BY:  RICK MARTIN & ELPIDA TZILIANOS Valuation Considerations for Distressed Securities
Agenda <ul><li>Overview of distressed securities </li></ul><ul><li>Defaults and availability of distressed debt </li></ul>...
Agenda <ul><li>Overview of distressed securities </li></ul>
Defining “Distress” <ul><li>Broad definition </li></ul><ul><li>Below investment grade debt (CCC or lower) </li></ul><ul><l...
What Causes Distress? <ul><li>Companies fall into distress for a number of reasons: </li></ul><ul><ul><li>Over-leveraged  ...
Corrective Actions <ul><li>Corrective actions </li></ul><ul><ul><li>Asset restructuring </li></ul></ul><ul><ul><li>Financi...
Ch 7 Liquidation Priority
Chapter 11 Process <ul><li>Under Ch 11, a company attempts to stay in business while a bankruptcy court supervises the “re...
<ul><li>A case filed under Chapter 11 of the United States Bankruptcy Code is typically used to reorganize a business, i.e...
Phase I: Steps 1-5 <ul><li>Two types of petitions can filed with a bankruptcy court: (1) a voluntary   petition, filed by ...
Ch 11 Filing Process – Phase II Section 341 Meeting  (Approx. 30-60 days) Disclosure Statement  (Timing Varies) Voting on ...
Phase II: Steps 6-10 <ul><li>The Meeting of Ceditors (often referred to as the “ Section 341 Meeting ”), which is a joint ...
Ch 11 Filing Process – Phase III Post-Confirmation: Modification/Administration  (Timing Varies) The Final Decree  (Timing...
Phase III: Steps 11-12 <ul><li>The debtor will then seek bankruptcy court approval, or confirmation of its plan of reorgan...
Chapter 11 Trading Securities <ul><li>A company’s securities may continue to trade after Ch11 filing. </li></ul><ul><li>Th...
Pluris Chapter 11 Bond Index <ul><li>Bonds in the Pluris Chapter 11 Bond Index include secured and unsecured, senior and s...
Pluris Chapter 11 Bond Index
Types of Distressed Securities <ul><li>Trade claims & receivables </li></ul><ul><li>Common stock, preferred stock, PIPEs, ...
The Distressed Market <ul><li>Money managers focus on bank debt, trade claims, & bonds </li></ul><ul><li>As of 2008, appro...
Investors in Distressed Securities <ul><li>Hedge funds are the largest buyers of distressed securities  </li></ul><ul><li>...
Investors Skills <ul><li>Skill sets  are highly specialized </li></ul><ul><ul><li>Legal backgrounds </li></ul></ul><ul><ul...
Active vs. Passive Investors ACTIVE PASSIVE Controlling Non-Controlling Seek Large blocks positions Senior secured/ Senior...
Target Returns <ul><li>Investments made during economic downturns </li></ul><ul><li>Profits realized during bull markets <...
Distressed Portfolios <ul><li>Top-down & Bottom-up strategies used in portfolio assessment </li></ul><ul><li>Investments b...
Basic Hedge Fund Strategies <ul><li>Outright short </li></ul><ul><ul><li>Bearish views on company’s credit fundamentals </...
Agenda <ul><li>Defaults and availability of distressed debt </li></ul>
Defaults <ul><li>U.S. business bankruptcies up 17% in 2nd quarter of 2008 as compared with the 1st quarter </li></ul><ul><...
Defaults <ul><li>Delaware saw a 100% increase from the 1st quarter to the 2nd quarter </li></ul><ul><li>Two to three compa...
Some  Notable 2008 Bankruptcies Company Name Filing Date Assets ($M) Liabilities ($M)  SIC Code Tribune Co. 12/8 7,600 12,...
Agenda <ul><li>Fair value and distressed securities  </li></ul>
FAS 157 <ul><li>Previous fair value accounting standards </li></ul><ul><li>Does not require any new fair value measurement...
