Distressed Debt Investing

Howard S. Marks / Daniel von Rothenburg

1.

Introduction

Distressed debt investing generally refers to the purchase of public debt securities and private indebtedness of companies that market participants believe will be unable to service their debt and thus either have entered into default, bankruptcy or financial restructuring or are considered likely to do so in the future. The debt of such companies often trades at discounts to face value and/or intrinsic value which are substantial. Depending on an asset managers style, investments in distressed debt may be made in a wide range of instruments, including publicly issued bonds and notes; bank debt; privately issued debt, often syndicated; trade credit; leases; preferred stock and warrants. The typical distressed debt situation involves an over-leveraged company that is thought likely to default on payment of interest and principal. Debt instruments promise interest and the repayment of principal, but when a company becomes distressed those promises become overwhelmingly likely to be broken. Because the companies are almost certain to require financial restructurings, investments are not motivated by the expectation that the promised payments will be received. In these situations, debt instruments may trade at discounts to the estimated risk-adjusted value of those assets. Rather, investors purchase distressed debt in order to obtain a creditor claim on company assets. The hope is to increase the value of the company by restoring it to financial viability through a financial restructuring either in or outside of bankruptcy and to capture both the discount at which the debt was bought and the amount by which the value of the company was increased. Upswings in distressed debt opportunities occasionally arise from the combination of lowered credit standards and the making of imprudent loans, and the subsequent onset of economic weakness or some other causative factor. As a consequence, a securities market of problem firms can develop that affords opportunities if their problems are resolved and if current prices are over discounted. Distressed debt investing is not to be confused with turnaround investing. While an investment in distressed debt can entail a turnaround situation, it doesnt necessarily do so. Distressed debt investors often concentrate on sound companies that have taken on too much debt (good company/bad balance sheet). Companies that need to be turned around generally have fundamental problems at an operational level. In general, its easier to repair a good company that has been overleveraged than it is to fix a fundamentally troubled company. The former can be returned to viability through a financial restructuring, while the latter requires serious curative measures.

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The incidence of a default or bankruptcy provides a trigger mechanism enabling creditors to force a restructuring as the first step toward unlocking the underlying value of the financially distressed company. In most bankruptcies and financial restructurings, the companys former owners are wiped out and the former creditors become its new owners. This process, which eliminates debt and reduces debt service requirements, represents a major step toward the restoration of the company to financial viability. Having taken a position in distressed debt, investors do not have to wait an indefinite period for results. The decision whether to participate in the debt of an overleveraged company is not an easy one, and it requires analytical skill and specialized expertise in restructuring. Distressed debt analysts must answer three questions: How much will the company be worth at the time the restructuring is concluded? How will the value of the entity be parceled out among its stakeholders (to include not only the various classes of creditors but perhaps also governmental authorities and litigants)? And how long will this process take? If one knows the answer to these questions and the price of the companys debt, it is a routine matter to calculate the return that can be earned by buying the debt. Of course, for the expected return to be received, the answers will have to turn out to be correct and the restructuring will have to be executed as expected.

2.

Investment Styles in Distressed Debt Investing

According to the degree of involvement and the holding period, distressed debt investing can be divided into three investment strategies: Passive trading, active non-control and control-oriented. Passive trading investors react to opportunities in the distressed debt market by investing in undervalued securities trading at deep discounts and hope to benefit from either restructuring work performed by those on the creditors committee or the mere movement of the price of the debt in the market. Sub-strategies include: active trading versus buyand-hold; senior or senior-secured versus subordinated debt; busted convertible bonds; capital structure arbitrage and long-short. The trading strategies are characterized by a high degree of liquidity and a short holding period (generally six to twelve months, but sometimes longer). Involvement in the target company typically does not occur. Traditionally, hedge funds have focused on short-term trading and were passive investors with regard to the company itself and the restructuring process. Most of the hedge funds active in distressed debt focus on trading liquid debt securities where the price has been affected by incidence of financial distress such as a default, voluntary reorganization, distressed sale or bankruptcy. Recently, however, some hedge funds have also begun pursuing a more active role by buying bigger positions and maintaining them longer, often becoming more active investors. Thus the lines of demarcation between distressed debt strategies are always vague and often subject to shifting.

