Distressed Debt Investing
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Distressed Debt Investing Howard S. Marks / Daniel D aniel von Rothenburg
1.
Introduction
Distressed debt investing generally reers to the purchase o public debt securities and private indebtedness o companies that market participants believe will be unable to service their debt and thus either have entered into deault, bankruptcy or nancial restructuring or are considered likely to do so in the uture. The debt o such companies oten trades at discounts to ace value and/or intrinsic value which are substantial. Depending on an asset manager’s style, investments in distressed debt may be made in a wide range o instruments, including publicly issued bonds and notes; bank debt; privately issued debt, oten syndicated; trade credit; leases; preerred stock and warrants. The typical distressed debt situation involves an over-leveraged company that is thought likely to deault on payment o interest and principal. Debt instruments promise interest and the repayment o principal, but when a company becomes distressed those promises become overwhelmingly likely to be broken. Because the companies are almost certain to require nancial 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 o those assets. Rather, investors purchase distressed debt in order to obtain a creditor claim clai m on company assets. The hope is to increase the value o the company by restoring it to nancial viability through a nancial restructuring – either in or outside o bankruptcy – and to capture both the discount at which the debt was bought and the amount by which the value o the company was increased. Upswings in distressed debt opportunities occasionally arise rom the combination o lowered credit standards and the making o imprudent loans, and the subsequent onset o economic weakness or some other causative actor. As a consequence, a securities market o problem rms can develop that aords opportunities i t heir problems are resolved and i current prices are over discounted. Distressed debt investing is not to be conused with “turnaround” investing. While an investment in distressed debt can entail a turnaround situation, it doesn’t necessarily do so. Distressed debt investors oten concentrate on sound companies that have taken on too much debt (‘good company/bad balance sheet’). Companies that need to be t urned around generally have undamental undamental problems at an operational level. level. In general, it’s it’s easier to repair a good company that has been overleveraged than it is to x a undamentally troubled company. The ormer can be returned to viability through a nancial restructuring, while the latter requires serious curative measures.
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The incidence o a deault or bankruptcy provides a “trigger mechanism” enabling creditors to orce a restructuring as the rst step toward unlocking the underlying value o the nancially distressed company. In most bankruptcies and nancial restructurings, the company’s ormer owners are wiped out and the ormer creditors become its new owners. This process, which eliminates debt and reduces debt service requirements, represents a major step toward the restoration o the company to nancial viability. Having taken a position in distressed debt, investors do not have to wait an indenite period or results. The decision whether to participate in the debt o 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 o the entity be parceled out among its stakeholders (to include not only the various classes o creditors but perhaps also governmental authorities and litigants)? And how long will this process take? I one knows the answer to these questions and the price o the company’s debt, it is a routine matter to calculate the return that can be earned by buying the debt. O course, or 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 o 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 benet rom either restructuring work perormed by those on the creditors committee or the mere movement o the price o 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 o 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 unds have ocused on short-term trading and were passive investors with regard to the company itsel and the restructuring process. Most o the hedge unds active in distressed debt ocus on trading liquid debt securities where the price has been aected by incidence o nancial distress such as a deault, voluntary reorganization, distressed sale or bankruptcy. Recently, however, some hedge unds have also begun pursuing a more active role by buying bigger positions and maintaining them longer, oten becoming more active investors. Thus the lines o demarcation between distressed debt strategies are always vague and oten subject to shiting.
