Alternative Investments

Topic 4: Distress Investing

Dr. Fangzhou Lu
 He that dies pays all debt.
--TEMPEST

2
Topics
} History, catalysts for growth and current situation
} What is distress investing?
} Concepts to study
} Legal framework
} Absolute priority rule
} Fulcrum security (Six Flags)
} Determinants of recovery (Enron, WorldCom)
} Substantive consolidation (Lehman)
} Double dip (GM, Lehman)
} Predicting bankruptcies
} Risks in the strategy
3
History of Bankruptcy Act in the US
} The history of the Bankruptcy Act goes back to the 18th
century.
} Prior to passing the Bankruptcy Act, the debtors in
default were sent to the ‘debtors’ prison’, where they
were required to work to pay off their debts.
} The first Federal Bankruptcy Act was passed by one vote,
partly to get revolutionary war financier Robert Morris
out of jail.
} The act was eventually repealed, but laid foundation for
the current bankruptcy act.

4
History of Bankruptcy Act in the US
} During the revolutionary war, states issued bonds to fund
the war
} After the war, the bonds were trading at a fraction of its
value
} Then Secretary of Treasury, Alexander Hamilton proposed
that federal government should assume the debt of the
state governments
} He believed that it would give states a stake in the new union
and will help to hold the union together
} He also proposed creating a Bank of the United States (a
central bank) and he believed assuming debts would give it
legitimacy
} Bonds were trading at 20c/$ and they were paid in full
5
Catalyst for Growth
} It was a small esoteric class in 1980s with less than 20
dedicated distressed investors.
} Drexel Burnham developed the high-yield market and
became one of the big counterparties in the distressed
debt market as many of the distressed names were junk
bonds issued through Drexel. It eventually failed in 1990s.
} Bank debt market developed in late 80s
} Around same time regulation was issued to make it
difficult for insurance companies to hold distress debt
} High yield and distressed debt markets fell precipitously
in early 90s and ensuing recovery and high returns
generated lot of interest from other investors

6
Catalysts for Growth
} Financial innovation lead to complex instruments and
excessive risk-taking
} Easing of credit underwriting standards and change of bank’s
role from investor to underwriter and distributor
} 2000-2002 stock market downturn following the dot-com
bubble and 9/11 attacks
} 2007-2008 financial meltdown
} Some of the large bankruptcies
} Railroads
} Asbestos related lawsuits
} Telecom
} Internet bubble
} Financial sector

7
Growth of Corporate Bond Debt

Source: Distressed investing, Whitman, Diz

8
Current Situation
} Highly evolved market in the US
} Europe still lags behind
} Governments are protective, e.g. Alstohm
} Employees are some times protected and form largest creditor
group, e.g. France Telecom
} But it is changing
} Received a boost from telecom sector fall
} Bankruptcy laws are evolving, e.g. Italy introduced new laws
following Parmalat

9
Current Situation-Size of the Market

10
Current Situation-Size of the Market

Source: Defaults and Returns in the High-Yield Bond and Distressed Debt Market:
The Year 2017 in Review and Outlook By Edward I. Altman and Brenda J. Kuehne

11
Causes for Financial Distress
} Deterioration of operating performance
} Lack of access to capital markets
} Large off-balance sheet contingent liabilities
} Deterioration of GAAP performance
} Economic downturn and changes in business cycles

12
Cyclicality in Default Rate

Source: Defaults and Returns in the High-Yield Bond and Distressed Debt Market:
The Year 2017 in Review and Outlook By Edward I. Altman and Brenda J. Kuehne

13
What is Distress Investing?
} Making investment in capital structure or derivatives
relating to companies that are in financial distress and/or
bankruptcy
} Distressed debt is defined as
} Trading 1000 basis points over treasuries
} Low rating by rating agencies
} Federal laws governing bankruptcy are known as the
Bankruptcy code
} Bankruptcy code offers protection to debtors
} Helps rejuvenate the debtor by restructuring the debt or
workout
} Treat creditors fairly-a ‘fair and equitable standard

14
Investing in Distress Market
} Hedge funds that invest in distress market as called
‘vulture investors’ as they feed on dying companies
} Vulture investors can enjoy excess returns due to
} Post-reorganization equity performance provides excess
returns (Altman 1998)
} Imperfect information—overall a more inefficient market
} Better control over restructuring by participating in the
bankruptcy process
} Academic research shows that active investors increase
firm value

15
Investing in Distress Market
} Why don’t existing stakeholder continue to hold their
investments?
} Legal restrictions: Some investors are not allowed to hold
below BBB by their charter
} Creditors are not always in the business of investing in distress
} Risk aversion: Distress investments are more risky
} Long waiting period before realising returns

16
 H Partners and Six Flags

17
Reasons for Six Flag’s Bankruptcy
} What are some of the reasons for Six Flag’s bankruptcy?
Build way too many parks, meet 2009, 2.7 billion debt
Senior bond trading at 60% of par

} How did H partner decide to invest in distressed companies?

Rehan Jaffer and Usman Nabi
Started with Daniel Loeb Third Point

} Does Six Flag fit the bill?

Enterprise Value=Debt+Equity-Cash=1.6 Billiion USD
To build all the parks Six Flag own cost 5 Billion USD
18
Evaluation of the Bankruptcy Plan
} What was the management’s plan?
Three lays of debt: Senior, SFO, SFI
Wipe out equity, debt for equity exchange for debt holders
Bank hold most of the senior debt

Bank does not want to own equity, 2/3 of the voters in each class
need to approve the debt for equity exchange, longer maturity
debt holders are fine, but shorter maturity debt holders are
angry

} What was the revised plan?

