DISTRESSED
DEBT / SECURITIES INVESTING - AN EXCEPTIONAL OPPORTUNITY
It has
often been claimed that the United States of America
was founded by religious zealots fleeing persecution
and by debtors trying to escape their creditors in
England. Certainly the punishment dished out to
bankrupts in the old country in the form of debtors'
prison, immortalized in the writings of many Victorian
novelists, was, no doubt, a factor in fashioning the
bankruptcy laws in the new country to ones seeking
recovery rather than revenge. Letting a bankrupt rot
in prison may have brought a certain amount of
satisfaction to the creditors but it would not have
repaid the debt. It is this more lenient system,
largely developed in the U. S. that has created
opportunity for distressed debt/securities investors.
Companies get into financial difficulties and enter
bankruptcy for many different reasons: Rapid
over-expansion, poor management, diversification,
over-leverage, fraud, recession, etc. Many
of these companies are still sound in many areas but
need help to sort out their problems and with that
help can emerge as strong, viable companies again.
Chapter 7 bankruptcy (liquidation) involves closing
the company down completely and dividing the assets
amongst its creditors, in other words throwing the
baby out with the bath water.
Chapter 11 bankruptcy (reorganization), on the other
hand, gives the company legal protection to continue
operating while working out a repayment plan with a
committee of its major creditors. Management of a
company is obliged to report to the Board of
Directors, and the Board reports to the Shareholders,
therefore there are three constituencies within the
definition of 'Debtor', the Management, the Board
and the Shareholders. When a company files for Chapter
11 the Management and Board are typically allowed to
stay in place and the Management usually receives a
generous stay-put compensation package and often an
additional payment should the restructuring be a
success. A little galling to many shareholders
considering the Management may be responsible for the
company having to file for bankruptcy in the first
place.
Bankruptcy is not the answer to a failing company's
problems, it is only a tool that can be used to fix
the company and, as is the case with any tool, the
process can be subject to abuse. The successful and
experienced distressed debt investor will know the
bankruptcy process and can determine how successfully
a company can use the process to become profitable
again.
So, what
exactly is Distressed
Debt/Securities? By definition these
are the stocks, bonds and trade or financial claims of
companies in, or about to enter or exit bankruptcy or
financial distress. As a result the prices of these
securities fall as the holders, reacting emotionally
to the threat of potential bankruptcy or financial
distress, panic sell ignoring the underlying true
worth of the company.
When this happens there are experienced investment
professionals who specialize in researching distressed
securities and who understand the true risks and
values involved and, using their knowledge and
expertise, purchase debt in bankrupt or financially
distressed companies at deep discounts, thereby
uncovering the silver lining behind the dark cloud.
It is generally accepted there are three distinct
phases in the distressed market breakdown:
-
The
Implosion Phase
when, after a period of boom, there is a period in
which companies hit the wall or implode. Think TMT
(technologies, media and telecommunications) in
the late 1990s.
-
The
Restructuring Phase when
companies restructure and reorganize under the
protection of Chapter 11.
-
The
Resurgence Phase when
companies emerge from bankruptcy having eliminated
the causes of their original problems and have
emerged as strong and viable companies.
Having
purchased debt in a bankrupt or financially distressed
company, the first phase, the distressed debt
professional will work through the restructuring phase
(perhaps taking a seat on the creditor's committee),
where creditors are typically given equity in the
reorganized company in exchange for the debt, known as
a debt-for-equity swap, and on through to the last
phase when, hopefully, it will emerge with a
significantly stronger balance sheet and an even
greater equity-to-debt ratio than its most viable
competitors.
When companies come out of bankruptcy they form a
class of what are called orphan equities. These stocks
have no research coverage or institutional following
and have been abandoned or ignored by the investing
public and, in many cases, have been substantially
undervalued. The experienced debt investor will be
more aware of their true value and the gains that can
be made.
So, simply put, distressed investing is about capturing
the difference between market price and fundamental
value, and working through a finite process to a
value-realisation end game. By studying the events
that drive down the value of a company's securities
the distressed debt manager can determine which
company to invest in and which will not survive the
bankruptcy process. They look for companies whose
problems can be sorted relatively easily under Chapter
11 such as a by a change of management, by a
debt-for-equity swap in an over-leveraged company or
one that has over-expanded but still has a strong core
market.
The research is painstaking and the investor will need
to know, not only everything about the company and its
financials, but also about the number of creditors and
their willingness to compromise. The complexity of the
creditors claims will help indicate how long the
re-organization will take, what the asset distribution
will be, and whether the expected returns are worth
the wait.
The effort though substantial can be extremely
rewarding for investors who get it right.
A 1998 study on the returns of all post-bankruptcy
equities for companies emerging from bankruptcy
between 1980 and 1993 found that the average
cumulative abnormal returns, (returns in excess of
those experienced in similar, non-bankrupt companies)
in the 200 days following emergence, of anywhere from 25%
to 139% (Eberhart, Altman and Aggarwal 1998).
So the returns are substantial,
but what about the timing?