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Active non-control (or restructuring) investors usually take positions in a class of a companys debt (senior-secured, senior or junior) and strive to join its creditors committee. Such investors are active participants in the restructuring process and hope to influence the process. They generally do not hold their debt positions much beyond the conclusion of the reorganization, which results in the creditors receiving some combination of cash, stock or new debt of the reorganized entity. These investors typically seek to exit the company as soon as possible, realizing the beneficial impact of the companys return to viability as soon as it is reflected in the price of the debt they have purchased or after conclusion of the restructuring by selling off the elements they receive when the restructuring is concluded. They may invest in large companies where even a significant investment cannot lead to influence or control over the subject company (e. g., Worldcom, Enron). The risk/return profile of such a strategy often shows higher IRRs, but lower dollar returns on capital invested. Portfolio characteristics are: generally less diversified and liquid than trading strategies but more diversified and liquid than control strategies. Holding periods usually run from one to three years Control-oriented distressed debt investors may attempt to gain control of a distressed or bankrupt company through the purchase of its debt and a subsequent financial reorganization. Other control investors seek to gain mathematical control over the reorganization process, but not necessarily over the company following the reorganization. In the United States, for example, changes affecting a class of debt in a voluntary restructuring require the consent of two-third of the holders. Thus, a control-oriented investor must hold onethird of a given class of debt to be assured of being able to block developments affecting its class (negative control) and two-thirds to be sure of being able to approve measures it views as desirable (affirmative control). By controlling the debt of a bankrupt company, the manager controls the reorganization process through its representation on the creditors committee. Its goal is to obtain majority control of the equity in the restructured company and then manage the investment like a typical private equity transaction. Investors who seek to do so can gain a controlling stake in the target company by obtaining a sufficient position in the class of debt which ownership will pass, influencing the restructuring in the proper direction and bringing about a so-called debt-for-equity swap. This is the most complex strategy to deploy, and a successful investor must possess fixed income analytical and trading skills in order to gain control, as well as private equity skills with which to then manage and eventually exit the company. Investors may act to fundamentally alter the company or even purchase related add-on businesses. The total holding period may run to three to five years or more, including a significant period spent managing the company post-restructuring. The risk/return profile of such a strategy often shows lower Internal Rates of Return but higher multiples of capital thanks to the much longer holding period. Portfolio characteristics are potentially the most concentrated and illiquid of all distressed debt strategies. It should be noted that there is a grey area between the last two strategies. After going through a restructuring, an investor is likely to end with a mix of cash, new debt/bonds and equity. Sometimes, depending on the outcome, an intended non-control investment can accidentally result in control of the subject company.

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Finally, the entities that employ these strategies come primarily in two forms. Hedge funds generally focus on purchasing liquid debt with the objective of reselling it at a higher price in a relatively short time period, while closed-end distressed debt funds focus on investing in companies in need of restructuring and/or about to enter bankruptcy, taking advantage of their ability to hold throughout the restructuring process, which typically takes six to eighteen months. By their form, hedge funds are best suited for short-term trading, and restructuring and control activities are best carried out in closed-end funds.

3.

