You are on page 1of 42

Distressed Securities Valuation

Copyright 2010 Investment Banking Institute

Table of Contents
I. Overview of Distressed Securities II. Corporate Debt Pricing III. How to get Control of a Distressed Asset IV. Case Study - Samsonite V. Financial Model


Distressed Securities
The year of the vulture
“The private equity firms that will thrive in the year ahead are those that know how to profit from others' misfortunes” 2007 was a tale of two halves
The first was ebullient: nine out of the ten biggest leveraged buyouts ever, and Blackstone becoming a publicly traded company The second was one in which LBOs fell from almost 40% of the dollar value of deals through July to a single-digit market share May 15, 2008 Fortune Magazine

What Are Distressed Securities?
Distressed securities are securities of companies that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition
Distressed fixed income securities are rated below investment grade The most common types of distressed securities are bonds and bank debt While there is no precise definition, fixed income instruments with a yield to maturity in excess of 1,000 basis points over the risk-free rate of return (e.g. Treasuries) are commonly thought of as being distressed

While sound methodologically, the absolute 1,000 basis-point benchmark may not be appropriate in all market environments
Average credit risk spreads can fluctuate widely

A basis point (often denoted as bp, bps) is a unit that is equal to 1/100th
of a percentage point

As we will see later in the presentation, the market for distressed securities is less efficient than other markets, enabling skilled investors to earn superior risk-adjusted returns


10 Largest Bankruptcies in US 1980 . Inc. Financial Corp of America Refco Inc. Inc. Pacific Gas and Electric Company UAL Corp Delta Air Lines.392 $35.864 $33. Inc.801 5 .892 $33.914 $63.770 $25.392 $61.185 $29.333 $30. Date 07/21/2002 12/21/2001 12/18/2002 4/12/1987 9/9/1988 10/27/2005 1/28/2002 4/6/2001 12/9/2002 9/14/2005 Assets $103.2007 Company Worldcom Enron Corp Conseco.197 $21. Texaco. Global Crossing Ltd.

BBB and above is classified as investment grade. while BB and below is characterized as speculative grade and was. during the 1980s.What is Distressed Debt? Most traditional way of categorizing debt is with reference to the ratings systems of the most prominent debt ratings agencies: Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P) While these firms use slightly different ratings notation. they have a functionally similar 10-grade scheme ranging from AAA to D S&P AAA AA A BBB BB B CCC CC C D Moody’s AAA Aa A Baa Ba B Caa Ca C Speculative Grade Investment Grade A prominent dividing line is between BBB and BB. labeled “junk” Fitch also provides rating of bonds 6 .

Description of Bond Ratings (S&P) AAA – highest rating assigned to a debt instrument. but certain protective elements may be lacking in the event of adverse economic conditions that could lead to a weakened capacity for payment 7 . Bonds in this category are often referred to as gilt edge securities AA – high quality bonds by all standards with strong capacity to pay principal and interest. but elements may suggest a susceptibility to impairment given adverse economic changes Bonds are regarded as having adequate capacity to pay principal and interest. These bonds are rated lower primarily because the margin of protection are less strong than those for AAA bonds A – these bonds possess many favorable investment attributes. indicating an extremely strong capacity to pay principal and interest.

Such bonds are extremely speculative and should be valued only on the basis of their value in liquidation or reorganization 8 .Description of Bond Ratings (S&P) BB – Bonds regarded as having only moderate protection of principal and interest payments during both good times and bad times B – Bonds that generally lack characteristics of other desirable investments. Assurance of interest and principal over any long period of time may be small CCC – Poor quality issues that may be in default or in danger of default CC – Highly speculative issues that are often in default or possess other marked shortcomings C – lowest class of bonds. These issues can be regarded as extremely poor in investment quality D – Issues in default with principal or interest payments in arrears.

and source Companies with high credit ratings have quick-turning. rating agencies have increased their responsiveness to and consideration of the economic cycle in recent years given the large impact that the economic cycle has on many companies 9 . rating agencies scrutinize a company’s management for their competence. structure. Berkshire Hathaway (BRK). Johnson & Johnson (JNJ). In the late seventies this number was 58 and in the nineties it was 22 Competition and willingness to take on more debt possible reasons Rating agencies conduct a very thorough review of the companies that they rate. They are Automatic Data Processing (ADP). There are numerous considerations that are weighed. the most important of which is a company’s cash flow Basically. Rating companies look closely at the source of a company’s cash flow as well as its variety. high quality accounts receivable. and composition. availability. Rating agencies also consider it important that a company have the ability to sustain their profitability Aside from cash flows. and Toyota (TM) – April 2008. there were only six companies left with "AAA" ratings from both S&P and Moody's. Exxon (XOM). GE (GE). meaning that they are getting paid on time and getting all that they are due. Other considerations include scrutiny of a company’s appetite for risk and competition Rating agencies must always consider external factors such as the economic cycle but the fundamentals of the companies that they rate always get first consideration and have a far greater bearing on a company’s overall rating – Nevertheless. it is very likely to have a high credit rating. strategic planning. if a company is a cash cow.Bond Ratings of Companies As of the spring of 2008.

