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Strategies for Investing in Distressed Securities:
Security Selection
Your selection of a particular security will depend in large part on how the company intends to
restructure. The securities of a company that reorganizes outside of court will probably fare quite
differently from the securities of a bankrupt company or an already reorganized company. For this
reason the following section is divided into three parts: Troubled But Non-Bankrupt Companies,
Bankrupt Companies, and Companies that have Emerged from Bankruptcy. Each section looks at
the risks and returns expected on securities under these different restructuring scenarios.
Troubled Non-Bankrupt Companies
The stock of a troubled company is typically very depressed and has the potential to rebound
sharply if the company can reorder its business. If the basic business is sound and it looks like the
company can meet its obligations without drastic restructuring, the stock is likely to reward patient
investors who are willing to go against the trend.
Offshore Logistics, which provides services to offshore drillers, demonstrates what can happen
when a troubled company is able to get back on its feet without going into bankruptcy. The
company was battered in the energy industry downturn of the mid-1980's. After a 1986 debt
restructuring, the stock went from 3/4 to more than 14 in four years.
The common stock of a troubled company is usually only worth considering, however, if you think
the company will be able to avoid filing for bankruptcy. Once the company goes into Chapter 11
the stock almost always fares poorly. While there have been some spectacular gains from
bankruptcy stocks in the past, in recent years creditors have been leaving less and less value for
the stockholders. The holders of the old common usually get very heavily diluted as new stock is
issued to satisfy creditors.
If a company manages to restructure without filing for Chapter 11, there can be substantial price
appreciation in other equity securities besides the common stock. If the company has issued
warrants, they are likely to be trading at a very low price and have tremendous price leverage.
However, the warrants also have a high level of risk because they will almost always be worthless if
the company files for bankruptcy.
Preferred stocks can also provide substantial appreciation, particularly if they have accrued
dividends. Frequently when a company encounters financial problems, it will stop paying
dividends on its preferred stock. Unlike missing an interest payment on a bond, skipping a
dividend on a preferred stock will not force a company into bankruptcy. Instead, unpaid dividends
(which are known as "arrearage") accumulate and can be paid off later.
As the company begins to recover, its preferred stock can move up sharply as investors see the
prospect of not only having the regular dividend restored, but also receiving all of the accumulated
dividend arrearage. For example, when International Harvester was in trouble in 1982, its Class C
Preferred dropped as low as 6 1/4. As the company solved its financial problems, the Class C
Preferred recovered dramatically, rising to 77 before being redeemed by the company in early 1987.
Assuming the company avoids filing for bankruptcy, the returns on the equity will probably be the
greatest but the public debt of a troubled company can also offer substantial price appreciation.
Interested investors should read the section on debt securities of bankrupt companies ? the
analytical considerations are similar in an out-of-court restructuring, but the time frame may be
much shorter.
Securities of Bankrupt Companies
Once a company files for bankruptcy, its fate (and the fate of its security holders) is controlled to a
large extent by the Bankruptcy Code. The Code establishes a framework within which the company
negotiates with its creditors to satisfy its debts. The goal of Chapter 11 is to come up with a "plan
of reorganization" that spells out how all the various types of debt will be satisfied and allows the
company to emerge from bankruptcy as a viable business. (If the company is unable to reorganize,
it will go into Chapter 7 which governs liquidations. )
The goal of Chapter 11 is to allow the company to emerge as a going concern. The rights of
creditors are generally determined by the seniority of their claims on the assets of the company. In
theory at least, each class of creditor, starting with the most senior, must be satisfied in full before
classes ranking below it receive anything. This "rule of absolute priority" is usually not strictly
followed in a successful reorganization, but it provides the starting point for any analysis of the
securities of a bankrupt company. Seniority is clearly the most important determinant of value in a
Chapter 11. Except as noted below in the discussion on secured bonds, coupon rates on bonds
usually do not play a major role in determining return once the issuer goes into bankruptcy. Also
the maturity date is often irrelevant once a company files for bankruptcy.
Secured Debt
Secured debt generally has the highest level of seniority and thus the lowest level of risk
among traded securities, but both the risk and the ultimate return from secured debt depend
on the value of the assets securing the debt. Obviously, if the liquidation value of the
assets is less than the principal amount of debt, the holders of the debt will not be paid off
in full if the company is liquidated. However, the value of the assets can affect the security
holder's return in other ways.
