Notes – Distressed Debt Analysis

Distressed Debt Investing: Strategies For Speculative Investors

by Stephen G. Moyer, published 2004

Distressed debt: a true contrarian investment strategy

The following note outline was rescued from my personal document archive. The outline consists of a summary of Stephen G. Moyer’s integral handbook on distressed debt dynamics, Distressed Debt Analysis. The notes currently cover chapters 1-4. They are incomplete at present. I will likely not revise these notes and instead plan to release a new series of notes on this book in the future when I re-read it.

Distressed Debt Analysis

Chapter 1 – Introduction
1. What is “distressed debt”
  1. Some define based off of credit ratings, which lacks rigor because:
    1. credit ratings lag fundamental credit developments
    2. credit ratings essentially only handicap the risk of default, they say nothing of whether the price is appropriate for the risk
  2. Martin Fridson advocates defining debt as distressed when it trades with a yield to maturity greater than 1000 basis points more than the comparable underlying treasury security
  3. Moyer suggests the following:
    1. equity value is diminimus (eg, under $1/share)
    2. all or some portion of unsecured debt trading at a market discount of more than 40%
    3. this pattern implies a balance sheet restructuring, resulting in creditors owning a significant portion of equity, or else a sale of assets and subsequent liquidation
2. Distressed debt investing is not for everybody
  1. significant risk of loss
  2. often an informational advantage for professional participants
  3. markets are often illiquid, significantly increasing transaction costs
  4. average trading size is sufficiently large to rule out the average investor
3. Potential restructuring events introduce significant levels of complexity
  1. Will restructuring occur within or outside of a bankruptcy context?
  2. What is the risk of a loss of economic value due to loss of key customers, suppliers or employees?
  3. How much economic value might be gained via bankruptcy?
  4. If balance sheet is restructured, what will new components look like and who will win and lose?
  5. What are the tax consequences?
  6. Any investors with “controlling” stake allowing them to unfairly influence the process at the expense of others?
4. Common considerations of a distressed investment:
  1. What is the cause of distress?
  2. How will the distress be resolved?
  3. What are the implications of that resolution on the value of the business or particular securities?
  4. What actions on the part of bondholders are being assumed to realize a particular outcome?
  5. Will the price of the instrument in question go up or will it be exchanged into other securities requiring a new analysis?
Chapter 2 – The Distress Debt Investing Opportunity
1. investment grade bonds
  1. BBB or higher – investment grade
  2. lower than BBB – speculative grade
  3. fallen angel – a company that goes from investment grade to speculative grade
  4. bonds that go from BBB to BB or lower may result in forced selling for fund managers who by law must hold BBB or higher, creating an opportunity for distressed debt investors
  5. alternately, fallen angels may force speculative grade fund managers into “forced buying” when they are added to an index, creating another opportunity
  6. PRECURSORS TO DEFAULT
    1. economic performance- economic softness generally gives rise to falling revenues and cash flows, putting many companies into distressed situations
    2. relative quantity of low-rated bonds
      1. low-rated bonds tend to default more often
      2. downgrades and new issuance can increase the number of low-rated bonds
    3. capital markets liquidity- highly leveraged companies are often more dependent on capital markets for on-going financing
      1. the appearance of a recession can restrain a levered companies ability to float more debt
      2. general risk aversion or investor disinterest with the junk bond market can increase financing challenges for companies
      3. a bear market in stocks can shut off another source of funding for these companies
  7. MARKET CONDITIONS THAT PERMIT SUPERIOR RETURNS
    1. equal access to information
      1. hundreds of high-yield issuers have no analyst coverage
      2. many transactions are done OTC
      3. many high-yield issuers have no public equity and thus do not fill out SEC reports
      4. when companies file for bankruptcy, they often delay or totally fail to file SEC reports
      5. two levels of information in bankruptcy proceedings: restricted nonpublic info; publicly available info
      6. the seller of heavily discounted bonds may know something you do not
    2. rational behavior- absence of “free will”, “coerced” sales:
      1. sales by banks to maintain portfolio quality standards often not based on “fair value”
      2. institutional investors may have earnings goals and sell an asset for less than they deem it is worth but still more than its carrying cost, satisfying the goal
      3. high yield, open ended mutual fund managers may be forced to liquidate holdings to meet investor demands for redemption following a swift change in sentiment about their asset class
    3. low transaction costs
      1. settlement fee, including commission to broker- generally nominal, but indeed higher than large-cap equity or other mainstream transactions
      2. “unwind” fee, represents bid-ask spread in the market
        
        this fee can often be a point or more
        
        on highly speculative bonds it can often consist of several % of the total value of the trade
        