Though distressed securities may trade at significant discounts. it is difficult to have an adequately diversified portfolio – – Risk of this asset class is such that investing should generally be done on a diversified basis Bank debt and corporate bonds generally trade in blocks of $5mm and $1mm respectively. this still implies that to own a diversified portfolio of approximately 15 companies could require a significant amount of capital 10 . which means there can be very high transaction costs for individuals investing on a “modest” scale – Transaction costs increase the relative risks and make it very difficult to earn appropriate risk adjusted returns Size of the average trading unit or block is so large that.Investing in Distressed Debt? Distressed debt is not a particularly suitable or practical investment for individual investors: Significant risk of loss – Annual total market returns could vary dramatically Professional participants in the market could have significant information advantages Distressed securities market is often fairly illiquid. except for the most wealthy.

How to look for Distressed Companies Public Stock Trading at 52-week/all-time low stock price Bonds Rating downgrade(s) Sell-off in bonds Distressed bond investors start accumulating bonds Bank Debt Liquidity crunch and concerns or ability to make coupon/amortization payments Reduced borrowing base and availability Waivers or amendments Internal Signals Declining operating performance Management turnover Extensive and recurring restructuring charges/asset write downs External Signals Weak economy Industry cyclical downturn 11 .

Case Study – Samsonite V. Overview of Distressed Securities II. How to Get Control of a Distressed Asset IV. Financial Model 12 . Corporate Debt Pricing III.Table of Contents I.

Term Loans and Bonds Revolver Claim on Assets Collateral Rate Principal Repayments Covenant Package Senior Secured Floating Amortizing Restrictive Term loans Bonds Senior Secured Fixed Amortizing Restrictive Subordinated Mostly Unsecured Fixed On Maturity Less Restrictive 13 .Revolver.

High Yield Debt High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies .Moody’s Investors Service. but typically pay higher yields than better quality bonds in order to compensate for their added risk and make them attractive to investors Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer’s ability to pay interest and principal as scheduled. Standard & Poor’s Ratings Services and Fitch Ratings High yield bond/non-investment grade bond/speculative grade bond or junk bonds have a higher risk of default or other adverse credit events. Those issuers with a greater risk of default—not paying interest or principal in a timely manner— are rated below investment grade These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality 14 .

S. high.yield debt rather than government bonds. double the current spread of 5.4 percentage points of extra yield to buy high-risk. the lowest since 1981 Forecast is based on an assumption that the U. according to Merrill Lynch & Co. In a recession.High Yield Debt Levels and Default Rates Moody’s said in a December 2007 report that Defaults by speculative-grade companies will quadruple next year as the era of ‘easy credit’ comes to an end and economic growth slows The global default rate will rise to 4. bondholders charged as much as 11. economy slows without falling into recession. the highest proportion since global defaults reached 10.2 percent by November from 1 percent now. defaults may approach 10 per cent More than one in 10 of the borrowers to which Moody's assigns ratings are treated as ‘distressed’ by bond traders.73 percentage points. indexes 15 .5 percent in 2002 At that time.

Credit Deterioration .0x.5x-4.Phase 1 and Phase 2 Phase 1: New High Yield Debt Issued $150 million of XYZ Corp 13% Senior Notes due 1/15/2017 Purchased by traditional new issue buyers Standard credit profile and ratios – Debt/EBITDA of 3.8x-2. bond price $100 Initially highly liquid and price driven by market fluctuations and demand for offering Liquidity deteriorates within 6 months because outperformance of Company financials results in few sellers and underperformance results in few buyers Phase 2: Company files 10-K or 10-Q Hosts management conference call and discloses a deterioration in operating performance and short term outlook not promising Immediate dislocation in market with bond price range typically from 7590 and issue supported by anchor buyers who put in lot of work in understanding the Company Price and credit deterioration trigger credit focus screens among distressed investors which may lead to short positions being established and further price pressure towards lower end of range 16 . EBITDA/Interest 1.2x.

