Distress Investing E-Book

Martin J. Whitman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 397

Veröffentlichungsjahr: 2009

Beschreibung

Financial innovation, new laws and regulations, and the financial meltdown of 2007-2008 are just a few of the forces that have shaped, and continue to shape, today's distress investment environment. Combine this with the fact that the discipline of distress investing doesn't always follow what conventional wisdom says, and you can see why it is one of the most challenging areas in finance. Nobody understands this better than Martin Whitman--the legendary founder of Third Avenue Management LLC and a pioneer in the field of distressed markets--and leading academic Dr. Fernando Diz of Syracuse University. That's why they decided to write Distress Investing. As an outgrowth of annual distress and value investing seminars the two have taught together at Syracuse University's Martin J. Whitman School of Management, this reliable resource will help you gain a better understanding of the essential principles and techniques associated with distress investing and show you how to effectively apply them in the real world. Divided into four comprehensive parts--the General Landscape of Distress Investing, Restructuring Troubled Issuers, the Investment Process, and Cases and Implications for Public Policy--this book comprehensively covers the practice of buy-and-hold investing in distressed credits, whether it be performing loans or the reinstated issues of a reorganized issuer. From the recent changes to U.S. bankruptcy code and creditor rights to cash bailouts, you'll quickly learn how to analyze distressed situations such as pricing issues, arbitrage opportunities, tax disadvantages, and the reorganization of funding plans. Along the way, case studies of both large and small distress investing deals--from Kmart to Home Products International--will give you a better perspective of the business. Critical topics addressed throughout these pages include: * Chapter 11 bankruptcy and why it's not considered an ending, but rather a beginning when it comes to distress investing * The "Five Basic Truths" of distress investing * The difficulty of due diligence for distressed issues * Distress investing risks--from reorganization risk to risk associated with the alteration of priority of payments in bankruptcy * Valuing companies by both going concern as well as their resource conversion attributes In today's turbulent economic environment, distress investing presents some enticing opportunities. Put yourself in a better position to excel at this endeavor with Distress Investing as your guide.

Leseprobe

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Foreword

Preface

Acknowledgements

PART One - The General Landscape of Distress Investing

CHAPTER 1 - The Changed Environment

TRENDS IN CORPORATE DEBT GROWTH AND LEVERAGE BEFORE THE FINANCIAL MELTDOWN OF 2007-2008

JUNK BONDS AND THE LEVERING-UP PERIOD

THE SYNDICATED LOAN MARKET AND LEVERAGED LOANS

FINANCIAL MELTDOWN OF 2007-2008

PRINCIPAL PROVISIONS OF THE 2005 BANKRUPTCY ACT AS THEY AFFECT CHAPTER 11 ...

CHAPTER 2 - The Theoretical Underpinning

WHAT MARKET?

TOWARD A GENERAL THEORY OF MARKET EFFICIENCY

EXTERNAL FORCES INFLUENCING MARKETS EXPLAINED

WHAT RISK?

CAPITAL STRUCTURE AND CREDIT RISK

VALUATION

THE COMPANY AS A STAND-ALONE ENTITY

CONTROL AND ITS VITAL IMPORTANCE

CHAPTER 3 - The Causes of Financial Distress

LACK OF ACCESS TO CAPITAL MARKETS

DETERIORATION OF OPERATING PERFORMANCE

DETERIORATION OF GAAP PERFORMANCE

LARGE OFF-BALANCE-SHEET CONTINGENT LIABILITIES

CHAPTER 4 - Deal Expenses and Who Bears Them

ATTORNEYS AND FINANCIAL ADVISERS’ COMPENSATION STRUCTURE AND THE DISTRIBUTION ...

TIME IN CHAPTER 11 AND NUMBER OF LEGAL FIRMS RETAINED

DETERMINANTS OF LEGAL FEES AND EXPENSES

DETERMINANTS OF FINANCIAL ADVISERS’ FEES AND EXPENSES

CAN PROFESSIONAL COSTS BE EXCESSIVE?

CHAPTER 5 - Other Important Issues

MANAGEMENT COMPENSATION AND ENTRENCHMENT

TAX AND POLITICAL DISADVANTAGES

CAHPTER 6 - The Five Basic Truths of Distress Investing

TRUTH 1: NO ONE CAN TAKE AWAY A CORPORATE CREDITOR’S RIGHT TO A MONEY PAYMENT ...

