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Distressed Investing Demystified: Lessons From Recent Cases

Distressed Investing Demystified: Lessons From Recent Cases. Chartered Financial Analyst Society of Des Moines May 7, 2008 Stephen G. Moyer, CFA Director Tennenbaum Capital Partners, LLC. General Disclaimer.

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Distressed Investing Demystified: Lessons From Recent Cases

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  1. Distressed Investing Demystified:Lessons From Recent Cases Chartered Financial Analyst Society of Des Moines May 7, 2008 Stephen G. Moyer, CFA Director Tennenbaum Capital Partners, LLC 2008 Stephen G. Moyer

  2. General Disclaimer The information/views discussed in this presentation are the author’s/speaker’s (“author”) alone and not necessarily those of Tennenbaum Capital Partners, LLC (“TCP”). The author has no direct holdings in any securities. TCP may from time to time have holdings of distressed securities of the type generically discussed herein. This presentation is for information purposes only. Nothing in these materials or the related discussion should be considered a recommendation to purchase or sell any specific security. Investment in distressed securities involves substantial risk. 2008 Stephen G. Moyer

  3. Tennenbaum Capital Partners • Institutional Asset Manager with ~$7.5 billion under management • $6.5B Credit Opportunities Funds • Long-Term Activist Orientation • 20 person investment team • $1.0B Multi Strategy Hedge Fund • Convert Arb, Risk Arb, Deep Value/Distressed, Capital Structure Arb, Special Situation Equities • 6 person investment team 2008 Stephen G. Moyer

  4. Highlights of the Current Distressed Market 2008 Stephen G. Moyer

  5. Historic Default Rates Source: E. Altman, NYU Solomon Center 2008 Stephen G. Moyer

  6. Leveraged Loan Market Has Grown 2008 Stephen G. Moyer

  7. Quality of Leveraged Loans Has Declined 2008 Stephen G. Moyer

  8. Growth in Sr Debt Crowding out Sub Debt Source: Bank of America/Carlyle 2008 Stephen G. Moyer

  9. Size of US Defaulted & Distressed Debt Mkt Source: E. Altman, NYU Solomon Center 2008 Stephen G. Moyer

  10. But Sprds Still Low Relative to Distressed Cycle 2008 Stephen G. Moyer

  11. Prices Too High for Outsized Returns 2008 Stephen G. Moyer

  12. Recession Could Trigger Explosion in Distressed Opportunities HIGH YIELD BOND MARKET 1972 – 2007 Periods of Recession: 11/73 - 3/75, 1/80 - 7/80, 7/81 - 11/82, 7/90 - 3/91, 4/01 – 12/01 Source: E. Altman (NYU Salomon Center) & National Bureau of Economic Research 2008 Stephen G. Moyer

  13. Four Reasons Why Superior Returns May Be Possible • Insufficient Information/Liquidity for Efficiency • Sale Decisions Not Related to Fundamentals • Investor Involvement Affects Returns • Imbalances in the Supply/Demand for Distressed Securities 2008 Stephen G. Moyer

  14. Analyzing Distress Debt Investment Opportunities 2008 Stephen G. Moyer

  15. Valuation Fallacies 2008 Stephen G. Moyer

  16. Beazer Valuation Volatility 2008 Stephen G. Moyer

  17. Bally’s Valuation Across Time 2008 Stephen G. Moyer

  18. AV = 302 Sr Debt = 500 Neg Equity = 398 Sub Debt = 200 Assets 302 Liabilities 700 Neg Equity 398 Equity 0 Total 700 700 A Picture of Distress 2008 Stephen G. Moyer

  19. Increase Asset Value Resize Capital Structure Sr Debt = 500 AV = 302 Sr. Debt = 150 AV = 700 E = 152 Sub Debt = 200 Cash 200 Sr Debt 500 Cash 200 Sr Debt 150 Tang Assets 500 Sub Debt 200 Tang Assets 102 Sub Debt 0 Total 700 Equity 0 Total 302 Equity 152 700 302 Its Nice to Have Options 2008 Stephen G. Moyer

  20. Fulcrum Security • General meaning is that claim class which will receive majority of its recovery in post-reorg equity • Typically is point in the claim waterfall where EV ends 2008 Stephen G. Moyer

  21. Distressed Investing Paradigm: How Much is There—Who Gets It—What Do They Get 2008 Stephen G. Moyer

  22. Step 1: Valuation • Valuation Approaches Standard • DCF • EBITDA Multiple • % of Revenues • Specialized Asset Valuations (e.g. Aircraft, Ships, Real Estate) • Use PV Discounting to Adjust for Cash Flow Timing • Length of Reorganization Process • Expected Distributions/Realizations • Challenge: • Predicting Ch 11 impact on EV • Analyzing the Impact of the Bankruptcy Rules on Recoveries - 2008 Stephen G. Moyer

