The Art of the Bankruptcy Stub: Adelphia Recovery Trust

Oftentimes, after a bankruptcy plan is confirmed and becomes effective, distressed debt investors' interest wanes and less eyeballs are focused on the case. Even after the bankruptcy changes from 2005, bankruptcies take a LONG time to be 100% completed. This is because, in most cases, claims have to be sorted and sifted through, checked-out and vetted, to see what the actual payout to various stake-holders will eventually be. I have, in the past, gotten checks for bankruptcies that occurred ten years ago.

In distressed parlance, a stub generally means a piece of an escrow or hold back that will receive a distribution depending on certain outcomes in case. Simply put: Either there are more assets to be distributed (due to litigation proceeds, insurance, refunds, default interest, etc) or less claims (due to some claimants doubling up, fraudulent claims, excessive claims, etc). There are many many cases like this - some that frankly I haven't even heard of. To those on the buy side, I have found Gleacher and Imperial to have the best listing of stubs (and if you know of anyone else that does a good job, please end me an email). A lot of these are amazing illiquid and probably have not traded in years. But they are out there ready to be studied and analyzed with potential for profit (Author Note: If you transact in these securities, make sure you have good counsel reviewing the docs & possibly purchase agreement, less you get left holding a worthless piece of paper not entitled to distributions).

To be frank, stub analysis is difficult. And it is oftentimes tedious and requires some guess-work as it relates to litigation recoveries and the amount of claims that will eventually be allowed. But that creates massive profit opportunities as these securities trades for, in many cases 0.5-2 bond points.

Some of the more liquid stubs traded institutionally include GGP, SSCC, Charter, Capmark, Chrysler CarCo, and GM (MTLQU - which someone just wrote up on the DDIC) just to name a few. One of the most well known stubs to distressed debt investors are the Adelphia stubs. You'll remember Adelphia filed for bankruptcy 10 years ago this past Monday (10 years goes by way to fast...June 25, 2002).

Distressed investors know the tickers and names of the claims pools all too well: ACC, ARAHOVA CVV, OLYMPUS, Holdco CVV, etc.  This week, one June 27th, the Adelphia Recovery Trust announced a settlement with Buchanan Ingersoll & Rooney PC which was a primary outside counsel for Adelphia. The Adelphia Trust even files 10Qs and financial statements and updates which can be found here: Adelphia Recovery Trust. I will note that this is probably one of the more transparent stubs out there - I'd venture to guess very few come close to this sort of disclosure. From its financial filings:

The Adelphia Recovery Trust (the “ART”) was formed as a Delaware statutory trust pursuant to that certain First Modified Fifth Amended Joint Chapter 11 Plan of Reorganization (the “Plan”) of Adelphia Communications Corporation (“Adelphia” or “ACC”) and certain of its subsidiaries (collectively the “Debtor”). The purpose of the ART is to prosecute the various causes of action transferred to the ART pursuant to the Plan (the “Causes of Action”) and distribute to the owners (the “Holders”) of the interests in the ART (“Interests”) the net proceeds of such Causes of Action (“Distributions”), according to the relative priorities established pursuant to the Plan, subject to the retention of various amounts to fund the prosecution of those Causes of Action and operations of the ART. Pursuant to the Plan, in addition to the Causes of Action, Adelphia transferred $25 million in cash to the ART, in connection with its formation, in order to fund the initial expenses of operation.

Basically the goal of the trust is to sue third parties for damages as it holds litigation claims against these parties. In this case, these parties include FPL, Prestige, and Goldman Sachs (and others which can be found in the 10-K: Adelphia Trust 10K). You can see the actual settlement press release here: Adelphia Settlement with Buchanan Ingersoll & Rooney. The trust is set to unwind on December 31st, 2014 unless its extended by the bankruptcy court. While you may think its a positive to just have this thing run forever, there are operating expense here: $3M in 2011 for G&A expenses. It's a balance between extend and probability of winning versus the cost of maintaining the trust.

The value of each security in Adelphia is set by a formula which can be found on Page 21 of the 10K (this changes based on who has been paid out).  Take ACC-1 for instance which trades in the market as ADPAS (ACC-1 claims pool).  These were Senior Notes issued out of ACC back in the day.  There are $4,839,988,165M of interest.  Let's say, after all is aid and done, the trust ends with $100M and the formula is the same (right now they have $47M on the balance sheet + $20M coming in from Buchanan).  At that level, according to page 21, ACC-1 receives 42.73% of proceeds which equates to a price of 0.0088 cents. Right now the market is .005-.01 so fairly close to market expectations.