TRUTH 2: CHAPTER 11 RULES INFLUENCE ALL REORGANIZATIONS

TRUTH 3: SUBSTANTIVE CHARACTERISTICS OF SECURITIES

TRUTH 4: RESTRUCTURINGS ARE COSTLY FOR CREDITORS

TRUTH 5: CREDITORS HAVE ONLY CONTRACTUAL RIGHTS

PART Two - Restructuring Troubled Issuers

CHAPTER 7 - Voluntary Exchanges

PROBLEMS WITH VOLUNTARY EXCHANGES

THE HOLDOUT PROBLEM ILLUSTRATED

MAKING A VOLUNTARY EXCHANGE WORK

TAX DISADVANTAGES OF A VOLUNTARY EXCHANGE VERSUS CHAPTER 11 REORGANIZATION

CHAPTER 8 - A Brief Review of Chapter 11

LIQUIDATIONS AND REORGANIZATIONS

STARTING A CASE: VOLUNTARY VERSUS INVOLUNTARY PETITIONS

FORUM SHOPPING

PARTIES IN A CHAPTER 11 CASE

ADMINISTRATION OF A CHAPTER 11 CASE

THE CHAPTER 11 PLAN

CHAPTER 9 - The Workout Process

PARTIES AND THEIR DIFFERING NEEDS AND DESIRES

TYPES OF CHAPTER 11 CASES

LEVERAGE FACTORS IN CHAPTER 11

PART Three - The Investment Process

CHAPTER 10 - How to Analyze: Valuation

STRICT GOING CONCERN VALUATION

RESOURCE CONVERSION VALUATION

LIQUIDATION VALUATIONS

CHAPTER 11 - Due Diligence for Distressed Issues

CHAPTER 12 - Distress Investing Risks

RISKS ASSOCIATED WITH THE ALTERATION OF PRIORITIES

RISKS ASSOCIATED WITH COLLATERAL OR ENTERPRISE VALUATION

REORGANIZATION RISKS

OTHER RISKS

CHAPTER 13 - Form of Consideration versus Amount of Consideration

PART Four - Cases and Implications for Public Policy

CHAPTER 14 - Brief Case Studies of Distressed Securities, 2008—2009

PERFORMING LOANS LIKELY TO REMAIN PERFORMING LOANS

SMALL CASES

LARGE CASES

CAPITAL INFUSIONS INTO TROUBLED COMPANIES

CHAPTER 15 - A Small Case: Home Products International

THE EARLY YEARS

GROWTH BY ACQUISITIONS

RETAIL INDUSTRY WOES

THE FIGHT FOR CONTROL

AMENDMENT OF INDENTURE AND EVENT OF DEFAULT

THE DECISION: PREPACKAGED CHAPTER 11

TREATMENT OF IMPAIRED CLASSES UNDER THE PLAN

FINANCIAL MEANS FOR IMPLEMENTATION OF THE PLAN

GOING-CONCERN AND LIQUIDATION VALUATIONS

CHAPTER 16 - A Large Reorganization Case: Kmart Corporation

LANDLORDS AND UNEXPIRED LEASES

VENDORS AND CRITICAL VENDOR MOTIONS

MANAGEMENT AND KERPs PRE-2005 BAPCPA

FRAUDULENT TRANSFERS

SUBSIDIARY GUARANTEES AND SUBSTANTIVE CONSOLIDATION

CHAPTER 11 COMMITTEES AND OUT-OF-CONTROL PROFESSIONAL COSTS

BLOCKING POSITIONS

BUYING CLAIMS IN CHAPTER 11

DEBTOR-IN-POSSESSION FINANCING

KMART’S PLAN OF REORGANIZATION AND PLAN INVESTORS

INVESTMENT PERFORMANCE

CHAPTER 17 - An Ideal Restructuring System

FEASIBILITY AND CASH BAILOUTS

GOOD ENOUGH RATHER THAN IDEAL

HIGHLY BENEFICIAL ELEMENTS IN THE U.S. RESTRUCTURING SYSTEM

GOALS OF AN IDEAL RESTRUCTURING SYSTEM

SUGGESTED REFORMS

Notes

About the Authors

Index

Additional Praise for

Distress Investing: Principles and Technique

“istress Investing: Principles and Technique presents a concise, practical description of the restructuring process, the various players in the process and the constraints and incentives motivating their actions, as well as the institutional and economic forces impacting the process. The power of this holistic view is demonstrated in many actual distressed investing situations. Without the wisdom in this book anyone investing in distressed securities runs the risk of becoming a distressed investor!”

—STAN GARSTKADeputy Dean and Professor in the Practice of Management,Yale School of Management

“Marty Whitman and Fernando Diz have produced an extraordinary guide to today’s world of distressed investing. Drawing on Whitman’s 50+ years of successful experience in the field, they have explained in straightforward terms how an investor can construct a portfolio of distressed investments within today’s complex variety of different securities. While there are no guarantees of ultimate investment performance, following these principles will enhance the probability of above average portfolio returns.”

—JOSEPH W. BROWN CEO, MBIA Inc.

“In a world puzzled about the reasons for the collapse of our economy, we are fortunate to have two gifted observers, the authors of this book, who understand the elusive intricacies of the problem and explain their details so effectively.”

—WILLIAM BAUMOLAcademic Director, Berkley Center for EntrepreneurshipStudies, New York University

“A very comprehensive and thorough analysis of a timely and interesting topic. Filled with exciting and sometimes provocative insights, this is a must-read for the uninitiated as well as those deeply immersed in the topic.”

—ANDREW DENATALE Partner, White & Case LLP

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Copyright © 2009 by Martin J. Whitman and Fernando Diz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Whitman, Martin J.

Distress investing: principles and technique / Martin J. Whitman, Fernando Diz. p. cm. - (Wiley finance series)

Includes bibliographical references and index.

eISBN : 978-0-470-48843-0

1. Investments. 2. Business cycles. I. Diz, Fernando, 1956- II. Title. HG4521.W.6-dc22

2008054928

To my wife Lois To my children and spouses and companions—Jim and Sara; Barbara and Dave; Tom and Mira

To my grandchildren—Daniel, Will, Nathaniel, Lucien, Raphael, and Rosalie

Martin J. Whitman

To my parents, Alfonso and Lelia, for their unwavering support

To Pepa for her patienceTo Claudia, Emmett, Mateo, and PatriciaFernando Diz

Foreword

Today, one only needs to read the press or view the media to see how most people are struggling to understand the problems brought on by the deepest financial crisis that our country has seen in decades.

