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Valuation Considerations for Distressed Securities

BY: RICK MARTIN & ELPIDA TZILIANOS

Agenda
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Overview of distressed securities

Defaults and availability of distressed debt

Fair value and distressed securities

Agenda
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Overview of distressed securities

Defining Distress
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Broad definition Below investment grade debt (CCC or lower) YTM > 1,000bps over risk-free Treasuries

Priced at or below 80 cents on the dollar


Highly concentrated in debt securities of companies

in headed toward restructuring, bankruptcy, or liquidation


Market primarily consists of debt securities caught up in


Ch 11 Reorganization Ch 7 Liquidation Other extraordinary transactions (e.g., out of court restructuring)

What Causes Distress?


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Companies fall into distress for a number of reasons: Over-leveraged Liquidity issues Slipping credit Poor operating performance Accounting irregularities Inadequate cash flows Competition

Corrective Actions
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Corrective actions Asset restructuring Financial restructuring = private workout or Ch 11 If all else fails Ch 7 = Company shuts down & assets distributed to creditors. Ch 11 = Stabilization, reorganization & approval Creditors may include: Banks Utilities & other trade vendors Investors with bonds Interest Holders

Ch 7 Liquidation Priority
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1. Secured claims 2. Administrative expenses 3. Post-petition unsecured claims

4. Wages earned within 180 days prior to filing $10,950/claimant


5. Employee benefit plan contributions (arising 180 days prior to filing) 6. Tax claims 7. Unsecured claims 8. Preferred stockholder claims 9. Common stockholder claims

Chapter 11 Process
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Under Ch 11, a company attempts to stay in business while a

bankruptcy court supervises the reorganization of the companys contractual obligations. This process can be divided it into 13 steps, embedded in three primary phases: (1) Filing
(2) Negotiation (3) Approval

Ch 11 Filing Process Phase I


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A case filed under Chapter 11 of the United States Bankruptcy Code is typically used to reorganize a business, i.e., a corporation, sole proprietorship, or a partnership. The Chapter 11 processes can be divided it into twelve steps, embedded in three primary phases: (1) Filing, (2) Negotiation, and (3) Approval. It is important to note that stock and commodity brokers are not eligible for Chapter 11 filings and may only file Chapter 7 petitions. Avoidable Transfers (90 days - 2years Prior to Filing)

Filing P H A S E 1

First Day Motions (1-3 days)

First Day Orders (1-3 days)

Creation of Creditors Committee (2 weeks)

DIP Financing (2-3 weeks)

PHASE 2

Phase I: Steps 1-5


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1.

Two types of petitions can filed with a bankruptcy court: (1) a voluntary petition, filed by the debtor or, (2) (a less common) an involuntary petition, filed by creditors. Upon filing a petition the debtor automatically assumes the identity of a debtor-in-possession (DIP). A DIP refers to a debtor that keeps possession and control of its assets while undergoing reorganization under Chapter 11.

2. First day motions (FDMs) are then filed by the debtor, usually 1- 3 days following the petition filing

and are intended to ensure that the debtor can operate its business normally with regards to its employees, suppliers, customers and other stakeholders.
3. The court considers the FDMs at a first-day hearing that usually takes place on the first or second

day of a Chapter 11 case. The court then issues first-day orders (FDOs) approving the FDMs.
4. The debtor obtains DIP financing to fund its ongoing operations and operates in the normal course of

business as a DIP.
5.

Within the first two weeks of a case, a government agency, called the U.S. Trustee appoints the Official Committee of Unsecured Creditors (the Creditors Committee) to deal with restructuring related issues. The U.S. Trustee will usually try to include several types of creditors (trade creditors, bondholders, etc.) so that the creditors committee is a representative body.

Ch 11 Filing Process Phase II


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PHASE 1

Section 341 Meeting (Approx. 30-60 days)

Claims Bar Date (4-6 months) P H A S E 2

Plan of Reorganization (Timing Varies)

Disclosure Statement (Timing Varies)

Voting on & Acceptance of the Plan (Timing Varies)

PHASE 3

Phase II: Steps 6-10


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6.

