Advanced Distressed Debt Concepts: Contesting Priming Liens in DIP Financing

Each month, we hope to feature a number of posts from some of our guest writers that we discussed about in the beginning of the year.  Last month I introduced readers to George Mesires, partner in the Finance and Restructuring Practice at Ungaretti & Harris LLP, who will be contributing articles focused on bankruptcy concepts for the blog.  Enjoy!

Contesting Priming Liens in DIP Financing
Within any chapter 11 business bankruptcy, a secured creditor runs the risk of having its interest primed in favor of a lender who provides the debtor additional operating capital during the pendency of the bankruptcy proceedings through debtor-in-possession (“DIP”) financing under § 364 of the Bankruptcy Code.  Such risk is not easy to quantify, is highly fact-specific, and may depend on, among other things, whether the creditor sought to be primed is oversecured or undersecured.  A recent case in the Bankruptcy Court for the Northern District of Illinois is illustrative of the circumstances under which a priming lien will be granted, and provides insight into the Court’s analysis for those secured lenders who would like a deeper understanding of this issue.  The case is notable for the detail the Court provides in its analysis of when a priming lien under § 364(d) is appropriate.  Fullsome court decisions have been few and far between in recent years as most DIP financing arrangements are consensual.

In In re Olde Prairie Block Owner, LLC, 448 B.R. 482 (Bankr. N.D. Ill. 2011), the Debtor owned “two parcels of choice real estate” located adjacent to McCormick Place in Chicago (one of North America’s leading convention centers), where the Debtor intended to develop a hotel complex to serve those visiting McCormick Place.  At an evidentiary hearing on the prepetition secured creditor’s lift stay motion, the Court found the value of the Debtor’s property to be approximately $81 million, based on evidence offered by the Debtor’s expert witness.  Because the prepetition lender was unwilling to advance any additional funds, the Debtor sought DIP financing that included a priming lien over the prepetition lender’s $48 million mortgage on the parcel.  Thus, the prepetition secured lender was oversecured by over $30 million.

Judge Schmetterer issued a thoughtful decision that set forth the analytical framework for considering priming DIP loans.  A debtor can obtain credit secured by a senior or equal lien on encumbered estate property with court approval and after notice and a hearing only if: (1) the debtor is unable to obtain credit otherwise and (2) the interest of the creditor to be primed is adequately protected.  11 U.S.C. § 364(d).  Generally, “adequate protection” requires that a secured lender receive compensation or something of value during the pendency of the bankruptcy case to protect it against the diminution or erosion in value through depreciation, dissipation, or any other cause, including the dollar value of the priming DIP loan.  Adequate protection can take many forms, including, but not limited to, periodic cash payments, postpetition security interests (replacement liens), liens in unencumbered property, or an “equity cushion” (the amount by which the secured lender is oversecured).

Under § 364 of the Bankruptcy Code, there is no requirement that the debtor explain or justify its proposed use of funds.  However, as the Court explained, if the Debtor’s borrowing request was granted, the funds would become property of the bankruptcy estate and therefore subject to the usage limitations set forth in § 363 of the Bankruptcy Code.  Under § 363, a debtor may use or sell estate property outside the ordinary course of business only after notice and a hearing, and after the debtor demonstrates an “articulated business justification” for the use of the funds.

In Olde Prairie, the Debtor demonstrated that it was not able to obtain credit under less onerous terms than those offered by the DIP lender.  Next, the Debtor was able to demonstrate that the existing senior lender’s interest was adequately protected by virtue of the large equity cushion (approximately 38% of value) to protect the senior lender from any potential diminution in value during the pendency of the case.  However, the Court noted that a large equity cushion is not a “debtor's piggy bank and the uses contemplated for the new loan must have serious likelihood of benefitting the property and advancing the purposes of reorganization. A priming lien without such a showing would impose an unwarranted burden on the secured creditor if reorganization fails.”  The Court further noted that because the valuation was based on expert opinion, which is not a substitute for testing the market to obtain actual sales or funding, “allowing a priming lien should be considered with caution to avoid transferring the entrepreneurial risk of failure by Debtor's investors and principals onto the secured creditor…Given the inherent uncertainty of determining valuation through methods commonly used by experts in appraising real estate, some restraint in allowing priming liens to fund particular expenses is warranted.”

The Court found that most of the expenses the Debtor sought to fund with the DIP loan would likely advance the value of the bankruptcy estate and further the Debtor’s reorganization. The Debtor anticipated using the funds to lobby for certain tax benefits, which would increase the overall value of the parcel and encourage outside investment.  The Debtor was also using the funds to further its hotel development plans.  The Court thus found that the Debtor had shown under § 363 that it had articulated a “serious . . . business justification for most of the proposed uses of the requested loan, regardless of whether they are inside or outside the ordinary course of business, and that those uses are in the best interest of the estate.”

The outcome might have been different in the Olde Prairie case had the prepetition secured lender been undersecured (that is, if the value of the collateral was less than the secured lender’s claim). Indeed, there is ample authority that holds that an undersecured creditor cannot be primed when the value of the prepetition secured lender’s collateral will decrease during the bankruptcy case and the debtor cannot provide any adequate protection for such decrease.  See, e.g., In re Swedeland Dev. Group, Inc., 16 F.3d 552 (3d Cir. 1994) (denying DIP financing on priming basis where debtor sought postpetition financing to fund construction of residential units on a partially finished real estate development, the prospects of which were inherently risky); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (Bankr. S.D. Fla. 2010)(denying postpetition priming loan where debtors sought postpetition financing to complete development of a hotel and casino that was only 70% complete and was not operating or generating any cash); In re YL West 87th Holdings LLC, 423 B.R. 421 (Bankr. S.D.N.Y. 2010 )(denying postpetition financing where debtor owned an unfinished real estate development project and its prospects for success were highly speculative).

In addition, an undersecured prepetition lender who holds a blanket lien on a debtor’s assets typically argues that it cannot be adequately protected for the diminution in value of its collateral caused by the priming loan because the debtor has no unencumbered assets to pledge as security for such decrease in value during the pendency of the bankruptcy case.  See e.g., In re Swedeland, 16 F.3d 552, 567 (3d Cir 1994)(“[t]he law does not support the proposition that a creditor ... undersecured by many millions of dollars, may be adequately protected when a superpriority lien is created without provision of additional collateral by the debtor.”).

After considering these cases, can a secured lender draw a bright line and conclude that a debtor can prime an oversecured lender but not prime an undersecured lender?  Not exactly; for there are circumstances where a debtor may provide an undersecured prepetition lender with adequate protection by preserving and maximizing the value of its collateral during the bankruptcy case.  See e.g., In re Hubbard Power & Light, 202 B.R. 680 (Bankr. E.D.N.Y. 1996)(holding that the secured creditor was adequately protected where a first priority priming lien “would enable the [d]ebtor to commence operating and as an operating business, all of the [d]ebtor’s assets would increase in value [and] [a]lthough it [was] not clear what that value would be, it certainly would be of a greater value than the value of the [d]ebtor’s property in its [non-operational] state”); see also In re 495 Cent. Park Ave. Corp., 136 B.R. 626 (Bankr S.D.N.Y. 1992) (holding that a prepetition secured creditor was adequately protected because “the value of the debtor’s property [would] increase as a result of the renovations funded by the proposed financing”)(“Although appraisers for both sides disagree as to what the value of the building would be following the infusion of approximately $600,000.00, there is no question that the property would be improved by the proposed renovations and that an increase will result.  In effect, a substitution occurs in that the money spent for improvements will be transferred into value.  This value will serve as adequate protection for Hancock’s secured claim.”); In re Yellowstone Mountain Club, LLC., No. 08-61570, 2008 WL 5875547 (Bankr. D. Mont. Dec. 17, 2008)(holding that secured creditors were adequately protected because, among other things, without the proposed financing, the debtor’s business would “go dark” to the detriment of all creditors and the DIP financing would, therefore, “preserve the value of their collateral and in fact enhance it in an amount that exceeds the amount of the DIP Loan by multiples.”).  Thus, in situations where a secured lender is undersecured, it may still be primed if the debtor can demonstrate that the value of the secured lender’s collateral will be preserved or enhanced through the DIP financing.

Because DIP financing is often the lifeblood of a debtor during a chapter 11 bankruptcy case, participants are well-advised to be familiar with the circumstances when a priming lien may be granted and when it may not.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires [at] uhlaw.com.

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Trident Microsystems (TRIDQ): Results of its Auction as an Example of Bankruptcy News Inefficiencies

After filing for bankruptcy, Trident Microsystems (TRIDQ) was written up as an equity investment on the Distressed Debt Investors Club (as well as VIC) earlier in the year.  For those interested in some background, here is the docket: Trident Microsystems Bankruptcy Information.  A central components of value for a possible recovery for shareholders (there has been an equity committee appointment) is the value of Trident's set top business.

