Distressed-Debt Investing Shows Great Promise
For distressed-debt investors, an industry not long ago written off as half dead is registering fresh vital signs.
When Centerbridge Partners, a New York–based private equity and distressed-debt investor, gained the right this spring to sponsor the reorganization of bankrupt Extended Stay Hotels, it was more than just a corporate coup. For Centerbridge managing directors Vivek Melwani and William Rahm, it was a personal triumph. For close to two years, Melwani, 38, at one time a bankruptcy lawyer, and Rahm, 31, formerly a private equity specialist for Blackstone Group, had been painstakingly combing through the convoluted debt of the 684-hotel, Spartanburg, South Carolina, chain.
“Extended Stay had a $4.1 billion mortgage that was securitized and sliced into 18 tranches, along with $3.3 billion of mezzanine debt divided into ten separate loans,” recalls Rahm with a shudder. Some prospective investors in the efficiency-hotel company had thrown up their hands after discovering what a mishmash its finances were — a situation exacerbated by the fact that this was the first-ever large-scale corporate bankruptcy involving commercial-mortgage-backed securities, and therefore posed extra uncertainty. (The numerous holders of CMBSs are presumably harder to round up to vote on a rescue plan than a smattering of banks holding shares of a mortgage.)
Yet Centerbridge saw opportunity buried beneath the complexity. “Based on our analysis, we recognized that there was a very good business here struggling under too much debt in a complicated structure,” says Rahm. Extended Stay had good management and a low-cost business model that produced high margins but was saddled with a bubble-era balance sheet, he explains.
Unfortunately for Centerbridge, other private equity operators and distressed-debt investors were arriving at the same conclusion. Thus, when Centerbridge, at Melwani and Rahm’s recommendation, bought a big chunk of Extended Stay’s CMBSs at a sizable discount in late 2008, other investors swooped in too. And when Centerbridge and New York hedge fund firm Paulson & Co. put up $450 million in February 2010 in a partial bid intended to give them effective control over Extended Stay’s reorganization (and which valued the company at about $3.3 billion), the offer was topped less than one month later by real estate mogul and glamour-hotel impresario Barry Sternlicht. His Greenwich, Connecticut–based Starwood Capital Group paired up with Fort Worth,Texas–based private equity giant TPG Capital in March to pony up $905 million in sundry forms (cash, a backstop rights offering and cash alternatives).
Centerbridge matched Starwood’s offer and sweetened it by agreeing to forgo the breakup fee and other expenses that it would ordinarily be entitled to as a stalking-horse bidder: the one that gets a corporate auction going by creating a floor price. Moreover, Centerbridge demanded that an open auction be held before long so that one of the investor groups could be picked to implement a reorganization plan to try to salvage the long-suffering Extended Stay.
So after 19 straight hours of bidding and counterbidding, Centerbridge, Paulson and a third partner, Blackstone, declared victory in the wee hours of Thursday, May 28. Their offer of $3.925 billion topped the Starwood group’s bid by just $40 million. The bidding war pushed up the value of Extended Stay by roughly $625 million. Thrilled at winning the auction, Melwani and Rahm assert that Centerbridge got a great price, especially considering that the firm’s holdings of cheap Extended Stay CMBSs will be paid back at 100 cents on the dollar.
For distressed-debt investors, the epic contest for Extended Stay is both good and bad news — a combination with which they are intimately familiar. On the positive side, it demonstrates that an industry not long ago written off as half dead is registering fresh vital signs. On the negative side, the sheer impenetrability of Extended Stay’s finances and the fierce bidding for the insolvent company attest both to the unprecedented complexity of distressed-debt investing today and the intense competition for deals.
Distressed-debt investors say that, compared with the high-yield bond market’s collapse in the early ’90s or the stock market bubble’s bursting a decade later, the recent financial crisis is characterized by considerably more-recondite corporate reorganizations. Creditors of Lehman Brothers Holdings, for example, are divided into more than 100 classes, each with what seems to be a different repayment priority. The freewheeling financial creativity of the past decade has added to the complications of many workouts.
The ferocious rivalry for deals, meanwhile, is in large part merely a function of overcrowding. In the downturn of the early 2000s, some $30 billion of capital was committed to distressed debt, according to Chicago-based data provider Hedge Fund Research. One expert on the subject, New York University Leonard N. Stern School of Business professor Edward Altman, gauges the sum at $300 billion today. The field is awash in deep-pocketed new entrants, such as Blackstone, KKR & Co., Paulson and Tudor Investment Corp.