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Active non-control (or restructuring) investors usually take positions in a class o a company’s 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 infuence the process. They generally do not hold their debt positions much beyond the conclusion o the reorganization, which results in the creditors receiving some combination o cash, stock or new debt o the reorganized entity. These investors typically seek to exit the company as soon as possible, realizing the benecial impact o the company’s return to viability as soon as it is refected in the price o the debt they have purchased or ater conclusion o the restructuring by selling o the elements they receive when the restructuring is concluded. They may invest in large companies where even a signicant investment cannot lead to infuence or control over the subject company (e. g., Worldcom, Enron). The risk/return prole o such a strategy oten shows higher IRRs, but lower dollar returns on capital invested. Portolio characteristics are: generally less diversied and liquid than trading strategies but more diversied and liquid than control strategies. Holding periods usually run rom one to three years Control-oriented distressed debt investors may attempt to gain control o a distressed or bankrupt company through the purchase o its debt and a subsequent nancial reorganization. Other control investors seek to gain mathematical control over the reorganization process, but not necessarily over the company ollowing the reorganization. In the United States, or example, changes aecting a class o debt in a voluntary restructuring require the consent o two-third o the holders. Thus, a control-oriented investor must hold onethird o a given class o debt to be assured o being able to block developments aecting its class (“negative control”) and two-thirds to be sure o being able to approve measures it views as desirable (“armative control”). By controlling the debt o a bankrupt company, the manager controls the reorganization process through its representation on the creditor’s committee. Its goal is to obtain ma jority control o 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 sucient position in the class o debt which ownership will pass, infuencing the restructuring in the proper direction and bringing about a so-called “debt-or-equity swap.” This is the most complex strategy to deploy, and a successul investor must possess xed 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 undamentally alter the company or even purchase related “add-on” businesses. The total holding period may run to three to ve years or more, including a signicant period spent managing the company post-restructuring. The risk/return prole o such a strategy oten shows lower Internal Rates o Return but higher multiples o capital thanks to the much longer holding period. Portolio characteristics are potentially the most concentrated and illiquid o all distressed debt strategies. It should be noted that there is a grey area between the last two strategies. Ater going through a restructuring, an investor is likely to end with a mix o cash, new debt/bonds and equity. Sometimes, depending on the outcome, an intended ‘non-control investment’ can accidentally result in control o the subject company.
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Finally, the entities that employ these strategies come primarily in two orms. Hedge unds generally ocus on purchasing liquid debt with the objective o reselling it at a higher price in a relatively short time period, while closed-end distressed debt unds ocus on investing in companies in need o restructuring and/or about to enter bankruptcy, taking advantage o their ability to hold throughout the restructuring process, which typically takes six to eighteen months. By their orm, hedge unds are best suited or short-term trading, and restructuring and control activities are best carried out in closed-end unds.
3.
Factors Underlying Success in Distressed Debt Investing
An investment in distressed debt will prove protable i the value o the cash, new debt and equity received in exchange as a result o the restructuring exceeds the original cost o the debt. To assess the likelihood o proting in a given case, as mentioned earlier, a distressed debt investor must answer questions in three primary areas: ◾
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What is the company worth today, how is the company likely to be aected 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 company’s 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 o the rate o return on a distressed debt investment. Obtaining correct answers requires expertise regarding company valuation, the bankruptcy process and the dynamics o restructuring. The analytical process requires both knowledge o the bankruptcy laws and also insight into their application in the real world. Substantial experience in the eld provides valuable insight into the likely behaviour o the other creditors and the judge. All o these things are required or optimal results. Even when conditions are good or distressed debt investing, perormance still cannot be accomplished without det 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 o an enterprise in crisis, and about the legal and real-politic restructuring process that will reset an overly indebted company’s balance sheet and turn many creditors into owners. These judgments have to be made rom the outside – there are no “dog-and-pony shows”, due diligence rooms or meetings with helpul corporate executives – and oten at a time when nancial inormation is in short supply and possibly o questionable validity. Six principal elements are critical to the attainment o success in distressed debt investing:
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Access to deal fow Valuation skills Legal/strategic analysis Restructuring ability Perorming corporate oversight Creating exit strategies
Personal investing skill based on aptitude and experience – that is, “alpha” – is the essential ingredient. Inecient markets may make mispriced investment opportunities available, but there’s never a sign pointing the way to the best bargains. Distressed debt investing rom time to time provides investment opportunities with great potential, but the outcome will always be dependent on skilul 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 ull prices are being charged in the marketplace, it can produce lacklustre results. Like everything else in the world o investing, success with distressed debt is a matter o opportunity and execution. The ability to invest in distressed debt at low prices depends rst on the existence o an ample supply. Historically, that supply has been created when a period o lax lending practices is ollowed by a period o both undamental and psychological weakness. The pattern o supply creation has been illustrated over the last two decades by the relationship between the issuance o high yield bonds in a given year and the incidence o deaults a ew years later. The graph that ollows illustrates two ull cycles in debt issuance and deault, each lasting about a decade. In short, high credit standards lead to low issuance o bonds and low deault rates. Low deault rates cause investors to become increasingly optimistic and willing to buy greater amounts o bonds (swelling the annual issuance, as can be observed) and also to be willing to buy bonds o lower quality (a phenomenon which initially remains invisible). Eventually, however, the lowered credit standards cause the deault rate to rise, increasing the supply o opportunities or buyers o distressed debt. Losses on the debt in their portolios sap the prior holders’ condence, causing them to become willing to accept ewer new issues o bonds and to raise their credit standards. And in this way, the cycle resumes. Put another way, rom time to time, the capital markets will approach a cyclical high in terms o generosity and a low in terms o discernment and discipline. Condence comes to outweigh caution. Providers o capital compete to buy securities and make loans. And one way they compete is by accepting less in terms o debt coverage and loan covenants.