New bank debt to substitute old bank debt, SFO and SFI gain
equity while a right offering plan for the SFI to inject another 700
million USD

19
Six Flag’s Valuation
} How can we value Six Flags?
} What is replacement value?
} What is management’s valuation as per the plan filed by
the management?
} What is the valuation based on comps?

EV/EBITDA
Will people want to come back to Six Flags?
Is this a one time crisis or recurring crisis?
Are there any holdout problem?

20
What Should H Partners Do?

Option Pros Cons

1. Exit
2. Rights Offering
3. Buy SFIs
4. Propose New
Restructuring Plan
5. Invest in post-reorg equity

21
Six Flags—What Actually Happened
} H Partners believed there was more value in the
company and the junior bonds were undervalued
} H Partners bought the SFI bonds at 20%
} SFI bondholders raised $700mm in rights issue
} Both bank debt and SFO was paid in full and SFI became
the new fulcrum security
} Usman Nabi became the Chairman of the Six Flags board

22
Six Flags Stock Price Post Bankruptcy

23
Legal Framework
} Types of bankruptcies
} Voluntary or involuntary
} Pre-arranged, Pre-packaged (“Pre-Pack”) and traditional Chapter 11
(reorganization)
} Chapter 7 (liquidation)
} We will be focusing on traditional Chapter 11
reorganizations

24
Description

Pros

Cons

25
Chapter 11 Process Court
Disclosure confirms
Statement Plan; Exit
Company financing
Formulate approved
Chapter 11 Negotiate should be
petition; business plan
Plan, line committed
automatic stay and execute Creditors
restructuring up exit
in place financing approve
transactions Plan

Preparation, Business
including restructuring and Plan disclosure and Exit
negotiating a DIP restructuring confirmation
financing deal “First Day” orders and negotiations
stabilization of business;
Cash Collateral use,
26 initial DIP approval
Creditors Hierarchy-Absolute Priority Rule
Highest DIP
Priority Bank Debt

Priority of liquidation in case of bankruptcy

Senior Secured

Senior
Unsecured

Senior
Subordinated

Junior
Subordinated

Privileged
Shares

Lowest Common
Priority Shares

27
Distribution of Value
Bank Debt New Bank Debt

Sr. Secured Debt New Sr. Bonds New Debt

Old Debt

New Equity New Equity

Junior Debt

Old Equity Equity

28
Fulcrum Security
} Fulcrum security is a security in the capital structure that
receives most post-reorg equity
} A common distress strategy is ‘loan-to-own’ where a
hedge fund invests in a fulcrum security in order to gain
control of the company
} ‘Loan-to-own’ strategy can benefit from equity upside
} Hedge fund can take active part in the restructuring to
unlock value
} However, identifying fulcrum security can be tricky and
depends on the enterprise valuation agreed upon in
bankruptcy

29
Valuation of Firms in Bankruptcy
} Valuation plays a central role in bankruptcy negotiations
as the firms estimated value determines the value of the
assets to be distributed among claimants
} However, the factors that lead to reliable value are absent
} No analyst coverage
} The securities trade infrequently
} Information about the firm is not easily available

30
Valuation of Firms in Bankruptcy
} How will you value a company in bankruptcy?
} What are some of issues you may face while using the
valuation methodologies?
} Is most of the value in terminal value?
} Will the assets be sold at true market value?
} How do you value intangibles?
} The valuation is further complicated by the fact that the
US Bankruptcy law resolves valuation through negotiation

31
Valuation of Firms in Bankruptcy
} During the first 120 days after filling of the Chapter 11
petition, management has the exclusive right to present a
plan of reorganization
} If the plan is not accepted within 180 days, other
interested parties can file a plan
} The plan includes valuation and proposed distribution to
various claimants
} The claimants vote on the plan. The plan is approved if
} Within a class, holders of simple majority in number and 2/3
dollar amount of claims agree to a plan
} In addition, law assumes votes of unimpaired (presumed to
vote for) and those who receive nothing (presumed to vote
against)

32
Valuation of Firms in Bankruptcy
} Different claimants have interest in high or low-balling the
valuation

Source: “Valuation of Bankrupt Firms”, Gilson, Hotchkiss,, Ruback

} Did Six Flag’s management have a conflict?

33
Determinants of Recovery
} Industry distress is an important determinant of recovery
(Acharya, Bharat, Srinivasan, 2006). Lower recoveries
during industry distress are a result of
} Overall economic downturn effect
} Asset fire sale effect
} The recovery is further affected if the industry is characterized
by assets that are specific, that is, not easily redeployable by
other industries
} Seniority (Absolute Priority Rule)

34
35
Historical Recoveries 1982-99

Source: Acharya, Bharath and Srinivasan (Journal of Financial Economics, 2007), based
on S&P data on defaulted bond and loan recoveries

36
Recovery Within a Class of Securities
} Recoveries are identical within a class of instruments (by
seniority, security)
} What is the rationale?
} Institutional: Bond covenants
} Empirical: Evidence from real-world examples
} Market: Convergence of bond prices as default approaches is a
popular strategy to bet on default

37
Evidence-WorldCom’s Default

38
Evidence-Enron’s Default

39