As with all markets the debt market is cyclical.
According to the above 1998 study the average time
spent in bankruptcy is just over 22 months. Defaults
reached record levels in 2002, reaching a high of
almost 11% by the third quarter (Altman and Bana
2002), and given the long term nature of those
restructurings, that supply will present opportunities
for at least the next 12 to 18 months and should
provide a major source of profitability, for
distressed debt investors, well into 2004 and beyond.
So
the returns are substantial and the timing is right,
but how do you invest in Distressed Debt/Securities?
From the above you will realize that it takes a
manager with very special skills to successfully
invest in this market and, not surprisingly, they are
few and far between. A further problem is that it is
normally impossible for small investors to access
these specialist managers who usually have a minimum
investment requirement of at least $ 1 million and the
best of whom are closed to new investment.
THE
THAMES RIVER DISTRESSED FOCUS FUND
(TRC)
TRC have a
certain expertise in putting together well run and
successful alternative strategy funds and we are sure
this new fund will only add to their reputation. TRC set out to attract
the most talented fund managers in a variety of
disciplines and ensure that their entire focus is
centered on their core competence. They have carried
on the tradition with their multi-manager team which
is responsible for this fund.
-
Ken
Kinsey-Quick
- Head of Multi-Manager:
Joined TRC in January 2003 and has a decade of
experience in hedge funds with an established
track record. While Chief Investment Officer and
CEO at Coronation International in London he
managed $ 1.3 billion in various top performing
multi-manager hedge funds.
-
Alex
Kuiper -
Assistant Fund Manager:
Joined TRC in September 2001. While at JP Morgan
in London he developed tactical software for the
risk management system to hedge complex derivative
portfolios.
-
Sheena
Wilkinson -
Due Diligence Analyst:
Arrived in September 2000 and completes the team.
They are
responsible for five multi-manager funds under the TR
Alternative Strategies Ltd. umbrella including the
Distressed Focus Fund.
Through their connections TRC have managed to get
limited capacity with a number of closed debt managers
and approximately 50% of the portfolio is currently
invested with them. The portfolio holds 4 'core',
blue chip managers, each with roughly 20%, the
balance, being the 'wild card' allocation, is split
into smaller percentages of up and coming and higher
compression managers where the returns may be higher
but with more volatility. TRC expect to dynamically
manage the portfolio in order to take advantage of
opportunities that present themselves at different
stages of the distressed cycle. At launch two wildcard
allocations were made comprising an orphan equity
focused manager and an EU distressed bank loan focused
manager.
The four core holdings funds are:
-
Cerberus
(Distressed-International):
Established in 1992, $ 8 billion under management.
The fund is closed.
-
Avenue
Asia
(Distressed-Asia):
Founded in 1995, $ 3.5 billion under management. The
fund is closed.
-
Levco
Debt
(Distressed-US):
Founded 1982, $ 300 million out of firm assets of
$11 billion. The fund is open but with limited
capacity.
-
King
Street
(Distressed-US):
Founded 1994, $ 425 million. The fund is closed but
with limited capacity available to TRC.
We
should point out that even if the above are open you
would need at least $1 million to invest directly with
them.
The fund has three currency classes: Dollar, Euro and
Sterling with a minimum entry of $
50,000 or currency equivalent (TRC will consider
smaller amounts). Dealing is monthly and
liquidity is quarterly with 65 days notice required.
There is a 5% initial charge and a 1% AMC, and a
performance fee of 10% p.a., on a high water mark
basis. Redemptions in the first 12 months are subject
to a 3% penalty.
The fund objective is to achieve a target return over
a cycle greater than the MSCI-W with less volatility
than the MSCI-W and a loss target of no losing 12
month period.
Now here is the bad news:
If you want to invest you will have to hurry. The
fund, initially, is being limited to a total size of $
30 million, with a possible increase to $ 50 million
depending on capacity from the 4 core managers. As at July
14, the fund had already attracted $ 16 million.
Please
note - risks:
Investors
should be aware that investing in distressed
situations has additional risks in addition to the
normal risks associated with investing in hedge funds.
These are liquidity and valuation risks. Distressed
securities are not traded on a recognized exchange and
the pricing of distressed securities is more akin to
private equity and therefore third party verification
may be difficult at times.
Nothing in this article should be construed as a
solicitation to buy or an offer to sell shares in any
of the funds/investments mentioned in any jurisdiction
where the offer or solicitation would be unlawful
under the securities law of the jurisdiction.
A word of warning!
Whenever you intend to buy an investment please,
please, please make out checks, drafts or TTs to the
financial institution concerned. Never make them out
to the intermediaries, middlemen or their companies no
matter how long you have known them or how much you
trust them.
Please remember that past performance is not
necessarily a guide to future performance and that the
value of units/shares/investments may fall as well as
rise. Where a fund invests in securities designated in
a different currency to the fund, the value of the
fund may fall and rise purely as a result of exchange
rate fluctuations. The investments described in this
article should be regarded as long term.
2007