Hierarchy <ul><li>Level 1: </li></ul><ul><li>Positions for which observable inputs used to determine fair value are: </li>...
Hierarchy <ul><li>Level 2: </li></ul><ul><li>Observable inputs are quoted prices for: </li></ul><ul><ul><li>similar  asset...
Hierarchy <ul><li>Level 3: </li></ul><ul><li>When there are not enough observable market inputs for the valuation to compl...
Which Level? <ul><li>Distressed securities may fall into Level 2 or Level 3 </li></ul><ul><li>High yield distressed debt s...
What needs to be fair valued? <ul><li>Reorganization value for fresh start </li></ul><ul><li>Creditor or debtor committees...
Conclusions <ul><li>Investments in distressed securities involve event-driven strategies </li></ul><ul><li>Company-specifi...
<ul><li>Rick Martin, CPA </li></ul><ul><li>(212) 248-4500 </li></ul><ul><li>Elpida Tzilianos, PhD </li></ul><ul><li>(212) ...
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Distressed Securities Primer

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7th Annual Distressed Investing Forum (Feb. 2008)

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  • Distressed Securities Primer

    1. 1. BY: RICK MARTIN & ELPIDA TZILIANOS Valuation Considerations for Distressed Securities
    2. 2. Agenda <ul><li>Overview of distressed securities </li></ul><ul><li>Defaults and availability of distressed debt </li></ul><ul><li>Fair value and distressed securities </li></ul>
    3. 3. Agenda <ul><li>Overview of distressed securities </li></ul>
    4. 4. Defining “Distress” <ul><li>Broad definition </li></ul><ul><li>Below investment grade debt (CCC or lower) </li></ul><ul><li>YTM > 1,000bps over risk-free Treasuries </li></ul><ul><li>Priced at or below 80 cents on the dollar </li></ul><ul><li>Highly concentrated in debt securities of companies in headed toward restructuring, bankruptcy, or liquidation </li></ul><ul><li>Market primarily consists of debt securities caught up in </li></ul><ul><ul><li>Ch 11 – Reorganization </li></ul></ul><ul><ul><li>Ch 7 – Liquidation </li></ul></ul><ul><ul><li>Other extraordinary transactions (e.g., out of court restructuring) </li></ul></ul>
    5. 5. What Causes Distress? <ul><li>Companies fall into distress for a number of reasons: </li></ul><ul><ul><li>Over-leveraged </li></ul></ul><ul><ul><li>Liquidity issues </li></ul></ul><ul><ul><li>Slipping credit </li></ul></ul><ul><ul><li>Poor operating performance </li></ul></ul><ul><ul><li>Accounting irregularities </li></ul></ul><ul><ul><li>Inadequate cash flows </li></ul></ul><ul><ul><li>Competition </li></ul></ul>
    6. 6. Corrective Actions <ul><li>Corrective actions </li></ul><ul><ul><li>Asset restructuring </li></ul></ul><ul><ul><li>Financial restructuring = private workout or Ch 11 </li></ul></ul><ul><li>If all else fails </li></ul><ul><ul><li>Ch 7 = Company shuts down & assets distributed to creditors. </li></ul></ul><ul><ul><li>Ch 11 = Stabilization, reorganization & approval </li></ul></ul><ul><li>Creditors may include: </li></ul><ul><ul><li>Banks </li></ul></ul><ul><ul><li>Utilities & other trade vendors </li></ul></ul><ul><ul><li>Investors with bonds </li></ul></ul><ul><ul><li>Interest Holders </li></ul></ul>
    7. 7. Ch 7 Liquidation Priority
    8. 8. Chapter 11 Process <ul><li>Under Ch 11, a company attempts to stay in business while a bankruptcy court supervises the “reorganization” of the company’s contractual obligations. This process can be divided it into 13 steps, embedded in three primary phases: </li></ul><ul><li>(1) Filing </li></ul><ul><li>(2) Negotiation </li></ul><ul><li>(3) Approval </li></ul>