Phase 3 Phase 3: Company files subsequent 10-Q Disclosure of further credit deterioration which may include – Violation of senior secured credit facility – Total Debt/EBITDA increases above 8x – EBITDA/Interest falls below 1x Further decline in bond price with stop at around 50 (estimated) dependent on size and condition of the shorts Bond price settles between 25-40 as mutual funds continue to exit credit and distressed buyers evaluate the opportunity Distressed buyers that started work on the credit early in the process dominate volume and may accumulate a control position OR The Company may report an improvement in operations and securities trend towards 75-90 – takes 2 quarters of continued steady / improvement in operations 17 .Credit Deterioration .

Phase 4 Phase 4: Further material adverse credit event Event of default under indenture but no Chapter 11 filing – Bonds prices trend flat and trend towards approximately 20. capital structure and timing of emergence Free fall Chapter 11 will lead to chaos and lack of disclosure pushing bonds to 15-25 18 .Credit Deterioration . material downward asset re-valuation which may result in almost zero value for unsecured creditors Voluntary Chapter 11 filing which could be a prepackaged or a prearranged deal – Reorganization Plan and disclosure statement make recovery analysis clearer – Prices dependent on asset valuation.

Recovery and Restructuring – Phases 5. 6. NewCompany capital structure becomes effective Pricing of old debt securities contingent on equity and or debt prices of NewCo securities Phase 6: Post restructuring First 4 quarters of stronger operating statistics therefore credit profile improves and equity value increases Phase 7: Post restructuring NewCompany experiences 6-8 quarters of steady operating performance – Process of refinancing restructured debt securities begins – Newco seeks access to new issuance market 19 . 7 Phase 5: Emergence Court approval of plan.

Table of Contents I. Case Study – Samsonite V. Financial Model 20 . How to Get Control of a Distressed Asset IV. Overview of Distressed Securities Valuation Overview II. Corporate Debt Pricing III.

Current Situation Companies are coming under increasing pressure from lenders at an earlier stage than before Banks have a large number of distressed credits in their loan portfolio The leveraged loan market has experienced a sharp contraction Banks no longer have patience with troubled companies Less willing to extend waivers indefinitely Demanding more in fees and amendments Banks are forcing more companies to go to auction or sell assets quickly Relationship lending is not as prevalent Presents an opportunity for creative investors 21 .

How to Get Control of Distressed Asset Out of Court Purchase bonds and exchange for equity in a privately negotiated transaction Exchange offer to completely recapitalize the Company In Court Formal process of a Chapter 11 reorganization Chapter 7 liquidation 22 .

Advantages and Disadvantages of In Court and Out-of Court for Distressed Investor In Court Advantages Can acquire assets free and clear of liabilities and encumbrances In Court Disadvantages Transaction costs associated with bankruptcy proceeding Potential for competing bidders and plans as part of the bankruptcy process Higher and Better offers Out of Court Advantages Can avoid competing bidders in open auction process Avoid bankruptcy costs Can privately negotiate a debt for equity swap that creates the right capital structure Out of Court Disadvantages Possibility of acquiring hidden liabilities May be stuck with acquired securities if situation deteriorates further 23 .

Debt for Equity Swaps Buying bonds at a discount and swapping into equity through a privately negotiated transaction with the company Can approach the original equity sponsor before buying the bonds to ensure a friendly transaction and potentially access detailed due diligence information Acquire enough of the bonds so that a swap will engineer the best capital structure for the company Exchange the bonds for most of the equity Leave original sponsor with a stub equity portion (5%-15%). warrants or other consideration – – – – More favorable than a long drawn out restructuring Other bondholders remain in place Now have par paper Senior lenders should be more comfortable and willing to stay committed to the credit Must get in early and exploit the situation before the credit is too distressed 24 .

Exchange Offers A more comprehensive approach could involve the combination of an exchange offer and new money investment Combines the restructuring of the old debt with a change of control Can often prove the most efficient method to gain control in the public forum Accomplished relatively quickly Low transaction costs compared to bankruptcy Avoid large number of competing bids Difficult to accomplish in complex situations Large vendor listings Publicly listed equity Diverse group of bondholders 25 .

Chapter 11 Distressed opportunity typically arises when a company. utilities and other vendors owed for their goods and services. though when it comes to dividing up the assets of the company they are paid back last and usually very little. the stock holders will get wiped out as they are last in line to receive any of the proceeds from the liquidation or reorganization 26 . files for Chapter 11 (reorganization) or Chapter 7 (liquidation) bankruptcy Chapter 7 involves shutting a company’s doors and parceling out its assets to its creditors Chapter 11 gives the company legal protection to continue operating while working out a repayment plan. if anything – If in a bankruptcy. unable to meet all its debts. and investors who own bonds Stock holders are also among the constituents.Chapter 7 vs. a company does not have sufficient assets to repay all claims. with a committee of its major creditors These creditors can be banks who’ve made loans. known as a plan for reorganization.

