Distressed Debt Analysis: Strategies for Speculative Investors

by Stephen Moyer

Overview

Providing theoretical and practical insight, Distressed Debt Analysis: Strategies for Speculative Investors presents a conceptual, but not overly technical, outline of the financial and bankruptcy law context in which restructurings take place. The book covers the broader financial environment of the reorganization and the basic process of investment analysis and investment strategies. The author uses numerous real-world examples and case studies to emphasize important concepts and critical issues. The developments that have created these extraordinary investment opportunities have also created tremendous demand for professionals with experience and knowledge in the restructuring process. Distressed Debt Analysis: Strategies for Speculative Investors addresses the complete knowledge needs of investors and professionals in the burgeoning world of financially distressed companies. It is perfect for financial analysts, portfolio managers, bankruptcy departments of law firms, restructuring advisory groups, turnaround consulting firms, and reorganization and distressed securities departments of investment banks.

Product Details

ISBN-13:	9781932159189
Publisher:	Ross, J. Publishing, Incorporated
Publication date:	11/01/2004
Edition description:	New Edition
Pages:	448
Sales rank:	591,378
Product dimensions:	6.00(w) x 9.00(h) x 1.20(d)

About the Author

Stephen G. Moyer has been a Portfolio Manager and Analyst in the Distressed Credit Group at Pacific Investment Management Company (PIMCO). Mr. Moyer has over 25 years of experience in investment analysis and corporate finance. His interest in distressed securities analysis began when he was a member of the High Yield Research Group at Drexel Burnham Lambert. He has also been affiliated with many other leading securities firms and investment managers including Tennenbaum Capital Partners, The First Boston Corporation (now Credit Suisse), Banc of America Securities, Kemper Securities (now Wells Fargo) and Imperial Capital. He began his career as a lawyer at Jones Day and later with Riordan & McKenzie. He is a recognized speaker and writer on the subject of distressed securities and a frequent lecturer at industry events and graduate business programs. Mr. Moyer received a J.D. from Stanford University Law School, an M.B.A. from the University of Chicago Business School, and a B.A. from Grinnell College. He is a member of the California and Texas bars, holds the Chartered Financial Analyst designation, and has passed the Uniform Certified Public Accounting Examination.

Read an Excerpt

CHAPTER 1

INTRODUCTION

The period from 1999 to 2002 witnessed an unprecedented number of corporate bankruptcies in the United States. A total of approximately 439 firms with assets greater than $100 million filed for bankruptcy during this period. For at least 13 of these firms, it was their second visit to bankruptcy court. For six firms, it was actually their third visit. Fortunately, there appears to be an informal "three strikes and you're out" rule, as each of the so-called chapter 33s appears destined to be liquidated and put out of its misery. The total amount of debt and claims involved in the insolvencies over this period is difficult to precisely estimate, but easily exceeds $400 billion.

For most investors and investment managers, this was a period of significant financial loss. For many investors, however, it was also a period of substantial opportunity. Prescient investors made money "shorting" securities, including debt securities they expected to fall in value. Still others made superior investment returns, adroitly investing in securities of companies in, or at risk of filing for, bankruptcy.

The purpose of this book is to provide the insight and skills necessary to invest successfully in the securities of financially distressed companies. First, we should discuss the subject matter. What is meant by distressed debt and why does it potentially represent an attractive investment? It sounds about as counterintuitive as wanting to invest in "junk bonds," and not surprisingly, the concepts are related. What often surprises many noninvestment professionals is the fact that debt securities — such as bonds and notes, bank loans, leases, and even simple unpaid bills — are traded among institutions and investors much like stocks. They can trade up and down in value, and the general approach to profiting from investment can be summarized by the maxim buy low, sell high.

AN EXAMPLE OF A DISTRESSED DEBT SITUATION

To provide some perspective on the process involved in, and investment return potential of, distressed debt investing, a short case study of Magellan Health Services is presented. The case was selected as being representative of the types of situations that arise and issues that are confronted in distressed debt investing, but was neither the most complicated nor the most lucrative — although the returns, depending on the timing of investment, were certainly attractive.