    9. 9. <ul><li>A case filed under Chapter 11 of the United States Bankruptcy Code is typically used to reorganize a business, i.e., a corporation, sole proprietorship, or a partnership. The Chapter 11 processes can be divided it into twelve steps, embedded in three primary phases: (1) Filing, (2) Negotiation, and (3) Approval. </li></ul><ul><li>It is important to note that stock and commodity brokers are not eligible for Chapter 11 filings and may only file Chapter 7 petitions. </li></ul>Ch 11 Filing Process – Phase I PHASE 2 First Day Motions (1-3 days) First Day Orders (1-3 days) Creation of Creditors Committee (2 weeks) DIP Financing (2-3 weeks) Filing Avoidable Transfers (90 days - 2years Prior to Filing)
    10. 10. Phase I: Steps 1-5 <ul><li>Two types of petitions can filed with a bankruptcy court: (1) a voluntary petition, filed by the debtor or, (2) (a less common) an involuntary petition, filed by creditors. Upon filing a petition the debtor automatically assumes the identity of a debtor-in-possession (DIP). A DIP refers to a debtor that keeps possession and control of its assets while undergoing reorganization under Chapter 11. </li></ul><ul><li>First day motions (FDMs) are then filed by the debtor, usually 1- 3 days following the petition filing and are intended to ensure that the debtor can operate its business normally with regards to its employees, suppliers, customers and other stakeholders. </li></ul><ul><li>The court considers the FDMs at a “first-day hearing” that usually takes place on the first or second day of a Chapter 11 case. The court then issues “ first-day orders ” (FDOs) approving the FDMs. </li></ul><ul><li>The debtor obtains DIP financing to fund its ongoing operations and operates in the normal course of business as a DIP. </li></ul><ul><li>Within the first two weeks of a case, a government agency, called the U.S. Trustee appoints the Official Committee of Unsecured Creditors (the “ Creditors Committee ”) to deal with restructuring related issues. The U.S. Trustee will usually try to include several types of creditors (trade creditors, bondholders, etc.) so that the creditors’ committee is a representative body. </li></ul>
    11. 11. Ch 11 Filing Process – Phase II Section 341 Meeting (Approx. 30-60 days) Disclosure Statement (Timing Varies) Voting on & Acceptance of the Plan (Timing Varies) Claims Bar Date (4-6 months) Plan of Reorganization (Timing Varies) PHASE 3 PHASE 1
    12. 12. Phase II: Steps 6-10 <ul><li>The Meeting of Ceditors (often referred to as the “ Section 341 Meeting ”), which is a joint meeting of the debtor’s representatives and the creditors, typically occurs approximately 30-65 days after a Chapter 11 filing. At this meeting the U.S. trustee and creditors may question the debtor under oath concerning matters regarding the nature and location of assets such as reporting its monthly income and operating expenses, establishing new bank accounts, and paying current employee withholding and other taxes.   </li></ul><ul><li>A notice is sent out to anyone who may have financial or other claims against the debtor requiring that they submit a proof of claim by a specific date or be barred from asserting that claim. This date is called the claims bar date . Once the court has gathered all of the claims that resulted from the bar date notice, hearings are held to determine the value of any claims that are disputed. </li></ul><ul><li>The debtor finalizes its long-range strategic business plan and develops a plan of reorganization , which sets forth how the debtor plans to repay its creditors. The debtor has the exclusive right to propose and file such a plan of reorganization during the first 120 days of the Chapter 11 process (called the exclusivity period ). If the debtor is proceeding in “good faith”, the exclusivity period may be extended (or in other cases reduced) by the bankruptcy court but may not exceed 18 months . After the exclusivity has expired, a party in interest or the U.S. Trustee may file a competing plan.   </li></ul><ul><li>The debtor must submit to the court a Disclosure Statement (DS) with its proposed plan of reorganization. The DS is a document presents information on: (a) the debtor’s current and projected financial conditions, (b) the debtor’s proposed plan for paying its creditors and (c) the business case for why the Plan should be approved. After this DS is filed, the court must hold a hearing to determine whether the DS is approved . </li></ul><ul><li>The debtor has 180 days after the petition date or entry of the order for relief (in the case of involuntary) to obtain acceptance of its plan. The court may extend ( up to 20 months ) or reduce this acceptance exclusive period. </li></ul>
    13. 13. Ch 11 Filing Process – Phase III Post-Confirmation: Modification/Administration (Timing Varies) The Final Decree (Timing Varies) Emerging from Chapter 11 (Timing Varies) Revocation of Confirmation (At Most, 180 days Post Confirmation) Plan Confirmation (Timing Varies) PHASE 2
    14. 14. Phase III: Steps 11-12 <ul><li>The debtor will then seek bankruptcy court approval, or confirmation of its plan of reorganization. The court holds hearings to consider whether the Plan of Reorganization complies with the requirements set forth in the Bankruptcy Code. If confirmed, the debtor may emerge from Chapter 11 as a reorganized company and operate its business as described in its plan of reorganization. </li></ul><ul><li>A final decree closing the case must be entered after the estate has been “fully administered.” Local bankruptcy court policies generally determine when the final decree is entered and the case closed.   </li></ul><ul><li>If the court approves the plan of reorganization, it is confirmed and usually within a few days the plan becomes effective . At that point, the company emerges from Chapter 11 as a reorganized entity. </li></ul>
    15. 15. Chapter 11 Trading Securities <ul><li>A company’s securities may continue to trade after Ch11 filing. </li></ul><ul><li>There is no federal law prohibiting securities trading of bankrupt firms. However, trading can be limited due to trading orders from the court. </li></ul><ul><li>These investments are very risky. </li></ul><ul><li>During bankruptcy bondholders stop receiving interest and principal payments and stockholders stop receiving dividends. </li></ul><ul><li>If company emerges, creditors and bondholders generally become the new equity holders. </li></ul><ul><li>Plan of reorganization usually cancels existing shares, because secured and unsecured creditors are paid from the company’s assets before common stock holders. So, if liabilities > assets = $0/share. </li></ul><ul><li>Note Ticker + Q = Bankruptcy filing; Ticker + V = Trading during bankruptcy proceedings; Ticker Alone = Newly issued shares. </li></ul><ul><li>Post-emergence , bond holders may receive new stock, warrants, new bonds, cash, or a combination in exchange for their bonds. </li></ul>
    16. 16. Pluris Chapter 11 Bond Index <ul><li>Bonds in the Pluris Chapter 11 Bond Index include secured and unsecured, senior and subordinate notes. </li></ul><ul><li>Generally, inclusion criteria for the Pluris Chapter 11 Bond Index are: </li></ul><ul><ul><ul><ul><li>U.S. Issuers </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Non-Financial Issuers (Excludes SICs 60-69) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Issuers undergoing pending Chapter 11 proceedings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Issuers that have not been acquired since the bankruptcy filing </li></ul></ul></ul></ul>
    17. 17. Pluris Chapter 11 Bond Index
    18. 18. Types of Distressed Securities <ul><li>Trade claims & receivables </li></ul><ul><li>Common stock, preferred stock, PIPEs, rights & warrants </li></ul><ul><li>High yield bonds, corporate & municipal bonds </li></ul><ul><li>Below par bank loans, DIP loans, bridge & mezzanine loans </li></ul><ul><li>Collateralized debt, second lien notes, & real estate assets </li></ul><ul><li>Futures, options, swaps, & indices </li></ul>