“There is an awful lot of money chasing too few opportunities,” contends Jeffry Haber, controller of the $558 million Commonwealth Fund, a New York–based private foundation. “People might pitch buying debt at 60 cents on the dollar. Then you see them buying things at 90 cents.”
Howard Marks, co-founder and chairman of one of the largest and most venerable distressed-debt firms, $76 billion-in-assets Oaktree Capital Management, sees interlopers as the big problem. “A lot of money can swing into distressed debt that is not technically allocated to it,” he points out. “Warren Buffett can be the biggest distressed-debt buyer. Hedge funds can swing into distressed debt. Knowing how much money has been raised by pure distressed-debt funds is only half of the picture.”
Excessive demand aside, there’s also a supply-side issue. Some insist that as the economy recovers, albeit haltingly, the great bargains tossed up by the worst financial upheaval since the Great Depression are growing a little scarce. At the end of 2008, the distressed-debt ratio — the proportion of junk bonds trading at truly distressed levels (1,000 basis points or more above Treasuries) — peaked at 85 percent, according to Standard & Poor’s. By May the ratio had improved (or, from a distressed-debt investor’s perspective, worsened) all the way to 9.4 percent. At the same time, the high-yield default rate, having peaked at 13.5 percent last November, had eased to 5.4 percent in July, reports Moody’s Investors Service.
The upshot, many were contending this spring, is that the grave dancers’ ball is well and truly over. The 28 percent average return on distressed-debt investing in 2009 (according to HFR) will not be repeated for some time, they insist.
Yet many distressed-debt investors beg to differ. Doom-mongerers by nature, they see a world of troubles ahead — they’re hardly alone — and past surveys have amply captured this Cassandra streak. According to an annual poll last January by publisher Debtwire, while one third of distressed-debt investors believed corporate restructurings had peaked, two thirds didn’t expect that to happen until this year, 2011 or even beyond.
“The fact is that over $1 trillion of bank loans and junk bonds are maturing over the next five years, and given the number of companies that are leveraged north of 5 times, the supply of overleveraged credit is as large as it has ever been,” contends Anthony Ressler, co-founder and senior partner of Los Angeles–based alternative-investments outfit Ares Management.
Jonathan Lavine, chief investment officer of Sankaty Advisors, the credit affiliate of private investment manager Bain Capital, adds: “We simply need to be patient. Our analysis on the ‘maturity wall’ suggests that the opportunity is significant — about 15 to 20 percent of maturing debt is potentially going to need to be restructured, which would be three times more than the last cycle.”
Credit Suisse was estimating in mid-July that about $985 billion of high-yield bonds and leveraged loans will mature between 2011 and 2014. That’s somewhat less than the bank’s December 2008 estimate of $1.2 trillion — reflecting a rush of refinancing — but it’s still a staggering figure. What’s more, the gloom-sayers gleefully note, the average annual default rate on U.S. speculative-grade corporate debt remained below 2 percent from 2005 through 2007 — a condition unseen in the 30 years before that. Implication: A slew of defaults are ready to erupt. On top of all that, the past three years witnessed a record $436 billion in high-yield U.S. bond issues.
“We see the default rate as a W pattern” with the slanted vertical on the right extending into the future, says Centerbridge co-founder Jeffrey Aronson. He figures that many overleveraged buyouts will hit snags and come asunder. “Amend and extend” deals merely delayed the underlying companies’ day of reckoning with an unsustainable debt load, Aronson asserts. He points out too that some buyouts during the precrash boom years relied on floating-rate loans and that the companies involved will be squeezed all the harder when rates eventually rise from their current record low. But he adds that overall, “it’s much more situational today in distressed debt — you have to do the work and focus on special situations.”
Gloom is apparently everywhere, though, if you look eagerly enough for it. High-yield bond issuance globally reached $178.9 billion last year, only 7 percent below 2006’s record volume. And these latest, postcrash bonds carry tighter covenants, meaning companies won’t find it so easy to slither through loopholes to avoid formal default. Jitters about European sovereign debt are a reminder that the global economy is not out of the Bretton Woods yet. Small wonder that the more optimistically pessimistic distressed-debt investors foresee returns this year ranging from the high teens to 20 percent.
“This is a better time than a year ago for distressed debt,” declares WL Ross & Co.’s Wilbur Ross Jr., a doyen of investing in ailing companies and whole industries. He notes that “we have a pillow somewhere that says, ‘Don’t buy anything you can buy off a Bloomberg screen.’” Ross is looking in particular at financial institutions. “Around 500 banks will fail before we are out of this mess,” he says.