First, if the debt is adequately secured at the commencement of a bankruptcy proceedings,
the holder of the debt is entitled to have interest continue to accrue during the bankruptcy.
Absent full security, a debtholder is only entitled to claim unpaid interest that accrued prior
to the bankruptcy filing ? known as "pre-petition" interest. If the bankruptcy court can be
convinced of the adequacy of the asset coverage, it may even allow interest to be paid
during the bankruptcy proceedings. For example, Public Service of New Hampshire's first
and second mortgage bonds paid interest throughout the bankruptcy proceedings.
Frequently, the adequacy of the asset coverage may be in dispute right up to the end of the
bankruptcy proceedings. Any uncertainty about asset coverage can have a substantial
impact on the market price of "secured" bonds. For example, LTV Corp. has two different
groups of secured bonds outstanding. They are both first mortgage bonds secured by
steelmaking facilities. One group is secured by the facilities of the former Youngstown
Sheet & Tube Co. , and the other is secured by plants of the former Jones & Laughlin Steel
Co. The Youngstown facilities are considered to be very modern and to provide adequate
security for the applicable bonds, while the value of the Jones & Laughlin facilities are more
questionable. As a result, the Youngstown bonds have traded from 30 to 70% above the
Jones & Laughlin bonds despite almost identical coupons.
When asset coverage is clearly inadequate, secured bondholders may face the unfortunate
prospect of only being given priority over other claimants to the extent of the value of the
underlying assets. The balance of their claim may be treated as a general unsecured claim.
For example, where the court found that the assets securing a certain bond issue were
worth only 30 cents for each $1 principal amount of bond, the holders would be given
priority treatment for only 30% of their debt with the other 70% being treated on a par with
trade debt, unsecured debt or other seemingly junior securities.
The potential returns on distressed secured bonds depend on how quickly and accurately
the market values the underlying assets. The Youngstown Sheet & Tube bonds mentioned
above roughly doubled in price during the early years of the LTV bankruptcy as investors
re-assessed the collateral value. At the other end of the spectrum, investors had precisely
valued the aircraft securing some of Eastern Air Lines' bonds, and so the prices of the
secured barely budged when the company filed for bankruptcy.
Unsecured Bonds
The term "unsecured bonds" can cover a variety of debt instruments, ranging from senior
debt that comes ahead of everything but secured obligations to junior subordinated debt
that comes behind everything except the equity interests. Thus, the first step in analyzing
an unsecured bond is to determine exactly where it ranks among the company's obligations.
This depends upon the covenants in the indenture under which the bond was issued.
The next step is to try to estimate how much value is likely to be distributed to the holders
of the bond in question. To figure the minimum amount that should be received by the
bondholders, you can take the liquidation value of the company and assume that all
securities senior to yours will be paid off in full (following the "absolute priority" rule
mentioned above). Whatever value is left would be available for distribution to your class.
Unfortunately, the foregoing analysis is not always helpful, for several reasons. First, in a
complex bankruptcy, even the liquidation value of the company may be hard to determine.
Second, the going concern value of the company may be substantially higher than the
liquidation value and will therefore ultimately determine the value of the bonds. Finally, the
reorganization plan is likely to deviate from the absolute priority rule.
While, as mentioned above, the absolute priority rule always applies, every bankruptcy or
restructuring is in fact a negotiation process. In a vigorously negotiated bankruptcy,
various parties may decide it is in their best interest to compromise some of their rights. For
example, senior bondholders may be willing to let more value flow down to the junior
bondholders in order to expedite the reorganization. While the senior bondholders might
ultimately prevail if they insisted on absolute priority, the junior security holders could
perhaps tie up the proceedings for years with various motions and appeals. As a result, any
valuation other than a liquidation based on absolute priority is tenuous at best.
The investor must try to predict what the company will look like when the reorganization is
complete, how much the new company will be worth and how that value will be divided
among the various classes of creditors. In general, the more junior the security, the greater
the uncertainty surrounding its ultimate value. This greater level of uncertainty, of course,
also leads to greater appreciation potential. It is not unusual to see junior bonds double or
triple in value during bankruptcy. Unfortunately, it is also not uncommon to see junior
bonds receive only a few cents on the dollar for their claims.