The Meeting of Ceditors (often referred to as the Section 341 Meeting), which is a joint meeting of the debtors representatives and the creditors, typically occurs approximately 30-65 days after a Chapter 11 filing. At this meeting the U.S. trustee and creditors may question the debtor under oath concerning matters regarding the nature and location of assets such as reporting its monthly income and operating expenses, establishing new bank accounts, and paying current employee withholding and other taxes. A notice is sent out to anyone who may have financial or other claims against the debtor requiring that they submit a proof of claim by a specific date or be barred from asserting that claim. This date is called the claims bar date. Once the court has gathered all of the claims that resulted from the bar date notice, hearings are held to determine the value of any claims that are disputed. The debtor finalizes its long-range strategic business plan and develops a plan of reorganization, which sets forth how the debtor plans to repay its creditors. The debtor has the exclusive right to propose and file such a plan of reorganization during the first 120 days of the Chapter 11 process (called the exclusivity period). If the debtor is proceeding in good faith, the exclusivity period may be extended (or in other cases reduced) by the bankruptcy court but may not exceed 18 months. After the exclusivity has expired, a party in interest or the U.S. Trustee may file a competing plan. The debtor must submit to the court a Disclosure Statement (DS) with its proposed plan of reorganization. The DS is a document presents information on: (a) the debtors current and projected financial conditions, (b) the debtors proposed plan for paying its creditors and (c) the business case for why the Plan should be approved. After this DS is filed, the court must hold a hearing to determine whether the DS is approved. acceptance of its plan. The court may extend (up to 20 months) or reduce this acceptance exclusive period.

7.

8.

9.

10. The debtor has 180 days after the petition date or entry of the order for relief (in the case of involuntary) to obtain

Ch 11 Filing Process Phase III


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PHASE 2

Plan Confirmation (Timing Varies)

Post-Confirmation: Modification/Administration (Timing Varies)

Revocation of Confirmation (At Most, 180 days Post Confirmation)

P H A S E 3

The Final Decree (Timing Varies)

Emerging from Chapter 11 (Timing Varies)

Phase III: Steps 11-12


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11.

The debtor will then seek bankruptcy court approval, or confirmation of its plan of reorganization. The court holds hearings to consider whether the Plan of Reorganization complies with the requirements set forth in the Bankruptcy Code. If confirmed, the debtor may emerge from Chapter 11 as a reorganized company and operate its business as described in its plan of reorganization. A final decree closing the case must be entered after the estate has been fully administered. Local bankruptcy court policies generally determine when the final decree is entered and the case closed.

12.

If the court approves the plan of reorganization, it is confirmed and usually within a few days the plan becomes effective. At that point, the company emerges from Chapter 11 as a reorganized entity.

Chapter 11 Trading Securities


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A companys securities may continue to trade after Ch11 filing. There is no federal law prohibiting securities trading of bankrupt firms.

However, trading can be limited due to trading orders from the court.

These investments are very risky.

During bankruptcy bondholders stop receiving interest and principal

payments and stockholders stop receiving dividends. equity holders.

If company emerges, creditors and bondholders generally become the new Plan of reorganization usually cancels existing shares, because secured and

unsecured creditors are paid from the companys assets before common stock holders. So, if liabilities > assets = $0/share.
bankruptcy proceedings; Ticker Alone = Newly issued shares.

Note Ticker + Q = Bankruptcy filing; Ticker + V = Trading during Post-emergence, bond holders may receive new stock, warrants, new

bonds, cash, or a combination in exchange for their bonds.

Pluris Chapter 11 Bond Index


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Bonds in the Pluris Chapter 11 Bond Index include

secured and unsecured, senior and subordinate notes.


Generally, inclusion criteria for the Pluris Chapter 11

Bond Index are:


-

U.S. Issuers Non-Financial Issuers (Excludes SICs 60-69) Issuers undergoing pending Chapter 11 proceedings Issuers that have not been acquired since the bankruptcy filing

Pluris Chapter 11 Bond Index


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Types of Distressed Securities


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Trade claims & receivables Common stock, preferred stock, PIPEs, rights &

warrants High yield bonds, corporate & municipal bonds Below par bank loans, DIP loans, bridge & mezzanine loans Collateralized debt, second lien notes, & real estate assets Futures, options, swaps, & indices

The Distressed Market


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Money managers focus on bank debt, trade claims, &

bonds As of 2008, approximately $200B of the $900B US high yield market can be considered distressed. Distressed securities markets are highly inefficient Securities often sell at deep discounts

Investors in Distressed Securities


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Hedge funds are the largest buyers of distressed

securities Money managers Mutual funds Private equity firms

Investors Skills
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Skill sets are highly specialized Legal backgrounds Restructuring expertise Strong negotiating skills Extensive networks Asset valuation skills

Active vs. Passive Investors


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ACTIVE
PASSIVE Controlling Non-Controlling