Even the very people we trust are struggling to find solutions to these problems. The current financial crisis has made it extremely important for all market participants, and the public alike, to better understand our nation’s reorganization and liquidation processes.

Renowned distress investor Martin J. Whitman and Professor Fernando Diz do just that in this volume. In layman’s terms, they walk the reader through the various processes that companies in financial distress use to either reorganize as going concerns or to liquidate. In doing so, they map the risks, rewards, conflicts of interests, and communities of interest faced by all participants in such processes: creditors, managements, control investors, passive investors, shareholders, professionals, employees, government, and the company itself. The book includes relevant discussions about the external forces, in today’s environment, imposing or not imposing discipline on market participants. These discussions should prove very helpful to policy makers trying to find solutions for the diverse constituencies involved.

During the current financial crisis, the U.S. government has become the credit enhancer of last resort and policy makers are now struggling to decide where and how such power should be used. The contents of this book should provide a roadmap for deciding where such enhancements may prove helpful and where they will not. Throughout the book the authors highlight the notion of a business as a going concern and how this notion is at odds with current mark-to-market accounting for the types of businesses that are at the heart of the current financial crisis. As politicians and government officials debate the “good bank/bad bank” and/or “buying toxic assets” ideas, it is clear that they are trapped in liquidating concepts of insolvency rather than the more realistic “going concern” concepts. This confusion has made it more difficult to change accounting rules that are unrealistic for many businesses and create regulatory insolvencies that have paralyzed such businesses.

Many of the ideas in the book are also quite helpful to private equity investors who will undoubtedly play an important role in the solution of this crisis.

This is a one-of-a-kind book, a must read if you truly hope to understand many of the problems that businesses face in today’s financial environment.

DANIEL D’NIELLO Co-founder and Managing DirectorThe Carlyle Group

Preface

This book is an outgrowth of annual seminars the two of us taught together at Syracuse University’s Martin J. Whitman School of Management for the past seven years. The subject matters of these seminars were distress investing and value investing. We hope that many of the teachings in this volume will be helpful not only to the distress investor and the value investor, but also to the control investor and other parties interested in corporate restructurings. There are many investors who deploy funds away from cashlike investments only into situations where they have, or believe they can get, elements of control over a going concern and/or the reorganization or liquidation processes for troubled companies. In 2008 and 2009 it seems obvious that an important future activity will be obtaining control of both reorganization processes and troubled companies that are being reorganized.

One area that this book hardly touches on is the trading environment for distress credits. That is not where our talents or interests lie. Rather, the book is about buy-and-hold investing in distressed credits. Most distressed credits are likely to be performing loans or reinstated issues in the event an issuer has to be reorganized. Reinstatement means that the contract rights inherent in the credit instrument are restored. Principal is paid in accordance with the terms described in the bond indenture or loan agreement, as are contracted-for premiums, if any, as well as interest and interest on interest if there are any nonpayments during the reorganization period. If the analyst managing a debt portfolio is right in postulating that a performing loan will remain a performing loan, or that in the event of reorganization the loan will be reinstated, then the analyst doesn’t ever have to worry about market prices. At this writing, for example, the Forest City Enterprisespercent senior unsecured debentures due October 15, 2011, are selling to afford the investor an approximate yield to maturity of 28 percent. If the analysis is correct that this performing loan will remain a performing loan, then the debenture holder, holding this issue to maturity, will garner an annual return of approximately 28 percent. In owning debt instruments that are likely to be performing loans or to be reinstated, we are perfectly content to be passive investors, and our relevant measures of return are yield to maturity, yield to an event, and current yield.

Where a security is likely to participate in a reorganization, either out of court in a voluntary exchange or as part of a Chapter 11 proceeding, we usually seek to have elements of control over the reorganization process and even sometimes elements of control of the reorganized company, as was the case for Nabors Industries, Mission Insurance Group, Home Products International, and Kmart. In these cases, returns are measured essentially by dollar price paid as compared to estimated workout values in an estimated time period. Whether owning a performing loan or an issue that will participate in a reorganization, this book gives very little weight to interim market prices or market price fluctuations.

Very little in distress investing lends itself to certainty. Rather, the investor always deals in probabilities. In the case of the Forest City debentures, it is our view, after thorough analysis, that the probabilities are 90 percent that thewill be a performing loan and only 10 percent that thewill participate in Chapter 11 reorganization. Further, it is our opinion that if Forest City Enterprises has to reorganize, the reorganization value attributable to thewill be well north of the current dollar price of 53. There is no Forest City parent company debt outstanding that is senior to the, and the $6.8 billion of secured obligations outstanding are all nonrecourse debt issued by Forest City subsidiaries, not the parent company. In other words, a creditor owning subsidiary-issued debt can look only to the individual property for repayment, not to any assets of Forest City as a parent company. So in effect, thebecome a blanket second mortgage where to be a performing loan, not all, but only a number of Forest City’s vast empire of prime real estate assets has to throw off cash to the parent company. It is possible that Forest City as a parent company could incur new debt that would be senior to the. This could be a problem, but it is lessened by the probability that Forest City as a parent would receive the cash generated by the incurrence of this new debt, and that such cash would be invested profitably. We discuss many of these distress investing risks in Chapter 12.

