BY: RICK MARTIN & ELPIDA TZILIANOS

Valuation Considerations for Distressed Securities

Agenda

Overview of distressed securities

Defaults and availability of distressed debt

Fair value and distressed securities

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Agenda

Overview of distressed securities

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Defining “Distress”

Broad definitionBelow investment grade debt (CCC or lower)YTM > 1,000bps over risk-free TreasuriesPriced at or below 80 cents on the dollarHighly concentrated in debt securities of

companies in headed toward restructuring, bankruptcy, or liquidation

Market primarily consists of debt securities caught up in Ch 11 – Reorganization Ch 7 – Liquidation Other extraordinary transactions (e.g., out of court

restructuring)

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What Causes Distress?

Companies fall into distress for a number of reasons: Over-leveraged Liquidity issues Slipping credit Poor operating performance Accounting irregularities Inadequate cash flows Competition

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Corrective Actions

Corrective actions Asset restructuring Financial restructuring = private workout or Ch 11

If all else fails Ch 7 = Company shuts down & assets distributed to

creditors. Ch 11 = Stabilization, reorganization & approval

Creditors may include: Banks Utilities & other trade vendors Investors with bonds Interest Holders

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Ch 7 Liquidation Priority7

Chapter 11 Process

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:

(1) Filing

(2) Negotiation

(3) Approval

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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.

It is important to note that stock and commodity brokers are not eligible for Chapter 11 filings and may only file Chapter 7 petitions.

Ch 11 Filing Process – Phase I

First Day Motions (1-3 days)First Day Motions (1-3 days) First Day Orders (1-3 days)First Day Orders (1-3 days)

Creation of Creditors Committee (2 weeks)

Creation of Creditors Committee (2 weeks) DIP Financing (2-3 weeks)DIP Financing (2-3 weeks)

FilingFiling

Avoidable Transfers (90 days - 2years Prior to Filing)

PHASE 2

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Phase I: Steps 1-5

1. 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.

2. 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.

3. 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.

4. The debtor obtains DIP financing to fund its ongoing operations and operates in the normal course of business as a DIP.

5. 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.

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Ch 11 Filing Process – Phase II

Section 341 Meeting (Approx. 30-60 days)Section 341 Meeting (Approx. 30-60 days)

Disclosure Statement (Timing Varies)

Disclosure Statement (Timing Varies)

Voting on & Acceptance of the Plan (Timing Varies)Voting on & Acceptance of the Plan (Timing Varies)

Claims Bar Date (4-6 months)Claims Bar Date (4-6 months)

Plan of Reorganization (Timing Varies)

Plan of Reorganization (Timing Varies)

PHASE 3

PHASE 1

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Phase II: Steps 6-10

6. 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. 

7. 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.

8. 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. 

9. 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.

10. 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.

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Ch 11 Filing Process – Phase III

Post-Confirmation: Modification/Administration (Timing Varies)Post-Confirmation: Modification/Administration (Timing Varies)

The Final Decree (Timing Varies)The Final Decree (Timing Varies)

Emerging from Chapter 11 (Timing Varies)Emerging from Chapter 11 (Timing Varies)

Revocation of Confirmation (At Most, 180 days Post Confirmation)

Revocation of Confirmation (At Most, 180 days Post Confirmation)

Plan Confirmation (Timing Varies)Plan Confirmation (Timing Varies)

PHASE 2

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Phase III: Steps 11-12

11. 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.

12. 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.  

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.

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Chapter 11 Trading Securities

A company’s securities may continue to trade after Ch11 filing. There is no federal law prohibiting securities trading of bankrupt

firms. However, trading can be limited due to trading orders from the court.

These investments are very risky. During bankruptcy bondholders stop receiving interest and

principal payments and stockholders stop receiving dividends. If company emerges, creditors and bondholders generally become

the new equity holders. 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.

Note Ticker + Q = Bankruptcy filing; Ticker + V = Trading during bankruptcy proceedings; Ticker Alone = Newly issued shares.

Post-emergence, bond holders may receive new stock, warrants, new bonds, cash, or a combination in exchange for their bonds.

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Pluris Chapter 11 Bond Index

Bonds in the Pluris Chapter 11 Bond Index include secured and unsecured, senior and subordinate notes.