Docket #14 of the case is the motion to approve the procedures in connection with the sale of the set top box business naming Entropic Communications (ENTR) the stalking horse bidder:

"The Sellers (Trident) entered into that certain asset purchase agreement, dated January 3, 2012 between the Sellers on the one hand and Entropic Communications, Inc. (the “Stalking Horse Purchaser”), pursuant to which the Stalking Horse Purchaser shall acquire the Purchased Assets on the terms and conditions specified therein (together with the schedules and related  documents thereto, the “Stalking Horse Agreement,” a copy of which is attached hereto as Exhibit B).

The sale transaction pursuant to the Stalking Horse Agreement is subject to competitive bidding as set forth herein.  Pursuant to the terms of the Stalking Horse Agreement, the Stalking Horse Purchaser has agreed to purchase the Purchased Assets for the assumption of certain liabilities and a cash payment of $55,000,000, subject to certain adjustments (the “Stalking Horse Purchase Price”)

From the Asset Purchase Agreement originally filed with the court, here is the defintion of assumed liabilities.

In bankruptcy court on January 30th, Cathy Hershcopf, counsel for Entropic Communications stated:

"We’ve got $55 million in cash, and the testimony will show today another assumed liabilities of about $18 million. So at $73 million, we see this bid protection at 6%."

So the cash value is $55M and the assumed liabilities are to be valued at $18M for $73M of value to the Trident estate.

The auction for the set top business was set to occur this past Thursday (remember that date).

This morning, Entropic Communications (ENTR) released a press statement (my emphasis added):

"SAN DIEGO, Feb. 27, 2012 (GLOBE NEWSWIRE) -- Entropic Communications, Inc. (Nasdaq:ENTR), a leading provider of silicon and software solutions to enable connected home entertainment, today announced it has been selected as the successful bidder to acquire Trident Microsystems' set-top box (STB) system-on-a-chip (SoC) assets for a purchase price of $65 million, a $10 million dollar increase to its original offer. 

Today's announcement follows the completion of an auction, and the final transaction is subject to approval of the United States Bankruptcy Court for the District of Delaware. A court order authorizing Trident to sell the STB SoC assets to Entropic is expected to be entered on or about March 6, 2012. 

"This acquisition marks an important milestone for Entropic and is an exciting new chapter in our company's history, enabling us to combine our best-in-class MoCA solutions, including MoCA 2.0, with Trident's STB SoC business to deliver a complete system solution to the world's premier cable, telco and satellite service providers, while expanding our total addressable market over the next several years," said Patrick Henry, president and CEO, Entropic. "Our successful bid brings us closer to adding Trident's complementary assets, portfolio, research and development and global presence to Entropic. We believe the acquisition brings inherent value to both organizations' customers, employees and partners, and we look forward to closing the transaction."  

Entropic expects to make employment offers to approximately 375 Trident employees worldwide. 

The transaction, which remains subject to customary closing conditions, is expected to close by the end of the first calendar quarter of 2012. Entropic will provide additional details as to the financial implications of the transaction and guidance for the combined business following the close of the transaction."

For all intents and purposes, if this was your sole source of information, you would think, as a TRIDQ shareholder, you were receiving an extra $10M in possible recovery proceeds.

This past Friday (Feb 24th) there was a hearing on Trident (i.e. a day after the auction took place).   During the proceedings, Richard Chesley of DLA Piper, which is the Debtors Counsel in the case stated (my emphasis added):

"As the Court is aware, we had an auction of the set top box assets yesterday in New York. The auction ended this morning at 2:47 a.m. in New York, and everyone made it down here on time, Your Honor. It was an enormously successful process. I think all of the creditors and stakeholders would agree to that. The value to the estates was increased by close to 40% through the competitive bidding of the two parties who were present. Because of SEC disclosure issues with respect to the prevailing bidder, they have requested that we not announce the identity of that bidder until Monday."

40% higher than the aforementioned $73M of value is a value closer to $102M.  Not the $65M value listed in today's press release from Entropic.

Here is a graph of the the three day chart of TRIDQ

You can see the value jump on the 24th when Chesley of DLA Piper noted that the value to the estates increased by 40%.  You would have had absolutely no idea what was happening with the move on the stock price unless you had called into the court on Friday.  Further, you may have been disappointed this morning with only a $10M bump in the purchase price.  Proceeds and value to the estate are very different things.  Yes, only $10M more of cash, but a nearly $30M increase in the value to the estate.  $20M of value / 183M shares is akin to 11 cents which is enormous considering a 35 cent baseline.

Disclosure:  I am long TRIDQ stock.  

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My Favorite Quote from Baupost's 2011 Annual Letter

Readers know in the past we have covered Seth Klarman's letter to investors numerous times (here is one such post: Wisdom from Seth Klarman).  This week, we received Baupost's 2011 Letter to Investor where Seth Klarman, along with heads of the public investing, private investing, and operations group talk about everything from the investment climate, the government policy, and Europe among many topics.  A special emphasis, like we've seen in past years, was on the process, culture, and modus operandi of Baupost.  It is a fantastic letter.

While I will not post or quote the entire letter, as a distressed debt investor, I found one set of paragraphs particularly relevant:

"But in a field where the vast majority of our competitors spend their time looking exclusively at equities to buy or sell short, we are truly fortunate to have a broad mandate and stable, long-term oriented client base that allows us to emphasize in our portfolio more complex, less liquid, and less widely analyzed investments, such as distressed debt--and the ability to concentrate our capital in the areas of greatest opportunity, which inevitably evolve over time.

A follow-up question was asked: Why, if distressed debt is such an attractive arena, didn't many more funds sprout up to take advantage of the excess returns there? I replied that there were indeed very capable competitors in this space, but that opportunities in distressed debt ebb and flow with economic cycles. At the not infrequent moments when there is literally no distressed debt worth purchasing, these competitors (especially narrowly siloed ones) often stray (dangerously) into origination of new debt instruments at par. They are unable to sit on their hands, fearing that their businesses would wither and their people would depart. While the yield expectations for newly-issued debt may, at times, superficially appear similar to the returns on distressed debt, new origination occupies a very different place on the risk/return spectrum, and also requires an extraordinary underwriting discipline that few firms have. Sometimes, the competition moves into highly subordinated junk bonds, reaching for current yield while ramping up risk. Such diversions usually end badly, leaving these competitors wounded and mostly on the sidelines when the distressed opportunity set once again becomes compelling."

This is an amazing quote. While a distressed fund investing in new issues may not represent "style drift", to me it does represent "upside/downside drift."  When marginal issuers come to market, they come with substantial OID (original issue discount or priced below par).  For instance, Station is in the market now trying to clear a bond deal in the 60s.  That is somewhat a special circumstance.  More often than not, this OID will be 5ish points (i.e. bond issued at 95) with a fat coupon.  Let's say you have a hold period of 2 years.  In theory the best you could ever do in that circumstance  is a T+50 make whole on a big coupon which could get you to 140 bond price.  Two years of say a 12% coupon so 45 points (140-95 issue price) + 12% coupon ~ 32% IRR.  This is fantastic. Unfortunately, this is the very best case, and the downside in this situation is a zero.  Ex the coupon, the upside downside is then 45 points up, 95 points down: Round numbers 1 up/2 down.

Let's take a distressed bond trading at 50.  Again the worst case is a total loss, but this is only 50 points.  On the flip side, a big win would be a pull to par and possible more depending if you get cheap equity (i.e. your recovery can be significantly more than par).  For simplicity less say best case is a par recovery:  2 up/1 down risk reward.  And as you buy bonds lower, and lower this upside / downside ratio works out better and better for you.  Readers will ask: Doesn't a lower bond price mean a worse credit?  Absolutely not - remember price does not determine whether a company is good or bad.  Warren Buffett said: "Price is what you pay, value is what you get."  He also said "Mr. Market is there to serve you, not to guide you."

One thing that I have become acutely aware in my years of investing is the effect of overall market sentiment on the risk and reward of individual value opportunities. In his most recent letter to investors, Third Avenue Management's Marty Whitman discusses this topic at length.  In discussing Graham and Dodd:

"G&D believe it is important to guard against market risk, i.e., fluctuations in security prices. Thus, it becomes important in their analysis to have views about general stock market levels. FF (fundamental finance) practitioners guard only against investment risk, i.e., the problems of companies and/or the securities they issue. In FF analysis, market risk is mostly ignored except when dealing with “sudden death” securities – derivatives and risk arbitrage securities; when dealing with portfolios financed by heavy borrowing; and when companies have to access capital markets, especially equity markets"

While I completely agree that an analyst should spend all energy understanding the individual aspects of nuances of the securities and companies he is investing in, one also has to remember another Warren Buffett quote: "We know that the less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs."

Intuitively this makes sense.  But a second order effect that many people miss is alluded to in the Klarman quote above which I'll repeat again: "Such diversions usually end badly, leaving these competitors wounded and mostly on the sidelines when the distressed opportunity set once again becomes compelling".  The fact of the matter is that buying a well followed, well covered large cap stock as an individual investor that may look cheap in an overbought market could produce good relative returns (i.e. your stock is marginally down, where the broad market is down harder), you'll still have capital at work.  In my opinion, it is better to wait until market sentiment is "blood in the street" to purchase anything.

