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8. Distressed Securities

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8. Distressed Securities
Distressed securities are the securities of companies that are in financial distress or near bankruptcy
8. Distressed Securities
In the US investing in distressed securities involves purchasing the claims of companies that have already filed for Chapter 11 (protection for reorganization) or are in immediate danger of doing so

Under Chapter 11 protection, companies try to avoid Chapter 7 (protection for liquidation) through an out-of-court debt restructuring with their creditors
8. Distressed Securities

Why is there an opportunity to make money in the Distressed Securities Markets?

Reason 1

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INVESTMENT STRATEGIES using distressed securities

Exploit the fact that many investors are unable to hold below-investment-grade securities because of REGULATORY or investment POLICY RESTRICTION*
8. Distressed Securities


Why is there an opportunity to make money in the Distressed Securities Markets?

Reason 2

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Furthermore, relatively few analysts cover distressed securities markets and bankruptcies, resulting in unresearched investment opportunities for knowledgeable investors who are prepared to do their homework.

Skill in influencing management and skill in negotiation are other qualities that can be rewarded in this field
8. Distressed Securities

What types of securities?
a. Debt
b. Equity

Who are the most common investors?

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Debt & equity are traditional asset classes

Yet, because of the special characteristics and risks of the debt and equity of distressed companies and the strategies that use them, distressed securities investing is widely viewed as an ALTERNATIVE INVESTMENT

Contributing to this perspective is the fact that among the most active investors in the field are hedge funds and private equity funds
8.1. The Distressed Securities Market

What increases the market opportunity?

What decreases the market opportunity?


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The market opportunities for this strategy

INCREASE with higher default rates on speculative-grade bonds (which have historically averaged about 5% per year in the United States)

and

DECREASE with the number of distressed debt investors competing for mispriced securities
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8.1.1. Types of Distressed Securities Investments

Investors may access distressed securities investing through two chief structures:

1. *Hedge fund structure
(dominant type)

Key characteristics:
1. HF manager can take in new capital any time
2. More profitable for the HF manager (AUM + Incentive)
3. Investors enjoy more liquidity (get the **** out more easily)

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For the hedge fund manager, it offers the advantage of being able to take in new capital on a continuing basis

The AUM fee and INCENTIVE structure, particularly when there is no hurdle rate associated with the incentive fee, may be MORE LUCRATIVE than with other structures

Investors generally enjoy more liquidity withdraw capital more easily) than with other structures
8.1.1. Types of Distressed Securities Investments

Investors may access distressed securities investing through two chief structures:

2. Private equity fund structure

Key Characteristics:
1. Fixed Term (set dissolution date)
2. Assets are HIGHLY ILLIQUID and HARD to VALUE (NAV FEE based structure is tough to calculate)
3. Can't get the **** out as easily as HF structure

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Private equity funds have a fixed term (i.e., a mandated dissolution date) and are closed end (they close after the offering period has closed)

This structure has advantages where the assets are highly ILLIQUID or DIFFICULT to value

An NAV fee structure may be problematic when it is difficult to value assets

When assets are illiquid, hedge fund-style redemption rights may be inappropriate to offer
8.1.1. Types of Distressed Securities Investments

Investors may access distressed securities investing through two chief structures:

3. Other Structures: Hybrids
There are also structures that are hybrids of the hedge fund and private equity fund structure

In addition, distressed securities investing may be conducted in traditional investment structures, such as separately managed accounts, and even in open-end investment companies (mutual funds)
Distressed securities managers may themselves invest or trade in many types of assets, including the following:


1st type of asset
The publicly traded debt and equity securities of the distressed company;
Distressed securities managers may themselves invest or trade in many types of assets, including the following:

2. 2nd type of asset
Newly issued equity of a company emerging from reorganization that appears to be undervalued

called ORPHAN equity
Distressed securities managers may themselves invest or trade in many types of assets, including the following:

3rd type of asset
Bank debt and trade claims, because banks and suppliers owed money by the distressed company may want to realize the cash value of their claims

When the company is in reorganization, these instruments would be bankruptcy claims
Distressed securities managers may themselves invest or trade in many types of assets, including the following:

4th type of asset
"Lender of last resort" notes
Distressed securities managers may themselves invest or trade in many types of assets, including the following:

5th type of asset
And a variety of DERIVATIVES INSTRUMENTS for hedging purposes

In particular, for hedging the MARKET RISK of a position
8.1.2. Size of the Distressed Securities Market
One measure would aggregate all the assets under management related to distressed securities in whatever investment structure such assets are managed.