Securities Issued by Different Entities
In some situations, particularly involving large companies, there may be technically more
than one issuer of the securities involved. For example, in the LTV case, some of the
unsecured bonds were originally issued by the parent company, some were issued by the
steelmaking subsidiaries and others were issued by the aerospace subsidiary.
In some situations, the bankruptcy cases may be "substantively consolidated" and the
various issuers treated identically. In other cases, however, the court will decide that
different entities should be treated differently. This is likely to happen where one entity is
viewed as having more value than others and where it has historically been treated
separately from the rest of the corporate family.
In addition to the LTV case, where it is not yet clear how the consolidation question will be
resolved, the significance of the issuer can be seen in the case of Allegheny International
where the parties agreed to different treatment for various Allegheny entities. Under the
company's reorganization plan, general unsecured claims of Allegheny International
received about 55 cents on the dollar, while general unsecured claims of Allegheny's
Chemetron subsidiary received about 92 cents on the dollar.
Non-Public Claims
In recent years, a number of investment firms have begun investing in, and even trading,
bankruptcy debt obligations other than public securities. These private debt obligations
include the claims of creditors such as bank lenders, trade suppliers and industrial revenue
bond holders. These claims can vary in their level of seniority, depending on the nature of
the underlying debt of the company.
The advantage of buying private claims is that they can often be obtained at a lower price
that comparable public securities. The holders of the private claims may be willing to sell
their claims at substantial discounts because they need liquidity or because they just do
not want to be involved in the bankruptcy proceeding.
The disadvantage of private claims is that they are less liquid and involve more paperwork
than public securities. Although some securities firms are beginning to make markets in
private claims, the buyer of a private claim should probably expect to hold it for the duration
of the bankruptcy. Also, all transfers of private claims must be approved by the bankruptcy
court. The procedures vary from court to court, and it is essential that they be carefully
followed.
Equity Securities
Once a company goes into bankruptcy, its equity securities (common and preferred stock
and warrants) are basically treated very much like junior bonds, and they should be
analyzed in much the same way. In principal, the equity holders are entitled to whatever
value is left in the company after all of the other creditors have been satisfied.
It is generally advisable for long-term investors to avoid the common stock. There may be
short-term trading opportunities in bankruptcy stocks, but over the longer-term common
stockholders almost always fare badly in Chapter 11. While there have been some
bankruptcies in the past where investors made spectacular profits in the common stock,
changes in bankruptcy law coupled with growing sophistication among creditors make it
increasingly likely that stockholders in a bankrupt company will end up with little or no
value.
The basic reason for this is that under corporate and bankruptcy law, stockholders have the
lowest priority claim on a company's business and assets. While in the past it was quite
common for creditors in a Chapter 11 reorganization to make fairly sizable concessions to
common stockholders so that the stockholders would support the reorganization plan, the
Bankruptcy Code of 1978 made it easier for creditors to enforce the rule of absolute priority.
As creditors learned how to operate under the 1978 Code, they realized that they did not
have to give as much value to the stockholders as had been common in the past. Now
stockholders often receive five percent or less of the equity in the reorganized company,
and it is not uncommon to see them get nothing.
Preferred stock is theoretically entitled to its liquidation preference before any distribution
is made to the common stock. This is rarely the case in actual practice, though, particularly
when the various equity classes are sharing a relatively small distribution. In some cases
preferred stock is treated identically with the common, while in many cases it receives a
modest premium over the common.
Only if the debt holders are paid off more or less in full are you likely to see the preferred
receive a much higher return than the common. This was the case in the Manville
reorganization, where the preferred holders received new securities worth about $27 per
share, while the old common stock was exchanged for new common stock worth only $1 per
share.
Some companies have several different classes of preferred with different levels of seniority
and different liquidation preferences. It is difficult to generalize about whether the
differences will ultimately be recognized in the reorganization plan.
Since common stocks almost always fare badly, it follows that warrants (which usually
depend on a rise in the stock price for their value) will also do poorly in bankruptcy. This
has been the case in virtually all recent bankruptcies. Recoveries on warrants have ranged
from a few cents to nothing, with the latter being the most common.
