Along with bill collectors and bankruptcy court clerks, distressed-debt investors are keeping busy these days. With the supply of distressed debt at an all-time high -- $900 billion in face value and $500 billion in market value for 2002 -- buyers of deeply discounted bonds and defaulted bank loans have a bounty of prospects at hand. That’s the good news. The bad news: The supply is so massive that prices remain under serious pressure.
One sign of the recent surge in supply: On a dollar-weighted basis, the corporate default rate on high-yield bonds for 2002 was 12.8 percent, up from 9.8 percent for 2001, according to Edward Altman, a professor of finance at the Stern School of Business at New York University and a widely respected bankruptcy expert. Illustrating the pressure this expanding universe of troubled debt places on prices, the ratio of market value to face value of bank debt, a measure of just how much value these instruments have lost, hit an all-time low of 0.44 in September. In December the ratio had edged up just a bit, to 0.46. The historical average is 0.7.
By mid-December 28.2 percent of junk bond issues were defined as distressed, which meant they were trading at least 1,000 basis points above ten-year Treasury bonds, according to data compiled by Merrill Lynch & Co. That’s up from 16.8 percent in May 2002. In addition to traditional high-yield issuers that borrowed heavily to fund expected growth, this roster of distressed investments contains fallen angels -- once-stable investment-grade companies that have hit tough times. Although many of the recent bankruptcy filings came from the telecommunications, energy, steel, airline and textiles sectors, other industries, like utilities and auto suppliers, now also look vulnerable.
“There’s a lot of debt out there, and it’s a terrific time to be buying,” says Henry Miller, chairman of Miller Buckfire Lewis & Co., a New Yorkbased investment bank that focuses on corporate restructurings. “The supply of distressed-debt product is only going to go up. For many names the securities will be oversold in the marketplace, and therefore there will be some real bargains and tremendous opportunities for investors who are able to separate the wheat from the chaff.”
Distressed-debt players such as Angelo, Gordon & Co., Matlin Patterson Asset Management, Oaktree Capital Management and WL Ross & Co. are busier than they’ve been in more than a decade. Of course, even the savviest investors have been singed in recent years. Many distressed hedge funds bought bonds of Enron Corp. and WorldCom in the 40 cent range and higher last year and in 2001, only to see the debt tumble further. WorldCom bonds now trade at about 27 cents, and Enron bonds range from 14 cents to 23 cents, depending on the tier. “It’s not for the faint of heart,” says one investor. “You have to know what you’re doing.”
Investors also appreciate that today’s market is different from past recession-induced bankruptcy peaks. In addition to the high-profile corporate accounting scandals that have created a new source of distressed debt, banks have contributed to the pool by tightening their lending standards. For instance, they now limit capital lending ratios to two times earnings before interest, taxes, depreciation and amortization, versus four to five times in the 1990s. That’s pushed otherwise solvent companies into bankruptcy as old loans mature.
The quality of the companies in peril is another factor that distinguishes today’s environment from past bankruptcy peaks. In the 1990'91 recession much of the distressed paper had been issued by otherwise healthy companies that had undergone leveraged buyouts and taken on too much debt. But with this wave many issuers face fundamental business problems aside from excess leverage. “Your ideal situation as an investor is a good company with a bad balance sheet,” Miller says. “Today there are a lot of business models out there that just don’t work.” Case in point: discount retailer Ames Department Stores, which was unable to compete with the Wal-Marts of the world and liquidated last year.
Not surprisingly, more than 30 percent of all defaulted bond issues in 2002 belonged to telecoms, according to NYU’s Altman. These companies sported high-flying stocks during the bull market and easily issued bonds.
“There was clearly a race among investment bankers to see who could bring a company to market at the most premature stage of its evolution,” says Wilbur Ross, CEO of New Yorkbased WL Ross. One result: Many more companies filing for bankruptcy never make it out because they lack a business plan, capital or strong management. Experts predict many more liquidations from today’s troubled companies than there were in the early 1990s. “Today they are less likely to make it through the bankruptcy process,” Altman says.