We feel strongly that understanding distress investing is extremely helpful to analysts deciding to focus on common stock value investing. It is essential when investing in common stocks to learn to benefit from the use of disclosure documents, to understand capitalizations, and to appreciate the fact that, certainly in 2008 and 2009, common stocks can have little value regardless of price if they are issued by companies that are not creditworthy. Interestingly enough, even the best of value investing literature (e.g., the 1963 edition of Security Analysis: Principles and Technique by Benjamin Graham and David Dodd with Sidney Cottrell) leave much to be desired in terms of credit analysis. Further, Franco Modigliani and Merton Miller, two eminent economists, received a Nobel Prize for postulating, “Assuming that managements work in the best interests of stockholders, corporate capitalizations are a matter of indifference.” What utter nonsense! This book, we hope, has lessons for value investors who invest only in the common stocks of strongly capitalized companies.

Probably the most striking thing about the distressed area is that so many of the operative facts in distress are 180 degrees opposite from what the conventional wisdom says the facts are, even among sophisticated professionals without any distress background. In 1979, one of us served as financial adviser to the Kemeny Commission on the accident at Three Mile Island, a nuclear facility in Pennsylvania. Subsequently, that same author was retained by Long Island Lighting to explore bankruptcy scenarios for that troubled electric utility. In 1985 he wrote a paper about what would happen if an electric utility actually filed for bankruptcy relief. In that paper he compared what was likely to happen (correctly, as it subsequently turned out) with what the conventional wisdom was (and unfortunately still seems to be), as postulated at that time by Arthur Young & Company, a public accounting firm; Morgan Stanley & Company, an investment bank; and Milbank, Tweed, Hadley & McCloy, a law firm. The wrong postulates of the conventional wisdom as put forth by these professionals at the time were about as follows. The three institutions wrongly believed that:

• There would be a loss of tax revenues for state and local governments.

• There would be a loss of state pension fund investments in securities of the affected utility.

• There would be higher levels of unemployment in the state.

• There would be a loss of business confidence in the state.

• There would be uncertainty as to future levels of service by a bankrupt utility.

• There would possibly be increased rates for utility customers over the long term.

• There would be an increase in the costs of capital for other utilities in the state.

• A trustee would replace management.

• Operating costs would go up.

• Investors would shun acquiring the securities of a bankrupt utility after it was reorganized.

It seems to us that the 1985 conventional myths are being reiterated at the end of 2008 in looking at the proposed government capital infusions into the automotive Big Three—General Motors, Ford, and Chrysler. In order to be viable, these companies have to be able to sell cars and trucks. Their current levels of financial distress, widely publicized, have already tainted these companies in the eyes of the consumers who are potential car buyers. It seems a stretch that Chapter 11 filing would realistically cause the taint to be greater that it already is. Further, the three have experienced dramatic losses in market share over the past 30 years. With or without Chapter 11, the Big Three already suffer from the stigma of being so poorly financed that many people avoid their products because they believe the companies may lack staying power. Why would filing for Chapter 11 relief increase the stigma over and above what it already is? A basic problem seems to be that neither corporate management nor governmental authorities have much of a conception of what Chapter 11 involves. General Motors and Chrysler already appear to be toast because they can’t sell cars and trucks and there seems to be little evidence that they will be able to compete effectively when the economy turns up. If the companies are to be feasible businesses, the advantages of making them feasible in Chapter 11, as discussed in this book, probably outweigh by a large margin the disadvantages of a Chapter 11 reorganization.

As part of distress investing, we pretty much reject, or largely modify, certain common beliefs held by economists and financial people. For example, it is not useful to state that a company or institution is “too big to fail.” Rather, a more productive view is that a company or institution can be “too big not to be reorganized.” Perhaps in this situation failure might be defined as having the old common stock interests become valueless. But the large company will not become valueless; it will be recapitalized and/or its assets will be put to other uses or other ownership.

Very often conventional wisdom stands in the way of understanding these real problems, and in Chapters 2 and 6 we lay out the foundation for a pragmatic understanding of many such problems. Economists all seem to say, “There is no free lunch.” More useful, though, especially if one is to participate in reorganization negotiations, is the view that “Somebody is going to have to pay for lunch.” In distress we do not consider general risk. For us, risk exists only where preceded by an adjective describing the specific risk. There is market risk, investment risk, credit risk, leverage risk, reorganization risk, failure to match maturities risk, commodity risk, hurricane risk, and so on. Also, there is no risk-reward ratio in distress investing. Rather, the lower the price, the less the risk of loss and the greater the potential for gain.

There are many other simple rules detailed in the book that are essential to be aware of if you are to enjoy success as a distress investor. Among these simple rules are the following:

• As a practical matter, in the United States no one can take away a creditor’s contracted-for right to a money payment unless that individual creditor so consents or the debtor obtains relief from a duly constituted governmental authority, usually a Chapter 11 bankruptcy court.