There have been only a handful of bankruptcies in the last few years where you could have
made money by buying the common stock after the company went into bankruptcy (other
than perhaps trading on the sharp, short-term swings that bankruptcy stock sometimes
take). The few bankruptcy stocks that have done well have been mostly "special"
bankruptcies such as Texaco and A.H. Robins that did not file for financial reasons.
The key to evaluating these special bankruptcies is to figure out how large the potential
liability is compared to the equity value of the company. In Robins, the value of the
company (largely because of its valuable consumer brands, mentioned previously) was
considered greater than the litigation claims against the company, and the excess value
flowed through to the stockholders. Texaco used bankruptcy to negotiate a favorable
settlement to its litigation, thereby leaving a lot of value for its shareholders. By contrast, in
Manville the value of the claims against the company was so large as to leave almost
nothing for the holders of the common stock.
Short-term Trading Opportunities
While there is not likely to be much profit potential for long-term holders of bankruptcy
stocks, there may be good opportunities for short-term traders. Many bankruptcy stocks
follow a predictable trading pattern over the course of the Chapter 11 proceedings, and
astute traders may be able to take advantage of these patterns.
In the days immediately preceding a bankruptcy filing, a company's stock usually drops
sharply. Then after the filing it may rebound somewhat, perhaps even quite sharply. For
example, Ames Department Stores stock dropped from 6 to 1 1/2 in the month before the
bankruptcy filing. Then it bounced back to 3 1/4 the week after the filing. Some of this
post-filing rebound may be attributable to speculation by investors who do not understand
the bankruptcy process, or it may be caused by short-sellers who sold the stock as it
approached bankruptcy and then covered their positions after the filing.
There may also be short-term trading opportunities in bankruptcy stocks around the end of
the calendar year. See the discussion of "Calendar Patterns" in the Timing section (Article
#4 entitled "Timing: When To Buy").
Reorganized Companies
Although the stocks of companies in Chapter 11 are generally quite unattractive, there can be
significant opportunities when the company emerges from bankruptcy. If the reorganization plan is
properly designed, the company will be getting a fresh start, having been relieved of many of the
burdens that forced it into bankruptcy.
The stock of the reorganized company will often be undervalued because it is still tainted in many
people's minds by the bankruptcy. Also, creditors who receive stock in partial satisfaction of their
claims will often sell their stock as soon as they can. This will depress the price of the stock and
may offer investment opportunities.
Using Bonds to Buy Stock
When a company is about to emerge from bankruptcy, there may be a chance to get new
stock at a bargain price by buying the old bonds (or other securities) that will be converted
into new stock under the plan of reorganization. For example, when Western Company of
North America (an oil drilling company) was about to emerge out of Chapter 11 in early
1989, its plan of reorganization called for its old bonds, preferred stock and common stock
to be exchanged for new common stock at varying exchange ratios.
Given the exchange ratios and prices of the Western securities just before the
reorganization took effect, you would have paid about $5.50 per share of new common if
you bought the old bonds or preferred stock, but you would have paid over $19.00 per new
share if you bought the old common stock. (This is another example of how over-priced a
bankruptcy stock can be.) When the Western reorganization took effect, the new common
stock began trading at 6 1/4, and it rose as high as 18 over the next year.
Possible Post-Bankruptcy Problems
Not every post-bankruptcy stock is a good buy. Quite often the company, or its investment
bankers, will be too aggressive in valuing its new stock. The stock will begin trading after
the reorganization at a level that is not supportable, and it will drop sharply in a short time.
Also, not every reorganization plan is well structured, and some companies continue to
have problems after they emerge from bankruptcy. In recent years, at least three New York
Stock Exchange listed companies ? Cook United, New American Shoe (formerly known as
Amfesco) and Towle Manufacturing ? have been forced to go into Chapter 11 within a
couple of years after they emerged. Needless to say, the stockholders in these companies
did not fare well.
The risks in post-bankruptcy stocks are well illustrated by Cook United, a discount store
chain in the Midwest. It emerged from Chapter 11 in September 1986, and its stock began
trading at 7. Within a few weeks, the stock had dropped to 2. The company's troubles
continued to mount, and it went into bankruptcy again in April 1987. The Company was
eventually liquidated and stockholders received nothing.
Thus, while a company emerging from bankruptcy may present an opportunity to buy into a
refurbished business at a bargain price, it is not a sure thing. As with any stock, it is
important to study the company's financial structure and business prospects before
investing. |