Magellan is the largest behavioral health managed care provider in the United States. Behavioral health issues, at one time or another, affect over 10% of the population and include a range of ailments from mild depression, to substance abuse and dependency, to more severe pathologies such as paranoia or schizophrenia. In general, Magellan acts as a specialty subcontractor of behavioral health care benefits for larger, full-service health care plans. Thus, if a particular Blue Cross/Blue Shield health care plan, for example, wanted to offer its customers behavioral health coverage but did not want, or did not find it economically feasible, to do the contracting and administration involved in providing such a benefit, it might subcontract with a firm such as Magellan. The very rough economics might be that the cost of providing full health care coverage (which is typically borne by employers) would be $400 per person per month (pp/pm) and the general provider might pay Magellan $5 pp/pm to provide the behavioral health care portion. Magellan might hope to provide that coverage for $4 pp/pm, with the difference representing profit. There are economies of scale in the administration of niche health care benefits; therefore, it might cost the primary provider more than $5 pp/pm to directly provide the behavioral health care benefit on its own. At its peak, Magellan served over 65 million covered lives and had approximately 35% market share.

Magellan grew to become the largest in its niche primarily through acquisition. A pivotal acquisition for the company occurred in 1998 when it purchased the behavioral health care business of Aetna Insurance for $422 million. Payment of the purchase price was structured with $122 million in cash due at closing and five annual cash payments of $60 million (which were subject to adjustment depending on how many covered lives Aetna delivered). Magellan operated on a fiscal year ending September 30. Magellan's revenues grew from $303 million in fiscal 1996 to $1.310 billion in fiscal 1998 (the first full year of the Aetna acquisition) to $1.728 billion in fiscal 2001. In late 1999, Texas Pacific Group (TPG), a well-known private equity investment fund, invested $55 million in the form of convertible preferred stock. When added to previous investments, this raised TPG's fully diluted ownership position to approximately 26%.

In fiscal first quarter 2002, problems began to surface on several levels. On the revenue side, Aetna, which was approximately 23% of Magellan's business, attempted to implement price increases and lost 1.5 million covered lives. In addition, Magellan was notified that it would lose a significant contract for the state of Tennessee. On the cost side, the economic recession, higher unemployment rates, and the aftermath of the September 11 tragedy resulted in higher utilization of behavioral health services, reducing Magellan's margins. In the simple terms outlined above, whereas Magellan had expected the cost of coverage to be only $4 pp/pm, it was perhaps $4.25 to $4.50 pp/pm. Further, Magellan was behind schedule and over budget on a $40 million information system integration project that had a goal of rationalizing 23 separate systems (accumulated during its acquisition phase) into one integrated system and faced additional system demands due to newly mandated patient privacy regulations.

Revenues went from an increasing trend to a declining trend. Cash flow from operations, as measured by earnings before interest, taxes, depreciation, and amortization (EBITDA), began to decline steadily. By June 30, 2002, EBITDA for the last 12 months was $187 million, down from the prior year's rate of $220 million. After a variety of working capital adjustments and special payments, however, true cash from operations was closer to $100–$120 million. While substantial in absolute terms, Magellan had considerable debt and significant cash obligations. Total debt was $1.079 billion, comprised of:

$ Million Security
Operationally, Magellan faced $88 million in interest costs and required approximately $35–$40 million for capital improvements. In addition, it had to pay the $60 million due to Aetna and needed to replace $22 million of surety bonds that could not be economically renewed with either letters of credit or cash escrow accounts. It was also suspected, but not quantified at the time, that as Magellan's deteriorating financial condition became more well publicized, state insurance regulators might demand increased statutory capital at various insurance subsidiaries. In its 10-Q filing for fiscal third quarter of 2002, management indicated that the company would likely be in technical default of certain covenants in the bank facility on September 30, 2002, and without access to the facility would likely face severe liquidity problems. The price of the seniors fell from 95 on May 15, 2002 to 69 on August 16, 2002. The subs fell from 77 to 30 over the same period.

On October 1, 2002, Magellan announced that it had retained a well-known financial advisor to advise the company with respect to a comprehensive balance sheet restructuring. Prior to this announcement, most observers had expected Magellan to simply try to amend the bank facility and restructure and defer the Aetna payment. The announcement of a "comprehensive restructuring," although recognized as a risk previously, significantly increased the probability of a chapter 11 proceeding. The seniors fell to 65 and the subs to 22. At a price of 22, the market value of the capital structure through the subs was $556 million, which represented 3.0x the last 12 months EBITDA of $187 million; of course, since a bankruptcy might negatively affect Magellan's contracts, making confident estimates of future EBITDA levels was difficult.

