There were a lot of reasons to dislike riskier credit in the second half of last year. The subprime mortgage fallout, tightening credit markets, an increasing backlog of postponed new issues in the high yield space and growing concern over the economy were enough to make even the most seasoned distressed investors re-evaluate their portfolio strategies.
Since June, bonds rated triple-C and below have lost over 10% of their value, and steeper declines have been seen for bonds with rating just above default. In November alone, high-yield spreads increased to their highest levels in four years (598 basis points). At the end of that month, bonds that traded at or below 70% of par increased to US$31.9 billion, representing a 258% increase in just one month. This is the highest level of debt trading below 70% in two years.
So what is a troubled company to do if it has debt coming due and cannot refinance in this credit environment? The solution in 2008 will be to work with existing bondholders to come up with alternative ways of refinancing. Part of Simran Capital’s strategy is to take an early investment and activist role in creating an alternative refinancing before a company runs out of time, what we call “pre-event” investing.
There are a number of innovative strategies to work through a debt maturity in this market if a company management team is able to negotiate with existing bondholders. Many of these bondholders have purchased this debt at significant discounts and are willing to offer some of that discount back to the company if it means keeping them out of default. Covenant waivers, extended maturities, debt exchanges, and secondary market purchases are just some of the strategies we see being negotiated.
All of this does not come cheap. Bondholders typically require consent fees between 1% and 15% of the face value of the bonds to agree to vote in favour of such plans. Companies are willing to pay rather than risk default. There needs to be a win-win outcome for all stakeholders. The deal has to work for everyone in order to get done.
The rewards can be substantial for investors who can successfully negotiate a deal with a struggling company. In addition to consent fees, these bonds typically offer a current yield of 10-20% because of the high coupon and price discount at which the bonds can be purchased. You need to do your homework: at Simran we spend a lot of time utilising investment banking models to analyse the raw recovery value of the company prior to buying the bonds. We want to know that our investment is protected in the event of a bankruptcy or liquidation. Because of the re-pricing of risk in the credit market, we now see much less downside risk and the upside potential is significant if we get a deal to work.
Bondholders are not the only the only stakeholders ready to be active in a restructuring. Equity holders are in danger of losing the total value of their stake if bondholders are impaired. Increasingly, private equity firms have been active in buying up debt at a discount of companies they own or know well. The yields are attractive for private equity firms and the increased presence up the capital structure gives them more say in how a restructuring will turn out.
These private equity firms are not about to lose their equity interests as a result of over-leveraging and could support many of these structures with additional cash infusions if needed. It is a rare event when we see a private equity firm write their investment to zero and walk away.
I believe 2008 will be a good year for Simran’s stressed debt activist strategy. Six months ago, it was difficult to talk about alternative refinancing strategies with company management teams. Now the phone has been ringing with CEOs and CFOs wanting to schedule a meeting with bondholders.
One example of a recent deal with bondholders was Tembec, a Canadian forestry products company. On 17 December, the company announced a proposal to convert US$1.2 billion of debt into equity. Bonds were up eight points in December on the news. Simran has been a holder of these bonds and we’re excited about the deal. The company has been working with existing bondholders for the past six months to get something done. We expect to see more of these types of deals coming in the next couple quarters.
There are currently stressed bonds in the retail, consumer products, automotive supplier and industrials sectors where there is value in pursuing these types of transactions.
Mesh Tandon is the president of Simran Capital, a pre-event driven activist manager that focuses on the stressed and distressed credit markets.
This article first appeared in www.finalternatives.com on 3 January 2008.