That kind of encouraging news (depending on one’s perspective) resonates with Marc Lasry, co-founder and CEO of New York–based, $18 billion-in-assets Avenue Capital Group. “I’m more optimistic because there are more problems out there,” he says. “The economy is not growing as fast as people had hoped. There’s a significant amount of debt and less capital available. You could end up having a lot of restructuring as companies choose to work with creditors to avoid bankruptcy. This could be a perfect storm, and that is great for distressed-debt investors like us.” From its inception in 2007 through March 31, Avenue’s nearly $17 billion Special Situations Fund V has run up a net annual internal rate of return of 11.6 percent.
But no matter whether they see Armageddon coming or merely bad times, or if they differ on which targets will be the ripest in the approaching disaster, distressed-debt investors agree on one thing: They are going to have to labor harder than they did in 2009 to bring home alpha. One area a number of firms are looking at closely is the sometimes neglected middle market, usually defined by distressed-debt investors as companies with ebitda (earnings before interest, taxes, depreciation and amortization) of anywhere from $10 million to $100 million. Close to $300 billion of middle-market debt is due to mature between now and the end of 2014, according to S&P. Moreover, these credits haven’t recovered in price to anywhere near the debts of large-capitalization companies. In July the spread between the loans of middle-market and large-cap companies was on average 300 basis points, compared with about 80 basis points historically.
“We expect middle-market companies with enterprise values ranging from $200 million to $800 million to remain underserved by middle-market lenders for several years to come,” says Michael Parks, head of distressed funds at Los Angeles asset manager Crescent Capital Group. “These companies tend to be less followed by Wall Street research, less liquid and undercapitalized.” Parks’s fund ordinarily invests $20 million to $30 million apiece in middle-market companies.
In a typical such exercise, Crescent spent more than $30 million between 2003 and 2006 buying up the debt of Brown Jordan International, a Florida maker of snazzy outdoor furniture. Plagued by mismanagement and overleveraged, the company wound up undergoing an out-of-court restructuring in 2007. Having gained 30 percent of the reorganized Brown Jordan, Crescent led a turnaround that saw ebitda go from $12 million in 2004 to $43 million in 2008.
“Everybody wants to do the big-name bankruptcies because they are liquid and you can invest a lot of cash, but there are only a handful of megadeals,” notes another middle-market enthusiast, Thomas Fuller, senior managing director of alternative-invesment specialists Angelo, Gordon & Co. in New York.“So what we are focused on are companies that have between $500 million and $3 billion of debt.”
Killings at all target levels are becoming rarer. The 63-year-old Marks, interviewed in his sun-splashed 28th-floor office at Oaktree’s spalike LA headquarters (marble floors, California artwork, white roses), is characteristically guarded about the outlook. “You can’t find bargains like two years ago,” he cautions, adding: “That’s okay; we can still make good investments. We just have to accept lower returns in order to avoid increased risk.”
And work as hard as ever. “We will continue to try to find bargains by constantly doing analysis and through close relations with brokers and debtholders,” vows Marks. “It’s all execution, just like baseball.”
Oaktree’s conservative investment stance has seen it through challenging times before. Founded in 1995, the firm has outlasted such potentially formidable rivals in the distressed-debt arena as Fidelity Investments; Goldman, Sachs & Co.; and T. Rowe Price Group. All three launched serious distressed-debt operations only to abandon them because of conflicts of interest or other concerns.
Oaktree’s working motto, in Marks’s words, is, “If we avoid the losers, the winners will take care of themselves.” He explains that the goal is to “match market returns in good times and do markedly better in bad times.”
For that, one needs strict discipline. During the 2004-’06 credit boom, when the default rate stayed below 2 percent, Oaktree did not raise a batch of money, as tempting as that would have been in a giddy market. Nor did it deploy all the funds at its disposal. “Oaktree only invested half of the money we committed,” confides one institutional investor client. “When the opportunities are not there, they don’t do deals.”
That defensive approach has resulted in pretty reliable performance, though Oaktree naturally fares better when companies do worse and defaults are abundant. The firm’s OCM Opportunities Fund IVb, whose strategy is to “influence” distressed debt (that is, it does not aim to take actual control of companies), was raised in 2002, when memories of the tech bubble bursting were still fresh, and through June had a net IRR of 46.5 percent. By contrast, OCM Opportunities Fund III, raised two years earlier during happier times, had a more modest IRR of 11.9 percent.
