high yield focused credit, restructuring advisory, and legal document analysis professionals. One of the themes was that although mispriced opportunities are fewer today, they do exist generally in the middle market. It is important for investors not to underestimate the importance of due diligence, understanding their rights and obligations laid out in the credit documents, and patience. Once the supply exceeds demand due to fewer investors for weaker credits that were part of “kicking the can down the road” phenomenon due to incomplete/inadequate restructurings done by banks and other lenders during the financial crisis, the opportunity set should become much wider for investors with appropriate investment fund structures.