If you were VERY bullish on more litigation recoveries coming in faster AND less money going out the door for some nuances in this case you'd be buyers of this security. How would you get there? You'd make a lot of calls and do a lot of legal leg work reading briefs, working with outside counsel probably, etc. Not much valuation work here: It's really dialing for information and pounding the phone to get insight on the probabilities of damage awards and Adelphia Trust winning. Aggregating that is tough but you can get an edge there. And these stubs (again generally) have little to no correlation with the market which makes them enticing to the distressed debt community.

I plan on doing a lot more stub posts in the future. And my offer still stands: Stub ideas for the application for the Distressed Debt Investors Club are looked up very favorably - they require a lot of work and synthesis and knowledge of docs - the perfect candidate to add value to our community.

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Distressed Debt Investing: Join the LinkedIn Group

Over the last few months I have started to make and effort to meet some members of the distressed debt community that I have not yet cross paths. I have met some amazing, incredibly smart people.

For those that do not know, a few years ago I started a Distressed Debt Investing group on Linked In. It is great to see how fast the group has grown. Unlike other distressed groups on LinkedIn, this one is solely focused on corporate securities (trade claims ok), and I do my best to keep typical CRE / Real Estate spam out of the discussions. I know quite a few people who have used the resource to find jobs, team up to form committees, and generate great ideas for a fairly treacherous marketplace.

If you'd like to join our ranks of 4500+, please visit the group here: Distressed Debt Investing Linked In Group.

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Howard Marks on Distressed Debt

Oaktree Capital's Howard Marks has been featured many times on the blog, especially in regards to his thoughts and takes on distressed debt. In his most recent memo (all of them can be found here: Howard Marks' memos), Marks expands on why distressed debt is such an "alpha" generating asset class as well as a few other salient points. In my estimation, it is one of the best memos in recent years. I have embedded it for you below. Here are some of my takeaways.

• Howard Marks starts out by discussing the concept of zero sum in investing. I.E. your gain is another person's loss. And that 'transaction' has to occur because one party has made a mistake in their analysis or they simply don't know what they are doing. If I had to go head to head with an investor in weather derivatives that specialize in weather risk management, I'd get my head blown off.
• "...in every investment transaction you're part of, it's likely that someone's making a mistake. The key to success is not have it be you." A concept I introduced early in the blog was that of the information disadvantage a new buyer has of an asset versus a long term holder (and now seller). You have to ask yourself WHY this person is selling. If its for uneconomic reasons (margin calls, downgrade, have to sell bankrupt assets), it could be a compelling buy. 
• Howard Marks notes he focuses on mistakes for three reasons: 1) mistakes are ever-present in the investment process 2) understanding why you are not the party making the mistake and 3) reducing the probability that you are the one making the mistake (better investment process?)
• Fantastic commentary on why the market efficiency hypothesis is wrong: "...while all investors are motivated to make money (otherwise, they wouldn't be investing), (a) far from all of them are intelligent and (b) it seems almost none are consistently objective and rational"
• Marks goes on to talk about the pendulum of optimism/pessimism that investors deal with on a daily basis. This creates a massive disconnect between asset's prices in the marketplace and their intrinsic value.
• Here are Mark's two rules for whether you should engage in active investing 1) pricing mistakes occur in the market they're considering and 2) they are capable of identifying those mistakes and taking advantage of them. 
• And a choice quote: "Active management has to be seen as the search for mistakes." You have to ask yourself: where is the consensus wrong? what is the market assuming that is blatantly wrong? An example I often point to in distressed is the valuation of Nortel's patents. The sell side, which I generally use as a proxy for market consensus because of buy side anchoring and frankly laziness, was well below the eventual sale price. And if you saw this mistake, you could have profitted handsomely
• Marks goes on to point out what would make a perfectly efficient market including market prices set by a thoroughly rational and unemotional being. As humans we are infallible to mental shortcuts and processes that we needed when we had to battle sabretooth tigers for our food. This is behavioral finance at its best. And what Marks points out that is most relevant: When investors fail at being rationale and unemotional, they all err in the same direction at the same time. Sounds like bubbles and crashes - some of the most profitable investment environments for contrarian.
• Why do people fail at investing, i.e. failure to buy cheap assets and sell expensive assets? 1) Biases (can't buy value stocks in the 1999 because everyone was buying tech), 2) Capital Rigidity 3) Psychological excesses (greed, envy, hubris) and 4) Herd behavior
• Another great quote: "In practice, there are numerous reasons why one asset can be priced wrong - in the absolute or relative to others - and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently."  What I think people will miss here is 'consistently'. As I've noted in the past investing is like a NASCAR race; you can only win if you make it to the finish line.
• The letter now turns to distressed debt as an example of an inefficient market. Oaktree's distressed team, led by Bruce Karsh, has returned 18% net for more than 23 years without the use of leverage. Amazing!
• This is probably the most interesting part of the letter: He notes that distressed debt isn't inefficient because people don't understand or play distressed, as there are MANY distressed debt funds. Instead it is because the usual mistakes an investor makes in investing are harder to make when investing in distressed.
• Bob O'Leary, a PM in Oaktree's distressed business says, distressed is "an examination of flawed underwriting assumptions." I.E. profiting from mistakes of par buyers and providers of capital that do not get it right when extending capital to leveraged borrowers. And when they do not get it right, these debt holders get too pessimistic in bad times = the most compelling risk/return environment for an enterprising investor. 
• What do we, as distressed debt investors do, that gives us an advantage over most? 1) We never invest in companies where things are going well and investors are enthralled = we buy at lower prices 2) We invest after problems have already emerged = less chance of getting sideswiped by a business failure, earnings miss, etc 3) We buy from motivated or forced sellers = we have an advantage over the seller in the "zero sum" analogy
• "It's not that distressed debt investors can't make mistakes; just that their likelihood of doing so is reduced by the very nature of their investment activity. Anything that decreases an investor's chance of erring - even an involuntary safety mechanism - works to his advantage" - great quote