        this reduces potential liquidity and volume of exchange in the markets
Chapter 3 – Conceptual Overview of Financial Distress and the Restructuring Process
1. the value of assets is typically uncertain and subjective
2. EMT theory suggests the market can be relied upon to accurately asses the value of assets and thus one can infer the value of a firm’s securities
3. in reality, the market makes dramatic reassessments of securities, positive and negative, often with very few fundamental changes in the business
4. declines in asset value can be handled fairly flexibly when the capital structure is composed of equity; when the capital structure is composed of large amounts of debt this becomes tricky (due to debt covenants)
5. two solutions
  1. increase the value of the company (unlikely possibility or management would’ve done it)
  2. resize the capital structure
6. resizing is accomplished via the restructuring process, a combined legal and financial operation
Chapter 4 – Legal OverView of Distressed Debt Restructurings
1. OUT OF COURT RESTRUCTURINGS: THE PREFERRED OPTION WHEN EFFECTIVE AND FEASIBLE
  1. The Financial Effects of an Out-of-Court Restructuring
    1. Firm and its most significant creditors negotiate a change in the terms of obligations or a voluntary exchange of financial interests
    2. debt for equity or reduced debt for new debt and equity are typical arrangements
    3. the post-reorganization capital structure is fairly “arbitrary”; the company may eventually flourish under a number of different capital structures
    4. because it is not handled in court, this settlement can not change or negate the interest of other claimants not participating in the restructuring
    5. the restructuring can involve payments of cash instead of exchanges of securities
  2. The Out-of-Court Restructuring Process
    1. Parties Involved
      1. With bank debt, the negotiating agent is usually self-evident and is often a previously chosen “agent” of a loan syndicate specified in the loan agreement
      2. With bonds, typically represented by a small group of significant bondholders who form an informal bondholder committee, in practice >=25% of all bonds
      3. There are often agendas involved; commonly people are united around the cause of achieving the most economic value from their claims as possible, but opportunists might see a way to cheaply “acquire” equity which might be profitable in the future
      4. The view of the “job” of forming a bondholder committee is subjective; a hedge fund may see it as an intended part of the investment; a mutual fund or insurance company might consider it to be an embarrassing but necessary evil
      5. The bondholder committee has no legal authority to bind either member or nonmember bondholders
    2. Strategic Considerations in Participating on the Bondholder Committee
      1. If the objective is to invest so as to participate in the bondholder committee, one must be prepared to accumulate a significant quantity of the bonds
      2. an investor may be forced to sign a “confi” (confidentiality agreement); the investor gains the best material information available but must make disclosures of possession of such information (but not the info itself) when trading, which could make trading more difficult
      3. restriction begins at the receipt of material non-public info and ends when the information becomes non-material or is publicly disclosed via an 8-K, 10-Q or 10-K
      4. counter-parties which have become restricted must execute a “big-boy letter”
        
        an acknowledgement by the nonrestricted party that they are aware the counter-party has material non-public info
        
        a waiver of claims the nonrestricted party might otherwise have under securities law
        
        typically executed by a broker-dealer to maintain anonymity
    3. Beginning the Process
      1. when the debt is bank debt, usually begins because the borrower is in or approaching technical default of some provision of the loan
      2. when the debt is bonds and there is no or little bank debt, an investment bank or other restructuring specialist is often hired on retainer for advice
      3. if out-of-court looks like an option, the firm can
        
        invite creditors to organize a bondholders committee
        
        propose a restructuring without prior consultation
    4. Implementing the Restructuring
      1. with bank debt, usually involves an amendment to the loan agreement
      2. with bonds and a bondholder committee, usually a relatively simple private exchange
    5. Feasibility: The Holdout Problem
      1. those not participating in the restructuring may be better off than those who do, but if nobody participates, all will be worse off
      2. with too many holdouts, the company’s only option is bankruptcy, which often just adds legal costs and reduces everyone’s final recovery
      3. holdouts may be managed via:
        
        moral sanction– the distressed debt market is small and the big players are well known so most deals happen within a context of familiarity and consideration for the future of relationships
        