Factors Underlying Success in Distressed Debt Investing

An investment in distressed debt will prove profitable if the value of the cash, new debt and equity received in exchange as a result of the restructuring exceeds the original cost of the debt. To assess the likelihood of profiting in a given case, as mentioned earlier, a distressed debt investor must answer questions in three primary areas: What is the company worth today, how is the company likely to be affected by reorganization, and thus what will it be worth at the time the reorganization is concluded? (valuation) How will this total enterprise value be divided among the companys various creditor classes as well as its other stakeholders and claimants? (apportionment) How long will the entire process take? (time) Correct answers to these questions will yield an accurate estimate of the rate of return on a distressed debt investment. Obtaining correct answers requires expertise regarding company valuation, the bankruptcy process and the dynamics of restructuring. The analytical process requires both knowledge of the bankruptcy laws and also insight into their application in the real world. Substantial experience in the field provides valuable insight into the likely behaviour of the other creditors and the judge. All of these things are required for optimal results. Even when conditions are good for distressed debt investing, performance still cannot be accomplished without deft execution. Compared to buying mainstream stocks and bonds, distressed debt investing is certainly a skill position. Judgments have to be made about the survivability, prospects and value of an enterprise in crisis, and about the legal and real-politic restructuring process that will reset an overly indebted companys balance sheet and turn many creditors into owners. These judgments have to be made from the outside there are no dog-and-pony shows, due diligence rooms or meetings with helpful corporate executives and often at a time when financial information is in short supply and possibly of questionable validity. Six principal elements are critical to the attainment of success in distressed debt investing:

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Distressed Debt Investing Access to deal flow Valuation skills Legal/strategic analysis Restructuring ability Performing corporate oversight Creating exit strategies

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Personal investing skill based on aptitude and experience that is, alpha is the essential ingredient. Inefficient markets may make mispriced investment opportunities available, but theres never a sign pointing the way to the best bargains. Distressed debt investing from time to time provides investment opportunities with great potential, but the outcome will always be dependent on skilful execution.

4.

The Historical Cycle of Distressed Debt Investing

Like all other assets classes and investment strategies, buying distressed debt is a great idea when it can be done at prices that are below intrinsic value, whereas at other times, when full prices are being charged in the marketplace, it can produce lacklustre results. Like everything else in the world of investing, success with distressed debt is a matter of opportunity and execution. The ability to invest in distressed debt at low prices depends first on the existence of an ample supply. Historically, that supply has been created when a period of lax lending practices is followed by a period of both fundamental and psychological weakness. The pattern of supply creation has been illustrated over the last two decades by the relationship between the issuance of high yield bonds in a given year and the incidence of defaults a few years later. The graph that follows illustrates two full cycles in debt issuance and default, each lasting about a decade. In short, high credit standards lead to low issuance of bonds and low default rates. Low default rates cause investors to become increasingly optimistic and willing to buy greater amounts of bonds (swelling the annual issuance, as can be observed) and also to be willing to buy bonds of lower quality (a phenomenon which initially remains invisible). Eventually, however, the lowered credit standards cause the default rate to rise, increasing the supply of opportunities for buyers of distressed debt. Losses on the debt in their portfolios sap the prior holders confidence, causing them to become willing to accept fewer new issues of bonds and to raise their credit standards. And in this way, the cycle resumes. Put another way, from time to time, the capital markets will approach a cyclical high in terms of generosity and a low in terms of discernment and discipline. Confidence comes to outweigh caution. Providers of capital compete to buy securities and make loans. And one way they compete is by accepting less in terms of debt coverage and loan covenants.

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High Yield Bond Issuance ($ Billions)