And professional money managers / hedge funds also have to deal with the fear that comes with allocating capital when you are down.  If you haven't been in that spot before, you probably can't understand the feeling.  If you do not have a sound process, you can freeze, or worse, get short, just went the opportunity set is at its ripest.

I often gets asked what my personal investment portfolio looks like.  Outside of my retirement accounts, here is an approximating of my portfolio:

• Cash: 30%
• Liquidating Bankrupt Trust (cash like): 15%
• Insurance Stocks: 15%
• Bankrupt Equities: 20%
• Special Sits (net): 10%
• Leaps: 2%
• Other "Value" Investments / Shorts: 8% (net)

(No distressed / high yield bonds: conflicts of interest)

In effect, I have approximately 45% of dry powder now (including the liquidating trust that is earning about 12-15% right now).  Some of this is a function of selling some winners earlier in the month.  

The two questions that will inevitably follow:

1. Why insurance stocks?
2. Bankrupt equities...are you crazy?

For insurance stocks: As I've mentioned a few times on the blog before, this is the industry I am most confident in my ability to analyze with the deepest set of connections across the industry's supply chain (brokers, producers, adjusters) as well as management teams.  I also think the insurance industry is one of the most misunderstood industries out there.  Further, if you had to look at a the hedge fund's universe of analysis of financials: Banks would take up about 95% of that analytical brainpower, with insurance capturing the balance.

For bankrupt equities: Would you be surprised that at one point my PA was 70% in bankrupt equities?  I read and do a quick analysis on every public company that files for bankruptcy. I understand the bankruptcy process, have my own PACER and CourtCall accounts, and know many players in the industry.  I also "riding the tide" as it were as many funds cannot invest in small bankrupt companies (they can't get any substantial size to move the needle) and many people shrug these investments off.  I'm playing against the general investment public the proliferate Yahoo! message boards and don't know what EBITDA or exit facility means.

I want to have the liquidity to get very aggressive when the cover of the New Yorker looks like this:

The corollary to an institutional investor reaching down for yield in Klarman's quote above for an individual investor is buying a marginally cheap, marginally out of favor big cap.  Don't be tempted to settle for marginal.  Patience is the HARDEST part of allocating capital.  But those that practice it will often be rewarded when everyone else is running for cover.

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Notes from the 2012 Wharton Restructuring Conference

Last week, Wharton held its 2012 Restructuring Conference.  Distressed Debt Investing was in attendance, taking notes.  The all day event featured keynote speakers as well as panels covering a range of topics in the distressed landscape.  Key note speakers included Rodgin Cohen Chairman of Sullivan & Cromwell, Bryan Marsal of Alvarez and Marsal and Marc Lasry of Avenue Capital.  As the title indicates, a great deal of the event’s focus was on where we are relative to the 2008 credit crisis and what the hurdles and opportunities going forward are.

Overall the theme conveyed by the panels was one of cautious optimism.  While the US in particular has come a long way in stabilizing the banking system and reducing systemic risk, Europe still has a lot of work to do.  Only in recent weeks has the ECB made it clear that it intends to support the overly indebted southern rim countries and that is only because the continents banks, particularly the French, are heavily exposed and would need a massive recapitalization in the event of a default of 1 or more of the so called PIIGS.  While the US banks appear to have stabilized the overall operating environment for banks remains constrained.

Regulations such as Dodd-Frank and the Volker Rule have the banks in regulatory which has impacted both market liquidity and bank profitability.  Several of the speakers predicted an era of lower shareholder returns and profitability as banks are forced to shed higher risk (return) assets and will be unable to make up the margin completely through cost cutting and efficiency.  Moreover, they remain exposed to risks from Europe as well as to further economic slowdown in the US which would increase default rates and stifle loan growth.

Opportunities in Distressed Private Equity
Panelists included executives from Sun Capital, Versa Capital, Alvarez & Marsal, Lazard, SSG and Insight Equity.  The panelists all were experienced distressed practitioners with a heavy bent towards operational turnarounds and distressed for control investing.  Many of the themes coincided with those of the private equity panel from a week earlier at the iGlobal distressed conference.  Eric Mendelson of Lazard echoed a time from my last post which was the merging of PE and hedge fund structures to better capitalize on opportunities in the markets as well as more appropriately match assets and liabilities.  These include longer lock-ups, the ability to invest across the capital structure as well as utilizing the division of labor between hedge funds who don’t mind owning businesses, but need the expertise and infrastructure of the PE funds to manage them properly.

Greg Segall of Versa Capital provided insight into the discipline required to be successful in the long term in distressed private equity and noted that many funds from both the distressed debt and traditional buyout arenas have attempted to enter the distressed private equity space and found that they were out of their depth in managing a long term turnarounds in struggling industries and troubled companies.  He cautioned mainstream investors that lack both the operational expertise and experience from jumping into distressed because it was the thing to do.  He pointed out his own funds discipline in that his fund made no investments in 2009and only 1 in 2010. In 2011 they looked at over 600 deals vs and average of 300 in previous years and invested in 8 of them.  Moreover, many of the deals they saw in 2011 were deals that they had seen come around 2 or 3 times where A-Es, equity cures or other deal mechanics provided a temporary respite but had now run their course and banks and owners were more realistic about pricing.

Scott Victor of SSG, a firm that specializes in selling distressed companies, pointed out that banks in 2011 were far more willing to sell troubled loans and take write-offs than they had been in the past.  He also noted that strategic buyers have become more comfortable with bidding in 363 sales as well as participating in auctions for distressed businesses, increasing the competition for PE firms.

One example he cited was Big Ten Tires, a Sun Capital portfolio company that went through a restructuring where Sun successfully credit bid the debt it held in the company and retained control through a restructuring.  Sun also successfully utilized this technique in Friendly’s recently. while junior creditors generally fare poorly in these instances and issues of fairness and whether equitable subordination are usually raised they rarely succeed.  The panelists would argue that the existing sponsor is generally the only one willing to put new money and has the most intimate knowledge of the business.

On the other hand, the presence of a sponsor trying to credit bid its debt likely has a chilling effect on other bidders as they feel they cannot compete against the information advantage and they do not want to devote resources to what they see as likely a foregone conclusion.  As a result we are likely to see a continuation of sponsors owning or acquiring the debt of their portfolio companies and to act aggressively to retain control of their investments.  Since sponsors must maintain a significant equity stake to generate their required 2-3x return on capital, they have less flexibility than a consortium of debt holders in sharing equity.

In certain instances the sponsor is the only constituent with ability to effect a successful restructuring.  The example of Jacuzzi Brands was cited where the existing sponsor Apollo was the only entity who could restructure the company out of court through its position in the 2nd lien facility.  This had to do with the fact that there was a change of control in the bank debt (remember Charter) and the current pricing was several hundred basis points below where a new facility could issued.  Since Apollo was both the sponsor and the second lien holder it was in the unique position of being able to equitize its 2nd lien position without triggering a change of control.

While Jacuzzi was an example of a novel and creative way to restructure and keep the existing equity alive, the panel also said there are many examples of sponsors and debt constituents (particularly banks and CLOs) that do not behave in a purely rational framework when it comes to their distressed loan books.  Agency costs related to amend and extend (or pretend as some refer to it as) are substantial since banks carry most of these loans as held-to-maturity and do not mark them to market.  Furthermore, CLOs have no incentive to restructure and hold equity and have been the primary driver behind the A-to-Es done in the last 3 years.  However, with many CLOs reaching the end of their reinvestment periods and some only a few years away from their legal finals, it will be harder for them to continue this phenomenon when the next wall begins to hit in the 2015-2017 time period.  CLOs cannot extend loans past the legal final maturities of their underlying fund lives.

Several key elements that need to be understood before making an investment in a distressed business were highlighted.

• Cost position: Know the cost position of your target as it is the “ultimate arbiter of corporate conflict”. An investor must know the cost position of the company it is investing in relative to that of its peers in order to gauge their ability to compete. 
• Competitive Landscape: Avoid industries where competition is savage, this was likened to sharks fighting with knives. These types of investments rarely work out, particularly when with the added constrain of leverage which leaves very little room for error.
• Historical Performance: How did the company perform in the 08-09 crisis? Several panelists noted that bankers are leaving the 08-09 financials out of their CIMs which is a bad sign. It is important to understand how the company performed under stressful scenarios in order to gauge its ability to withstand another shock and preserve the equity invested.
• Management: Finally it is important to know how management handled the last downturn. Were they a deer caught in the headlights or did they respond aggressively and pro actively? It is important to see how those who are going to be managing your company perform in the face of adversity.

Market Overview from Bryan Marsal 
The lunch keynote address was given by Bryan Marsal where he discussed a variety of topics including his role of running Lehman Brothers for the last three and half years.  Mr. Marsal shared the difficulties banks are having and are going to continue to have as the result of Dodd-Frank and the confusion that is surrounding it and the Volker Rule in the market place.

