December 1, 2001

Silver Linings

The economy is sputtering, but advisors say this i

It's hard at first glance to find much to smile about with the New Economy crash and the subsequent downturn in the economy and markets that followed, not to mention the events of September 11. Maybe there is a renewed emphasis on asset allocation and maintaining a diversified portfolio. Yet there's one bit of good news amid the misery: A number of advisors are taking advantage of the increased activity in the marketplace for distressed debt--the obligations of companies that have either already declared bankruptcy or stand a good chance of doing so in the near future.

By most accounts, the amount of such debt has grown dramatically over the last three years. Diane Vazza, managing director of Standard & Poor's Global Fixed Income Research, reports that 130 global bond issuers defaulted on $78 billion in debt so far this year. Those figures are up from 108 issuers defaulting on $34 billion last year, 89 issuers defaulting on $24 billion in 1999, and 30 issuers defaulting on $7 billion in 1998. Defaulting on one's debt simply means that you can no longer make the interest payments, Vazza says. It does not necessarily mean the company has declared Chapter 11 bankruptcy, although such a possibility is very real once default occurs.

These statistics are music to the ears of some investors. "Because of the economic downturn, there are a lot more opportunities in [distressed debt] today," says advisor Mark Spangler, of the Spangler Financial Group in Seattle. Indeed, the last time the country witnessed such activity in this asset class--during the early 1990s--vulture and distressed debt funds routinely yielded returns in the 30% to 40% range. Spangler, for one, has raised the allocation into distressed debt of his clients worth more than $2 million in liquid assets to 2.5% from nothing a year ago, while Charles Haines of the Birmingham, Alabama firm Charles D. Haines Inc. has gone a similar route. "Until this year, the deal flow had not been great," says Haines, "but there's opportunity today."

Of course, the risk and stakes are high (distressed debt is only for clients with at least $1 million in liquid assets), and the asset class is perhaps among the worst for dilettantes to become involved in. But for those who are willing to put the time and research in for their clients, distressed debt investing could be a boon to one's practice.

Empty Seats

When was the last time that you went to a movie theater that was actually full, or even close to full? Most likely, aside from going on opening night, the instance was too far in the past to be memorable. This is interesting because such empty theaters are indicative of the current opportunities in distressed debt. During the late 1980s and '90s, movie companies built larger and larger movie theaters known as megaplexes, with incredible numbers of seats relative to how many used to exist in the smaller theaters of the past. To build these leviathans, the companies borrowed heavily. The demand never materialized and the theaters are now paying the price.

Among those theater companies that have filed for bankruptcy in the last two years are Loews Cinemas, United Artists Theaters, Regal Cinemas, Resort Theaters, Cinema Star Theaters, and Wehrenberg Theaters. But "it's not necessarily the case that the underlying business is poor when a company declares bankruptcy," says John Puchalla, senior economist with Moody's Investors Service. "In many cases, the company simply grew too quickly and borrowed so much that it could not service its debt load." There are other examples of this, notably telecommunications companies that borrowed billions to build high-speed data networks.

What distressed debt investors hope for is to gain a piece of such quality companies once they declare Chapter 11 bankruptcy. Chapter 11 simply means that interest can no longer be accrued on unsecured debts, and creditor lawsuits cannot be filed to gain control of assets. In short, such protection gives all involved the chance to sort through a company's options, assets, and prospects to come up with the best solution. All of this is done in court.

There are a few things that can happen here: the bondholders can be awarded cash on their loan, as well as equity in the new venture. Here, a new capital structure is formed. What the bondholders hope will happen is that the new concern will arise from the ashes with new ownership and generate profits into the future. Chrysler and Lockheed are examples of how this played out in the 1980s. Indicative of this is a study out of New York University's Salomon Center and the Georgetown School of Business, showing that newly distributed stocks emanating from Chapter 11 proceedings during the period 1980-1993 outperformed the relevant market indices by over 20 percent during their first 200 days of trading.