160 140 120 100 80 60 40 20 0

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

16 % 14 % Annual Default Rate

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12 % 10 % 8% 6% 4% 2% 0%

New Issue Volume

Default Rate

Sources: JP Morgan, Citigroup/NYU Salomon Center, Professor Edward I. Altman

Graph 1: High Yield Bonds Issuance and Annual Default Rates

In other words, they settle for a skimpy margin of safety. Credit standards are pushed to the point where many borrowers will be unable to service their debt if conditions in the environment deteriorate, as inevitably will become the case at some point. It is in this way that a base of potential distressed debt supply is built through the process we call the unwise extension of credit. But even the creation of a large potential supply is not enough to give would-be distressed debt investors a superior investment opportunity. The potential supply has to be turned into actual supply through the occurrence of one or more igniters which diminish either the strength of the economy, and thus creditworthiness, or investors psychological wellbeing, equilibrium and resolve. When things in the economic and business worlds are going swimmingly and investors are in firm grasp of their composure, few forced or motivated sellers crowd the exits, and thus there are few bargains. But when negatives accumulate in the environment, investors often become unable to hold onto assets (for legal, organizational, economic or psychological reasons) and bargains can become rife. Oftentimes these influences can be seen most clearly in the market for distressed debt, as that is where the extremes of the cycles in corporate creditworthiness and investor psychology are reached. Over the last twenty years, there have been two periods when it was possible to access highly outstanding returns through bargain-basement purchases. There have also been times when buying opportunities were nothing special.

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1990 witnessed a fairly serious recession, a credit crunch, the Gulf War, the meltdown of many of the prominent LBOs of the 1980s, and the governments war on junk bonds, which shuttered Drexel Burnham, rendering high yield bond holders unable to find bids and issuers of the bonds unable to effect remedial exchanges, obtain waivers of covenant breaches or refinance maturing issues. The accumulation of these events had tangible effects on the business climate, on the operation of the market and on debtholders psyches. Investors are usually happy to hold unbesmirched assets marked at high prices, but they can become entirely unwilling to deal with holdings when their flaws become evident and their prices are brought low. This is the process that generates opportunities for bargain purchases in distressed debt as elsewhere. And this is what happened in the world of low-grade debt in 1990. The supply of distressed debt spiked upward, as the weakened economy drove the default rate on high yield bonds to 10 % in 1990 and 1991. Many holders became forced sellers, and there were few buyers to bid for their offerings. Thus prices for bonds and other debt collapsed, creating the potential for ultra-high returns. Lenders and other providers of capital experienced losses when they liquidated their positions obtaining liquidity but sacrificing on price as is usually necessary at moments like these. The few whose capital and equilibrium remained intact were able to take advantage of this opportunity to purchase distressed debt at depressed prices. As a result of all of the above, distressed debt investments made in 1990 and 1991 produced very high realized returns in terms of both IRR and times-capital-returned. Banks, bond buyers and other providers of capital were chastened by the collapse of debt of highly leveraged companies. As a result, the level of high yield bond issuance in the early 1990s was low and stringent credit standards were applied. Because of this and the strong economy that prevailed, relatively few bonds defaulted in the mid-1990s: the annual default rate on high yield bonds was below 2 % for six straight years, from 1993 to 1998. Additionally, because investors were sanguine and risk-tolerant, few non-defaulted bonds were marked down to distressed prices. Thus, at the end of 1996, the total outstanding amount of bonds that were in default or were yielding more than 20 % stood at only $ 12 billion. Distressed debt investors had little do, and there was no way for them to manufacture high returns. Just as had been the case in 1990, in 2002 we again saw a recession and credit crunch, this time along with the aftermath of 9/11, the invasion of Afghanistan, the collapse of the telecom industry, and the disclosure of corporate scandals beginning with Enron and eventually affecting several other companies. And again we witnessed the corrosive effects of fundamental deterioration and psychological undermining. The default rate in high yield bonds once again soared past 10 percent in 2001 and 2002, and downgrades turned holders of debt on many former high grade companies now fallen angels into highly motivated sellers. Just as in 1990, many purchases of distressed debt made in 2002 led to ultra-high realized rates of return. Its very much worth noting how quickly and dramatically the supply of distressed debt can change. The high level of bond issuance and lower credit standards in the mid- and late

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1990s led to an increase in the amount of defaulted bonds outstanding from $ 8.3 billion in December 1996 to a high of $ 165.9 billion (up 1,899 %) by December 2002. Also, risk aversion began to rise following the Long-Term Capital crisis, and investors became less tolerant of companies difficulties; this, along with a slower economy, raised the amount of distressed bonds more than 20 % from $ 3.8 billion to $ 140.0 billion (up 3,584 %) over this same period. These factors are illustrated in the following graph.