Recent results have been robust. About the time the U.S. stock market peaked precrash, Oaktree raised its largest-ever distressed-debt fund — the $10.9 billion OCM Opportunities Fund VIIb — and the firm invested it aggressively during volatile 2008 and 2009. From its inception in 2008 through June 30, the fund had a net IRR of 23.5 percent.
In February, Oaktree finished raising a $3.3 billion fund, OCM Principal Fund V, that will act as a principal in taking control of companies and forcibly extricating them from trouble. Marks says he wants to be prepared for opportunities in overleveraged buyouts and commercial real estate if the recovery stalls. However, he also wants to be well positioned in case the economy gets better on schedule. Over at $12 billion Centerbridge, the 51-year-old Aronson is cheered by the case for pessimism.
“Last year everyone could buy debt at maybe around 50 cents,” he says. “Today it may trade at 80 cents. So it must be over, some people think. In our view it is all about value versus price. The default rate will decline this year, but as this massive amount of buyout-related debt matures from 2011 to 2015, some of those companies will be refinanced; others will have to be restructured.” The result, he predicts, will be a default rate trending up smartly in 2011 and 2012. “The macro environment is quite fragile,” he notes.
That is halfway good news for Centerbridge. The reason is that this bipolar firm is virtually unique among distressed-debt shops in also doing substantial private equity investing as a way to smooth out returns — in theory, private equity should thrive in good economic cycles and distressed debt in bad.
“What is attractive about Centerbridge is its combination of buyout and distressed debt,” contends Jay Fewel, senior investment officer at Oregon’s Public Employees Retirement System, which manages $53 billion. “The firm can take advantage of whatever economic environment we are in.”
Consider Centerbridge’s hybrid approach to investing in Dana Holding Corp. When the Maumee, Ohio, auto-parts manufacturer filed for bankruptcy in 2006, Centerbridge was able to form an alliance with the United Auto Workers and United Steelworkers — a process helped, no doubt, by the firm’s in-house auto expert at the time, Stephen Girsky, once a special adviser to former GM CEO Rick Wagoner and since March the automaker’s vice chairman for corporate strategy and business development. (He was also the top-ranked automotive and auto-parts analyst in Institutional Investor’s All-America Research Team while at Morgan Stanley.) With the unions’ blessing, Centerbridge’s distressed-debt team negotiated a recapitalization with Dana’s creditors. The investment firm itself bought $250 million of the company’s convertible preferred shares, giving it sway in appointing directors; other debtors bought $500 million of the shares, which paid a 4 percent dividend.
Once Dana emerged from bankruptcy in February 2008, Centerbridge’s private equity specialists took over. Centerbridge co-founder Mark Gallogly and a managing director, David Trucano, were installed on Dana’s seven-member board. A Centerbridge turnaround expert, Brandt McKee, was brought in to cut costs and shore up the company’s capital structure. Dana’s ebitda profit margin has increased from 0.3 percent at the end of 2008 to 10 percent in this year’s second quarter. Once highly leveraged, the company now has $1.06 billion in cash versus $939 million in debt.
More than two years after Dana exited Chapter 11, Centerbridge still holds its original complement of convertible preferreds, which if converted would make it the company’s largest shareholder. And Dana’s shares have risen from $0.23 last year to $11 as of mid-August.
Founded in 2006, Centerbridge has prospered from its baptism by fire in the financial crisis. The firm’s $3.2 billion Capital Partners fund, which invests in both buyouts and distressed debt, has a net IRR of 21.5 percent from inception through March 31. And its $6.4 billion Credit Partners Fund, focusing on just distressed debt, returned 62.5 percent in 2009 after suffering a 23.2 percent loss in 2008. For this year through June, the fund’s IRR was 10.4 percent. Meanwhile, Centerbridge’s $2 billion Special Credit Partners Fund, which does nothing but buyouts, had an IRR of 76.5 percent from its inception in June 2009 through March 31. (All these numbers come from an investor in Centerbridge funds.)
Scanning the horizon for opportunities, Aronson fixes on commercial real estate. “Today there are hundreds of billions in commercial real estate debt on banks’ books, which they’re holding while hoping things will get better,” he observes. “But as banks heal themselves and build up equity cushions, eventually they will write down those loans and sell them” to distressed-debt investors like Centerbridge.
Distressed-debt investing requires patience even more than capital. “People come and go,” says Oaktree’s Marks. “For those people who raised funds in 2007, the best ones will survive and the worst ones will disappear.” Much like the companies in which they invest.