Chapter 11 Equity nearly always wiped out Intense pressure to sell the Company Most restructuring advisors are bankruptcy or M&A specialists High risk of change of management Lawyers control process with constant court appearances Most restructuring advisors are bankruptcy or M&A specialists Average time in Chapter 11 is over 12 months Extremely costly in fees with $3 mm to $10 mm in fees for lawyers and advisors in large assets 27 .

Overview of Distressed Securities II. Corporate Debt Pricing III. How to get Control of a Distressed Asset IV. Case Study – Samsonite V. Financial Model 28 .Table of Contents I.

strategic decisions taken by management – Recovered to 18% in fiscal 2001 under new CEO 29 .S.Company Overview Samsonite is the world’s largest designer and manufacturer and distributor of luggage products Only global luggage brand Approximately 31% market share in Europe and 19% in US in 2002 Competed in a highly fragmented market against much smaller regional companies Products marketed under Samsonite and American Tourister brands .S. and over 70% in Europe.90% brand recognition in the U. 80% American Tourister brand recognition in U. Expanded product line to include casual bags and computer cases Europe market share – 31% in 2002 CAGR of 11% growth in sales since 1996 Asia sales growing at CAGR of 19% from fiscal 1997 to 2002 US market share fell from 30% in 1996 to 17% in 1999 due to product and marketing.

High risk/low probability of execution of Company’s five year business pan and forecast without a de-leveraging event 30 .000 per day and the bid ask spread is approximately 65% of the bid price Absence of institutional support/coverage for common stock Total obligations (debt and preferred stock) senior to the common stock have a face value of approximately $800 mm Existing preferred is increasing through PIK dividends at such a high rate that it grows by approximately $50 mm per year Onerous terms of the Existing Preferred Stock increasingly causing significant earnings dilution for common shareholders and could precipitate a Company-sponsored exchange offer or bankruptcy Overall leverage is too high 1.Background and Situation in Late 2002/early 2003 Company’s capital structure has had many issues: Company stock was virtually illiquid at the end of 2002 – – Traded an average of under $5. Lack of financial flexibility to mitigate potential shortfall in earnings performance 2.

vendors and other constituencies Management stock option plan is not able to provide incentive to management in a way to benefit common shareholders The impact of the downturn in the economy and the Company’s industry Company’s revenues and EBITDA were highly dependent upon performance of international operations and global travel industry Current geopolitical and economic climate puts downward pressure on tourism and travel related industries. and adds uncertainty to the Company’s business model and operating forecast going forward US war with Iraq Terrorism concerns and is effect on international travel Spread of SARS virus Continued global economic softness These issues have led to another significant decline in travel beginning in early 2003. which have impacted the Company beginning in February-March 2003 31 .Background and Situation Assessment Balance Sheet and the reported financial statement losses continued to affect Company’s business and relationships with the Company’s suppliers.

particularly with respect to maturity as the Company’s existing senior credit facility matures in June 2003 32 .Objectives of the Recapitalization Transaction Recapitalization Transaction incorporates a financial restructuring which accomplishes the three principal objectives set by the Company to reduce total debt and preferred stock of the Company Convert preferred stock into common or convertible securities Reduce leverage through issuance of equity securities Address senior debt.

with upward or downward adjustments after year 8 depending on “control issues” Conversion Price: $0.4 million of Existing Notes remain outstanding after the recapitalization transaction 33 .3 million contributed by OTPP $54 million of additional New Preferred Stock via conversion by Existing Preferred Stockholders Terms of New Preferred Stock Dividends: 8% (PIK option) compounded quarterly.42 per common share Senior Debt Approximately $60 mm of new revolver availability 103/4% Senior Subordinated Notes due 2008 $323.3 million contribution by Bain Capital $35.$160 million Convertible Preferred Stock $106 mm of new equity investment in cash $35.Summary of the Recapitalization Transaction Equitization of the balance sheet .