Generally, inclusion criteria for the Pluris Chapter 11 Bond Index are:

- U.S. Issuers - Non-Financial Issuers (Excludes SICs 60-69)- Issuers undergoing pending Chapter 11 proceedings- Issuers that have not been acquired since the

bankruptcy filing

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Pluris Chapter 11 Bond Index17

Types of Distressed Securities

Trade claims & receivablesCommon stock, preferred stock, PIPEs, rights

& warrantsHigh yield bonds, corporate & municipal

bondsBelow par bank loans, DIP loans, bridge &

mezzanine loansCollateralized debt, second lien notes, & real

estate assetsFutures, options, swaps, & indices

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The Distressed Market

Money managers focus on bank debt, trade claims, & bonds

As of 2008, approximately $200B of the $900B US high yield market can be considered “distressed.”

Distressed securities markets are highly inefficient

Securities often sell at deep discounts

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Investors in Distressed Securities

Hedge funds are the largest buyers of distressed securities

Money managersMutual fundsPrivate equity firms

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Investors Skills

Skill sets are highly specialized Legal backgrounds Restructuring expertise Strong negotiating skills Extensive networks Asset valuation skills

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Active vs. Passive Investors

ACTIVEPASSIVE

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

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Target Returns

Investments made during economic downturns

Profits realized during bull markets

Targeted annual returns rest in 20-25% range

On average = 12%

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Distressed Portfolios

Top-down & Bottom-up strategies used in portfolio assessment

Investments based on market/trading dynamics, assessed position values, risk/return profiles, etc.

Portfolios based on: Standard risk management measures Arbitrage risk Sector diversification and position limits Leverage limits Credit information (past, present & future) Tail risk Cost & effectiveness of hedging instruments Liquidity analysis

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Basic Hedge Fund Strategies

Outright short Bearish views on company’s credit fundamentals Often done through CDS purchases

Long/short Assumes securities are undervalued (overvalued) and will

depreciate (appreciate)Capital structure arbitrage

Mispricing between securities of the same issuerValue trading

Assumes securities undervalued; purchased before Reorganization Plan announced or immediately following restructuring

Rescue financing Lending to companies prior to Ch 11 filing

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Agenda

Defaults and availability of distressed debt

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Defaults

U.S. business bankruptcies up 17% in 2nd quarter of 2008 as compared with the 1st quarter

Almost 29,000 companies filed for bankruptcy in the 1st half of 2008

States with the biggest increases in filings included Delaware, Montana, Oregon, Maryland, and Connecticut

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Defaults

Delaware saw a 100% increase from the 1st quarter to the 2nd quarter

Two to three companies go out of business for every one that files for bankruptcy

About $184 billion of distressed debt is trading

One in three junk bonds is distressed

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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

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Agenda

Fair value and distressed securities

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FAS 157

Previous fair value accounting standards

Does not require any new fair value measurements

Does require new and expanded disclosures

Establishes a three level hierarchy Categorization primarily depends on observables

inputs

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Hierarchy

Level 1:

Positions for which observable inputs used to determine fair value are: unadjusted market prices of identical assets in an active market.

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Hierarchy

Level 2:

Observable inputs are quoted prices for: similar assets in active markets,

Or, quoted prices for: identical or similar securities in inactive markets, or

Other observable market inputs, orOther inputs derived from or corroborated by the

market.

Many distressed securities would likely fall into Level 2

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Hierarchy

Level 3:

When there are not enough observable market inputs for the valuation to comply with the Level I or Level II requirements. Level III valuations represent the most difficult path Additional disclosures are required for Level III assets.

Available market data on similar securities must still be considered in determining fair value.

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Which Level?

Distressed securities may fall into Level 2 or Level 3

High yield distressed debt securities may fall into Level 2

Bankruptcy claims may fall into Level 2 or 3

Nonperforming assets may fall into Level 2 or 3

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What needs to be fair valued?

Reorganization value for fresh start

Creditor or debtor committees

Analyzing bankruptcy claims

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Conclusions

Investments in distressed securities involve event-driven strategies

Company-specifics often drive prices (not stock market) = Investor’s research critical

Many valuation approaches but few KEY factors: Fundamentals! Understand the law and the state of the economy Examine management quality and motivation Know the creditors involved and claim complexity Diversify distressed portfolios Patience during reorganization/workout process

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Rick Martin, CPA(212) 248-4500

Elpida Tzilianos, PhD(212) 248-4639

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