And the final quote I think we should all remember: "Nothing is more likely to make as asset too cheap than excessively negative psychology." 

Fantastic read! Enjoy the entire document below.

It's All a Big Mistake_06_20_12

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Distressed Debt: CMEDY and Cayman Insolvency

I am short CMEDY stock.

I will be honest: This is one of the weirdest situations I have ever been involved in. But instead of offering opinions or commentary on my thinking behind my position, I want to lay out facts related to the case and hopefully bring a little clarity to the situation.

Fact #1
CMEDY has two convertible notes outstanding: 6.25% of 2016 and 4% of 2013.  CUSIPs are 169483AE4 and 169483AC8 respectively. They are in default due to missed coupons.


Here are two dealer runs from the last few days, the first from Barclays and the second from DB (I've removed my sales coverage information):

As you can see, both converts are trading at distressed levels.


Fact #2
On June 15th, a wind-up petition against China Medical Technologies was filed in the Cayman Islands. I have uploaded the relevant documents. In one of the filings, this is written:

"The Company has failed and refused to communicate with the Petitioner with respect to the events of default or the amounts now due and owing under the Notes. As noted above, the Company failed to respond to the Petitioner’s notices of defaults and of acceleration. The Petitioner sent a copy of the 2 March Notice to the Company's counsel as identified in the 6.25% lndenture, in response to which the Petitioner received a letter advising that such counsel no longer represented the Company in any matters. Additionally, the Company and its counsel did not respond to email communications from counsel to the Petitioner. 

Petitioner is advised that counsel to the 6.25% Notehoìders and the 4% Noteholders (together, the ”Noteholders”) has been unsuccessful in its efforts to engage with the Company regarding the events of default.

Relevant Documents:


Winding-Up Petition - Sealed


and

First Affidavit of Steve Cimalore - Sealed

Fact #3
CMEDY stock has been on a tear in the last week. Here is the YTD chart.

The movement has been driven from from a 13D filed by AER Advisors, Inc ("AER"). which listed that along Peter Deutsch and William Deutsch, wine magnates, they owned 36.95% of the company. That filing was amended today to note that the group now owns 42.01% of the company. I will note that in neither filings was a detailed transaction history listed.

On May 7th, 2012, AER Advisors filed a 13G/A, that did not include the Deutsch's, but did list that they owned 6,833,873 shares. The 13D filed last week (June 12th) noted AER owned 11,923,452 shares.

From May 7th to June 11th (the time in which AER could have acquired shares in the open market between the respective filings), here is the volume trading history of CMEDY:

The total shares traded in this time is 5,767,094. The change in AER/Deutsch ownership is 5,089,579. If there were no insider transactions (i.e. AER/Deutsch buying directly from management), they would have represented 88.2% of the volume of the stock in this period.

Fact #4

AER Advisors, Inc SEC FORM ADV can be found here: AER Advisors, Inc Form ADV. Their adviser brochure can be found here: AER Advisors Brochure. 