        coercive structural devices– use of tender offers to strip out covenants on the holdouts, forcing them to participate
2. IN-COURT RESTRUCTURINGS: AN OVERVIEW OF THE BANKRUPTCY PROCESS
  1. Intro
    1. it is hardly ever a surprise when a firm files for bankruptcy
      1. market prices have typically adjusted prior to the filing to represent the fear and uncertainty
    2. many firms send signals and warnings to the market before doing so
      1. distressed debt situations are often illiquid and you can not wait for the “bottom” to accumulate a position
    3. some or all of the creditors will usually incur some financial loss
    4. the key is not to buy at the bottom but to buy for less than things are worth
  2. Declaring Bankruptcy
    1. begins with a petition filed at a bankruptcy court, filed by the debtor and known as a “voluntary petition”
    2. in a few cases, three or more creditors may have grounds for filing an “involuntary petition”
    3. Chapter 11 contemplates allowing the existing management to reorganize the debtor as a going concern
    4. Chapter 7 anticipates that a court-appointed trustee will supervise the liquidation of the debtor’s assets
    5. Jurisdiction of Filing
      1. if a prepackaged plan has been put together, a jurisdiction with a reputation for expediting the process may be chosen
      2. if management anticipates a fight with creditors, it might choose a more “debtor” or “home-town” friendly jurisdiction
      3. DDI need to consider the relative level of bankruptcy planning that has occurred or may be possible, the probable jurisdiction of filing and what this implies for the timing of the resolution and the potential effect on the treatment of various claims
    6. Timing of Filing
      1. debtor will typically choose to file before it is in material breach of an agreement, which would allow creditors to make an involuntary filing
      2. the debtor will often try to conserve or charge up liquidity prior to the filing by stretching payment to vendors and creditors and utilizing revolving lines of credit
      3. everything that occurs before filing is considered “prepetition” and everything afterward is “postpetition”, which are senior to “prepetition” claims
      4. when the management of the debtor continues to operate the business postpetition, it does so as fiduciary of the creditors, known as “debtor in possession”
        
        tasked with managing day-to-day operation of biz
        
        anything outside the scope of ordinary business, such as sale of a major asset, requires approval of the bankruptcy court
      5. chapter 11, creation of “official committee of unsecured creditors”
        
        appointed by U.S. Trustee under the Bankruptcy Code
        
        supposed to consist of the seven largest creditors willing to serve
      6. equity holders are allowed to participate in the process and vote on acceptance of the plan for reorganization in certain cases
  3. The Goal: The Plan of Reorganization
    1. Intro
      1. plan of reorganization is a legal document that discusses what will happen to the debtor, its assets and all constituent liabilities, including equity interests, upon the debtor’s exit from bankruptcy
      2. confirmation of the plan is a pivotal legal event which instantaneously alters, with significant uncompensated loss in most cases, preexisting legal relationships such as lending agreements, leases and other contracts
    2. The Role of Exclusivity and Prefiling Coordination
      1. in cases of significant cooperation, management and creditors may work out a tentative plan and have it readied for a vote before the bankruptcy petition, called “prenegotiated” chapter 11 filing
      2. opposite end of the spectrum, an abrupt filing or one lacking consensus is called “free-fall” chapter 11
        
        often a warning sign that the bankruptcy process may be especially lengthy (1-3yrs) and expensive
        
        may signal the reorganization will involve a change of management, introducing a new element of risk
    3. Content and Structure of the Plan
      1. identifies claimants and assigns them to classes for purposes of voting and priority
      2. class usually determined by commonality of interest
      3. similarity involves similar priority against the debtor
      4. provides for what, if anything, each class will receive in the reorganization
      5. all claims grouped within a class must be treated similarly
  4. Operating Under Chapter 11
    1. Stabilizing Operations
      1. automatic stay freezes all creditors in their prepetition state
      2. grants debtor some “breathing room” and financial flexibility
      3. debtor-in-possession allows a super-priority interest against assets to be granted to postpetition lenders
      4. rollup, conversion of a prepetition claim into a postpetition claim through an offer to become a DIP lender
      5. critical vendor motion occurs when the bankruptcy court allows the debtor to pay critical vendors to allow for the continuance of business
      6. KERP, key employee retention plans are often negotiated
    2. Developing a Going-Forward Business Plan
      1. downsizing the labor force, closing unprofitable facilities, selling noncore lines of business or assets and renegotiating various contracts are typical
      2. making a new acquisition is not common although not technically prevented by the law
    3. Determining the Assets and Liabilities
      1. assets
        
        voidable preferences are transactions and distributions that occurred before bankruptcy filing which need to be unwound
        
        fraudulent conveyance, occurs when a debtor did not receive fair value in the transaction in question and at the time or as a result of the transaction was insolvent
        
        debtor may be seeking assets through ongoing legal actions and complaints
      2. liabilities
        
        executory contract rejection and expunging of unexpired leases
    4. Determining the Valuation and the New Capital Structure
      1. “best interests test”, no creditor should come out with less in a reorganization than they would under a liquidation
  5. Voting on and Confirming a Plan of Reorganization
    1. a solicitation package is approved by the creditors and then sent to all holders of impaired claims and interests
    2. for acceptance, 50% in number of claims representing 66 ⅔% of the amount must vote in favor
  6. Summary
    1. chapter 11 is the result of a failure to reach a consensual restructuring
    2. bankruptcy proceedings are complicated and involve substantial negotiation and gamesmanship
    3. the DDI must gain an appreciation for the other participants and their leverage
    4. secured claims will have greater assurance of recovery but lower return potential
Chapter 5 – Overview of the Valuation Process

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