Following this announcement, as is often the case, information from Magellan was less forthcoming. On February 23, 2003, Magellan released fiscal first quarter 2003 results that were stronger than the market expected. Although no official word had been released, the market was generally aware that the company was attempting to organize a preplanned chapter 11 reorganization that would likely involve the bank debt, Aetna obligation, and seniors being essentially reinstated, while the subs would be converted into a majority of the equity. This scenario implied that TPG, and other significant stockholders, essentially would be wiped out. The stock had traded from a high of $28 per share in mid-1998 to $0.08 per share. The improved operating results caused the seniors' price to improve to 82, but the subs only improved to 25.

On March 11, 2003, Magellan filed for chapter 11 protection. Included with its petition was a proposed plan of reorganization (the plan) that provided for the senior claims to be reinstated and the subs to receive, before adjustment for certain stock sales in a rights offering, 92.5% of postreorganization equity (with management and certain other unsecured creditors receiving the balance). The plan also contemplated a rights offering (i.e., a right to purchase a share of stock at a specified price) to raise $50 million in new capital. Both the seniors and subs could participate in the offering, the final terms of which had not been determined, and a major hedge fund that had purchased the subs at a significant discount would "backstop" the offering (i.e., purchase any shares not purchased by holders of the seniors or subs). The proposal effectively valued Magellan's equity at $188 million. The seniors improved to 85 and the subs to 28.

Then a bidding war of sorts broke out. On May 28, 2003, Magellan announced that Onex Corp., a private equity fund, had agreed to invest $100 million for 29.9% of Magellan's equity and backstop a $50 million rights offering to the various note classes for 14.9% of the stock. The equity value implied by this transaction was $335 million, with the rights offering tentativelypriced at $18.57 per share. The seniors continued to firm to 99 and the subs rose to 35. On June 30, 2003, in response to more direct negotiations with creditors, a revised valuation, and the potential involvement of other parties, Onex increased its offer to one using an implied equity valuation of $436 million. This time it offered to invest $75 million for 17.2% of the equity at a price of $28.50 per share and backstop a $75 million rights offering at the same price to creditors. The significance of this adjustment was that it gave the creditors the right to purchase just as much of the equity as Onex. The seniors improved to 101 and the subs (which would receive approximately 60% of the equity directly) jumped to 49. At that point, appreciation in the value of the subs from an October low of 22 was approximately 122%.

Over the next several months, there continued to be fine-tuning, and the final plan of reorganization proposed to give the seniors full recovery (i.e., full face value) in a virtually identical new 9.375% note and a cash payment equal to 9%, for an implied recovery of 109%. From the low of 63, this represented appreciation of 73% over an approximately 15-month period. The subs received 33.1 shares per bond and had the right to purchase an additional 8.5 shares per bond at a price of $12.39 per share. When the shares began to trade on January 7, 2004, the closing price of $27 implied a total recovery to the subs (assuming participation in the rights offering) of approximately 102. Factoring in the time periods and the incremental investment required for the rights offering, from the low the total rate of return on investment was approximately 231%. Even if one had waited until July 1, 2003 and purchased the subs at the then offered price of 50, the recovery would have represented 104% of the amount invested.

If at this point you are not quite sure exactly what happened and why — that's all right; you should understand by the end of the book. If you are an experienced distressed investor whose head was nodding because you purchased the subs at 22, good for you, but hopefully you will still benefit from some of the nuances discussed later.

The point of this example is not to suggest that every distressed investment will offer this type of return potential. It is easy to exaggerate returns by choosing low and high prices, although it should be noted that investors had many months to purchase the subs in the 20s and a significant volume of bonds did trade at those price levels. As the Magellan case attests, returns can be very volatile. If an investor had bought at 29 and sold at 20 thinking a mistake had been made, a 31% loss would have been incurred. Of course, someone originally paid 100 for the subs. When the original investors sold, as they must have or there would have been no bonds to trade, they incurred losses. The bigger point of the example, and a main theme of this book, is that distressed debt investing is a process that must be proactively monitored because investment circumstances change. Often these changes can be anticipated and capitalized on to earn superior investment returns.

