Silver Linings

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.