• Reorganizations can be voluntary or mandatory. In a voluntary exchange, each creditor makes up his or her mind whether to exchange the securities owned for a new consideration. In a mandatory reorganization, the creditor is required to take the new consideration, provided there is the requisite vote of each class (in Chapter 11, the required vote for participants in a reorganization is, of those creditors voting, two-thirds in amount and one-half in number), or there is a court-ordered cram-down Chapter 11 plan.

• It is hard for voluntary exchange offers to succeed. The purpose of the voluntary exchange offer is to credit-enhance the company. In order to succeed, the exchange offer has to result in specific classes of nonexchanging creditors being credit degraded. This can’t always be accomplished.

• Noncontrol participants in reorganizations need a cash bailout. For noncontrol participants, cash bailouts can come from only two sources: payments by the company or sale to market. Payments by a company to creditors take the form of principal, premium if any, and interest. Payments by the company to equity holders consist of dividends and/or share repurchases.

• Distress investors are by and large without political clout. The Internal Revenue Code in particular treats harshly investors who buy credits at a discount and also severely restricts the ability of most troubled companies to use favorable tax attributes created by past losses.

• Investing for cash return, especially in performing loans, tends to have different dynamics than investing for total return (i.e., income plus price appreciation).

• U.S. Chapter 11, which encourages corporate reorganization, seems to be a sounder law for troubled companies than that which exists in most other countries.

• Whereas individual debt obligations mature, aggregate indebtedness for companies, governments, and most individuals is almost never retired. Rather, it is normally refinanced and, as an entity progresses, expanded in size.

• The worldwide 2007-2008 financial meltdown is unprecedented. Many unknowns will be worked out in distress markets with at this time unknowable results. Even the best companies can be, and frequently are, denied access to capital markets in 2008.

• Accounting under generally accepted accounting principles (GAAP) can never give investors more that objective benchmarks. In one or more specific contexts, GAAP is almost always misleading.

• Some markets tend to become efficient. Some markets tend toward efficiency but never arrive there. Some markets are inherently inefficient.

• Reorganization of troubled companies is a very expensive process, whether undertaken out of court or in a Chapter 11 reorganization, or in liquidation proceedings in Chapter 7 or Chapter 11.

• Management entrenchment, management compensation, and corporate governance postreorganization are important issues in assessing troubled companies.

• From the point of view of participants in reorganizations, the form of consideration (new senior debt versus, say, common stock) is frequently as important as the amount of consideration.

• Distress investing really revolves around four different businesses:

1. Performing loans likely to stay performing loans.

2. Small reorganizations or liquidations.

3. Large reorganizations or liquidations.

4. Making capital infusions into troubled companies.

• There are four avenues used to create corporate wealth:

1. Discounted cash flow (DCF).

2. Earnings, with earnings defined as creating wealth while consuming cash.

3. Asset and liability redeployments, including changes in control.

4. Super-attractive access to capital markets.

The word bailout has pejorative connotations. It is more productive to look at capital infusions and credit enhancements by the government as necessary sources of financing for essential institutions at a time when all other sources of access to outside capital for these institutions have disappeared. It is our view that for delivering such capital infusions or credit enhancements, the government should seek, and be entitled to, reasonable profits. The elements of control given the government in return for its capital infusion or credit enhancement ought to be limited. It seems as if the terms of the Troubled Asset Relief Program (TARP) capital infusions ought to come close to achieving the two objectives the government ought to have of (1) prospects for a reasonable profit plus (2) limited control over the businesses receiving the capital infusions. The government, however, in making capital injections ought to avoid making deals on terms that amount to the expropriation of private property without fairly compensating the former owners of that property. This is what seems to have happened when the government took 80 percent equity interests in American International Group (AIG), Fannie Mae, and Freddie Mac. The theoretical standard for fair compensation revolves around the old Internal Revenue Code standard—“the terms, including price that would be arrived at in negotiations between a willing buyer and a willing seller, both with knowledge of the relevant facts and neither under any compulsion to act.” In fact, AIG, Fannie Mae, and Freddy Mac were not willing sellers. They were, on behalf of their shareholders, coerced sellers faced with a compulsion to act in order to avoid draconian consequences.

Adam Smith described the “invisible hand” of the marketplace that will direct the allocation of resources to their most efficient use without government interference. This type of invisible hand does not exist in the United States. Instead, government will always have a huge role to play in how resources are allocated by the private sector. Activists in the U.S. private sector are very efficient in reacting quickly and powerfully to government actions in regard to tax policies, credit granting, credit enhancement, and, to some extent, direct subsidies. The rules of Chapter 11 have an important bearing on what “invisible hand” incentives participants will react to. For example, trade vendors unwilling to grant trade credit prepetition may become anxious to ship goods after a Chapter 11 filing occurs and they become postpetition creditors.

Finally, this Preface would be incomplete if the authors did not state that despite all its warts and problems, Chapter 11 seems to have been rather productive in permitting troubled companies to reorganize as feasible entities contributing to the general economic well-being of our nation. Chapter 11 seems to have a dual goal: (1) to result in the reorganized debtor becoming feasible so that it is unlikely to have to go through the reorganization process again, and (2) to deliver to claimants and parties in interest an approximation of the maximum present value to which they are entitled, all in accordance with a strict rule of absolute priority. At least in dealing with companies that have publicly traded securities, and where the businesses are reorganizable, we believe that Chapter 11 meets these goals at least approximately, much more often than not.