Mr. Marsal noted that while banks may be better capitalized than before the crisis, shareholder returns for bank stocks were going to be under intense pressure as the result of the loss of proprietary trading revenue, increasing regulation, higher administrative costs to implement the additional regulation and the movement of many derivatives to exchanges.  Moreover, banks are divesting risky assets in an attempt to bolster capital and appease regulators.  As a result banks will be left with lower return assets and lower profits, thus painting a bleak outlook for investors in bank stocks.  This phenomenon is not unique to the US banks as he noted that European banks are facing a similar outlook with the implementation of Basel III.  Regardless, of the speed with which European regulators allow Basel III to be implemented, the long term profit generating abilities of these institutions will fundamentally altered as a result.

Some of the most interesting insights pertained to both the over reaction of regulators as well as a frank assessment of the behavior of many of the financial institutions that lead up to the 2008-09 crisis.  He cited an example of how the head of food services at Lehman Brothers was making $1.1MM when he took over as CEO as an example of how bloated and divorced from reality the big financial institutions had become.  This behavior has lead to a backlash by regulators and the public who now view our nation’s financial institutions on about the same level as Congress.  These swings between greed and fear are unhealthy for the country and seem to result in poorly thought out policies filled with unintended consequences.

Financial Restructuring Panel – Europe
The financial restructuring panel began with an introduction from the legendary Professor Edward Altman of the Stern School of Business at NYU.  Professor Altman walked through his latest credit metric which dubbed “The Son of Z-Score” called Z Score PD which uses CDS spreads to estimate the implied probability of default.  He applied this model to the Euro zone on an historical and projected basis to show the dramatic increase in the spreads between 09-11, particularly for the southern rim countries and Ireland.  The 10-year borrowing cost implied by yields on these countries’ debt he pointed out was unsustainable and he predicted increasing distress in Europe and thought it was too early in game to start putting money to work in Europe.

On the other hand, several of the practitioners on the panel indicated that they have been moving aggressively into Europe to capitalize on the opportunities.  While they conceded that it was going to be a long, arduous process, perhaps up to 10 years until it is fully worked out, they felt the returns were quite worth it.  In particular when one compares the pricing of European distressed assets versus US distressed assets.  It is likely that the assets may turn out to be long-term good investments, while those looking to trade in the securities of those assets may not fair nearly as well.  Asian investors, particularly China and India are pouring money into European assets as a long term investment and as a hedge against their investments in the US.

The question of whether the combination Basel III’s capital heightened capital requirements and budget austerity measures will actually do more harm than good. It was asked whether the so-called cure is worse than the disease. Several of the panelists were worried that austerity was short-sighted and that ultimately the only way was to solve the sovereign debt problem was to generate economic growth.  While there seems to be a consensus forming around the Greek bailout package, it was noted that Italy is “Too big to save”.  An Italian default would overwhelm the northern European countries and the ECB’s resources.  This would be met with stiff resistance from Germany who is the most firmly in the austerity camp and whose frugal tax payers and politicians have the most resistance to bailing out what they view as the profligate and less industrious southern European counterparts.

Additional concerns from the perspective of distressed investors in Europe are the lack of any uniform bankruptcy laws across the continent as well as the fact that many European countries are operating and have securities issued in multiple jurisdictions.  These factors greatly increase both the cost and complexity of any European restructuring.

Furthermore, European insolvency systems do not have the same methods for providing liquidity particular when it comes to DIP financing.  Most insolvencies wind up as liquidations for the benefit of the secured creditors.  Moreover, pensions generally receive super-priority status in European insolvencies making it harder to shed liabilities and reorganize.  Complicating matters further is the fact that most insolvency regimes in Europe make it illegal to continue to run an insolvent enterprise and subjects the Directors to personal liability. Directors of non-debtor, potentially solvent subsidiaries of companies whose parents file for bankruptcy usually file for bankruptcy as well in order to shield themselves from crippling person liabilities.  Another factor making European restructurings more complicated is the limited ability to cram down plans on junior creditors and no ability to cram down the equity class.

The takeaway seemed to be that while there is a tremendous opportunity set in Europe for distressed investors, those wishing to capitalize need to have experience, patience, boots on the ground and an intimate knowledge of the procedures of the various jurisdictions.  Those looking to trade in and out of the securities rather than making long term asset plays may find themselves with steep losses, particularly if their capital is not locked up long enough to endure what may be a long, painful turn around.

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David Einhorn and Levered Equities

Last week, the Financial Services Authority released its transcript that they used (as evidence) to fine David Einhorn 7.2 million pounds in relation to Greenlight selling its stake in Punch Taverns after a conference call with Punch's CEO.  I have tremendous respect for David Einhorn and Greenlight Capital and am a huge fan of Einhorn's book Fooling Some of the People All of the Time.  I think opining on the subject matter at hand is impossible given the one sided nature of the news flow / information (i.e. FSA is in the power position here).  With that said, I thought one of Einhorn's comments on the conference call was quite interesting for our readers.

In the conference call, Einhorn comments on his opinion that on a levered balance sheet, the equity is really an option on the debt part of the capital structure:

"Right.  You know, it seems to me that -- that much of the potential attractiveness of coming and selling equity at this point stems from probably the fact that a few months ago the equity was at 40 pence, and now it’s at a £1.60 or something like this.  And so, it’s up from the bottom.  On the other hand, if you look back a couple of years ago, it’s -- the equity is really down a lot.  It trades at a very low multiple of the book value and, you know, the comp – the company -- the equity continues to trade as if it’s really an option on the debt side of the  capital structure.  That’s -- that’s the way that we look at it.  And we think it’s a very cheap option because of the types of things that you’ve been -- already been able to execute on, and I think that you’re going to be likely to be able to execute on, uh, going forward. I think that in -- if the equity was -- was overpriced and you had an  opportunity to reduce the financial risk of the company, I think it would make some sense to considering equity at that point.  But I think, if you just looked in a slightly different world and thought “Jeez”, if the stock had come from where it was and it had never gone to 40 pence but instead was sitting at 1.60, then 1.60 represented a new low, down from whatever previous higher price it had used to have been at, I don’t even think you would be considering selling equity at this point."

He then goes on to give a rule of thumb on how he looks at this sort of option:

I would say as a -- I would say as a rule of thumb, if the market capitalization of the equity is less than half of the face value of the debt, the -- the stock remains sort of in an option area.

In the previous cycle, and in previous letters, David Einhorn commented that Greenlight put to work capital in a basket of these sorts of options.  The basket as a whole generated a substantial gain.  In a letter dated January 19th, 2010, Einhorn, commenting on his "levered stub basket" which generated a 227% (!) return wrote:

"We bought small stakes in 22 companies in late 2008 that we thought would survive, even though they traded as if they would fail.  They all survived."

I ran a screen in Bloomberg using this aforementioned rule of thumb (excluding financials) on companies with a market cap of $100M.  The usual suspects turn up: HCA, Sprint, Hertz, CYH, CZR, lots of shipping names, RAD, HOV, most of the airlines.  Frankly most of these names are well studied and followed by the high yield community.  I wanted to get a sense of the weighted average (by market cap) return of these names this year.  I thought the number would be good - but didn't realize it would be this good:  17.3%. The biggest winners on the list were EGLE and HOV, followed by a number of ADR Solar companies and airlines.

There have been many academic papers written about the concept of equity as an option in regards to debt. Because equity is at the bottom rung of the ladder, as the value of the firm increases, the call option of equity becomes more in the money.  If a firm is liquidated, and you receive zero, you are out the premium you paid, which is in effect the price of the stock.  The exercise price in this example is the amount of debt outstanding.

In theory this is all well and good.  A better way to think about it, in my opinion, is to think of a number of expected values for a number of scenarios.  Let's use something like Hovnanian's equity.  We can construct a myriad of scenarios for recovery of the various parts of the capital structure.  For simplicity, let's take three examples:  1) Housing roars back, HOV crushes it and generates a ton of cash flow, 2) Housing meanders where it is, and HOV muddles along until it runs out of cash, 3) Housing falls off a cliff, and HOV is forced to liquidate.  As the probability of scenario 1 increases, the value of HOV's equity should also increase.  When the stock was at a dollar just a few months ago, the market's view of the plausibility of scenario 1 was very low, with the balance allocated to scenarios 2 and 3 which have more consequence for recoveries of the right side of the balance sheet.

There is a bit of wrinkle though with the above analysis:  The availability of credit dramatically influences the probability of survival for levered issuers.  As credit investors, we should always be on top of how "open" the debt markets are, specifically the high yield and levered loan markets.  Let's think of the absolute extreme scenarios:

1. Credit markets are completely frozen for everyone
2. Credit markets are wide open and any company, of any shape or size could issue debt

Under scenario 1, the default rate would spike to historic levels:  Remember, very few issuers ever pay off their debts - they just constantly refinance them.  Under scenario 2, there would be no defaults as companies could just issue debt to refinance maturities, plug cash shortfalls, etc.