On Schedule A of their ADV, a Thomas Joseph Steffanci is listed as a 5%-10% owner of AER (Director/Shareholder) class. His biography can be found here: Thomas Steffanci biography and his LinkedIn page here: Thomas Steffanci LinkedIn

When I do a search on Bloomberg for Tom Steffanci here is what comes up:

Tom Steffanci is also the name of the President of W.J. Deutsch & Sons, Ltd, owned by William and Peter Deutsch, who, if you remember, was party to the AER 13D filed above. 

They are obviously different people. From some sleuthing, I believe they are father and son.

Now, I do not know if this actually means anything. I just wanted to point it out to people that may not have caught it.

Fact #5

CMEDY is party to an class action complain, stemming from claims of fraudulent disclosures. You can find the docket here for those that have Pacer. 

https://ecf.nysd.uscourts.gov/cgi-bin/DktRpt.pl?838114947902028-L_452_0-1

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Value Investing: Hidden Stock Price = Deliberate Practice

A little over a year ago, Geoff Gannon wrote a post where he gave readers the salient financial information of company, but didn't give the ticker/name of the company. He then had readers guess the stock price. It was an amazing little experiment derived from a quote of Warren Buffett where WEB goes on to say he likes to guess the stock price before looking at the actual price when he analyzes investments.

As always, WEB was well ahead of his time. Much work and study from behavioral finance/economics, like that of Daniel Kahneman, had discusses the effects anchoring has on each of us. If we see a stock price before valuing the company, we will unconsciously fix our valuation near the actual price.

Ever since Geoff's original post I have been fascinated by the experiment. I even went as far as making an Excel program that would randomly generate ticker from the Russell 3000, display the financial information with ticker and price hidden. I could then go about valuing the company and check my work to see how I was doing. Here are three takeaways from probably doing this a couple thousand times in the past year:

1. There are many companies out there that I did not know existed. While very few were "cheap" per se, it felt like a healthy change from names you hear about every day on the press or in the value investing community
2. I have improved my valuation skills
3. I can feel the bias in stocks that are easily dismissed. For instance, the for profit education sector screens amazing well (i.e. I guess the stock price substantially higher than the actual trading level). This is similar to some of the stocks spit out by Joel Greenblatt's Magic Formula.

I equate the exercise to deliberate practice, a concept that is somewhat difficult to point to a true exercise for investing.

Here is an example:

(You will note I have added a number of line items from Geoff's original exercise)

I have not looked at the ticker or stock price. The first few things I would notice:

• Sales and earnings are growing very quickly
• Dividends have come down
• Lots of free cash flow. Scalable business with essentially flat capex in the last few years along with growth
• Industry: Hard to tell. Not a utility or a REIT. Definitely asset light, working capital heavy (people)

I am going to guess a pretty high multiple here. 25x FCF maybe which equates to a sales multiple of around 3x and a stock price ~$48. (In my spreadsheet I have a place where I can pound numbers in to get the various sales, cash flow, book, and earnings multiples):

The actual price: $57.61. Ticker: SYNT. Another company I've never heard of before: From their website "Syntel is a leading global provider of integrated information technology and Knowledge Process Outsourcing (KPO) solutions spanning the entire lifecycle of business and information systems and processes. The Company leverages dedicated Centers of Excellence, a flexible Global Delivery Model, and a strong track record of building collaborative client partnerships to create sustainable business advantage for Global 2000 organizations." 

I do not think I have ever paid, or will ever pay 25x FCF for a company but I know lots of people that do. So SYNT might not be one for me to allocate capital to. 

With that I am going to throw three examples up. And I'll make it interesting: The reader that is closest (on average) to the various stock prices (as of close today), I'll invite out for drinks as well as the next Distressed Debt Investors Club Meet Up. Email me your guesses by the end of the month (and, to keep it less mundane, your favorite non investing book)

Stock #1

Stock #2

Stock #3

Good luck! If you think you need more information, drop it in the comments and I'll respond accordingly.

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Some Lessons from 1Q 2012 Hedge Fund Letters

Distressed Debt Investing is back from vacation.

Over the past few weeks, I have received a number of hedge fund letters from managers large and small. Like I have done in past posts, I think drawing out some of the most salient or interesting takeaways is good exercise for the enterprising investor (while not discussing specific fund performance). Unfortunately, I cannot send a lot of these out as they are water-marked in some capacity. If you have any other letters that I may have missed, please send them my way to hunter [at] distressed-debt-investing [dot] com.