Nevertheless, the size of the high-yield bond market can give an indication of the potential supply of opportunities, because distressed debt is one part of that market—in particular, the highest-risk part.

Based on a maximum quality rating of Ba1 (as determined by Moody's Investors Services), the US high-yield market consisted of US$548 billion at face value and US$552 billion at market value as of the end of May 2004

This size can be compared with the market size of only US$69 billion at face value as of the end of 1991
8.2. Benchmarks and Historical Performance
Hedge fund industry data are the chief source for evaluating modern distressed securities investing
8.2.1. Benchmarks

In the context of HFs, DS investing is classed as
EVENT DRIVEN STATEGIES
In the context of hedge funds, distressed securities investing is often classed as a substyle of EVENT-DRIVEN strategies

All major hedge fund indices that we discussed in the hedge fund section have a subindex for distressed securities
For example
For example, the EACM, CISDM, and HFR indices all have distressed securities subindices
8.2.2. Historical Performance

Using the monthly HFR Distressed Securities Index for the period January 1990-December 2004


RETURN DISTRIBUTION is distinctly NON-NORMAL*
The returns on distressed securities investing can be quite rewarding

Exhibit 37 shows that the return distribution for distressed securities is distinctly non-normal
Downside risk

KEY SLIDE (M)

LARGE DOWNSIDE RISK; LARGE NEGATIVE SKEW

BIAS TO DOWNSIDE
In particular, it reflects significant downside risk, with a negative skewness of -0.68

The negative skewness indicates that, for distressed securities, large negative returns are more likely than large positive returns

Hence, there is a bias to the downside
Kurtosis (outlier event)


KEY SLIDE (M)

LARGE DEGREE OF KURTOSIS - LARGE OUTLIERS EVENTS
In addition, the monthly return distribution displays a large degree of kurtosis (5.55)

This indicates that these securities are exposed to large outlier events

The two statistics together indicate significant downside risk
Conclusion

SHARP RATIOS: CANNOT BE USED TO MEASURE RISK RETURN TRADEOFF ..
Consequently, the Sharpe ratio, which is based on the NORMAL DISTRIBUTION assumption,

MAY NOT capture the COMPLETE RISK-RETURN trade-off of DISTRESSED SECURITIES investing
When does the strategy performs best?

WEAK business cycle (=GOOD PERFORMANCE)

STRONG business cycle (=BAD PERFORMANCE)

KEY TO ADD PERFORMANCE IS = EVENT RISK PREDICTION (can you predict when company will leave the bankruptcy)
In terms of performance, this strategy depends a great deal on the business cycle and how well the economy is doing

When the economy is NOT DOING WELL, bankruptcies increase and this strategy DOES WELL.

An important risk factor that may not be captured by the performance data is event risk.

The ability to correctly predict whether an event will occur will ensure the success of the strategy
NOT ONLY YOU CAN INCREASE RETURN BUT ALSO THERE IS LOW CORRELATION WITH STOCKS AND BONDS....

INCREASE RETURN

DECREASE RISK
Moreover, the minimum one-month return is less negative for distressed securities than for US and world equities

Low correlation with world stock and bond investments suggest that adding distressed securities to a portfolio of world stocks and bonds might increase return and reduce risk*
BECAUSE THE NEG SKEW AND HIGH KURTOSIS
STANDARD DEVIATION IS UNDERSTATED
Because returns of distressed securities display negative skewness and high kurtosis (see Exhibit 37), however, risk represented by STANDARD DEVIATION is probably UNDERSTATED
8.2.3. Interpretation Issues
In estimating the size of the distressed debt market, we gave figures for the high-yield debt market

Non-investment-grade or high-yield bonds are not necessarily on the brink of default; thus, they are not necessarily distressed

Distressed bonds constitute the highest credit-risk segment of the high-yield bond market.