The last few years have been amazingly volatile in terms of the openness of the credit markets.  Currently they are pretty open (again a 4ish on the risk spectrum), but still doesn't feel like early 2007.  But over the past 36 months we've seen credit markets that felt very frictional - only the best issuers could issue into the market.  And this volatility of the availability of credit is, in my estimation, a major driver of returns of many players participating in junior parts of the capital structure (include sub debt).  Unfortunately, this is a macro construct that is hard, if not impossible, to forecast.

Valuation is always of the utmost importance.  We want to buy 50 cent dollars all day long.  In a perfect world, with locked up capital, no redemptions, and no monthly/quarterly performance numbers to defend, we could do that and probably do a fine job at it.  Unfortunately, only few funds have that luxury.  With that in mind, at times like these when levered equities have massively outperformed the major indices, each of us should be watching closely the spigot that is credit for signs of a pullback that could ultimately hurt otherwise well positioned companies.

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Notes from iGlobal's Distressed Investing Summit: Part 3

This is our final installment of the notes from iGlobal's Distressed Investing Summit.  Our contributor, Josh Nahas, of Wolf Capital Advisors did an amazing job on this series - and tonight, with a more macro bent, is no exception.   Later this evening, I have a post on David Einhorn's view on levered equities, and this weekend a comprehensive post on the RMBS market, using material penned by Canyon Capital.  Enjoy!

In the third installment of our coverage of the iGlobal Distressed Investing Summit we are going to focus on the Risk Management panel.  This panel represents and interesting counter point to the views expressed by the Leveraged Loan panel which given the current technicals in the HY/Leveraged Loan markets is quite bullish about the prospects for those markets. While it is hard to dispute the current technical factors driving spreads tighter, the question really is whether the underlying economic fundamentals can support the cash flow needed to support a deleveraging of the many broken capital structures out there. If you look at the data presented by the Risk Management panel the answer is decidedly negative without serious impairment to creditors and existing equity holders.  A note of disclosure, the charts in this article are not from the presenters but are based on topics referenced by the presenters.  Many of the conclusions are extrapolated from the panelists’ remarks and therefore represent the author’s own opinion.

Tepid Economic Recovery
The panel kicked off with an interesting way to look at risk defined as Risk = Exposure + Uncertainty. Uncertainty and corresponding volatility has plagued the markets since the credit crisis ended in 2009. Since then there have been periods of exuberance, the first 6 months of 2011 and the last 3 months , along with violent sell offs in July and September/October of 2011.  This lead one panelist to observe that the “The pain of uncertainty is ALWAYS greater than the certainty of pain”. The tepid the economic recovery, uncertainty regarding regulation and increasing negative public sentiment towards the financial sector has created a great deal of uncertainty in the markets over the direction economy has caused sharp turns in the market. These types of rallies and sell-offs are more reflective of secular bear markets which can see large rallies followed by steep sell-offs and prolonged stagnation.

The economic fundamentals paint a bleak picture indicating that these market rallies are likely technical driven and unlikely to be sustained.  Some startling facts include that 72% of GDP is driven by consumption while 10% of Americans are responsible for 40% of that consumption. With a great deal of that 10% employed by the financial sector which is under increasing pressure, the ability to sustain growth in GDP is limited at this point. Moreover, the outsized attention paid to manufacturing vs service by politicians distorts resources away from the areas that will drive growth in the future.

Weak Underlying Economic Fundamentals
Given that manufacturing accounts for such only about 12% of GDP, it is mathematically impossible for it to drive GDP growth. During every previous recession since the Great Depression household net worth grew on average 4%, however, in this previous recession house hold net worth fell almost 25%. The consumer represents almost 150% of GDP including debt, combining this with the drop in net worth portends badly for the fundamental economic outlook. According to the panel, the US consumer has experienced 13 consecutive quarters of income decline. Which begs the question of how we can have a sustained rally in the credit and equity markets with such weak underlying fundamentals?

Moreover, the unemployment statistics based on the U3 calculate by the BLS and frequently cited in the press and by politicians arguing that the economy is improving are misleading. These headline unemployment numbers do not include those who have stopped looking for work, those who have been out of work over 6 months, or those who are under employed. Moreover, headline monthly unemployment numbers are subject to revision as the result of the birth/death adjustment which attempts to estimate how many jobs were created as the result of new businesses being formed as well as those lost by firms going out of business.

These estimates tend to overstate the number of jobs created and are subject to big downward revisions in later months. The BLS’ U6, which is a much broader measure of and includes those who need work but have given up the search, and those who have taken part-time jobs while still seeking full time employment.  In February, that figure rose by 0.6% to 16.0%.  The U3 unemployment numbers have been further distorted due to adjustments made as a result of the 2010 Census. The BLS has indicated that the current series is no longer comparable to historical data as a result and has not supplied what the adjustment is.

Compounding the already strapped consumer are demographics which are going to be a drag on growth over the next couple decades as more baby boomers retire. The dependency ratio, or those who are out of the labor force (usually over 65 ) vs those in the labor force 65 is steadily increasing indicating that there are more retirees than workers. This is going to cause significant tension with respect to entitlements and taxes between those in the work force and the retired population.



This will put additional strain on workers in the form of additional taxes or force retirees to take less benefits. Neither one of these are politically attractive and at this point we seem to have found a third option which is called quantitative easing, or more accurately printing money. This will ultimately result in inflation, which the panel expects to see an outbreak of at some point. The panel also mentioned that current government statistics do not accurately capture inflation. This is the result of changes to the CPI’s calculation during the 1990s by the Boskin Commission (See ShadowGovernmentStats.com for a complete explanation). As a result CPI no longer accurately reflects the cost of a basket of goods used by the average consumer, but is now distorted by econometric adjustments.  Under the old method of calculating CPI inflation would is running almost double the official statistics.

 

Short-Term vs Long Term Factors
Short term technical trends favor leveraged credit instruments in 2012.  At the end of the 2011 and to start 2012 we saw managers begin to put cash to work that has been sitting on the side lines for some time.  Given that large inflows into HY/Leveraged Loan funds, managers were going to have to start putting money to work.  Banks then pounce with as many new issues in their pipeline while the window is opened.  We saw this same pattern in 2010 and 2011.  Furthermore, election years tend to be good years and spending will be in excess of $2bn.

While technicals will dominate in the near terms, given the longer term fundamentals the panel has highlighted indicates that there still needs to be a substantial deleveraging.  Wall Street is focuses on the balance sheets of fortune 500 companies, but it’s the balance sheet of middle market companies and consumers that drive GDP at the margin.  Since growth by definition is at the margin, it appears that the US economy is facing at best prolonged economic stagnation or another contraction.  As evidenced by the chart below the spread on Middle Market loans to large corporate loans are trading at significant premium to their historical average.

 

On the plus side the banking system does appear to be on sounder footing and far less leveraged to exotic instruments such as conduits, arbitrage CDOs and subprime.  Nevertheless, given the large stack of maturities between 2015-2017, particularly for middle market borrowers who have not been able to refinance, there will be significant restructuring activity as these companies are forcibly deleveraged.  Compounding matters is the fact that by 2016-2017 all of the vast majority of CLOs will be outside their reinvestment window, which has been a major drive of the current A&E cycle.  Moreover, many of these CLOs will be approaching their own legal final maturities and therefore will not be able to extend even if they wanted to.  New CLO activity is running at a fraction of its historical highs seen in 2007 at $150bn annually.  For 2012 CLO issuance is expected to be about $12bn.  Not nearly enough to replace the lost supply.

 





Sovereign Debt Effects
Europe appears to have pulled back from the abyss with ECB now embracing the US approach of monetizing the continent’s debt problems.  During the 2001-2007 credit boom European banks were large investors in CLOs and other leveraged US credit products.  Now European banks are investing in sovereign debt which the ECB is accepting as collateral for ECB loans and capturing the spread.  The recap of southern rim EU countries is essentially being financed by the ECB who is providing the banks with cheap loans secured by sovereign debt.  This is why sovereign spreads in Italy and Portugal have been tightening in their latest government bond auctions.  With this money no longer flowing into the US market, and CLO activity no where near its historical levels in the boom years, HY and Leveraged loans will need to find new sources of demand to meet the 2015-2017 maturity wall.  Moreover, given that the US’s large budget deficits are being financed with Treasuries, might produce a “crowding out effect” on the HY market and lead to much wider spreads.

Conclusion
Given the poor underlying economic fundamentals and potential supply demand imbalances at the onset of the 2015-17 maturity wall, there will likely be substantial opportunities in the distressed market.  The effects will be most pronounced in the middle and lower middle markets where distressed hedge funds and distressed PE players will be competing for control of the choicest deals

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Notes from iGlobal's Global Distressed Investing Summit: Part 2

In the second installment of our coverage of the iGlobal Distressed Investing Summit (first installment here: Notes from February 2012 Distressed Debt Conference) we are going to focus on the Leveraged Loan panel.  That will be followed by a comparison to the risk management panel in our next installment. These two panels presented back-to-back and held starkly contrasting view of where the markets are headed. As would be expected the Leveraged Loan panel had a fairly bullish outlook for performance for the asset class as well as the broader market, the risk management panel highlighted some of the serious headwinds that need to be overcome.  Comments for the leveraged loan panel were off the record so no panelists will be given individual attribution.