MARTIN J. WHITMAN FERNANDO DIZ

Acknowledgments

Over the years, we had frequently talked about the extremely narrow and limited understanding that academic finance has about the very real issues faced by investors investing in the common stocks and/or credit instruments or claims of troubled corporations. The tangible result of our dissatisfaction with traditional academic finance was the creation of the Distress Investing Seminar at Syracuse University, which has been in operation since 2002. It was not until the 2007-2008 financial meltdown started to unravel companies that we realized how little people in the media, political decision makers, and the general public knew about the reality of corporate restructurings. Until then, the material in this book had been confined to the classroom at Syracuse University, and seminars at a few other universities. Early in 2007 we decided that the time was ripe for us to make a small contribution outside of the classroom to the understanding of the many issues faced by companies, creditors, managements, investors, and other constituents before and during corporate restructurings; this book is the end result.

The names of people who have helped us in various capacities are too numerous to mention, but our thanks go to all of them—family members, friends, students, colleagues, Wall Street professionals, guest speakers at the Distress Investing Seminar at Syracuse University, accountants, and restructuring lawyers.

Among the people who deserve special mention are Beth Connor at Third Avenue Management and Betty Ross at Syracuse University, who have kept us on track throughout this highly demanding period. We are grateful to Emilie Herman, Kate Wood, and Pamela van Giessen at John Wiley & Sons, Inc., for helping us make this project happen.

Errors and shortcomings belong to us alone.

PART One

The General Landscape of Distress Investing

CHAPTER 1

The Changed Environment

Three earthshaking events have resulted in a markedly changed financial environment since the late 1980s and early 1990s: first, financial innovation; second, new laws and regulations; third, the 2007-2008 financial meltdown. The past three decades have witnessed a tremendous amount of financial innovation that has led to significant changes in the levels of debt, the types of credit market instruments, and the overall capital structures of nonfinancial U.S. corporations. These changes accelerated after the late 1980s. Such innovation has also been responsible for the acceleration of the claims’ transformation process—loans into securities issued by structured investment vehicles (SIVs) like collateralized loan obligations (CLOs), for example—that has had important effects on the traditional roles of financial intermediaries and the creation of new credit markets.

After the 1999 Gramm-Leach-Bliley Act and prior to the 2008 financial meltdown, commercial banks tended to act more like underwriters and distributors than like financial intermediaries and investors. These banks no longer take the credit risks that they used to take in the 1970s and early 1980s, albeit they switched to instruments with vastly increased credit risk for their portfolios of consumer loans, including residential mortgages and consumer credit card debt. The development of securitization and financial derivatives markets has contributed to a major transfer of credit risk from commercial banks to other types of market participants, who have assumed active and growing functions in new markets for claims that were the traditional realm of regulated banks. New derivatives markets include credit default swaps (CDSs), which are bets, mostly by speculators, on the probabilities of money defaults on individual debt issues. Before the financial meltdown of 2007-2008, and even after, hedge funds speculated on the credit quality of an issuer using credit default swaps with very large amounts of leverage, and literally influenced market perceptions of the creditworthiness of issuers even though they might have been less knowledgeable than a bank or a credit rating agency making such assessments.

Another outcome of innovation was the development of new primary and secondary markets that have improved the liquidity for traditional and transformed claims. The creation of the original-issue below-investment-grade bond market in the 1980s and early 1990s and of the leveraged loan markets are but two examples of such transformation. With increased participation by nontraditional market participants, more liquid, efficient, and potentially unstable secondary markets have also developed. As an example of increased efficiency, back in early 1980s one could buy secured loans of distressed companies at about 40 cents on the dollar, whereas after the early 1990s and before the 2007-2008 financial meltdown one would have to pay 85 or 90 cents on the dollar for the same loans. As an example of the potential funding instability, almost 70 percent of the par value outstanding of leveraged loans is held by nonbank institutions like hedge funds, collateralized debt obligation (CDO) trusts, and the like.

Financial innovation has not been the only driver of change in the distress investment environment. The legal environment for reorganizations has also changed with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which made changes to the Bankruptcy Reform Act of 1978. Among the many changes with respect to business bankruptcy reorganizations, the 2005 Act has imposed new time limits on the debtor’s exclusive right to file a Plan of Reorganization (POR), has shortened the time period during which debtors can decide whether to assume or reject nonresidential real estate losses, has attempted to limit executive compensation paid under key employee retention plans (KERPs), and has enhanced the rights of trade vendors. The administrative costs of a Chapter 11 reorganization have become quite onerous to many estates, and as a consequence we see a larger number of prepackaged and/or prenegotiated filings today.

These are just a few of the important forces that have shaped and continue to shape today’s distress investment environment. In this chapter we try to give the reader a broad perspective on some of these trends and changes both during the period from 1990 up until 2007 and after the 2007-2008 financial crisis.