    19. 19. The Distressed Market <ul><li>Money managers focus on bank debt, trade claims, & bonds </li></ul><ul><li>As of 2008, approximately $200B of the $900B US high yield market can be considered “distressed.” </li></ul><ul><li>Distressed securities markets are highly inefficient </li></ul><ul><li>Securities often sell at deep discounts </li></ul>
    20. 20. Investors in Distressed Securities <ul><li>Hedge funds are the largest buyers of distressed securities </li></ul><ul><li>Money managers </li></ul><ul><li>Mutual funds </li></ul><ul><li>Private equity firms </li></ul>
    21. 21. Investors Skills <ul><li>Skill sets are highly specialized </li></ul><ul><ul><li>Legal backgrounds </li></ul></ul><ul><ul><li>Restructuring expertise </li></ul></ul><ul><ul><li>Strong negotiating skills </li></ul></ul><ul><ul><li>Extensive networks </li></ul></ul><ul><ul><li>Asset valuation skills </li></ul></ul>
    22. 22. Active vs. Passive Investors ACTIVE PASSIVE Controlling Non-Controlling Seek Large blocks positions Senior secured/ Senior unsecured Undervalued trading securities Involvement Extensive/ Restricted Influence process/ Usually restricted Trading oriented/ Unrestricted Horizon ≈ 2-3Y ≈ 1-2Y Long or Short (usually ≈ 6M-1Y) Opportunity Always Always Cyclical
    23. 23. Target Returns <ul><li>Investments made during economic downturns </li></ul><ul><li>Profits realized during bull markets </li></ul><ul><li>Targeted annual returns rest in 20-25% range </li></ul><ul><li>On average = 12% </li></ul>
    24. 24. Distressed Portfolios <ul><li>Top-down & Bottom-up strategies used in portfolio assessment </li></ul><ul><li>Investments based on market/trading dynamics, assessed position values, risk/return profiles, etc. </li></ul><ul><li>Portfolios based on: </li></ul><ul><ul><li>Standard risk management measures </li></ul></ul><ul><ul><li>Arbitrage risk </li></ul></ul><ul><ul><li>Sector diversification and position limits </li></ul></ul><ul><ul><li>Leverage limits </li></ul></ul><ul><ul><li>Credit information (past, present & future) </li></ul></ul><ul><ul><li>Tail risk </li></ul></ul><ul><ul><li>Cost & effectiveness of hedging instruments </li></ul></ul><ul><ul><li>Liquidity analysis </li></ul></ul>
    25. 25. Basic Hedge Fund Strategies <ul><li>Outright short </li></ul><ul><ul><li>Bearish views on company’s credit fundamentals </li></ul></ul><ul><ul><li>Often done through CDS purchases </li></ul></ul><ul><li>Long/short </li></ul><ul><ul><li>Assumes securities are undervalued (overvalued) and will depreciate (appreciate) </li></ul></ul><ul><li>Capital structure arbitrage </li></ul><ul><ul><li>Mispricing between securities of the same issuer </li></ul></ul><ul><li>Value trading </li></ul><ul><ul><li>Assumes securities undervalued; purchased before Reorganization Plan announced or immediately following restructuring </li></ul></ul><ul><li>Rescue financing </li></ul><ul><ul><li>Lending to companies prior to Ch 11 filing </li></ul></ul>
    26. 26. Agenda <ul><li>Defaults and availability of distressed debt </li></ul>
    27. 27. Defaults <ul><li>U.S. business bankruptcies up 17% in 2nd quarter of 2008 as compared with the 1st quarter </li></ul><ul><li>Almost 29,000 companies filed for bankruptcy in the 1st half of 2008 </li></ul><ul><li>States with the biggest increases in filings included Delaware, Montana, Oregon, Maryland, and Connecticut </li></ul>
    28. 28. Defaults <ul><li>Delaware saw a 100% increase from the 1st quarter to the 2nd quarter </li></ul><ul><li>Two to three companies go out of business for every one that files for bankruptcy </li></ul><ul><li>About $184 billion of distressed debt is trading </li></ul><ul><li>One in three junk bonds is distressed </li></ul>