Leveraged Loans and the Wavering Maturity Wall
The Leveraged Loan panel pointed out that market has made big strides since the 2008-09 trough including a reduction in the maturity wall between 2012-2014 of approximately $587bn.  Moreover, a significant portion of the highly leveraged 2007 LBO cohort has been able to Amend and Extend at attractive rates. On the new issue front leverage for most large cap LBOs has ticked down to more reasonable levels than the 6x+ that were seen in the boom. In particular, on the middle market front leverage is quite modest at 2-3x for senior leverage and 4-4.5x all in.

In the panels opinion, the market has begun to price risk based on individual credit specific basis as opposed to correlating all leveraged credit instruments. Several of the recent larger bankruptcy filings such as Kodak and Hostess are the result of crushing OPEB obligations as opposed to lack of credit or. Moreover, in looking at the universe of stressed and distressed HY/LL one would see that on a dollar basis they are concentrated in few large LBOs such as TXU, CCU, FDC and the publishing space (directories, book stores).  While this is true on a dollar basis, as a proportion of deals outstanding basis there is large number of issuers who cannot refinance. This is more pronounced in the middle and lower middle market, where credit has yet to open up to the same extent as the larger on-the-run market.

An interesting phenomenon currently taking place are European issuers coming to the US markets given the lack of access to capital in their home markets. These are large cap HY/LL issuers who previously did not need to access the US$ HY markets.  Those who are familiar with the European markets, particularly in loans, will appreciate that issuers wanting to raise funds in the US credit markets are doing so on US terms including doing away with terms that discourage trading of the securities such as borrower consent and high minimum assignments. New issues are required to provide deemed consent (allowing assignment to another lender without the borrowers consent) as well as $1mm minimum assignments as opposed to $5-10mm minimums in the European markets.  Additionally, lenders are also demanding European borrowers to comply with US reporting standards such as filing of quarterly financials and providing MD&A.

The CLO market is also showing sings of life with JP Morgan estimating CLO issuance $20bn in 2012. The panelists suspected that would be on the low end as the market has been pricing deals at tight spreads with AAA trances recently pricing at L+150, allowing for significant arbitrage.  Furthermore, CLO equity is generating 30-40% IRRs which should attract more deal flow given that the equity has been more difficult to place since the credit crisis.  Nevertheless, this is a far cry from the days of 2006-07 when CLOs peaked around $150bn of annual issuance.  There is also the issue that a majority of the CLOs are closing in or have reached the end of their reinvestment period. The fact that the CLOs could continue to redeploy capital towards refinancing and amend and extends has been a major factor supporting the credit markets these last two years. As the chart below demonstrates, this is ending as the reinvestment periods are ending just as the maturity wall begins to rise significantly.

Finally with respect to the middle market it was pointed out that while institutional demand for middle market paper remains tepid, the Pro Rata market has been quite active.  Spreads on BB Pro Rata vs TLB tranches are at 219bp, indicating a strong appetite fro banks to hold middle market loans. For those of you unfamiliar with leveraged loan terminology the pro rata tranche, or TLA, is the tranche held by banks and includes a pro rata share of the revolver and the TL. These loans are generally held by traditional banks while the TLB or institutional tranche is held by asset managers and hedge funds.

The wide spread on pari-passu debt indicates a combination of an unwillingness of institutional investors to be exposed to the middle market and banks actively beginning to put money to work again.  For lower middle market borrowers cash flow loans are more difficult, however the ABL market is open for up to 2-3 turns of leverage.

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Notes from iGlobal's Global Distressed Investing Summit: Part 1

This past week, iGlobal hosted its 3rd Global Distressed Investing Summit at the Park Central Hotel in NYC.  The event covered a broad range of topics and opportunities from distressed middle market bank debt, distressed CMBS and Commercial Real Estate, to the return of CLOs and the impending maturity wall. Distressed Debt Investing's contributor Joshua Nahas was in attendance taking notes (and speaking on panels). This article will cover the morning session, while his next article will cover the afternoon  panels. Enjoy!

Distressed Strategies and the State of the Capital Markets
The morning panel started off with a discussion of Distressed Strategies and the State of the Capital markets.  As anyone following the High Yield and Leverage Loan space knows, the market has been experiencing strong performance since December and is up almost 3.5% in the December-February period.  As a result many of the larger on-the-run HY credits have been accessing the capital markets and pricing for all risky assets has improved.

Access to capital is much more credit specific which is creating opportunities for distressed players.  Additionally, the improved overall market has led banks to be more willing to put loans up for sale at distressed prices.  From a distressed PE perspective this has limitations given their focus on a 2x return on capital, not an IRR. In many instances there is not enough of the loan available or the size of the issue itself does not allow for the deployment of sufficient capital to meet the return threshold.

Nevertheless, panelists pointed out the there are always opportunities resulting from poor management to economic dislocation that there is no lack of potential deals.  In 2011 Versa looked at over 640 deals in 2011 and is seeing more opportunities coming in from distressed trading desks. Given the uncertainty over the elections and regulatory environment she predicts less robust M&A activity from strategics and feels that PE firms will have to look to dividend recaps for liquidity.

With respect to distressed real estate, Spencer Garfield of Hudson Realty Capital is seeing strong deal flow, albeit at higher prices than a year ago. Where they were once able to purchase pools of distressed CMBS at 18 cents on the dollar they are now seeing prices in the 30-50 cents range.  Both securitization and conduit lending have returned as many distressed CMBS deals have been cleaned up and recapitalized and can be placed in to securitization vehicles. S&P did throw a monkey wrench into the process when it without warning altered its ratings methodology for CMBS deals, but the market has adjusted.

Another area of the market rich in opportunities is special situation lending.  As pointed out earlier, the markets are open for selective credits, however, most lower middle market and small business have little or no access to bank or capital markets.  Brenden Carroll of Victory Park Capital sees a market with increasing negotiating leverage for lenders. When companies think they can access the capital markets they tend to shop deals for a long time before coming to a specialty lender such as Victory Park. However, he has seen more CEOs increasingly concerned about the operating environment who are willing to accept onerous term sheets on the first go round.  In cases of sponsor owned companies they are more willing to accept higher interest rates in lieu of equity give ups while family owned business will accept dilution in exchange for a lower yield. This is driven by fact mention earlier that sponsors need to affect a 2x return on capital, any dilution significantly impairs returns from that perspective.

Tracing the Liquidity Squeeze
As a result of the liquidity squeeze and 2008 credit contraction we saw many new players entering the distressed space.  Robert Koltai of Hain Capital pointed out that many of these players entered to take advantage of large cases such as Lehman and began trading products such as trade claims. However, outside of the Lehman complex many of these instruments are incredibly illiquid and labor intensive to administrate.  It is not clear whether these players will remain in the market absent significant new large Chapter 11 filings. While this should increase expected returns, it may impact liquidity. Liquidity has become a major factor as dealers begin to implement the Volker rule and allocate less capital to trading and holding inventory. This is likely to exacerbate volatility and have negative unintended consequences.

Another factor that will be impacting liquidity and market opportunity is the shifting of many large PE funds to their harvesting periods. It was pointed out that 6,000 companies were acquired by Financial Sponsors between 2005-2009. Given the average fund has a life of about 10 years, sponsors are going to need to star realizing investments. Moreover, there is still an overhang of $400bn in undeployed capital in the hands of Private Equity. Since they are unlikely to return the cash to investors and forgo fees and carried interest, they will need to begin to put the capital to work before the investment periods of their funds close. While these windows can be extended, it cannot be done indefinitely and it will be interesting to see how the deployment of this capital impacts the market. Assuming 4x leverage the $400bn in equity capital equates to $1.6 trillion in buying power.

Opportunities in Distressed Private Equity 
One of the more interesting panels was the Opportunities in Distressed Private Equity discussion. The participants were heavily middle market focused, and it given how picked over the large cap distressed/HY universe is more and more funds are wading into the middle market. In essence they are willing to exchange liquidity for better returns.

In middle market deals there is far less liquidity and when you enter a distressed one, you have to assume your only exits are a refi (unlikely if its in distress), sale, or restructuring and converting to equity. The returns are more akin to PE than HY/Distressed but you need to have the expertise and appropriate fund structure. Many large distressed funds have rolled out middle market platforms to capitalize on these opportunities. Interestingly, the PE firms that used to have this space to themselves are finding increasing competition from their distressed debt counterparts and are having to become more flexible, including taking non-control stakes, purchasing debt in the secondary market and making DIP loans.

Another phenomenon pointed out by Todd Feinsmith at Pepper Hamilton is that in the wake of GM and Chrysler, courts more comfortable approving accelerated sales. We have seen companies routinely using 363 sales to be out of bankruptcy in 60-90 days. These quick sales used to be frowned upon by the courts and were viewed as disguised or Sub Rosa plans of reorganization. However in the absence of financing or aggressive DIPs that were de facto credit bids, courts have become more accustomed to approving deals that usually leave junior and unsecured creditors out of the money. Most middle market bankruptcies are now filed with a Stalking Horse/Plan sponsor which can have a chilling effect on auctions or producing other viable bidders. Nonetheless, this was not evident in the recent

Hussey Copper auction where you saw companies vying for the stalking horse bidding slot and the asset was finally sold for almost 12x EBITDA.