First off is Avenue Capital's letter to investors in their Avenue Investments, L.P. fund (this is the distressed fund that investment in the Milacron and MagnaChip bankruptcies in the past). After discussing some of their successes and thoughts on the quarter, specifically with Avenue taking some of their bets off the table, Avenue goes on to discuss their hedging strategy:

"We added to the Fund’s single-name short positions in the quarter as we continued to recognize certain negative secular trends and company-specific challenges. This reflects our cautionary stance regarding the approach 20% of the Fund on an exposure basis, versus less than 5% just a year ago. This growth is reflected in both the increased size of these positions, as well as more than doubling the number of singlename shorts in the portfolio...

...In summary, we are encouraged both by the current portfolio and our pipeline of opportunities. As of December 31, 2011, there were over 100 companies with approximately $400 billion debt outstanding with average gross leverage of greater than 9.0x in our pipeline.  Approximately 80% of these companies are in the middle market space. While we see opportunities across many sectors, the largest focus is within power and energy, retail and consumer products, and media-related companies."

Given the timing of the letter, the hedging strategy looks amazing prescient.  Personally, I allocated very little to the high yield / leveraged loan space from March - May as investors were "yield crazy" and deals that were marginal at best were coming to market from marginal dealers. This dynamic has changed significantly in just a few weeks with a number of high yield deals being pulled and terms being tightened up and IRRs improved fairly dramatically in the sell off of high yield. The last paragraph of Avenue's, which discusses, the up coming distressed opportunity set is mighty exciting.

Seth Klarman's Baupost Group's letter is, as usual, fascinating. In the letter, Klarman discusses the reach for yield across asset classes, spurred by governments across the globe pushing interest rates to zero. He then writes:

"The fact that this strong rally has been spurred by government policy--low interest rates forcing investors into risky instruments in search of yield--makes it riskier still. Government interventions in markets can be ephemeral, subject to the vicissitudes of politics, and at the mercy of market action that can force the government’s hand. The government is winking to investors that the coast is clear, that speculation should commence and will be rewarded. That is the kind of message that only a short-term trader can love. In a sense, investors are once again treating all news as good. Signs of strength are greeted with exuberant rallies. Signs of weakness are met with a few days of decline, followed by yet another rally as investors anticipate further government intervention.

We will not be tempted into making investments based on such absurdly short-term thinking, which sadly still dominate wall Street."

I have written in the past to friends and colleagues that an ECB Bond, QE 4, 5, 6, or an aggressive China FE isn't a viable investment strategy. While I may give up short term performance in a government fueled rally, the longer the can is kicked down the road (i.e. the more risks investors are taking), the more pain will be felt on the other side.

Larry Robbins' Glenview Capital's 1Q letter to investor is as usual full of goodies. It goes on to talk about the long hospital thesis Larry Robbins presented at the most recent Ira Sohn. Before that though, Robbins discusses the current "macro vs micro" argument quite prevalent in any discussion you have a with another buy-side analyst these days.

"While the market often debates about the two ends of the barbell – will Europe recover or implode – we think that a sound portfolio strategy needs to also take into account the option that economies in countries with bloated sovereign balance sheets and imbalanced income statements may limp along, wounded, for an extended period of time. As such, we are seeking strong alpha opportunities by owning companies which are high in quality, low in valuation, and supported by both intermediate term liquidity and strong free cash flow, while maintaining market hedges in those companies and equities that are less well positioned along each attribute."

Love it. I think if I was focused on running an equity book, the combination of a Tiger like approach of getting long the best companies in an industry that sport reasonable valuations and short the weakest, fundamentally broken companies, with an overlay of tail-risk portfolio hedges makes a lot of sense in this environment.

Greenlight Capital's 1Q letter made the rounds in the past week or so. David Einhorn uses the letter to discuss a number of their portfolio positions and as well as a review of some of their more macro-centric trades.  In addition, if you have not seen it, Einhorn spoke at the Grant Conference earlier in the year. His comments can be read here: Davin Einhorn comments at Grant's 2012. From the letter, my favorite take-away was his comments on Japan / Japanese Yen:

"The Japanese Yen finally showed some weakness, falling more than 7% during the quarter to Y82.79 per dollar. Several times during the past couple of years, we've though the Yen was on the verge of weakening, only to be proven wrong. While the long-term fundamentals of Japan's economy has not improved, the Yen has nonetheless continued to strengthen, to the point where many Japanese corporations can no long compete effectively. Last year, Panasonic, Sharp, NEC and Mazda all lost money. Industrial Japan is hurting and the country is no longer running a trade surplus. Politicians have taken note and are calling for a lower Yen and an end to deflation. The Bank of Japan (BOJ) has largely dragged its feet, but not it might have to capitulate. The mood at the BOJ is changing and, more importantly, so is the makeup of its Board. Within the next year, five of the nine governors, including the Chairman and both Deputy Chairmen, will be replaced. Two of those seats are currently vacant, and the Japanese legislature has already rejected one candidate because he was deemed unlikely to push for aggressive action to weaken the Yen. The Partnership remains positioned to benefit from a weakening Yen."