    29. 29. Some Notable 2008 Bankruptcies Company Name Filing Date Assets ($M) Liabilities ($M) SIC Code Tribune Co. 12/8 7,600 12,130 2711 PFF Bancorp, Inc. 12/5 3,724 3,6778 6035 Pilgrim’s Pride Corp. 12/8 3,299 2,947 0251 LandAmerica Financial Group, Inc. 11/26 3,325 2,840 6361 Circuit City Stores, Inc. 11/10 3,400 2,323 5731 VeraSun Energy Corp. 10/31 2,913 1,842 2869 Washington Mutual, Inc. 9/26 309,731 283,645 6035 Lehman Brothers Holdings, Inc. 9/15 693,000 613,000 6211 Luminent Mortgage Capital, Inc. 9/5 13 484 6798 WCI Communities, Inc. 8/4 2,178 1,941 1531 Frontier Airlines Holdings, Inc. 4/10 1,250 1,098 4512 SIRVA, Inc. 2/5 894 1,149 4213
    30. 30. Agenda <ul><li>Fair value and distressed securities </li></ul>
    31. 31. FAS 157 <ul><li>Previous fair value accounting standards </li></ul><ul><li>Does not require any new fair value measurements </li></ul><ul><li>Does require new and expanded disclosures </li></ul><ul><li>Establishes a three level hierarchy </li></ul><ul><ul><li>Categorization primarily depends on observables inputs </li></ul></ul>
    32. 32. Hierarchy <ul><li>Level 1: </li></ul><ul><li>Positions for which observable inputs used to determine fair value are: </li></ul><ul><ul><li>unadjusted market prices </li></ul></ul><ul><ul><li>of identical assets </li></ul></ul><ul><ul><li>in an active market. </li></ul></ul>
    33. 33. Hierarchy <ul><li>Level 2: </li></ul><ul><li>Observable inputs are quoted prices for: </li></ul><ul><ul><li>similar assets </li></ul></ul><ul><ul><li>in active markets, </li></ul></ul><ul><li>Or, quoted prices for: </li></ul><ul><ul><li>identical or similar securities </li></ul></ul><ul><ul><li>in inactive markets, or </li></ul></ul><ul><li>Other observable market inputs, or </li></ul><ul><li>Other inputs derived from or corroborated by the market. </li></ul><ul><li>Many distressed securities would likely fall into Level 2 </li></ul>
    34. 34. Hierarchy <ul><li>Level 3: </li></ul><ul><li>When there are not enough observable market inputs for the valuation to comply with the Level I or Level II requirements. </li></ul><ul><ul><li>Level III valuations represent the most difficult path </li></ul></ul><ul><ul><li>Additional disclosures are required for Level III assets. </li></ul></ul><ul><li>Available market data on similar securities must still be considered in determining fair value. </li></ul>
    35. 35. Which Level? <ul><li>Distressed securities may fall into Level 2 or Level 3 </li></ul><ul><li>High yield distressed debt securities may fall into Level 2 </li></ul><ul><li>Bankruptcy claims may fall into Level 2 or 3 </li></ul><ul><li>Nonperforming assets may fall into Level 2 or 3 </li></ul>
    36. 36. What needs to be fair valued? <ul><li>Reorganization value for fresh start </li></ul><ul><li>Creditor or debtor committees </li></ul><ul><li>Analyzing bankruptcy claims </li></ul>
    37. 37. Conclusions <ul><li>Investments in distressed securities involve event-driven strategies </li></ul><ul><li>Company-specifics often drive prices (not stock market) = Investor’s research critical </li></ul><ul><li>Many valuation approaches but few KEY factors: </li></ul><ul><ul><li>Fundamentals! </li></ul></ul><ul><ul><li>Understand the law and the state of the economy </li></ul></ul><ul><ul><li>Examine management quality and motivation </li></ul></ul><ul><ul><li>Know the creditors involved and claim complexity </li></ul></ul><ul><ul><li>Diversify distressed portfolios </li></ul></ul><ul><ul><li>Patience during reorganization/workout process </li></ul></ul>
    38. 38. <ul><li>Rick Martin, CPA </li></ul><ul><li>(212) 248-4500 </li></ul><ul><li>Elpida Tzilianos, PhD </li></ul><ul><li>(212) 248-4639 </li></ul>

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