TRENDS IN CORPORATE DEBT GROWTH AND LEVERAGE BEFORE THE FINANCIAL MELTDOWN OF 2007-2008

Over the past 60 years, U.S. nonfinancial corporate credit market debt outstanding grew, on average and in real terms, faster than the gross domestic product (GDP). Corporate debt grew at an annual real rate of 4.1 percent, whereas GDP grew at an annual real rate of 2.7 percent for the same period. Growth was volatile and generally tied to the business cycle (see Exhibit 1.1),

EXHIBIT 1.1 Annual GDP Growth Rate versus Corporate Credit Market Growth Rate, 1946-2007

but in the last 30 years the credit cycle became considerably more volatile than it had been in the previous 30 years.

For the 1945-1969 period, the volatility of the real rate of growth in GDP and corporate debt measured by their standard deviations were 4.00 percent and 2.39 percent respectively, whereas comparable numbers for the 1970-2007 period were 2.37 percent and 4.45 percent. Today, larger credit contractions are associated with much shallower slowdowns than in the past. The increased levels of leverage used by corporations brought about this larger volatility in the corporate credit cycle. In 1979, credit market debt at nonfinancial corporations was only 17.8 percent of assets, but by the end of 1990 it had grown to represent 26.2 percent of assets, surpassing the previous high level of 24.4 percent in 1970 (see Exhibit 1.2).

Increased levels of leverage were made possible by easier access to credit markets, which in turn resulted in an overall deterioration of creditworthiness. Understanding how these new levels of leverage came about is quite important to understanding the current distress investing environment. At the heart of this change in financial leverage was an unprecedented amount of financial innovation and regulatory change.

JUNK BONDS AND THE LEVERING-UP PERIOD

The leveraged restructuring movement and the development and growth of the original-issue below-investment-grade bond market played a major role in the levering-up process of the 1980s. The highly successful going-private transaction of Gibson Greetings, Inc. in 1982 and the astonishingly quick placement of $1.3 billion of junk bonds for Metromedia in 1984 signaled the beginning of a trend. From 1984 to 1989, use of proceeds for share purchases accounted for more than 80 percent of the net issuance of corporate bonds and bank loans put together.1 Although below-investment-grade bonds had been around for a long time, a large proportion of the amount outstanding during the 1970s was investment-grade debt that had been downgraded to below investment grade—fallen angels—and represented only a small fraction of the total corporate bond debt outstanding.

Junk bonds are generally unsecured obligations (debentures), with covenants that are much less restrictive than those of bank loans. Primary offerings come to market either as registered issues or under the exemption of Rule 144A that allows public companies to issue quickly and avoid the delays of a public registration.2 Deals that do not have registration rights are usually exchanged for an identical series of registered paper, which enhances their liquidity. Typical holders of this paper include mutual funds, pension funds, insurance companies, collateralized debt obligation (CDO) structured vehicles, and hedge funds. Many of the junk bonds are subordinated issues that rank junior to senior unsecured debt. In bankruptcy, senior unsecured debentures are always put into a class of unsecured claims with payment priority below bank loans and other secured senior debt to the extent of the value of the security behind the secured debt. By the early 1980s, the junk bond market had become the preferred financing mechanism for leveraged buyouts (LBOs) and other mergers and acquisition (M&A) activities. By 1989, junk bonds represented 20 percent of the total amount of bond debt outstanding at U.S. nonfinancial corporations.

EXHIBIT 1.2 Nonfinancial Corporations’ Credit Marker Debt to Total Marker Value of Corporate Assets, Based on Federal Reserve Data

A parallel development to the growth of the junk bond market was the development of its younger cousin, the mezzanine finance market. Companies that were too small to tap the bond market became the users of mezzanine debt. Mezzanine debt issues are much smaller and are almost always privately placed, highly illiquid, and bought with the expectation of being held to maturity. Like junk bonds, mezzanine paper is unsecured and virtually always subordinated in right of payment to bank loans and other senior debt.

Two other phenomena occurred during the levering-up decade: the substitution of junk bond debt for bank lending, and the easing of credit underwriting standards. By the end of 1990, outstanding bank debt stood at 21.5 percent of total credit market debt, a substantial decrease from 26.2 percent at the end of 1985 (see Exhibit 1.3). This decrease was matched by an increase in total credit market debt represented by bond debt, most of which was below investment grade. By 1990, outstanding bond debt had grown to 39.8 percent of total credit market debt from a low of 35.7 percent in 1985, while total credit market debt represented by both bank lending and bond debt remained virtually unchanged in 1985 and 1990.

The substitution appears even more dramatic when one looks at the net issuance of credit market debt for the two five-year periods ending in 1985 and 1990 shown in Exhibit 1.4. Net new bank loans represented only 13.2 percent of total credit market debt issuance during the 1985-1990 period, compared with a 27.4 percent figure for the 1980-1985 period.

Although outstanding bank debt grew in excess of 5 percent per year, its share of the corporate capital structure declined. These statistics show an aggregate picture for the U.S. nonfinancial corporate sector. Confirming this aggregate trend, an influential study of buyouts in the 1980s showed that while bank debt represented upwards of 70 percent of all debt used in such transactions during the first half of the 1980s, it represented only 55 percent by the end of the decade.3

The reduced participation of bank lending in corporate capital structures was a result of the competitive pressures faced by banks in the past two decades. The role of commercial banks in channeling deposits to corporations was being eclipsed by lower-cost funding alternatives. On the liability side, both deregulation and the emergence of money market funds largely eliminated large banks’ ability to fund themselves at below-market rates. On the asset side, large corporate borrowers started to reach investors directly through the commercial paper market and the public market for below-investment-grade issues. As we shall discuss later in this chapter, the principal role of many commercial banks started to shift from that of a financial intermediary and investor to that of an underwriter and distributor.