42 per share Common shareholders would initially own approximately 3.5 million as of March 15. 2003 Holders will elect to exchange their Existing Preferred Stock for either New Preferred Sock or common stock or a combination of both.42 per share) Aggregate implied valuation of Existing Preferred Stock is $140.1 million Common Stock Proposal involves a conversion of the New Preferred Stock into common stock at a conversion price of $0.3 million face value of Existing Preferred Stock with liquidation value of $333.9% of liquidation preference ($54 million/$129 million) Remaining $204.9% of face and converting into common stock at $0.9 million of Existing Preferred Stock converted to common stock at $1.3% of the Company pro forma the proposed Recapitalization Transaction New investors have the right to elect five out of the nine Board Members 34 .00 per share (equivalent number of shares to valuing at 41. subject to a proration in the event that he holders of Existing Preferred Sock collectively elect to receive more than $54 million in New Preferred Stock $129 mm converted into $54 million face value of New Preferred Stock – Valued at 41.Summary of the Recapitalization Transaction 137/8% Senior Redeemable Exchangeable Preferred Stock (Existing Preferred Stock) $320.

Alternates to Recapitalization Issues with status quo with new senior credit facility Management issues Capital structure issues Refinancing difficulties of new facility Issues with sale process with other parties Prior sale process yielded no or low interest Effect on business while conducting sale Management issues will still remain Capital structure issues – buyer will not be comfortable 35 .

Table of Contents I. Corporate Debt Pricing III. Case Study – Samsonite V. How to get Control of a Distressed Asset IV. Overview of Distressed Securities II. Financial Model 36 .

2002 and 2003 Make sure we check our data after we complete the income statement Net Income ties in to the NI from Income Statement barring any unusual or non-recurring items we took out Assets = Liabilities + Shareholders Equity Income Statement Observe the drop in revenues and EBITDA in 2002 vs. as opposed to cash payouts ) 37 .3 mm from 2001 to 2003 as it is PIK interest (paid in kind – a type of bond that pays interest in additional bonds or interest is added to the principal.0 mm to $320.IS. BS and Old Capital Structure Let us model the historical income statement and balance sheet for year ended January 31. 2002 and 2003 Information is available in Samsonite 10K for January 31. 2001 See how the Preferred Stock dividends (37. 2001.5 mm dividend in 2002 are impacting the Company’s Net Loss every year Balance Sheet Observe how the redeemable preferred is increasing from $240.

Sources and Uses Let us prepare sources and uses for the recapitalization transaction Pay down old term loan and revolver Fees paid to bankers. lawyers and miscellaneous expenses is $20mm $106 mm of new preferred equity is being put in by private equity investors Use the January 31. 2003 numbers Keep the cash balance the same as before at $22.7mm Sources equal uses and the balance will be the new revolver balance 38 .

2003 incorporating the sources and uses for the recapitalization Capitalize $5 mm of the $20 mm of fees and the other $15 mm get expensed Uses the sources and uses table to make the adjustments In the pro forma capitalization see how the following ratios change as a result of the recapitalization – look at these ratios before the recap and after the recap Total Debt to EBITDA (Total Debt + Preferred Stock) / EBITDA 39 .Pro Forma Balance Sheet and Capitalization Let us make a pro forma balance sheet for January 31.

2003) Find out how many shares and % of the Company the common and preferred shareholders get (Old preferred and new preferred shareholders) The private equity investors end up owning more than 50% of the Company after the recapitalization for the $106 mm equity investment they made as they owned some of the old Preferred also (41.7% as the result of the $106 mm investment and over 10% from the Old Preferred shares) 40 .Pro Forma Ownership What % of the Company do the Existing Common Shareholders and the Preferred Stockholders get after the recapitalization? Conversion price of preferred shares to common stock is $0.42 per share Find the current common shares outstanding for Samsonite from the most recent 10K or 10Q (January 31.

0x-8.Valuation Analysis We did a valuation analysis to see how much would Samsonite common shareholders and preferred shareholders get in the current company without the recapitalization Comparable Company – looked at other brands – challenging to find appropriate comps to Samsonite – Comps included apparel companies like Nike.forecast free cash flow for 5 years. terminal multiple of 7. Ralph Lauren as one group and luxury groups like Coach. Gucci and Waterford Comparable Transaction – challenging to find appropriate comparable transactions also – Antler was sold to an investor group etc Discounted Cash Flow Analysis .0x and discount rate of approx 10%-14% We see that common shareholders get zero in most of the scenarios 41 .

4 mm 19.5 mm of liquidation preference of preferred valued at $.1 mm 333.9 mm common shares valued at $.2 mm Preferred stock is valued at 140.42 per share Equity is valued at 8.Implied Enterprise Value We calculate the implied EV of the Company of the recapitalization Existing debt of $423.42 per share 42 .