Here are some distressed debt concepts.
How do you set up a screen for distressed debt/special situations opportunities?
Use Bloomberg to narrow down quantum of debt that fits in your fund’s mandate and have EBITDA/leverage screens to see if they are worth pursuing further/simpler to understand.
Where do trade claims rank in the capital structure?
Trade creditors rank alongside unsecured creditors, including senior unsecured creditors.
What are some benefits to investing in distressed trade claims?
They are illiquid and may trade at a significant discount to equal priority bonds.
What are some ways to hedge a distressed debt investment?
One way is through derivatives, such as credit default swaps.
Another way is through shorting another security in the capital structure that should move directionally the same way (preferably in a less pronounced manner if you are right).
For convertible bonds, you can short the underlying equity.
A company has two pari passu bonds with the same guarantors with one $100 million series maturing 2022 and one $100 million series maturing 2025 while it is 2021.
Assume that the company has $100 million cash on hand and generates free cash flow in the normal course of business. Which bond should trade higher?
In theory, the 2022 notes should trade higher as they are advantaged by time priority. It will likely be serviced by the $100 million and/or cash flow in one year, leaving less for servicing the 2025s.
If the corporate is a healthy investment grade credit, they should be trading close to each other at par, although the longer dated bond should have a higher yield.
If the companies are trading at the same price, for example 50 cents on the dollar, what is the market pricing in?
The market is pricing in a default or the bonds have already defaulted – and likely to go into a restructuring process whereby the bonds are equal to each other (both being at the same seniority level).
Likewise, should an event occur whereby one of the notes defaults and there are cross default provisions that are triggered, the closer maturity bonds which were trading higher than the longer dated bonds should see the price converge.
How would a distressed debt investor look to invest if they felt like a default was imminent and could not be cured?
They could long the longer dated bonds and short the shorter dated bonds to bet on the price convergence.
What are some superpriority claims to factor in when a company enters Chapter 11?
Administrative claims include accountants/liquidators/bankruptcy monitors, workout experts/restructuring advisors, lawyers, investment bankers, court costs
What are some important documents for distressed debt investors who are looking to purchase post-filing (bankruptcy has been declared) securities?
There may be no more normal financial reporting (quarterlies and annuals) so analysts should look at the initial petition and schedules to the petition, monthly operating reports and the debtor schedule for unsecured creditors as they can influence the restructuring.
Knowing the creditor composition is key as it gives context as to how the restructuring may play out. Hedge funds may be receptive to a wider range of outcomes as long as it meets return thresholds – their cost base may be much lower as they usually enter when other market participants are selling off. They may push to receive equity or may not look for a long-term sustainable outcome at all.
Other distressed investors may have playbooks that they repeat in other processes, so distressed debt investors will want to have their finger on the pulse across various special situations.
Also important are any motions filed – for example to allow the sale of assets, the rejection or repudiation of onerous leases and for the preferential payment of specific creditors. These all influence the go forward cash flows and the size of the pie to be divided.
If a longer bankruptcy is expected, should the bonds trader higher or lower, all things equal?
A longer bankruptcy should result in lower bond prices. Substantial equity value can be destroyed as suppliers will have stricter credit terms and diminished brand value and uncertainty for customers may result in them switching out.
Declaring bankruptcy, especially when it is unexpected (a major negative information event), can have a major effect on bond prices and a rotation of noteholders. Firms that previously were investors must cycle out as it no longer fits their mandate or they do not want to get involved in workout situations.
When there is uncertainty and the investor universe has not yet put in the time to conduct real analysis, securities in general will trade down to a worst case scenario.
What are some dangers to holding out in an exchange offer that is not maturing?
If there is sufficient buy-in to the exchange offer, holdouts may be stuck in an illiquid security that does not trade.
Also, if the exchange offer is coercive and puts the participants in a priority position (1L status where the securities to be exchanged were unsecured), depending on where value breaks in the firm, the recovery on the bonds may be weakened substantially.
An investor is putting together an outcome probability tree to value a distressed debt investment at 4x EBITDA – he assigns a 20% probability to EBITDA staying the same as this year (a trough, historically), 30% at 2x higher, and 50% for a few turns of EBITDA higher back to a peak year – how should he assess his EBITDA selection?
The investor has to assess carefully whether the drop in EBITDA was due to mismanagement or cyclicality as opposed to potential obsolescence or lack of competitiveness in a difficult market.
If the industry is undergoing secular decline (newspapers), liquidation value may be more relevant.
If the company has strong brand power and can come out strong post-restructuring with a good management team, rejected executory contracts and this is supported by the gross margins and EBITDA margins of their comparable peer universe, the peak EBITDA may be reasonable.
What is voidable preference?
Voidable preference or unfair preference is when a legal person pays down debt to a creditor or transfers assets in a set time period prior to bankruptcy. This transaction may be reversed by the bankruptcy trustee or liquidator and is a major risk for distressed debt investors.
What is substantive consolidation?
Substantive consolidation is when a subsidiary (which is legally separate from the parent company and has its own liabilities and assets) does not show sufficient autonomy and is treated as a single entity with the same priority by the courts.
Substantive consolidation has implications for distressed debt investors when they map out the capital structure organizational chart and the priority waterfall of payments.