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160
16 %
) s n o i l 140 l i B $ ( 120 e c n 100 a u s s I 80 d n o B 60 d l e i Y 40 h g i H 20
14 %
e t a R t l 10 % u a f e 8 % D l a u 6 % n n A
12 %
4% 2%
0
0% 1980
1982
1984
1986
1988
1990
1992
1994
New Issue Volume
1996
1998
2000
2002
2004
2006
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 or a skimpy margin o saety. Credit standards are pushed to the point where many borrowers will be unable to service their debt i conditions in the environment deteriorate, as inevitably will become the case at some point. It is in this way that a base o potential distressed debt supply is built through the process we call the unwise extension o credit. But even the creation o 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 o one or more “igniters” which diminish either the strength o 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 rm grasp o their composure, ew orced or motivated sellers crowd the exits, and thus there are ew bargains. But when negatives accumulate in the environment, investors oten become unable to hold onto assets (or legal, organizational, economic or psychological reasons) and bargains can become rie. Otentimes these infuences can be seen most clearly in the market or distressed debt, as that is where the extremes o 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 airly serious recession, a credit crunch, the Gul War, the meltdown o many o the prominent LBOs o the 1980s, and the government’s war on junk bonds, which shuttered Drexel Burnham, rendering high yield bond holders unable to nd bids and issuers o the bonds unable to eect remedial exchanges, obtain waivers o covenant breaches or renance maturing issues. The accumulation o these events had tangible eects on the business climate, on the operation o the market and on debtholder’s 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 faws become evident and their prices are brought low. This is the process that generates opportunities or bargain purchases – in distressed debt as elsewhere. And this is what happened in the world o low-grade debt in 1990. The supply o distressed debt spiked upward, as the weakened economy drove the deault rate on high yield bonds to 10 % in 1990 and 1991. Many holders became orced sellers, and there were ew buyers to bid or their oerings. Thus prices or bonds and other debt collapsed, creating the potential or ultra-high returns. Lenders and other providers o capital experienced losses when they liquidated their positions – obtaining liquidity but sacricing on price as is usually necessary at moments like these. The ew whose capital and equilibrium remained intact were able to take advantage o this opportunity to purchase distressed debt at depressed prices. As a result o all o the above, distressed debt investments made in 1990 and 1991 produced very high realized returns in terms o both IRR and times-capital-returned. Banks, bond buyers and other providers o capital were chastened by the collapse o debt o highly leveraged companies. As a result, the level o high yield bond issuance in the early 1990s was low and stringent credit standards were applied. Because o this and the strong economy that prevailed, relatively ew bonds deaulted in the mid-1990s: the annual deault rate on high yield bonds was below 2 % or six straight years, rom 1993 to 1998. Additionally, because investors were sanguine and risk-tolerant, ew non-deaulted bonds were marked down to distressed prices. Thus, at the end o 1996, the total outstanding amount o bonds that were in deault or were yielding more than 20 % stood at only $ 12 billion. Distressed debt investors had little do, and there was no way or them to manuacture 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 atermath o 9/11, the invasion o Aghanistan, the collapse o the telecom industry, and the disclosure o corporate scandals beginning with Enron and eventually aecting several other companies. And again we witnessed the corrosive eects o undamental deterioration and psychological undermining. The deault rate in high yield bonds once again soared past 10 percent in 2001 and 2002, and downgrades turned holders o debt on many ormer high grade companies – now “allen angels” – into highly motivated sellers. Just as in 1990, many purchases o distressed debt made in 2002 led to ultra-high realized rates o return. It’s very much worth noting how quickly and dramatically the supply o distressed debt can change. The high level o bond issuance and lower credit standards in the mid- and late
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1990s led to an increase in the amount o deaulted bonds outstanding rom $ 8.3 billion in December 1996 to a high o $ 165.9 billion (up 1,899 %) by December 2002. Also, risk aversion began to rise ollowing the Long-Term Capital crisis, and investors became less tolerant o companies’ diculties; this, along with a slower economy, raised the amount o distressed bonds more than 20 % rom $ 3.8 billion to $ 140.0 billion (up 3,584 %) over this same period. These actors are illustrated in the ollowing graph.
