Jon Henes: The Four Questions of Distressed Investing
In the Great Recession and today’s era of de-leveraging, much is being made of the so-called “fulcrum security”.
In distressed investing, the investor wants to locate the fulcrum security, which is the security or debt instrument that will be converted into the equity of the distressed company when it restructures its balance sheet and operations. Locating the fulcrum security is key because it provides the investor with the right to vote on (and potentially control) the company’s plan of reorganization – i.e., the agreement approved by a bankruptcy judge that governs the distressed company’s restructuring in bankruptcy and the distribution of value to stakeholders.
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Identifying the fulcrum security and making the decision on whether to invest in the capital structure of a distressed company requires a deliberate and thoughtful process. It requires significant analysis of the company’s capital structure, operations, industry and ability to generate income in light of macro-economic conditions. It also requires a decision on tactics, which will be driven by the specific goal and style of the investor. For example, the investor needs to decide whether it is purchasing debt to gain control of the distressed company or to make short term trading profits. (These are just two examples. There are many ways invest in and profit from distressed companies.) All investors have their own techniques of deliberation and analysis.
Nonetheless, there are four key questions for all distressed investors:
Does the company need to exist?: The first question a distressed investor needs to ask is whether they like the company and whether the company needs to exist. This is an important question. Many companies and business models have gone the way of the dinosaurs and an investor wants to be sure that a company in which it may invest is a good company that will survive once its balance sheet is fixed, operational issues are worked out and the economy recovers. For instance, large, well-run companies that are necessary for the construction of homes (e.g., manufacturers of windows, doors, etc.) will remain in business and grow once the housing market eventually rebounds. However, distressed retailers that sell products that can be purchased from other retailers at stores or over the Internet do not necessarily need to survive. So, an investor should ask the following questions: Is the company inherently strong and well run? Is the problem with the company its business model (which may not be able to ever be fixed) or its capital structure (which, through negotiation, can be fixed)? If the company is facing operational issues, can bankruptcy help it fix its problems? The answers to these questions are critical in determining whether to take the next steps of analyzing a potential investment opportunity.
What is the value of the company? After determining that the company is viable over the long term, the distressed investor needs to determine what it believes the company is worth. Here, the investor will analyze all information available to it about the company’s financial performance. It will review the company’s past earnings, current earnings and estimate the company’s future earnings. The future earnings will be estimated based on numerous factors, including whether the company is poised for growth as compared to its competitors, whether the macro-economic environment will support growth and whether management can effectively operate the company and manage costs. Based on this, the distressed investor will come up with a range of future earnings and then estimate what the company will trade at (be sold for) in the future. Specifically, the investor will determine what multiple should be combined with the projected earnings to determine a range of values for the company. At the end of this valuation process, the investor will have a range of values for the company on a pro forma basis.
What is the fulcrum security? Armed with a range of values, the investor will analyze the company’s capital structure. The investor compares the total amount of debt with the company’s estimated value to determine which instruments or securities are “in the money.” By way of example, assume that the investor estimates the midpoint value of the company to be $500 million. Assume further that the company has $750 million of senior secured debt and $250 million of unsecured debt. The fulcrum security would be the senior secured debt because the enterprise value of the company (i.e., $500 million according to the distressed investor) is less than the total amount of secured debt. (The unsecured debt is “out of the money.”) However, the analysis is not over. The distressed investor now needs to see what the market believes the enterprise value of the company is so the distressed investor can determine whether to purchase the senior secured debt. If the senior secured debt is trading at 50 cents on the dollar in the market– thereby assuming a $350 million enterprise value – the distressed investor should buy. However, if the senior secured debt is trading at 80 cents on the dollar, the distressed investor will not buy because it believes the market is overvaluing the company.
What is the investment thesis? Obviously, the distressed investor is buying debt to make money. That is why investors invest! However, what is the investment thesis: is it a short term play (i.e., buy low, sell high)? Is it to take control of the company through the restructuring process? Based on the answer to these questions, the distressed investor will employ different tactics. For instance, if the investor is looking for short term trading profits – i.e., it believes the value is $500 million ($.67), but the senior secured debt is trading at $350 million ($.50) – then the investor will buy whatever it can for a price significantly less than $.67 and wait to trade out at an appropriate time. However, if the distressed investor is buying the senior secured debt to influence the restructuring and attempt to take control or own the restructured company, the investor may seek to purchase 34% of the senior secured debt (one of the requirements for confirming a plan is to get 66.7% in amount of class of claims to vote yes) or join a group of other likeminded investors to purchase a controlling position. The amount of debt purchased and whether the investor will be active or passive in the restructuring process depends on each investor’s make up and philosophy.
As distressed investing increases as the number of distressed companies increase, these four key questions need to be considered. Distressed investing is not easy, but when done right, it is lucrative and, thus, highly satisfying.
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.