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Sunday June 25 2017
 
Distressed Securities Investing
  Articles by Dion Friedland
  Protection Against An Aging Bull
  Reducing Market Risk with Merger Arbitrage
  Interview with Dion Friedland
  Taking the Mystery Out of Hedge Funds
  About Special Situations Fixed Income
  The Kingdom of Hedge Funds
  Distressed Securities Investing
  The Case for Convertibles
  Private-to-Public Investing
  Global Macro Investing
  Market Neutral Long/Short Equity Trading

by Dion Friedland, Chairman, Magnum Funds

A company teetering on bankruptcy doesn’t sound like a great investment opportunity, but in many instances it can be -- for those who understand distressed securities investing. Distressed securities are stocks, bonds, and trade or financial claims of companies in, or about to enter or exit, bankruptcy or financial distress. The prices of these securities fall in anticipation of the financial distress when their holders choose to sell rather than remain invested in a financially troubled company. These sellers may be reacting emotionally to the stigma of current or potential bankruptcy, causing them to overlook or ignore the company’s true worth. In cases like these, investment professionals who specialize in researching distressed securities and who understand the true risks and values involved can scoop up these securities or claims at discounted prices, seeing the glow beneath the tarnish.

A distressed opportunity typically arises when a company, unable to meet all its debts, files for Chapter 11 (reorganization) or Chapter 7 (liquidation) bankruptcy. Chapter 7 involves shutting a company’s doors and parceling out its assets to its creditors. Chapter 11 gives the company legal protection to continue operating while working out a repayment plan, known as a plan for reorganization, with a committee of its major creditors. These creditors can be banks who’ve made loans, utilities and other vendors owed for their goods and services, and investors who own bonds. Stock holders are also among the constituents, though when it comes to dividing up the assets of the company they are paid back last and usually very little, if anything. If in a bankruptcy a company does not have sufficient assets to repay all claims, the stock holders will get wiped out as they are last in line to receive any of the proceeds from the liquidation or reorganization. So a distressed securities investor focuses mostly on the bank debt, the trade claims (claims held by suppliers owed for goods or services by the company), and the bonds (which can vary in terms of their place on the bankruptcy-claim totem pole, with senior bonds paid ahead of junior, etc.) when looking for bargain-priced securities.

The strategy is to capitalize on the knowledge, flexibility, and patience that a distressed securities fund manager has that the creditors of a company often do not have. Many institutional investors, like pension funds, are barred by their charters or regulators from buying or holding onto below investment -grade bonds (BBB or lower) – even if the company is a viable one. So they may sell at steeply discounted prices which has the effect of lowering prices further. And banks often prefer to sell their bad loans (which are no longer paying interest) in order to remove them from their books and to use the freed-up cash to make other investments. Plus, a bank is not in the business of trying to figure out how a reorganization process, which can last several years, will be resolved for the creditors. Likewise, holders of trade claims are in the business of producing goods or providing services and have no expertise in assessing the likelihood of getting paid once a company has filed for Chapter 11. When Barney’s Inc. filed for Chapter 11 in early 1996, for example, many clothing designers chose to sell their trade claims and recoup a portion of their money – if only to cover their production costs. It didn’t matter whether Barney’s was a solid company that had simply over-borrowed. Investors who knew this and believed the company would emerge successfully out of bankruptcy and pay back a large portion of these trade claims purchased the claims for as low as 25 cents on the dollar; the price subsequently rose 50 percent within months when it was announced a potential buyer for Barney’s had been found.

"As companies get into financial trouble," explains Steve Van Dyke, president and chief executive officer of Bay Harbour Management, a large investor in the Barney’s distressed bonds and trade claims, "there is usually the opportunity to buy at steep discounts from people to whom money is owed who don’t want to or can’t wait for the reorganization to be completed."

How do investors like Van Dyke know when the distressed company is worth investing in? For one thing, they study the events driving down the value of a company’s securities. Maybe, like with Barney’s, the company overexpanded or diversified but still has a strong core market. Or maybe it is in debt due to a lawsuit or natural disaster not related to the viability of its core business. Or maybe it has management problems that a change in leadership can correct. In short, this may be a viable company whose price slide doesn’t reflect its real worth.

Investors also conduct extensive calculations to determine if the purchase price of the security is below not only its potential value but its bare-bones liquidation value. In other words, they ask themselves, How much would the claim be worth if the company’s assets were divided among the creditors? If, in a simplified example, the company has $75 million in assets and $100 million in debt, its assets would be divided at an average of 75 cents on the dollar to its creditors, less all expenses incurred in realizing those assets (assuming all the debt has the same priority). Creditors, who don’t have the knowledge, interest, ability, or time to make such an analyses, may sell their claims at much lower prices than they would ultimately be worth, in which case the investor who buys the claims or securities may be doing so at a large discount to liquidation value.