According to Varun Bedi of Tenex Capital we have entered a Dickensian “tale of two markets” where larger companies with international diversification have access to capital while smaller domestic companies do not. This creates opportunities for funds such as his that have significant operating expertise.

Most middle and lower middle market companies are experiencing gross margin pressure from both rising input and energy costs.  Their lack of international diversification makes it hard for them to generate pricing power and leaves them vulnerable to deflating consumer demand in the US.  At this point these companies have taken out most of the low hanging fruit in their SG&A and now need to restructure their balance sheet and pursue more operationally intensive restructurings.

Another factor impacting these companies is that deferred capex which has moved from 4% of revenue to 2% of revenue over the last couple of years. This leaves little opportunity to drive growth and generate the necessary working capital to fund expansion. Given that we are likely in protracted period of below potential GDP gowth, or worse potential GDP is has moved lower, these businesses will need to restructure and recapitalize.

As mentioned earlier Distressed PE firms are seeing increasing competition from their distressed debt counter parts. David Simon of Littlejohn & Co pointed out the need for increased flexibility and creativity in structuring deals including finding ways to effect control without having 51% of the economic ownership through board control or other provisions.

Moreover, PE firms are becoming more active in the secondary debt markets as way of being in position prior to a trigger event.  In general, he has found that the PE funds and Hedge Funds are a good compliment to one another as most hedge funds do not have the infrastructure or operating principals to manage businesses and are more than willing to let the PE firms handle those aspects.

As far as future opportunities, Littlejohn expects corporate carveouts to be a good source of deal flow as companies have now stabilized from the 08-09 dislocation and are willing to divest lagging businesses. It was also noted that while in distressed for control transactions funding is still available, the diligence process has become much more disciplined and takes far longer.

In concluding the Distressed Private Equity panel, Mr. Simon provided an interesting observation with regards to corporate turn arounds.  It is getting more difficult to attract and retain top talent even in light of significant equity should the turnaround succeed. In most cases these positions are not in the most desirable locations and younger executives are less apt to stay for the duration of a turnaround.

Trends and Opportunities in Distressed Investing 
The morning session concluded with panels covering trends in distressed investing as well as one covering domestic opportunities. One of the trends highlighted was the changing structure of many distressed and PE funds. Many distressed funds were structured to offer quarterly or annual liquidity during the credit bubble because that made it easier to attract fund-of-funds money. However, this had a disastrous effect during the 2008-09 period as many funds were hit with a wave of redemptions when they needed to be deploying capital. In addition, many distressed funds had suffered from style drift and had taken on large amounts of leverage through TRSs in order to flip new issues and juice returns on leveraged loans.

In the aftermath funds are now looking to lock up capital for longer periods and we are seeing longer lock ups as well as PE based structures with investment and harvest periods and 5-10 year locked up money. Better matching of assets (investments) and liabilities (investor capital) is critical for the distressed asset class where a bankruptcy can last several years or an operational turn around can take several year to realize. As was mentioned earlier PE funds are also having to adopt as more  distressed funds move down market and are taking larger, less liquid stakes in private companies.  The morphing of the PE and Hedge Fund structure is likely to continue in the distressed space as PE funds seek the ability to invest in debt instruments and hedge funds look for more stable capital.

Micahel Cerminaro of Sound Harbor Partners pointed out that funds need to have the flexibility to pursue opportunities that maximize risk-adjusted returns across the capital structure. The ability to capitalize on senior secured loans with high teens to low 20s IRRs is essential when there are fewer opportunities to write larger equity checks for control.

Having the right structure including being able to make your pref return (usually around 8%) and still generate a sufficient return is essential. This may include more flexible recycling provisions and the ability to utilize side cars with you LPs when necessary. Duran Curis of Ocean Avenue Partners which invests as both an LP and a co-investor relayed that they want to be active in investing alongside the GPs in order to maximize returns and minimize the drag from fees. Again we are seeing increasingly more creative structures as funds learn from the 2008-09 and adapt accordingly.

In addition to trends in fund structures, Robert Kline of R.W. Kline Companies which specializes in distressed commercial real estate is seeing opportunities in discounted note purchases and restructurings of CMBS tranches. They have been active in recapitalizing and restructuring distressed CMBS pools and are seeing a lot of interest in Real Estate assets, particularly luxury hotels which have attracted sovereign wealth funds attracted to their premium brands.

Another trend in the lower middle market space was highlighted by Raquib Abdullah of BFG Holdings which specializes in distressed lending and private equity for small and middle market businesses. They generally offer debt financing at reasonable rates (12-15%) to privately and family owned businesses in exchange for taking a large share of equity 50-80%. Unlike traditional sponsor owned companies, these businesses are willing to give up large shares of equity in order to keep their businesses afloat.  Mr. Abdullah has seen more of these opportunities being sourced from banks who need to clean up their balance sheets and are looking to move problem loans and avoid liquidations which will yield de minimis  recoveries.

In the next article we will cover some interesting topics including the impending maturity wall, risk management and economic fundamentals for the US and Europe as well as the global macro picture. Stay tuned.

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Bankruptcy Concepts: Rule 2019

It is my pleasure to introduce readers to a net set of contributors to Distressed Debt Investing.  As I've spoken about in past months, I've been trying to add a number of regular guest writers that cover topics ranging from advanced distressed / bankruptcy concepts to European distressed debt situations.  It's my pleasure to introduce three lawyers from the bankruptcy practice at Dewey & LeBoeuf LLP: Martin Bienenstock, Phil Abelson, and Vincent Indelicato.  Dewey has a fantastic practice in the restructuring / bankruptcy space and we are absolutely thrilled to have them as regular contributors.  Enjoy!

Distressed Debt Investors Beware:  Amended Bankruptcy Rule 2019

With the increasing participation of distressed hedge funds in chapter 11 cases through the collective action of ad hoc committees and groups, Federal Rule of Bankruptcy Procedure 2019 (“Bankruptcy Rule 2019”) ignited vigorous debate over the scope of its disclosure requirements in recent years.

The controversy set in motion a titanic collision between bankruptcy judges who wanted to know which litigants held short positions and wanted the debtor’s estate to fail or diminish, and a distressed investing community that has fiercely guarded proprietary trading strategies.

In an ostensible effort to shatter the judicial uncertainty surrounding the application of Bankruptcy Rule 2019 in modern day chapter 11 cases, the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States proposed a series of amendments which the Supreme Court of the United States adopted into law last April, effective December 1, 2011.

Although the drafters of amended Bankruptcy Rule 2019 sought to bring much needed clarification, the new rule did not directly address its target.  The new rule could have required that each group member simply declare whether it owned any economic interests that would increase in value if the debtor’s estate decreased in value.  It does not do that.

Rather, the new rule requires listings of each group member’s economic interests.  In some cases those listings will make clear whether the member benefits from the estate’s diminution (i.e., short sales of debt).  In other cases the court will only be able to scratch its head (i.e., synthetic total return swap).

Among other considerations, distressed debt investors must consult their legal advisors to consider the implications of the following new requirements:

Parties Required to Disclose:  Amended Bankruptcy Rule 2019 requires disclosure by “every group or committee that consists of or represents, and every entity that represents” multiple creditors or shareholders “acting in concert to advance their common interests.”  Fed. R. Bankr. P. 2019(b)(1)(A).

Notably, the new rule defines “represents” as “to take a position before the court or to solicit votes regarding the confirmation of a plan on behalf of another.”  Fed. R. Bankr. P. 2019(a)(2).  A group of creditors or shareholders that retains a law firm to monitor case developments without a court appearance does not fall within Rule 2019 disclosure requirements absent its solicitation of votes or other acts in concert to advance their common interests.

Significantly, amended Bankruptcy Rule 2019 contains numerous ambiguities that present a fertile source for litigation as bankruptcy courts begin to enforce the new rule.  For example, when and if it takes a position in court as a group, Rule 2019 disclosure would be triggered.  Other acts to advance the group members’ common interests are subject to many meanings.  Does it mean discussions with parties in interest by or on behalf of the group?  Negotiations with parties in interest by or on behalf of the group?  Are entities that execute a plan support agreement or secured lenders that submit a joint credit bid “acting in concert” in a manner that compels 2019 disclosure?  Indeed, the answers to these and other questions may ultimately determine the strategies that distressed debt investors pursue at the outset of and throughout a chapter 11 case.

Scope of Disclosure:  Those parties required to make disclosures under the amended rule must file a verified statement that shall include “the pertinent facts and circumstances” surrounding the formation of the group or committee.  See Fed. R. Bankr. P. 2019(c)(1) (as amended).  Specifically, in the case of a committee or group, each member must provide (i) its name and address and (ii) the nature and amount of its “disclosable economic interests” held in relation to the debtor as of the date of the statement on a member-by-member basis, and not in the aggregate.  See Fed. R. Bankr. P. 2019(c)(3) (as amended).  Members of a statutory committee, however, must only provide this information as of the date of committee formation.  See Fed. R. Bankr. P. 2019(c)(2)(B) (as amended).