  23. Equity in Control But May Only Have Option Value 2008 Stephen G. Moyer

  24. Can Voluntary Restructuring Resolve Distress? • If Over Leverage/Liquidity the Primary Source of Financial Distress: • Bond Buy Backs or Exchange Offers May Be Effective • e.g. Rescap • If Problem is Management/Operations/Non-Financial Liabilities • Voluntary Acts by Financial Creditors Can’t Address Problem • Highly Liquid Markets Often Allow Deferral of Either Problem • The Holdout Problem 2008 Stephen G. Moyer

  25. Hold-Outs Often Prevent Voluntary Solution That Would Avoid Dead Weight Loss 2008 Stephen G. Moyer

  26. Key Considerations in Bankruptcy Recoveries • Pre-Planning/Time-In/Damage to Franchise • Amt of Secured Debt and Type of Holders • Recognition of Off-BS Liabilities • Budgeting Exceptions to Absolute Priority Rule • Tax Asset Preservation 2008 Stephen G. Moyer

  27. Acceptance or Rejection of Executory Contracts BRC §365 • Std. Def. Of Executory: Sufficient Performance Remaining on Both Sides that Nonperformance is a Material Breach • Used to Reject Uneconomic Contracts—Rejected Party Has Damage Claim as Pre-Petition Creditor. • Real Estate Lease Rejections Subject to Cap: 1Y or 15% not in excess of 3Y. • Additional Considerations for Collective Bargaining, Retiree Benefit and Electric Power Agreements 2008 Stephen G. Moyer

  28. Acceptance v Rejection Tradeoff 2008 Stephen G. Moyer

  29. Step 2: Determine Claim Status • General Rule: All Claims equal unless: • Secured • Statutory Priority • Legally Subordinated • Structurally Subordinated 2008 Stephen G. Moyer

  30. Contractual Subordination • All Unsecured Claims Essentially Equal Unless They Agree to Subordination • Subordination is Contractual Provision Entitling Benefited Claim to Recover Value Until Whole Before Sub Claim Gets Anything • Subordination Provisions Should be Reviewed to Determine What Claims Specifically Benefited • Issues Can Arise Relating to Acquired or Later Issued Debt 2008 Stephen G. Moyer

  31. Operation of Subordination Provisions 2008 Stephen G. Moyer

  32. Structural Subordination in Complex Capital Structures 2008 Stephen G. Moyer

  33. Every Structure Unique 2008 Stephen G. Moyer

  34. Step 3: Predicting Outcome of Reorganization Process • Reorganization v. Liquidation • Post-Reorganization Capital Structure • Allocation of Capital Structure to Creditor Constituencies • Political Considerations 2008 Stephen G. Moyer

  35. Politics of Plan Valuation Desired Valuation Party Motive Sr Creditors Jr Creditors + Equity Management Low High Low Claim >% of EV More EV to share Options/Equity in the Money Importance: Be Skeptical of Plan Valuation 2008 Stephen G. Moyer

  36. Example: Sub Note Outcomes Turn on Plan Structure and Valuation • Analyze the Impact of • Lower (4.5x) v Higher (5.5x) Plan Valuation • Amount of Post-Petition Unsecured Debt • $0 v $600 • Assume • Sr Debt Claim = $850 Px = 75 • Sub Debt Claim = $250 Px = 25 2008 Stephen G. Moyer

  37. Equity Split: Low Valuation 2008 Stephen G. Moyer

  38. Low Valuation/Change Debt 2008 Stephen G. Moyer

  39. Equity Split—Higher Valuation 2008 Stephen G. Moyer

  40. High Valuation—Change Debt 2008 Stephen G. Moyer

  41. Recovery Upside From Conservative Plan 2008 Stephen G. Moyer

  42. Analyzing a Complex Case: Calpine 2008 Stephen G. Moyer

  43. Calpine Corporate Structure 2008 Stephen G. Moyer

  44. Calpine – Liquidity Challenge in 2007 2008 Stephen G. Moyer

  45. Calpine Filing • Files Ch 11 on 12/20/05 at 10:57 NYT—no bond or coupon payments for at least 30 days • Since CDS contracts expire at 11:59PM GMT, all CDS expiring on 12/20/05 lapsed without Credit Event • Date of filing likely driven by requirement to make large payments to gas suppliers on 25th of each month. 2008 Stephen G. Moyer

  46. 2008 Stephen G. Moyer

  47. 2008 Stephen G. Moyer

  48. GUC Claim Assumption • Initially reflected significant executory contract rejection claim assumption • CPN had forward power delivery contracts with no gas hedge • When gas prices increased, contracts became unprofitable • Four largest contracts were estimated to be underwater by $1B • Weigh risk that public policy would prevent rejection 2008 Stephen G. Moyer

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  50. 2008 Stephen G. Moyer

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