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By Stephen Moyer. The period from to witnessed an unprecedented number of corporate bankruptcies in the United States. For at least 13 of these firms, it was their second visit to bankruptcy court. For six firms, it was actually their third visit. 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. 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. In general, Magellan acts as a specialty subcontractor of behavioral health care benefits for larger, full-service health care plans. Magellan grew to become the largest in its niche primarily through acquisition. Magellan operated on a fiscal year ending September In fiscal first quarter , problems began to surface on several levels.
In addition, Magellan was notified that it would lose a significant contract for the state of Tennessee. 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. While substantial in absolute terms, Magellan had considerable debt and significant cash obligations.
In its Q filing for fiscal third quarter of , management indicated that the company would likely be in technical default of certain covenants in the bank facility on September 30, , and without access to the facility would likely face severe liquidity problems. The price of the seniors fell from 95 on May 15, to 69 on August 16, The subs fell from 77 to 30 over the same period.
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 Following this announcement, as is often the case, information from Magellan was less forthcoming.
On February 23, , Magellan released fiscal first quarter 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. On March 11, , 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, The plan also contemplated a rights offering i.
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. The seniors improved to 85 and the subs to Then a bidding war of sorts broke out. On May 28, , Magellan announced that Onex Corp.
The seniors continued to firm to 99 and the subs rose to The significance of this adjustment was that it gave the creditors the right to purchase just as much of the equity as Onex. 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. The subs received 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. Of course, someone originally paid 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. There is no universally recognized definition of distressed debt. While these firms use slightly different ratings notations see Table , they have a functionally similar grade scheme ranging from AAA to D.
BBB and above is classified as investment grade, while BB and below is characterized as speculative grade and was, during the s, pejoratively labeled junk. 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. Fridson classified distressed debt as debt trading with a yield to maturity of. While sound methodologically, the absolute basis-point benchmark may not be appropriate in all market environments.
Historically, average credit risk spreads fluctuate widely. For example, from to , the average speculative-grade spread was basis points.
However, in the third quarter of , the average spread was 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 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.
The title references debt, but the scope of this book includes a wide variety of investment instruments, including bank loans, bonds of various seniority, leases, trade claims, and even preferred stocks — which, it can be argued, are really very junior debt securities. The common stock of such companies will, except for its potential as a short-sale or hedge security, generally not receive much attention because in distressed situations it is, more often than not, worthless.
The role of shareholders as owners of the equity, although in distressed scenarios this may be more of a technical fact than economic reality, is discussed within the context of chapter 11 bankruptcy reorganizations. Investing in distressed securities can be a risky endeavor.
If CCC-rated bonds are, for convenience, used as a proxy for distressed, then the negative market returns for this group over the — period, shown in Table , illustrate the dangers, while returns demonstrate the opportunity.
Distressed debt is not a particularly suitable or practical investment for individual investors for at least four reasons. First, as illustrated in Table , there is significant risk of loss. Second, professional participants in the market could have significant information advantages.
Third, the distressed securities market is often fairly illiquid, which means there can be very high transaction costs for individuals investing on a modest scale. Such transaction costs increase the relative risk and make it very difficult to earn appropriate risk-adjusted returns.
Finally, the size of the average trading unit or block is so large that, except for the most wealthy, it is difficult to have an adequately diversified portfolio — and the risk of this asset class is such that investing should generally be done on a diversified basis.
Thus, though distressed securities may trade at significant discounts, this still implies that to own a diversified portfolio of 20 different companies could require a significant amount of capital.
Accordingly, individual investors who want to invest in this asset class are strongly advised to invest through a professionally managed vehicle such as a mutual fund or hedge fund. The cover of this book depicts a chessboard and two kings: the victorious towering over the vanquished foe. Chess is an appropriate metaphor for distressed investing because, more than any other form of investment, to be successful it requires a well-conceived strategy.
As mentioned earlier, a key aspect of distressed debt situations is that a balance sheet restructuring has occurred or may occur. That event, or the risk of that event, introduces a significant level of complexity into the investment process. Just a few of the issues that arise in the context of a restructuring, which this book discusses in detail, include:. Will the restructuring occur within or outside of a bankruptcy context? What is the risk a company could lose economic value if it is forced to go though a formal bankruptcy reorganization because of the loss of key customers, suppliers, or employees?
How much economic value might be gained through a bankruptcy? If the balance sheet is restructured, what will its new composition be, and how will those parts be distributed to existing creditors or other stakeholders? What are the tax consequences of a restructuring?
While it could be argued that all investments require a degree of strategic foresight, the degree involved in distressed investing is fundamentally different. Take, for example, the standard stock investment.
But at the end of the day, the investor chooses a stock and buys it because he or she expects it to go up or sells short if it is expected to go down. Without diminishing the difficulty of the analytical process involved in these types of investment decisions, it is less complex compared to the multistep analysis that a distressed debt analyst must undertake.
Among the many considerations involved in the analysis of a potential distressed investment are:. What is the cause of the distress? How will the distress be resolved? What are the implications of that or another resolution on the value of the business and, more specifically, any particular security?
Distressed Debt Analysis : Strategies for Speculative Investors
By Stephen Moyer. The period from to witnessed an unprecedented number of corporate bankruptcies in the United States. For at least 13 of these firms, it was their second visit to bankruptcy court. For six firms, it was actually their third visit. For most investors and investment managers, this was a period of significant financial loss.
Distressed Debt Analysis: Strategies for Speculative Investors