In previous reports it been suggested that, similar to Kyle Bass, Greenlight is expecting much higher interest rates in Japan along with being short the Yen. The thesis is well developed and the new make-up of the BOJ board could be the catalyst that moves the trade. I have heard everything from 10x10 swaps, swaptions, and long calls on interest rates as ways to express the trade, but I am sure there are more technical ways to maximize leverage while keeping carry costs low.

Third Point's 1Q letter has been out for some time. It is, as usual, a fantastic read.  The discussion on tail risk was the most enlightening to me, especially the idea of betting long term Aussie rates would fall in a China slow down.

"First, since 2009, we have maintained a basket of "tail" trades, usually amounting to about 50-100 basis points of protection. We try to cushion the portfolio against various tail event risks including a war in the Middle East, EU sovereign defaults, contagion from Eastern Europe peripheral countries' stress, Japanese fiscal weakness, the sustainability of China's pace of growth, pressure on the Fed's control over rates and its balance sheet, and a global growth slowdown. We structure these trades in a variety of warys including via commodities, currencies, rates, swaps, puts and calls. This "tail risk" portfolio has remained fairly steady in overall size since its inception, and we expect it to remain roughly in this range indefinitely. The key is that these positions should provide some insurance when and if we most need it, with limited costs in the (hoped for) event that the worst never materializes."

Just fantastic stuff. The examples he goes on to list are brilliant (again the Aussie rates falling if China slows down) and a clear example of second derivative thinking.  I.E. a less developed would be just to short China, but that is expensive with non optimal upside / downside characteristics. A friend commented to me that Dan Loeb could be the best manager out there these days given the breadth his bringing to the portfolio including mortgage related activities, distressed, event driven, macro-hedging, etc.

Finally, Bill Ackman's Pershing Square's 1Q letter was released this week.  I am currently reading The Alpha Masters (I'll be doing a thorough review soon). Coincidentally I finished the Ackman chapter on the subway today. Simply amazing - especially the part about contacting Seth Klarman when he was at HBS back in the day. So far I'd highly recommend the book.

Ackman leads off the letter with his discussion of time arbitrage, an issue we've covered on the blog in the past.

"In our investment approach, we wait for the opportunity to purchase a great business at a highly discounted valuation, when investors overreact to negative macro or company-specific events. This is the time arbitrage part of the strategy. Our time frame for value realization is long term so we don’t typically react to short-term factors that have little impact on long-term, intrinsic values. While the opportunity to take advantage of time arbitrage is a competitive advantage for Pershing Square, it is a limited one because there are other investors who share our longer-term horizon.

Our greatest competitive advantage is the ability to buy a stake in a company with the ability to intervene in the decision making, strategy, management, or structure of the business. We are one of the few investors in the world who can implement this approach at large corporations, which gives us an enormous long-term competitive advantage."

Ackman goes on to discuss some of the big changes going on at both CP and JCP (I am long various parts of each's capital structure), as well as a few others.  He does tease us with this:

"We have begun to build a large stake in a business that meets our high standards for business quality at a low valuation. We have also added an equity short position to the portfolio. We look forward to sharing our thinking about each of these investments when appropriate."

While its hard to get a sense of what name he is shorting, I was thinking of candidates for the long investment.  The name I keep coming back to is Walgreen's (WAG) which I am very very long and continue to get longer. The handling of the ESRX issue has been horrendous, they own a solid real estate portfolio (Ackman has gravitated to these), the stock has gone no where in 10 years, and their board owns basically no shares. At $26B of market cap, it might be too big though.  Other names that pop up in my head are Safeway (serial under-performer, real estate ownership, lots of cash flow), Avon Products, and Sysco.

We will have to wait to see. If you have thoughts, I'd love to hear them.

Given the market volatility in the past 6 weeks, it seems that the defensive positioning of some of the funds mentioned above will pay off. As usual, with a little blood in the water, it's getting more and more fun out there.