Furthermore, distressed securities include distressed EQUITIES
8.3. Distressed Securities:

Investment Characteristics and Roles
Although certain types of distressed securities investing may be considered for RISK-DIVERSIFICATION potential

SOME of its typical risks are NOT WELL CAPTURED by such measures as CORRELATION and STD DEVIATION, which are usually the guideposts in portfolio optimization
Why do investors look for distressed securities?

Two main reasons:
1.
2.
Investors look to distressed securities investing primarily for the possibility of

HIGH RETURNS from security selection
(exploiting mispricing)

&

ACTIVISM
8.3.1. Investment Characteristics
The market opportunity that distressed securities investing offers to some investors arises from the problems that corporate distress poses to other investors
Source of distressed securities opportunities

Two reasons:
1. Regulatory Constraints
2. Policy Restrictions

What are FALLEN ANGELS....
Many investors are barred from any substantial holdings in below-investment-grade debt because:

1. Regulations
2. Investment policy statements

These investors must sell debt that has crossed the threshold from investment grade to high yield

This is the so-called FALLEN ANGELS
Source of distressed securities opportunities

one more reasons...

1. Banks
2. Failed Leveraged Buyouts
1. BANKS may prefer to convert their claims to cash rather than participate as creditors in a possibly long reorganization process

2. Failed leveraged buyouts
Source of distressed securities opportunities

Why does the mispricing of these securities occur?
Old equity claims may be wiped out in a reorganization, replaced by new shares issued to creditors, and sold to the public as the company emerges from reorganization

These shares may be shunned by investors and analysts, and thus be mispriced
Distressed securities

Who can do well or is able to explore opportunities in this markets?

1. Experts in CREDIT ANALYSIS & TURNAROUNDS
2. Investor needs to assess the bare-bones liquidation value of the company
3. Understand the source of the company problems
4. Due diligence is high
5. Private or Institutional Investors inherits the ILLIQUID characteristic of DS
Distressed securities may offer a fertile ground for experts in credit analysis, turnarounds, business valuation, and bankruptcy proceedings to earn returns based on their skill and experience

A common theme in distressed securities investing is that it often demands access to specialist skills and deep experience in credit analysis and business valuation

Distressed companies are potentially near the end of their life as going concerns

The investor needs to assess not only potential outcomes for the company as a going concern but also the bare-bones liquidation value of the company

The investor needs to understand the sources of the company's problems, its core business, and its financing structure

A distressed securities fund's abilities in this regard are one element in due diligence

For a private or institutional investor investing indirectly via a hedge fund or other vehicle, this type of investment inherits the liquidity characteristics specified in the structure of the vehicle
8.3.2. Roles in the Portfolio

Long-Only Value Investing

Expectation security will rise in value as other see improv.
For debt = HIGH-YIELD investing
For Equity= ORPHAN-YIELD investing

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Investing in perceived undervalued distressed securities in the expectation that they will rise in value as other investors see the distressed company's prospects improve

When the distressed securities are public DEBT, this approach is HIGH-YIELD investing

When the securities are ORPHAN EQUITIES, this approach is ORPHAN EQUITIES INVESTING
Distressed Debt Arbitrage

1. BUY the BONDS
2. SELL the EQUITY (SHORT)


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Involves:

1. BUYING the traded BONDS of bankrupt companies

AND

2 .SELLING the common EQUITY short

The hedge fund manager attempts to buy the debt at steep discounts

If the company's prospects WORSE:
The value of the company's debt & equity should DECLINE, but the hedge fund manager hopes that the EQUITY, in which the fund has a SHORT position, will DECLINE to a GREATER degree

If the company's prospects improve:
Manager hopes that DEBT will appreciate at a HIGHER RATE than the equity because the initial benefits to a credit improvement accrue to bonds as the SENIOR CLAIM

Typically, the company will have already suspended any dividends, but DEBT HOLDERS WILL receive ACCRUED INTEREST
Private Equity OR Active Approach