Seek

Large blocks positions


Extensive/ Restricted

Senior secured/ Senior unsecured


Influence process/ Usually restricted

Undervalued trading securities


Trading oriented/ Unrestricted

Involvement

Horizon
Opportunity

2-3Y
Always

1-2Y
Always

Long or Short (usually 6M-1Y)


Cyclical

Target Returns
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Investments made during economic downturns Profits realized during bull markets Targeted annual returns rest in 20-25% range On average = 12%

Distressed Portfolios
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Top-down & Bottom-up strategies used in portfolio

assessment Investments based on market/trading dynamics, assessed position values, risk/return profiles, etc. Portfolios based on:

Standard risk management measures Arbitrage risk Sector diversification and position limits Leverage limits Credit information (past, present & future) Tail risk Cost & effectiveness of hedging instruments Liquidity analysis

Basic Hedge Fund Strategies


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Outright short Bearish views on companys credit fundamentals Often done through CDS purchases Long/short Assumes securities are undervalued (overvalued) and will depreciate (appreciate) Capital structure arbitrage Mispricing between securities of the same issuer Value trading Assumes securities undervalued; purchased before Reorganization Plan announced or immediately following restructuring Rescue financing Lending to companies prior to Ch 11 filing

Agenda
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Defaults and availability of distressed debt

Defaults
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U.S. business bankruptcies up 17% in 2nd quarter of

2008 as compared with the 1st quarter


Almost 29,000 companies filed for bankruptcy in

the 1st half of 2008


States with the biggest increases in filings included

Delaware, Montana, Oregon, Maryland, and Connecticut

Defaults
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Delaware saw a 100% increase from the 1st quarter

to the 2nd quarter


Two to three companies go out of business for every

one that files for bankruptcy


About $184 billion of distressed debt is trading
One in three junk bonds is distressed

Some Notable 2008 Bankruptcies


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Company Name Tribune Co. PFF Bancorp, Inc.

Filing Date 12/8 12/5

Assets ($M) 7,600 3,724

Liabilities ($M) 12,130 3,6778

SIC Code 2711 6035

Pilgrims Pride Corp.


LandAmerica Financial Group, Inc. Circuit City Stores, Inc. VeraSun Energy Corp.

12/8
11/26 11/10 10/31

3,299
3,325 3,400 2,913

2,947
2,840 2,323 1,842

0251
6361 5731 2869

Washington Mutual, Inc.


Lehman Brothers Holdings, Inc. Luminent Mortgage Capital, Inc. WCI Communities, Inc.

9/26
9/15 9/5 8/4

309,731
13 2,178

283,645
484 1,941

6035
6211 6798 1531

693,000 613,000

Frontier Airlines Holdings, Inc.


SIRVA, Inc.

4/10
2/5

1,250
894

1,098
1,149

4512
4213

Agenda
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Fair value and distressed securities

FAS 157
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Previous fair value accounting standards Does not require any new fair value measurements Does require new and expanded disclosures Establishes a three level hierarchy Categorization primarily depends on observables inputs

Hierarchy
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Level 1:
Positions for which observable inputs used to

determine fair value are:


unadjusted market prices of identical assets in an active market.

Hierarchy
33

Level 2:
Observable inputs are quoted prices for: similar assets in active markets, Or, quoted prices for: identical or similar securities in inactive markets, or

Other observable market inputs, or


Other inputs derived from or corroborated by the market. Many distressed securities would likely fall into Level 2

Hierarchy
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Level 3:
When there are not enough observable market

inputs for the valuation to comply with the Level I or Level II requirements.

Level III valuations represent the most difficult path Additional disclosures are required for Level III assets.

Available market data on similar securities must still

be considered in determining fair value.

Which Level?
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Distressed securities may fall into Level 2 or Level 3 High yield distressed debt securities may fall into

Level 2
Bankruptcy claims may fall into Level 2 or 3 Nonperforming assets may fall into Level 2 or 3

What needs to be fair valued?


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Reorganization value for fresh start Creditor or debtor committees Analyzing bankruptcy claims

Conclusions
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Investments in distressed securities involve event-

driven strategies Company-specifics often drive prices (not stock market) = Investors research critical Many valuation approaches but few KEY factors:

Fundamentals! Understand the law and the state of the economy Examine management quality and motivation Know the creditors involved and claim complexity Diversify distressed portfolios Patience during reorganization/workout process

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Rick Martin, CPA (212) 248-4500

Elpida Tzilianos, PhD (212) 248-4639