350 300 Distressed Debt Market ($ in Billions) 250 200 150 100 50 0
Total
Non-defaulted bonds w/YTW > 20 %

Defaulted bonds

Dec-96 $12.1 $3.8 $8.3

Jun-97 Dec-97 $15.7 $19.1 $6.1 $9.0 $9.6 $10.1

Jun-98 $21.8 $12.5 $9.3

Dec-98 $54.4 $43.9 $10.5

Jun-99 $63.8 $38.7 $25.1

Dec-99 $97.0 $60.0 $37.0

Jun-00 $132.2 $82.9 $49.3

Dec-00 Jun-01 Dec-01 $219.1 $224.1 $257.8 $158.4 $131.0 $151.4 $60.7 $93.1 $106.4

Jun-02 $245.2 $105.6 $139.6

Dec-02 $305.9 $140.0 $165.9

Jun-03 $203.0 $54.5 $148.5

Dec-03 Jun-04 Dec-04 $168.3 $115.6 $85.8 $31.8 $29.4 $20.0 $136.5 $86.2 $65.8

Jun-05 $82.9 $23.2 $59.7

Dec-05 $75.1 $16.9 $58.2

Jun-06 Dec-06 $60.5 $76.9 $13.1 $32.5 $47.4 $44.4

Data used to derive information contained herein was obtained from Credit Suisses Global Leveraged Finance Strategy and Portfolio Products Group.

Graph 2: Distressed Debt Market

As the graph shows, the total of defaulted bonds and bonds yielding over 20 % rose from $ 12.1 billion at the end of 1996 to $ 305.9 billion less than six years later. And those statistics cover U.S. public bonds only; they ignore the increase in bank and private debt, debt outside the U.S., and the vast extension of credit that has accompanied the expansion of the private equity industry over the last few years.

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5.

Distressed Debt Opportunity

After years of positive economic and corporate fundamentals, improving psychology, easy access to capital, voracious demand for debt instruments and broad acceptance of financial innovation, in the summer of 2007 the financial markets lost an essential element: investor confidence. While the immediate fundamental impact of the subprime mortgage problem was limited in size and scope, the second-order repercussions were many. Even before the subprime mortgage problem occurred it was widely agreed that the unwise extension of credit had been taking place since roughly the end of 2003. The issuance of high yield bonds had been at a record high. This was supplemented and far surpassed by issuance in a new market niche: non-investment grade second lien loans largely syndicated to hedge fund buyers. The percentage of high yield bond issuance rated below single-B, and thus particularly risky, was at a high level. In addition, an unusually high percentage of low-rated debt was issued for the purpose of making cash distributions to the issuing companies equity owners re-caps adding further to the companies leverage. Further, many recent buyout-transactions were structured quite aggressively, with high purchase prices relative to cashflow and with leverage at high levels. In July and August 2007, having suddenly became more risk conscious, investors and providers of capital repriced risk, realizing they had been taking too much of it and demanding too little (in terms of interest rates and debt terms) for doing so. They came to see leverage as a possible source of risk, not just a way to magnify gains. They became uncertain about credit ratings, their own credit judgments and the reliability of companies continued access to funds. They realized that stated values for assets are undependable in chaotic times, and that liquidity can dry up in a heartbeat. In a number of cases, we got to witness in action the time-honored formula for financial crisis: short-term borrowing used to finance highly leveraged purchases of assets that suddenly become illiquid. This combination led to the meltdown of a number of investment funds and raised questions about others. These psychological and technical developments led to a fairly typical credit crunch, in which no-longer-open capital markets deny financing to borrowers. Because of these changes in the environment, the optimism of distressed debt investors regarding the timing and extent of the next heightened instance of distress has risen. But the development of dramatically improved buying opportunities is unlikely to precede the onset of an economic slowdown and fundamental corporate difficulty, in which results fail to live up to the expectations on which borrowing decisions were based. Like all other future developments, this one is uncertain. But the events in the summer of 2007 seem to have tilted the odds in distressed debt investors favor.

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