This analysis requires understanding the different kinds of claims involved in a reorganization or bankruptcy, as not all are paid back evenly and at the same time. A first mortgage that’s backed by the collateral of a company’s property has higher priority than a second mortgage when it comes to which gets paid first and at what portion of face value. The second mortgage, in turn, has priority over an uncollateralized loan or trade claim, which, for their part, are senior to publicly held bonds that are not secured by the assets of the company. Holders of senior or secured securities, then, may get back all or most of their claims (depending on the company’s assets), while junior or unsecured bond holders will get less. The distressed securities investor analyzes this "debt structure" in assessing the value of each security.

For example, when El Paso Electric underwent a Chapter 11 reorganization, Dickstein Partners, which specializes in distressed investments, bought junior bonds in the utility that had fallen to 50 cents on the dollar calculating that, after the holders of senior bonds were paid in full, there would sufficient funds left over to more than cover the investment. Senior mortgage bonds in the company were selling at close to par (or 100 percent of their face value), so there was little upside. This is often the trade-off in choosing between senior and junior debt: senior debt tends to hold less risk but also offer lower potential returns; junior debt has less guarantee of repayment, though its discounted purchase price offers higher risk but also greater upside. Further, companies in the process of reorganizing their debts often issue new shares to the junior creditors when they can’t repay them in full. If a fund manager’s research gives him confidence that the company will emerge from bankruptcy as a viable company (creating demand for its equity), he will buy these junior bonds for the opportunity to receive shares in the company.

Which is exactly what Dickstein Partners did in the El Paso Electric investment. Understanding that the company’s financial problems stemmed from expensive nuclear assets and overleveraged balance sheets, and armed with knowledge that El Paso Electric, with a steady customer base, had a 10-year rate freeze agreement with state regulators that would assure an attractive level of predictable cash flow, Dickstein bought the junior bonds expecting additional profits from shares parceled out as part of the reorganization plan. Such shares are commonly referred to as orphan equities when the issuer (the company) has no Wall Street coverage. The lack of Wall Street coverage is due to the fact investment banks tend not to view companies emerging from bankruptcy as potential clients. Further, these companies are "tainted" in general by the financial distress and thus do not make it onto the list of companies to which Wall Street investment banks allocate expensive research resources. As a consequence, the only people who are fully able to understand the value of these newly issued "orphan equities" are investment professionals who took the time and effort to adequately research the liquidation value of the company’s securities, trade claims, or bonds during the Chapter 11 process. These investors now profit from buying the newly issued "orphan equities" at low prices, as other creditors who were issued these shares in exchange for their claims dump them because they don’t understand their value. That’s what happened after orphan equities were issued as part of El Paso Electric’s plan for exiting bankruptcy in February 1996. First issued at $5 a share, the stock dropped initially as less knowledgeable (or less patient) former creditors, stuck with an unwanted investment, hastily sold their new holdings. Seeing the opportunity, Dickstein purchased additional equity from these sellers and watched as the stock steadily climbed over the next two years to over $9 a share.

"Orphan equities can be very profitable," explains Stephen Cornick, vice president at Dickstein Partners, "as the investment community, at first overlooking the stocks, gains more understanding and confidence in the values which ultimately leads to Wall Street coverage and, as a result, higher prices."

In fact, according to a study out of New York University’s Salomon Center and the Georgetown School of Business, newly distributed stocks emanating from Chapter 11 proceedings during the period 1980-1993 outperformed the relevant market indices by over 20 percent during their first 200 days of trading.

Such new stocks, too, tend to have little correlation to the bond and equity markets, their prices already hammered so low and their coverage so far beneath the radar of Wall Street they are little affected by market downswings. These stocks, instead, tend to move when company-specific events are significant and sustained enough to catch the eye of Wall Street.

Distressed securities investing, then, has little stock market dependence or correlation to the performance of the stock market, succeeding or failing based on how effective the investor’s research has been in uncovering all of the variables specific to a distressed company. The investor, if he’s employing this strategy wisely, will not only know everything about the company and its financials but will have studied the creditors involved in the reorganization as well. Their numbers, their willingness to compromise, and the complexity of their claims help indicate how long the reorganization will last, what the asset distributions will be, and whether the expected returns are worth the wait. The investor seeking to best capitalize on his investment may even go so far as to buy up enough of the company’s debt or trade claims so as to earn a seat on the creditor committee and have an influence in the distribution process. In theory, the creditor committee decides on a plan of reorganization, which includes the issuance of new equities to reduce the liabilities of the company -- so that when the company ultimately exits Chapter 11, it emerges with a significantly stronger balance sheet, often with even a greater equity-to-debt ratio than even its most viable competitors.

Distressed securities investing allows the investor who has gained adequate knowledge through his research and due diligence to limit the downside of his investment by effectively buying $1 for 50 cents. This usually results in distressed securities investing yielding consistent returns to competent practitioners of the strategy.


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