THE ACTIVE APPROACH = CORPORATE ACTIVISM
This has also been called an active approach because it involves corporate activism
Private Equity OR Active Approach

Main way it is done
1. FIRST: Investor becomes a MAJOR CREDITOR of the target company to OBTAIN INFLUENCE on the BOARD OF DIRECTORS or if the company is already in reorganization or liquidation, on the CREDITOR COMMITTEE . The investor buys the debt at deep discounts*

2. Then influences and assists in the recovery or reorganization process

The objective of this focused active involvement is to increase the value of the troubled company by deploying the company's assets more efficiently than in the past

If the investor obtains new shares in the company as part of the reorganization, the investor hopes to sell them subsequently at a profit
Private Equity OR Active Approach

A variation: PREPACKAGED BANKRUPTCY

1. The firm takes a dominant position in the distressed DEBT of a "PUBLIC COMPANY"

2. Seeks to have a prepackaged bankruptcy in "PRIVATE company"

3. Then sell to private or public investors (IPO again)
Converting DISTRESSED DEBT to PRIVATE EQUITY in a PRE PACKAGED BANKRUPTCY

This type of operation is typically conducted by private equity firms

1. The firm takes a dominant position in the distressed DEBT of a "PUBLIC COMPANY"

Working with the company and other creditors, the firm seeks to have a prepackaged bankruptcy in which the firm becomes the MAJORITY OWNER of a private company on favorable terms (the previous public equityholders losing their complete stake in the company).

After restoring the company to better health, the firm has a company that can be sold to private or public investors
Active Approach: Other main points

Investors are aggressive = called VULTURES running VULTURE FUNDS or VULTURE CAPITAL
Investors will be AGGRESSIVE in protecting and increasing the value of their claims*

Practitioners of the PRIVATE EQUITY APPROACH are often referred to as VULTURE investors, and their funds, as vulture funds or vulture capital.

Nevertheless, if the company is turned around, other parties may benefit, and the vultures are bearing risk that presumably other investors wish to transfer to them
Investors need to assess the risks that a particular distressed securities strategy may entail

The risks may include one or more of the following:

Event risk
any company specific event
Any number of unexpected company-specific or situation-specific risks may affect the prospects for a distressed securities investment

Because the event risk in this context is company specific, it has a low correlation with the general stock market
Investors need to assess the risks that a particular distressed securities strategy may entail.

The risks may include one or more of the following:

Market liquidity risk
Much less liquidity than other securities, depends on supply and demand and it is highly cyclical in nature
Market liquidity in distressed securities is significantly less than for other securities, although the liquidity has improved in recent years

Also, market liquidity, dictated by supply and demand for such securities, can be highly cyclical in nature.

This is a major risk in distressed securities investing
Investors need to assess the risks that a particular distressed securities strategy may entail.

The risks may include one or more of the following:

Market risk
Economy - IR - State of Equity Markets
The economy, interest rates, and the state of equity markets are not as important as the liquidity risks
Investors need to assess the risks that a particular distressed securities strategy may entail.

The risks may include one or more of the following:


J factor risk
Judge track records
The judge's track record in adjudicating bankruptcies and restructuring as J factor risk

The judge's involvement in the proceedings and the judgments will decide the investment outcome of investing in bankruptcy

judge factor is also an important variable in determining which securities, debt or equity, of a Chapter 11-protected company to invest in.
Other risks may also be present:

1. actions of the trustees
2. Identity of creditors
3. Tax issues
Some are associated with the legal proceedings of a reorganization:

The actions of the trustees as well as the identity of creditors can affect the investment outcome.

The distressed securities investor may lack information about the other investors and their motivations

Tax issues may arise in reorganizations.
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A normality assumption is not appropriate in evaluating this class of strategies.

It has become quite well known that the return distribution from this strategy is not normally distributed (it has negative skewness and positive kurtosis);

thus, if normal distribution is assumed, risk measurement tends to underestimate the likelihood of downside returns
...
Distressed securities are illiquid and almost nonmarketable at the time of purchase

As the companies turn around, values of the distressed securities may go up gradually

Typically, it takes a relatively long time for this strategy to play out; thus, valuing the holdings may be a problem
...
It is difficult to estimate the true market values of the distressed securities, and stale pricing is inevitable.

