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Fixed-Income Insights

When leveraged buyouts turn sour, close collaboration among portfolio managers, analysts, and traders becomes essential.

As a pioneer in high-yield bond investing, Lord Abbett has a long history of analyzing potential investments in companies whose debts are secured by underlying assets. However, every so often, some of them encounter trouble repaying creditors and look to restructure. In worst-case situations, companies that were taken private in highly leveraged buyouts (LBOs), have had to restructure or, in some cases, reorganize under the federal bankruptcy law.

This is where active management becomes a contact sport. On one side, you have the company’s management, investment bankers, lawyers, investor relations professionals, and spin doctors. On the other side, there are the company’s lenders and shareholders, often led by an elite group of mutual funds, activist hedge funds, and private equity firms vying for potentially advantageous positions on the company’s capital structure.

In distressed situations, bonds, senior bank debt, and convertible notes of the issuing company may change hands at significant discounts, junior obligations may be converted to shares, and overall equity may be highly diluted. Large creditors may wield outsized influence on restructuring, including management changes and controlling interest. Certain assets may be sold to other companies who think they can operate them more efficiently and profitably—all of which may present a number of investment opportunities. But collaboration among portfolio managers, analysts, traders, and attorneys is essential.

Just ask Lord Abbett research analyst Mitchell Moss, who covers power and utility companies for the fixed-income team and often liaises with his counterparts on the equity research and municipal bond research teams, as circumstances warrant. For the last four years, Moss has been following the travails of a giant merchant power and utility company with several overleveraged subsidiaries that sought bankruptcy protection as a result of low power prices stemming from a glut of natural gas.

“My approach as management was getting ready for bankruptcy was to just think of the core underlying valuation of the two main parts of the business: the regulated low-risk utility and the wholesale/retail power generator,” said Moss. “Then it became a question of segregating the different classes of debt [loans and bonds] into buckets in terms of risk and return and then figuring out the most likely recovery or repayment outcomes, especially since a lot of debt would become new equity in the reorganized firm.”

Because there were so many stakeholders in this bankruptcy—shareholders, creditors (including an aggressive hedge fund that specializes in distressed debt), regulators, utility customers—the process of estimating recovery outcomes has been extremely complicated.

“Getting the highest creditor recovery isn’t very high on the regulators’ list of priorities,” said Moss. “And that is partly why this restructuring has taken so long.”

The longer the restructuring goes on, the more interest is accrued on different debts, so the balances due creditors (including second-lien holders) get bigger, which may increase their recoveries while diminishing the prospects for unsecured bondholders.

Other Restructuring Ahead
Moss expects a number of other power companies whose fortunes also have fallen short of original financing assumptions will have to restructure debt as it matures over the next 18–36 months.   

“The original loans of those companies were issued four to five years ago; they’re trading well below par, and new investors are not going to come in and pay par for them,” Moss said. “The companies have all missed their budgeted numbers, and 90% have missed their targets for debt paydown.”

Should some of those companies seek protection in bankruptcy court, some active managers knowledgeable about their capital structure also may provide “debtor-in-possession” (DIP) financing to help management fund continuing operations. DIPs are a highly secured first lien on a company’s asset(s) that became widely used in the 1980s. Back then, lenders could charge a premium of LIBOR [London interbank offered rate] plus 800 basis points. Now pricing has become much more competitive, with rates as low as LIBOR plus 200–300 basis points—very similar to other term loans.

DIP financing has two purposes: it helps a business operate in bankruptcy and it’s also an important tool for creditors to have a seat at the table in restructuring talks, which may be critical if DIP-lenders’ restructuring preferences are different from other creditors’ preferences.

Given the “super-secured” collateralization of DIP financing and overall returns, Lord Abbett has been involved in a variety of DIP-financing scenarios. “The question is, For how long will the DIP be outstanding?” Moss explained. “Another question is, How much of an equity cushion is above the DIP? particularly if legal fees in a protracted restructuring eat up available cash.”

Tranche Warfare
After 10 years of covering the gaming, lodging, and leisure sector, Lord Abbett research analyst Kevin Coyne has evaluated a wide range of investment-grade and high-yield opportunities, but nothing quite compares to the elaborate capital structures of LBOs, where the private equity firms behind such deals may have an advantage under certain circumstances.  

“If the deal goes great—that is, the fundamentals really play out as described—then the LBO sponsors might very well pay a dividend to themselves, and then when their equity is out, they won’t have as much skin in the game,” Coyne said. “If things get tough, the sponsors may still have the option to improve their positions’ optionality, sometimes at the expense of lenders.”

If that sounds precarious, consider the saga of a bankrupt hotel and casino company. It was loaded up with so much debt, that it would take several years to determine how much the various stakeholders would recover after the company reorganized and shuffled assets into new entities that some creditors would challenge in court.

Once the wrangling over assets, liquidity, collateralization, lien hierarchy, and recovery subsided, the original LBO sponsors ceded a majority of their equity to bondholders in exchange for a release from future litigation. Shrewd investors sensed substantial upside on certain types of debt that were trading at deep discounts.   

“In mid-2017, some players started buying certain distressed debt in the mid-80s,” Coyne recalled. “As of September 21, 2017, those same bonds were selling at 99 cents on the dollar, as holders were positioned to benefit from the reorganization plan that would provide for cash payments, new debt securities, and issuance of a new convertible note that would have attractive covenants and call protection. In fact, some investors felt the equity was rather attractively priced.”

To describe the transformation of this company another way, its previous capital structure included about $18 billion in debt. Following reorganization, it will be about $8 billion, according to court filings. Some of the debt became equity (as mentioned above); some became new debt instruments; some of the debt took haircuts from the notional value; and the equity is about to become significantly diluted.

How diluted? Prior to bankruptcy, the company had 147 million shares outstanding; in its new incarnation, once the latest convertible issue turns into equity, the share count would exceed 800 million shares.  

“Some investors are not only getting equity with their own bonds but also the more their equity goes up, the more that convertible may go up in value,” said Coyne. “When they increased some of their position, they felt very comfortable with the simplification of the company’s capital structure, significant cost savings, and the way overall debt was being refinanced.”

The bottom line is that distressed investing may be risky, but with diligent research, patient portfolio management during the restructuring process, and close collaboration with traders, the potential for rewards is significant.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds, including a higher risk of default.

High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

This article is being provided for informational purposes only and is intended to illustrate certain information analyzed during the research process. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described above.

basis point is one one-hundredth of a percentage point.

LIBOR (London Interbank Offered Rate) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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