EXHIBIT 1.3 Percentage of Total Corporate Debt Accounted for by Bank Lending and Corporate Bond Debt, Based on Federal Reserve Data

At the time when U.S. corporations were levering up their balance sheets and substituting junk bond debt for bank debt, credit underwriting standards were easing considerably in the below-investment-grade market. One sign that standards were loosened was the emergence of financial innovations designed to reduce cash interest payment burdens. One such innovation was the payment in kind (PIK) bond, or bunny bond, which reproduced itself instead of paying cash interest. Another sign of such deterioration in credit standards was the reduction in the required cash flow support per dollar of debt, which translated to much higher ratios of debt per dollar of cash flow measured by earnings before interest, taxes, depreciation, and amortization (EBITDA). In Exhibit 1.5 we show the average EBITDA debt multiples prevalent for bank and nonbank lending (mostly subordinated bond debt) for the 1987-2007 period. The very high multiples of the late 1980s are a very clear indication of the easing of underwriting standards.

EXHIBIT 1.4 Composition of U.S. Nonfinancial Corporate Credit Marker Net Debt Relative Issuance, Based on Federal Reserve Data

EXHIBIT 1.5 EBITDA Multiples for Bank Debt and Nonbank Debt, 1987-2007

It turned out that the levering-up trend of the 1980s, coupled with the substitution of high yield debt for bank lending brought about by relaxed underwriting standards, created the stage for the large supply of distressed credits of the early 1990s. Although there is controversy about all the factors that ultimately contributed to the sharp decline of liquidity in the high yield market, McCauley et al. in 1999 suggested the following as the plausible contributors:4

• Bank regulators’ policies frowned on highly leveraged transactions at the end of 1988 and beginning of 1989.

• Passage of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) forced savings and loans to liquidate their portfolios of junk bonds in late 1989. The Resolution Trust Corporation (RTC) rapidly disposed of junk bonds in 1990.

• Junk bond mutual funds investors redeemed about 5 percent of investments in such funds in September and October 1989.

• Campeau Corporation defaulted on an interest payment on its Federated Department Stores junk bonds in September 1989.

• RJR Nabisco’s bonds were downgraded.

• Drexel Burnham Lambert bankruptcy in early 1990 removed a major source of liquidity from the market.

The final onset of the early 1990s recession brought about a very sharp increase in the default rates for high yield debt. A much deeper recession in 1980 had brought about substantially lower default rates in the below-investment-grade bond market, a sign that the creditworthiness of issuers was much higher in 1980 than in the 1990s (see Exhibit 1.6).5

From 1990 on, the levering-up trend abated and debt-to-asset ratios remained relatively stable (around 25 to 26 percent) until 2001 when leverage started to decline, reaching a low of 22 percent in 2005. The rapid growth trend of the high yield market had subsided during the early 1990s recession but promptly resumed after 1992.

However, unlike the 1980s when the bulk of junk bond issuance went to finance acquisition-related activities, in the 1990s these bonds were used for other purposes, including the refinancing of previous junk bond issues. By the end of 2005, junk bonds represented almost 36 percent of the corporate bond debt outstanding held by nonfinancial corporations.

The financial innovations of the 1980s facilitated the levering up of the capital structures of nonfinancial corporations, and this process resulted in a marked change in the composition of their credit market debt. Junk bond debt began to represent an ever-increasing mezzanine portion of the capital structure of U.S. nonfinancial corporations. Increased leverage and relaxed credit standards contributed to the deterioration of creditworthiness of the late 1980s that brought about the large supply of distressed credits we saw in the early 1990s. Moreover, financial innovation facilitated the shifting of credit risks from banks to other less regulated market participants who had become large providers of credit. The fundamental reasons responsible for the increased volatility of the credit cycle were in place throughout the 1990s and remain in place today.

THE SYNDICATED LOAN MARKET AND LEVERAGED LOANS

The trend toward further substitution of bond debt for bank debt did not abate until the end of 2005 when corporate bonds represented 56.9 percent of the outstanding credit market debt and bank loans were only 9.8 percent (see Exhibit 1.3). The apparent disintermediation was simply a reflection of the fact that commercial banks gradually stopped taking the credit risks that they had taken in the seventies and the eighties. The below investment grade portion of corporate capital structures was abandoned by banks and taken over by mutual funds, pension funds, insurance companies, and other institutional investors, but it took two decades for banks to effect such transformation and at its heart was the emergence of the syndicated loan market.

EXHIBIT 1.6 Relationship between Real GDP Growth and Default Rates on Junk Bonds

Syndications had been around for a while. Syndicated lending in the 1970s and early 1980s consisted of loans extended by large commercial banks to sovereign borrowers. The large number of sovereign defaults following Mexico’s default in 1982 effectively closed the syndicated market to emerging market borrowers. The essential change between syndications and the newer syndicated loan market was the role of the lead agent bank. Historically, the lead agent was a representative of the bank group and it negotiated terms and conditions on behalf of the other banks.6 This role changed with the development of the syndicated loan market where the lead agent began to act more like an investment bank, viewing the issuer as the client and lenders as investors.