350
300
) s n o i l 250 l i B n i 200 $ ( t e k r a 150 M t b e D 100 d e s s e r 50 t s i D 0 Total Non-defaulted bonds w/YTW > 20 %
Defaulted bonds
Dec-96 $12.1 $3.8 $8.3
Jun-97 $15.7 $6.1 $9.6
Dec-97 Jun-98 Dec-98 $19.1 $21.8 $54.4 $9.0 $12.5 $43.9 $10.1 $9.3 $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 Dec-02 $245.2 $305.9 $105.6 $140.0 $139.6 $165.9
Jun-03 Dec-03 $203.0 $168.3 $54.5 $31.8 $148.5 $136.5
Jun-04 Dec-04 Jun-05 $115.6 $85.8 $82.9 $29.4 $20.0 $23.2 $86.2 $65.8 $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 Suisse‘s Global Leveraged Finance Strategy and Portfolio Products Group.
Graph 2: Distressed Debt Market
As the graph shows, the total o deaulted bonds and bonds yielding over 20 % rose rom $ 12.1 billion at the end o 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 o credit that has accompanied the expansion o the private equity industry over the last ew years.
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Distressed Debt Opportunity
Ater years o positive economic and corporate undamentals, improving psychology, easy access to capital, voracious demand or debt instruments and broad acceptance o nancial innovation, in the summer o 2007 the nancial markets lost an essential element: investor condence. While the immediate undamental impact o the subprime mortgage problem was limited in size and scope, the second-order repercussions were many. Even beore the subprime mortgage problem occurred it was widely agreed that the unwise extension o credit had been taking place since roughly the end o 2003. ◾ ◾
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The issuance o high yield bonds had been at a record high. This was supplemented and ar surpassed by issuance in a new market niche: non-investment grade second lien loans largely syndicated to hedge und buyers. The percentage o high yield bond issuance rated below single-B, and thus particularly risky, was at a high level. In addition, an unusually high percentage o low-rated debt was issued or the purpose o making cash distributions to the issuing companies’ equity owners – “re-caps” – adding urther to the companies’ leverage. Further, many recent buyout-transactions were structured quite aggressively, with high purchase prices relative to cashfow and with leverage at high levels.
In July and August 2007, having suddenly became more risk conscious, investors and providers o capital “repriced risk,” realizing they had been taking too much o it and demanding too little (in terms o interest rates and debt terms) or doing so. They came to see leverage as a possible source o risk, not just a way to magniy gains. They became uncertain about credit ratings, their own credit judgments and the reliability o companies’ continued access to unds. They realized that stated values or assets are undependable in chaotic times, and that liquidity can dry up in a heartbeat. In a number o cases, we got to witness in action the time-honored ormula or nancial crisis: short-term borrowing used to nance highly leveraged purchases o assets that suddenly become illiquid. This combination led to the meltdown o a number o investment unds and raised questions about others. These psychological and technical developments led to a airly typical credit crunch, in which no-longer-open capital markets deny nancing to borrowers. Because o these changes in the environment, the optimism o distressed debt investors regarding the timing and extent o the next heightened instance o distress has risen. But the development o dramatically improved buying opportunities is unlikely to precede the onset o an economic slowdown and undamental corporate diculty, in which results ail to live up to the expectations on which borrowing decisions were based. Like all other uture developments, this one is uncertain. But the events in the summer o 2007 seem to have tilted the odds in distressed debt investors’ avor.
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