Stale valuation makes the distressed securities appear less risky

The risk of this strategy is probably understated, and its Sharpe ratio overstated
...
Whether a distressed securities investment will be successful or not depends on many factors

The outcome depends heavily on the legal process and may take years

Of course, the vulture investor's timeframe is often months, not years.

The role played by vulture investors has a significant bearing on the outcome.

If vulture investors do not participate in the restructuring or if they decide to sell prior to the final settlement, the flood of shares into the market will create further downward pressure on the stock price
...
This may have a significant impact on the whole industry.

Because any move by vulture investors may be heeded by other investors, they take great care not to divulge their intentions

Thus, investing in distressed securities requires legal, operational, and financial analysis
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From an investment perspective, the relevant analysis involves an evaluation of the source of distress

The source could be the operations, finances, or both

This is a complex task, and each distressed situation requires a unique approach and solution

As a result, distressed investing involves company selection.

In this reading, we focus on the legal aspects
8.3.3. Other Issues
In this section, we describe the bankruptcy process to highlight how the process may affect the investment outcome and considerations that investors need to ponder.
Bankruptcy in the United States versus Other Countries
For all practical purposes, the relevant legislation for distressed investment in the United States is the Bankruptcy Reform Act of 1978, which applies to all bankruptcies filed since 1 October 1979
...
In the Code, there are several chapters of the substantive law of bankruptcy.

Chapters 1, 3, and 5 generally apply to all cases, whereas Chapters 7, 9, 11, 12, and 13 provide specific treatment for particular types of cases

Of particular interest to distressed securities investors are Chapters 7 and 11, which provide specific treatments for, respectively, liquidations and reorganizations
Key for this section
Branch and Ray pointed out that a US Chapter 7 bankruptcy is conceptually (emphasis ours) similar to the bankruptcy procedures followed in most other countries

That is, when a person seeks protection under Chapter 7, that person's assets are collected and liquidated and the proceeds are distributed to creditors by an appointed bankruptcy trustee
...
The debtor is normally discharged from the debts that were incurred prior to bankruptcy

As in most other countries, under Chapter 7, rehabilitation of the debtor is not especially important

It is in this sense that the US Chapter 7 is conceptually similar to other countries
...
In contrast, Chapter 11 emphasizes rehabilitation of the debtor and provides an opportunity for the reorganization (restructuring) of the debtor.

This is the distinctive feature of US bankruptcy that separates it from most of the rest of the world

This is where opportunity arises for distressed debt investors
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In Chapter 11, the debtor retains control of its assets and continues its operations

While under this protection, the debtor, now known as a debtor-in-possession, seeks to pay off creditors (often at a discount) over a period of time according to a plan approved by the bankruptcy court.

Some of the liabilities may be discharged

By filing Chapter 11, a debtor can protect its productive assets from being seized by creditors and have time to plan the turnaround of the business
...
A Chapter 11 case can be initiated voluntarily by a debtor or involuntarily by certain of the debtor's creditors or their indenture trustee

The indenture trustee—typically a bank, trust company, or other secure, respected institution—is named in the indenture agreement (contract between bondholders and the bond issuer) as the bondholders' agent charged with enforcing the terms of the indenture
...
A plan of reorganization is submitted to the court for approval

The plan is typically proposed by the debtor with the blessings of creditors, especially the senior creditors.

In most cases, the debtor works with its creditors to formulate a plan of reorganization.
...
This plan details how much and over what period of time the creditors will be paid.

Prospective distressed securities investors should pay attention to the exclusivity period

The exclusivity period occurs at the beginning of each case.

During this time (set at 120 days but often extended by the court), only the debtor can file a plan of reorganization

After the exclusivity period expires, any party with an interest in the bankruptcy can file a plan proposing how the estate's creditors are to be paid under Chapter 11.