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Berkshire Hathaway Requests Examiner in the Rescap Case

Berkshire Hathaway has filed a request for an examiner in the Rescap bankruptcy. From the Rescap docket:

"Berkshire, which has for several years held in excess of 50% of ResCap’s outstanding unsecured bonds and in excess of 40% of ResCap’s junior secured bonds, has a significant stake in the outcome of these cases. As one of ResCap’s largest non-insider unsecured creditors, Berkshire agrees with the Official Committee of Unsecured Creditors (“UCC”) that an investigation is necessary into the Debtors’ prepetition transactions with Ally and its affiliates, and the settlements underlying the reorganization plan that the Debtors now seek to confirm on a highly abbreviated schedule."

Following this item (embedded below), Ted Weschler, one of the investment manager's Warren Buffett tapped to run Berkshire investment portfolio declared in a declaration of support (Docket #209), reiterates the point above and notes that "With the exception of less than approximately one percent of the face amount of Berkshire's holdings of junior secured bonds, Berkshire purchased its holdings of the unsecured and junior secured ResCap bonds more than two years ago."

Ted Weschler has tremendous experience in bankruptcy as the former chairman of the Equity Committee in W.R. Grace. It is good to see him getting involved in distressed debt again.

As I talked about in my first post and analysis of Rescap, there were a litany of transactions between Ally and Rescap in the years prior to Rescap's recent Chapter 11 filing. From the Berkshire motion:

"Here, the Debtors’ first-day pleadings and public securities filings reveal dozens of transactions with Ally and its affiliates involving billions of dollars of asset transfers and intercompany financing—transactions whose net effect was to transfer a substantial share of ResCap’s operating assets to its parent. The Debtors now seek to release Ally from any claims arising from these transactions, even while they admit that the Debtors possess valid claims against Ally, including for fraudulent transfer, equitable subordination, and alter ego. An examiner should determine whether this proposed release is fair to the Debtors and all their stakeholders."

The Berkshire motion stands in contrast with the Unsecured Creditor's Committee (UCC) of Rescap that has filed a Rule 2004 motion, or a motion for discovery. Examiners and discovery are different animals.  For instance, and again from the Berkshire motion: "this Court can empower the examiner to access the Debtors’ communications with their counsel and other advisors. An examiner therefore can review critical documents and other information that are not available to the UCC."

This is a great read. Enjoy!

Berkshire Hathaway Motion for Examiner in Rescap

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Hot Topics in Distressed: Coal Names

On May 22nd, Patriot Coal (PCX) announced that it had engaged The Blackstone Group "to achieve an optimal financing package." Here is the chart of the opco Senior Notes:

I have covered Patriot Coal, in one form or another, since their spin-off from Peabody in 2007. My more mean spirited friends and colleagues like to remind me how I got long the stock in late 2008 in the mid-teens only to see it fall to a price ~$3.  I held on, added to the position, and eventually sold out in early 2010 (luckily). Since then, I have not established a position across the capital structure.

When Patriot Coal first announced a new bank deal to refinance their convertible notes due 2013, I began to look under the hood at the situation given the attractive terms that the new deal was being marketed. I had a few inbound suggestions that the best play here was to short the converts on the deal falling apart. The trade made a lot of sense: very little downside of 1-1.5 points, with big upside if the deal did indeed fall apart. Unfortunately I was a tad late to the game and there was no borrow.

And then the deal fell apart and the converts proceeded to drop 40+ points, now trading in the low 60s from a price of 98/99.

Coal has a rich history in distressed "war stories." Many people point to the success Wilbur Ross had building ICO which was eventually sold to Arch Coal at the absolute top of the met coal market since the crisis. And now analysts are sharpening their pencils again with sentiment caused by the PCX news sending ripples throughout the prices of capital structures across the space, with specific names such as James River and Xinergy, as well as the majors (moreso in the equities).

Patriot Coal's near term situation is difficult to handicap. They have an impending maturity a year away of hold-co, non guaranteed debt. They have a few options:

1. File
2. Exchange / Refinance converts for more senior opco debt
3. Exchange converts for equity 
4. Extend converts for like converts of a longer maturity
5. Sell assets and refinance converts

...or some sort of the combination of the above 5.

It is my contention that sometime in the next few years Patriot Coal has to file for bankruptcy to deal with the massive post-retirement health benefits they carry on their balance sheet which will be a significant drain on cash flow for the foreseeable future: $1.386B of accrued postretirement benefit costs as of the most recent 10Q with approximately 80-100M of cash payments each year. Further, as of the most recent 10K, a 50 bps drop in the discount rate for postretirement health benefits is a $92M swing. The 10K discount rate of 5.1% which will most surely go lower and push the legacy liability higher.