Some distressed-debt investors look to gain a controlling stake in a business to boost their returns. Take the movie theater business, which fell on hard times in 2000 in the wake of a late 1990s building binge that created a glut of seats. Slackening demand in 1999 and 2000 pushed Regal Cinemas into bankruptcy when it was unable to service its $1.8 billion of debt. Oaktree Capital Management, a Los Angelesbased distressed-debt investor, bought a stake in Regal in 2000, seeing the silver lining in the company’s rich asset base of mostly new theaters and prime locations, as well as its strong management team. Oaktree partnered with Philip Anschutz, the billionaire founder of Qwest Communications International, snatching up 70 percent of the bank debt and 85 percent of the subordinated debt at about 70 cents on the dollar.
The firm merged Regal with two other bankrupt chains -- United Artists Theatre Circuits and Edwards Theatre Circuit -- and renamed the company Regal Entertainment Group. After combining management, shuttering unprofitable locations and swapping debt for stock in the restructuring, the consortium brought Regal public in June 2002 at $23.60 a share. Although Oaktree principal Stephen Kaplan declined to cite a specific gain from the investment, the stock was trading in early January at $21.40, well above Oaktree’s cost basis of about $6 a share. “We wouldn’t have been able to buy Regal as cheaply if it were just a regular company on the market,” says Kaplan.
Ross tends to invest in midmarket Old Economy names. Focusing on companies with $100 million or more in liabilities gives him plenty of possibilities: In 2001, 172 companies in Chapter 11 fit the bill, with a total of $230 billion in liabilities. For 2002 total liabilities from bankruptcies were expected to top $300 billion. Although Ross would not reveal returns, sources close to his firm say its $1.6 billion in assets are doing well. For example, WLR Recovery Fund I ($200 million in assets) has reportedly notched a 30 percent annualized return since its inception in 1997, and the firm’s Bermuda-based Absolute Recovery Hedge Fund ($300 million in assets), created in June 2001, has averaged a 10 percent annual return, sources say.
Ross likes simplicity in the balance sheet, as his investment in textile producer Burlington Industries suggests. After Burlington filed for Chapter 11 in December 2001, WL Ross bought enough bonds and bank debt to become the largest creditor of the Greensboro, North Carolinabased company. Burlington had one tier of bank debt and one tier of public unsecured bonds, which limited the potential for squabbling among creditors during the bankruptcy process.
Burlington offered several divisions that produced strong cash flow, such as commercial carpets and domestic uniforms. Poor cash flow generators, such as a Georgia denim plant, were shut down, with the businesses shifting to Mexico. Production of other domestic divisions was transferred to China. Burlington’s $200 million debtor-in-possession financing is now paid in full, and the company has built up more than $150 million in cash. Bonds Ross bought at 9 cents recently traded at 33 cents. Bank debt he picked up for 60 cents now trades at 92 cents.
Although most distressed-debt investors won’t go anywhere near technology or telecom debt, George Hicks, a principal at Minneapolis-based Värde Partners, will make occasional forays into the sector. Värde recently profited from a stake in Flag Telecom Holdings, a Bermuda-based company that filed for bankruptcy protection in April. Hicks was attracted to Flag’s strong cash position: $424 million at the end of 2001 -- an asset even if Flag’s global fiber-optic network proved to be worthless. Värde bought bonds early last year at 20 cents on the dollar. It took a cash distribution on the bulk of the bonds in April, at about 40 cents, when the workout had begun to pay off.
U.S. auto-parts suppliers have been beset by overcapacity and unrelenting price pressure and have lost market share to their foreign rivals. They could be the next sector to contribute to the distressed-debt supply. Such publicly traded companies as Collins & Aikman Corp., which supplies car interior components like instrument panels and acoustic systems, and Tower Automotive, which manufactures auto bodies and suspension systems, are getting hit hard, and each carries $1.6 billion in debt. “It’s a very troubled industry,” says Craig Fitzgerald, a partner at Plante & Moran, a consulting firm in Southfield, Michigan.
And for distressed-debt investors, trouble is the name of the game.