Although the new rule does not require a group member to disclose (i) the price paid and (ii) the specific acquisition date for each of its disclosable economic interests, a member of a committee or group that claims to represent an entity that is not a committee or group member must disclose the quarter and year in which it acquired each disclosable economic interest, except for those disclosable economic interests acquired more than one year before the petition date.  See Fed. R. Bankr. P. 2019(c)(2)(C) (as amended).  The phrase “claims to represent” may relate to those situations where an ad hoc group purports to speak on behalf of an entire class of creditors or shareholders without any instrument evidencing the express authority to do so.  Most importantly, distressed debt investors must understand that nothing in the new rule eliminates the ability of a judge or party in interest to discover the price paid and the precise date of acquisition for each of an entity’s disclosable economic interests.

Like old Bankruptcy Rule 2019, the new rule does not require disclosure by indenture trustees or agents or class action representatives.  See Fed. R. Bankr. P. 2019(b)(2) (as amended).

Disclosable Economic Interests:  While amended Bankruptcy Rule 2019 does not require a party to disclose the price paid for its holdings, the new rule expands the scope of disclosure to include any “disclosable economic interest.”  The amended rule defines “[d]isclosable economic interest” as “any claim, interest, pledge, lien, option, participation, derivative instrument, or any other right or derivative right granting the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest.”  Fed. R. Bankr. P. 2019(a)(1) (as amended).  Translated, this definition encompasses all long and short positions, including, without limitation, all options, swaps, derivatives and other claims relating to the debtor’s securities and other debts.

Supplemental Statements:  Amended Bankruptcy Rule 2019(d) requires a party to file a supplemental 2019 upon the material change of any fact previously disclosed in a Rule 2019 statement whenever it takes a position before the court or solicits votes on the confirmation of a plan.  See Fed. R. Bankr. P. 2019(d) (as amended).  The conspicuous absence of any definition of “materiality” in amended Bankruptcy Rule 2019(d), however, makes compliance with this section of the new rule very challenging.  Parties required to disclose under amended Bankruptcy Rule 2019(d) may look for guidance to the reporting requirements approved by the United States trustee in a trading order governing their respective case.

For those entities with numerous trading desks, it appears that amended Bankruptcy Rule 2019(d) would only apply to material changes that impact the holdings of the entity that serves as a member of the respective committee or group, and not those resulting from trading activities of non-committee or group personnel on the other side of the trading wall.

Failure to Comply:  Bankruptcy courts do not take the failure to comply with Bankruptcy Rule 2019 lightly.  Specifically, amended Bankruptcy Rule 2019(e) recognizes the authority of the bankruptcy court to impose sanctions for any violation of the new rule.  See Fed. R. Bankr. P. 2019(e) (as amended). Vote designation may conceivably be used by judges as a sanction that would also facilitate confirmation of a plan the group members oppose.  Beware!

Conclusion:  While the contours of amended Bankruptcy Rule 2019 largely remain undefined, one fact appears certain: the debate over the appropriate scope of 2019 disclosure will create much jurisprudence.  Accordingly, distressed debt investors will need to think carefully about the implications of the new rule before they decide to participate in a chapter 11 case as a member of a committee or group.

Martin Bienenstock
Phil Abelson
Vincent Indelicato

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Capital Structure Arbitrage: Part 1

Capital structure arbitrage is a strategy used by many directional, quantitative, and market neutral credit hedge funds.  In essence, it is going long one security in a company's capital structure while at the same time going short another security in that same company's capital structure.  For instance, "long sub bonds, short senior bonds", or "long equity, short CDS", or maybe "long 1st lien bank debt, short 1st lien bonds."  A portfolio manager can express many different view points inside a single company's capital structure that exploits things like variations from mean differences, covenant irregularities, market supply/demand technical, etc.  This is the first part in a number of posts I plan to do on this topic over the next few months (with others focused on secured vs unsecured, covenant differences, basis trading, etc)

The capital structure arbitrage trade is, in theory, less risky than going outright long one security or the next.  With that said, because a number of cap structure arbitrage strategies require leverage (via repo, TRS, etc) to hit firm's target IRRs, a trade going against you can be devastating.

One of the more common capital structure trades seen in the market is long senior paper versus short subordinated paper.  All else being equal, in very bullish times the difference between the spreads of the two bonds will be tighter than in very bearish times.  This is because in bull markets, investors search and reach for yield thereby increasing demand for the more yieldy paper.

One of the most common functions I use in Bloomberg is HS < go >.  This function is dubbed the "Historical Spread Graph/Table"  You can pull in two bonds and look at the difference in spread between the two (these can be any bonds...in fact you can pull in all sorts of statistics, but for this exercise we will focus on a select few).

Below is a chart of the FDC's 9 7/8% of 2015 (Seniors) vs FDC 11.25% of 2016 (sub) over the past year. The top part of the chart lays out the spread to treasury of each of the bonds with the bottom chart showing the difference between the two.

What is not shown are the relative statistics.  Over this period (since 2/8/2011) the mean spread difference between these bonds was ~350 bps.  Today it stands at 268 bps.  The low occurred on 5/10/2011 with a spread differential of 92.  The high occurred at 843 pm 9/29/2011.  Here is another chart of those two dates highlighted:

The above chart is a chart of the VIX over the same time period.  As you can see when markets are bulled up (i.e. VIX is low), the spread differential between the senior and sub bonds are tight.  When markets are bearish (i.e. VIX is high), the spread differential between the senior and sub bonds are wide.

The question then becomes: What is the right spread differential?  Or better, what should be the intrinsic compensation and investor receives for taking on additional leverage and further subordination?  There is a term in credit analysis: Spread per turn of leverage (or in some cases, yield per turn of leverage).  If XYZ issuer has $100M of EBITDA, $200M of Senior Debt and $300M of Sub Debt (so $500M of total debt, with both notes maturing on the same day and trading at par), senior leverage would be 2.0x and sub or total leverage would be 5.0x.  If the Senior Bonds were yielding 6% and the Sub Bonds yielding 10%, you would be receiving 300bps of yield per turn (6%/2.0x) and for the sub bonds you'd be receiving 200bps of yield per turn (10%/5.0x).  All else being equal, the seniors would be a better value.

But let's add a little bit of complexity to the issue.  Let's say the business of XYZ is worth 10x EBITDA.  In that case, in a simple world, the recovery on both bonds would be par+. Then wouldn't the subs be better value?  You are picking 400 bps for the same recovery.  With that said, determining the recovery rate of each security becomes fundamental to determining if yield / spread differentials are appropriate.  The situation dramatically changes when one layer of the capital structure is levered 2-3x and another is levered 8-9x.  More leverage = more swings in recovery.  If one bond is pricing in a recovery rate significantly different than you are calculating, this could create opportunities on either the long or the short side.

And just to add a little more complexity (because this is getting fun): Depending on if the bond is trading above or below par changes the equation as well.   This is more relevant for higher quality issuers, but if you have two pari bonds of the same issuer trading at 120 and 100 respectively, the bond trading at 120 will have a higher spread than the bond trading at par.  Assume this issuer's recovery rate in a restructuring is 30 cents.  If you buy the 120 bonds today, you stand to lose 90 points whereas if you buy the par bond, you stand to lose 70 points.  You thus have $20 extra dollars at risk (Price bond 1-Price bond 2).  If the average spread on the bond is 300 bps, and our recovery rate is 30, the implied default rate = 9%.  9% * those 20 extra points at risk = 180bp of extra compensation needed.  Lets say the 120 bond is trading 250 bps wide of the 100 bond.  Well that would be an interesting opportunity that could be arbitraged by going long the 120 bond, and short the par bond.

As a quick side / corollary point to the above analysis: In his most recent letter, Howard Marks notes that:

"...we don't undertake the tactical actions described above in response to what we or some economists think the future holds, but rather on the basis of what we see going on in the marketplace at the time.  What things do we react to?

The simplest signs surround valuation.  What's the yield spread between high yield bonds and Treasurys?  And between single-B and triple-C?  What are the yields and premiums on convertibles?  Are distressed senior loans trading at 60 cents on the dollar or 90?  ..."


Here is a chart from JP Morgan's Peter Acciavatti depicting the difference in yields between bonds rated B and CCC:

As you can see, in very bearish times (late 2008-mid 2009, as well as 2001-2003), this spread blows out.  In bullish times the spread is smaller.  Currently at 465 bps versus a median of 508 bps, it stands the market is probably slightly overvalued (we have silently moved into the low 4s on my "risk pendulum scale"), which is not to say the market will not continue grinding higher - I just don't think you are getting compensated for taking that risk.  Some strategists are starting to throw in the flag (Goldman Sachs just got marginally constructive on credit).  Full capitulation which equates to bubble territory has not happened yet with still many parties on the sell side calling for a pull back which would have been blasphemy in 1Q 2011.

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