WHAT IS DISTRESSED DEBT?

There is no universally recognized definition of distressed debt. The most traditional way of categorizing debt is with reference to the ratings systems of the most prominent debt rating agencies: Moody's Investors Service (Moody's) and Standard & Poor's (S&P). While these firms use slightly different ratings notations (see Table 1-1), they have a functionally similar 10-grade scheme ranging from AAA to D. A prominent dividing line is between BBB and BB. BBB and above is classified as investment grade, while BB and below is characterized as speculative grade and was, during the 1980s, pejoratively labeled "junk." S&P's category descriptions paint a grim picture: BB = speculative, B = highly speculative, CCC = substantial risk, CC = extremely speculative, C = may be in default, and D = default. It might be fun to add E = exterminated and F = flushed.

These schemes are only marginally useful for two reasons: first, because the ratings often lag fundamental credit developments, and second, they essentially only attempt to "handicap" the risk of a default. In general, bond ratings do not attempt to provide any information about whether the trading value of any particular bond is appropriate. Indeed, there have been cases where the secured debt of a company in default was technically rated D, but trading at full face value.

One of the more widely accepted definitions of "distressed debt" is generally attributed to Martin Fridson, one of the deans of high-yield bond analysis. Mr. Fridson classified distressed debt as debt trading with a yield to maturity of greater than 1000 basis points more than the comparable underlying treasury security. This approach essentially relies on the "efficiency" of the market, which is presumed to accurately discount all available credit information into trading prices to establish risk parameters. While sound methodologically, the absolute 1000-basis-point benchmark may not be appropriate in all market environments. Historically, average credit risk spreads fluctuate widely. For example, from 1983 to 2000, the average speculative-grade spread was 487 basis points. Excluding the impact of the volatile 1989–1991 period (discussed in Chapter 2), the average spread would have been under 400 basis points. Thus in normal market environments, the 1000basis-point distressed benchmark basically implies a risk premium of 100–150% of the average risk premium. However, in the third quarter of 2002, the average spread was 1064 basis points. While a great many situations during that period may have been appropriately characterized as distressed, to a certain extent, the descriptive power of the 1000-basis-point benchmark declined.

For the purposes of this book, an exact definition of "distressed debt" is unnecessary. The investment situations examined will generally have a couple of fairly consistent and telling characteristics: the market value of the equity of the "distressed" company will be diminimus (e.g., stock trading under $1 per share), and all or some portion of unsecured debt will be trading at a market discount of more than 40%. What this fact pattern generally implies, if not invariably results in, is some type of balance sheet restructuring, in which the creditors eventually own a significant percentage of the company's equity, or a sale of assets and subsequent liquidation. As will be shown later, these balance sheet restructurings and/or liquidations often lead to misvaluations of the company's securities and provide an opportunity for superior investment performance.

(Continues…)

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Copyright © 2005 Stephen G. Moyer.
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Table of Contents

Notes on Style,
Acknowledgments,
About the Author,
Web Added Value,
Chapter 1 Introduction,
Chapter 2 The Distressed Debt Investment Opportunity,
Chapter 3 Conceptual Overview of Financial Distress and the Restructuring Process,
Chapter 4 Legal Overview of Distressed Debt Restructurings,
Chapter 5 Overview of the Valuation Process,
Chapter 6 Leverage and the Concepts of Credit Support and Capacity,
Chapter 7 Capital Structures and the Allocation and Management of Credit Risk,
Chapter 8 Causes of Financial Distress and the Restructuring Implications,
Chapter 9 Options for Alleviating Financial Distress: The Company's Perspective,
Chapter 10 Profiting From Financial Distress: The Investor's Perspective,
Chapter 11 Practical Aspects of the Investment Process and Due Diligence,
Chapter 12 Dynamics of the Workout Process: The Endgame,
Chapter 13 Postreorganization Considerations,
Endnotes,
Literature Survey and Selected References,
Appendix: Chess Notation And Game Moves,
Disclosure of Possible Conflicts of Interest,