Creditors and shareholders of the debtor eventually must approve the plan and have it confirmed by the bankruptcy judge
...
The judge can refuse to confirm a case if the plan is not proposed in good faith or if each creditor receives less than it would receive in a Chapter 7 liquidation.

The judge can overrule the disapproval by some dissenting creditors, however, on economic grounds or for other considerations, such as social or legal grounds
Cram down
This is commonly referred to as the cram down

Thus, a cram down is basically a compromise between the debtor and certain classes of creditors when they cannot come to an agreement on the reorganization plan.
...
Referred to as the impaired class,those who object to the reorganization plan are those who believe their interest in the reorganization is impaired by the proposed plan.
...
Put another way, an approved reorganization plan by the court of law may not necessarily make economic sense, and such an erroneous presumption may be costly to distressed investing.

The uncertain nature of the outcome of legal proceedings makes analysis of such investment challenging, and it must be accompanied by extensive due diligence.
Absolute Priority Rule
In the United States, a reorganization plan must follow the rule of priority with respect to the order of claims by its security holders

In general, claims from senior secured debtholders (typically, bank loans) will be satisfied first*

The debtor's bondholders come next

The distribution may be split between senior and subordinated bondholders

Last on the list are the debtor's shareholders
...
In a cram down in which the court overrules the objection of a dissenting class of creditors, the priority rule becomes absolute

The rule is absolute in the sense that, to be "fair and equitable" to a class of dissenting unsecured creditors, the plan must provide either that the unsecured creditors receive property of a value equal to the allowed amount of the claim or that the holder of any claim or interest junior to the dissenting class does not receive or retain any property on account of the junior claim
...
In other words, the classes ranked below the dissenting unsecured class must receive nothing if the dissenting class is to be crammed down

It is in this sense that the law treats the holders of claims or interest with similar legal rights fairly and equitably, even if they do not accept the proposed plan.
...
There is an exception to the absolute priority rule, which is referred to as the new value exception

In the new value exception, the debtor's shareholders seek to retain all or a portion of their equity interest by making what amounts to a capital contribution
...
In exchange for their contribution, they retain their interest even in the face of a dissenting vote by a senior class of creditors
...
The US Supreme Court has held, however, that the new value exception does not permit contribution of such value without competitive bidding or some other mechanism to establish the adequacy of the contribution.
...
Branch and Ray (2002) concluded that this ruling removes substantial uncertainty over whether or not a lower class of creditors can receive distribution under a plan of reorganization by contributing new value to the bankruptcy confirmation process.

In other words, it helps reduce uncertainty in purchasing an interest in a Chapter 11 debtor.
...
Most of the time, holders of senior secured debts are "made whole" whereas the debtor's shareholders often receive nothing on their original equity capital.

This is the residual risk that equity shareholders ultimately must bear.
Relationship between Chapter 7 and Chapter 11
Why must distressed investors pay attention to Chapter 7 filings?

Chapter 11 reorganization can start from a Chapter 7 filing, whether voluntarily or involuntarily.

A debtor against whom an involuntary Chapter 7 is filed has a right to convert the case to a Chapter 11 proceeding.
...
Similarly, a Chapter 7 debtor that filed a voluntary petition can convert the case to a Chapter 11, unless the case started as a Chapter 11.

In addition, the court can convert a Chapter 11 case to Chapter 7 or dismiss the case for cause (e.g., the inability of the debtor to carry out a plan) at any point in the case.

The latter uncertainty adds much risk to bankruptcy investors.
Prepackaged Bankruptcy Filing
In a prepackaged bankruptcy filing, the debtor agrees in advance with its creditors on a plan or reorganization before it formally files for protection under Chapter 11.

Creditors usually agree to make concessions in return for equity in the reorganized company.

This is tantamount to obtaining advance approval of an exchange offer of public debt with less stringent requirements than those found in the public indenture.

This way, a debtor expedites the bankruptcy process to emerge as a new organization.
...
Whether it is Chapter 7 or Chapter 11, a filing for protection under law will affect the value of the debtor.

Especially under forced bankruptcy (i.e., involuntary Chapter 7 filing by creditors), its reputation is severely impaired by the stigma of being forced into bankruptcy.
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