Of course, overexuberance isn't to blame in all instances--there are plenty of companies that simply failed because of terrible flaws in the underlying business. In these cases, it is most profitable for all involved to liquidate the company's assets and pay off the bonds in that fashion. In this case, it's a matter of deciding how much you'll get in relation to the current price of the bonds.

A third scenario involves a good, but still budding, company that can no longer access the capital markets with the success it once could. "The capital markets aren't as interested in financing young companies as they were in years past," says Spangler. "For them to borrow, they have to give you really favorable terms." Spangler related a story where a hedge fund manager he uses lent $100 million to a just such a company at 15%. But the loan came with a catch. Even though the stock was trading for $10, the manager was given warrants to buy stock at a penny a share. "The manager could turn around the very next day, exercise the options for a penny, and sell the stock for $10," Spangler says.

Not for Amateurs

Dabbling in distressed debt is not for tyros. There is an enormous amount involved in successfully managing a vulture fund, from negotiations in the courtroom over what is your rightful piece to how a new company will be structured. Different creditors are going to want different outcomes. Bankruptcy litigation is notoriously acrimonious, with lawyers and financiers fighting it out. This is why it is of paramount importance that one find a credible distressed debt manager to oversee client funds.

Big names in the business include Los Angeles, California-based Oaktree Capital Management, which manages some $6 billion in distressed debt funds. The way that Oaktree works is by setting up a limited liability company or limited partnership with a number of distressed debt investors. The L.P. or L.L.C. will be managed by an Oaktree distressed debt expert, and will seek favorable opportunities in the marketplace.

Another route is through hedge funds. Some $40 billion is currently in distressed debt hedge funds, compared with only $25 billion just 18 months ago. However, Haines says this route comes with the distinct label of caveat emptor. "The spotlight is on [distressed debt managers]," Haines says. "You have a lot of money chasing the same stuff."

A final method is represented by the private fund that Haines and 21 other advisory firms established six years ago. The venture began as a study group to explore the issue of distressed debt and the role it could play in client portfolios. Now, the group is involved in a number of deals that are managed by a distressed debt expert. Haines declines to go into explicit details about the firm, its manager, or its deals. He says that the venture focuses on private debt from primarily family-owned businesses. "We buy the debt from the bank at a very reduced rate and then take over the business," he says. "From there, there are a number of turnaround experts we have to get the business back up on its feet and successful again."

Barriers to Entry

Entry fees into the market are high for a number of reasons. There is the necessity in most cases of buying enough of a company's debt that the fund or partnership can play a leading role in whatever end result will take shape. "That's why it's good to get a number of firms involved," says Haines. Secondly, when dealing with such hedge funds, LPs, and LLCs, the SEC imposes in all but the most extraordinary of circumstances a minimum net worth threshold for those eligible to invest. "They have to be accredited investors," Spangler says. "They need to have either at least a million dollars to invest, or have made $200,000 for the past two years. That's the rule of thumb." Even with such rules, Spangler won't consider any client for distressed debt who doesn't have at least $2 million in liquid assets because of its illiquidity. Haines says he hopes for an 18-month cycle--from the initial deal to the time when capital is pulled out of the investment--but he admits that this is a best-case scenario. Spangler agrees, saying many debt deals can take several years to work themselves out.

Part of such thinking springs from the high risk that Spangler knows is associated with the asset class. Figures for standard deviation for distressed debt are hard to come by--Ibbotson Associates said they had none, and so investors are left with qualitative phrases like "very risky." The primary risk comes from incorrectly judging a situation, whether because of the players involved (creditors are fickle, especially banks with billion-dollar loans), the evaluation of asset values (no one knows what a company's inventory, supply, and equipment will bring on the open market), or knowing who will get what in the end. Also, bankruptcy lawsuits can take years to sort out, and so one risks tying up money without any return for long periods of time. That said, returns can be very high. Spangler says that the primary manager he uses is up 39% to date, while Haines says that his oldest fund has returned 9% from March 31, 1999 to June 30, 2001, after all fees. "Distressed debt is sexy," Haines adds. "It's a good story, and good to have in your practice."

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