The problem of course for the converts: The legacy liabilities are at the guarantor subsidiaries and the converts are issued at the holding company with no opco guarantees. A good assumption in a Chapter 11 filing is that there will be a large rejection claim for the post retirement health benefits which will, at a high level of confidence, donut the converts.

In the interim then, Patriot can push off the filing (kick can down the road?) with some sort of exchange / refinancing. With the TOUSA decision so recent in everyone's mind, would bank lenders or other new providers of credit (second lien) chance the risk of lending to a potentially insolvent company and be at the bottom of the heap in a few years. Therefore I think option 2 is a possibility but there are technical hurdles to get there - I also have to think that the consortium invoked the MAC given the news that one of PCX's largest met customers is facing a default.

There is no doubt that PCX's asset value comes from their met assets. Some of their mines are better than others in terms of coal quality (vol). A lot of their met assets are leased reserves which hampers value realization potential. They could sell one or more mines, use the cash on the balance sheet (over $100M at holdco), and possibly issue equity to refinance the converts.

Options 3 and 4 seem the most plausible, technically feasible options outside of bankruptcy. In a conversion to equity, the convertible note holders would end up owning the lion share of the equity. I would also lop in a possible case, where Peabody, and possibly selling Australian thermal assets to a China, injects equity into Patriot, gets some ownership (non consolidated stake) and removes the risk of damages of the $150M in black lung damages disclosed in BTU's 10K (if PCX doesn't pay them) and any other damages that may flow to BTU in a PCX bankruptcy.  

Here are my expected values and recovery values on the converts:

• Near Term Bankruptcy: 35%: 0
• Exchange / Refinance into Second Lien Debt: 15%: 90 - assume if they refinance = par, if convert they trade to 80, splitting difference
• Debt for Equity Exchange: 15%: 75 - probably the hardest to figure out...i.e. what kind of market cap does this thing have, what's dilution of current equity, etc.
• Conversion into New Holdo, higher coupon, but longer maturity Convert:: 25%: 75
• Sell Assets, Refinance Converts: 10%: 100

for an expected value of right around 53 versus a market price in the low 60s. I think the largest delta between my valuation and the markets is I am more pessimistic on a refinancing into a senior / opco security based on fraudulent transfer issues. I am not a buyer of bonds at these levels though realize they could be par when I wake up tomorrow. The risk of permanent capital loss is just too high.

From a management incentives perspective, new CEO, Irl Engelhardt, veteran in the coal industry (CEO of Peabody from 1990-2005), now owns ~650k shares after being granted 200k in his new CEO appointment.  At a price of $2/share, that is $1.3M of economic interest.  While not small, that is nearly 50% less than he made at Peabody in his last year. A filing here would enable him to delever the company, deal with legacy liabilities, and give him a healthy portion of the equity. Not filing in a non-dilutive exchange would not be terrible as he could extend the runway, clip a very health salary, and give himself "non-diluted" option value.

Senior note holders do not want a filing and at the same time do not want  to be primed. To them the best option is either a debt for equity swap (or a BTU injection) or a like for like swap. In a bankruptcy the senior note holders would be pari with rejected legacy claims and even at a healthy multiple would be still recovering far far less than par.

Converts want to be paid off, or exchanged into a better security.

The banks do not want to fund the new facility they signed on for but also want to protect themselves from damages claims brought against them by PCX.

Equity holders are praying for an non dilutive exchange.

The unions want to not want to see a filing (reword wages - though uphill battle b/c of coal union protection).

And we haven't even talked about CAPP coal which is facing increasing costs, declining volumes on excess supply, and environmental regulation that is going to make it very hard to operate. With PCX's coal being high in sulfur content it makes the situation all the worse. A filing at PCX would allow them to lower costs to at least be competitive in a very tough market.

If you made me put on a trade here it would be long the senior notes hedged with long puts though this trade would be difficult to put on given the liquidity of the puts. In a refinancing, even one that primes, the bonds should trade up to cover loss on puts. If they file down the line, at a purchase price of 50, after a few years of coupon, your effective cost drops by 1/3 and you're puts will probably expire in the money. If they file tomorrow, the wildcard becomes the unsecured legacy claims, bonds would trade down, but you'd make it up in the puts. In a debt for equity exchange, bonds go higher, puts go higher, you win across the board. 

Coal is a space we will be covering extensively as the situation plays out not just at Patriot, but across the industry. In the last few days, I've received many inbound emails on the situation. The above are summary thoughts - if you want to discuss more, email me at hunter [at] distressed-debt-investing [dot] com.

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