Value in Distressed and Bankrupt Securities

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Most investors avoid investing in financially distressed and bankrupt securities. These investments appear too risky and complex for most people to handle.

However, this avoidance creates opportunities for those willing to do the work. When institutional investors and individuals refuse to buy these securities, prices can drop well below the actual value of the underlying assets.

In his 1991 book "Margin of Safety," Seth Klarman shows how distressed and bankrupt securities can offer strong returns to investors who understand how to analyze them. While these situations require analyzing more variables than typical investments, the potential payoffs make the extra work worthwhile.

Companies encounter financial distress for three main reasons:

1. Operating problems: When a business deteriorates seriously, it can cause continuing operating losses that eventually lead to financial distress. Put simply, the company cannot generate enough cash from its operations to cover its expenses and debt payments.

2. Legal problems: Severe legal issues can create tremendous financial uncertainty for companies. These problems can force businesses to seek bankruptcy court protection even when their underlying operations might otherwise be profitable.

3. Financial problems: Results almost entirely from carrying too much debt. Many companies that issued junk bonds in the 1980s shared this experience, where the business itself was viable but the debt burden proved unsustainable.

Financial distress creates a cash shortage that sets off a dangerous chain reaction. When companies cannot meet their operating expenses or debt payments, the situation quickly spirals downward.

Short-term loans become impossible to renew, while suppliers worry about getting paid and either stop deliveries or demand cash upfront, which worsens the cash crunch.

This financial strain spreads to other parts of the business as customers switch to competitors and valuable employees leave for more stable jobs.

The impact of financial distress varies depending on the type of business and how its debt is structured:

Industry Differences and Recovery Patterns

Capital-intensive businesses like manufacturing companies tend to weather financial distress better than others. Often, these businesses continue operating during financial distress because of their reliance on factories and equipment over customer trust.

This operational continuity helps them bounce back to full profitability after resolving their financial problems.

However, businesses that rely on customer trust and reputation face much tougher challenges. Banks, retailers, and other image-dependent companies may suffer permanent damage once customers lose confidence in them and often never fully recover.

Capital Structure Matters

Where a company places its debt also matters significantly. Companies that keep most of their debt at the holding company level, separate from their operating businesses, often see minimal disruption to daily operations.

The holding company can file for bankruptcy while profitable subsidiaries keep running normally. Companies with debt directly at the operating level typically face more serious business disruptions.

The Reality of Bankruptcy

Contrary to popular images of shuttered factories, most bankrupt companies actually continue operating with court protection from creditors.

These companies have usually hit their lowest point and often start improving quickly because they get relief from debt payments, can reject unprofitable contracts, and receive new financing to stabilize operations.

New lenders provide debtor-in-possession financing, suppliers resume normal relationships because they get priority treatment, and cash starts accumulating as the business stabilizes.

When companies face financial trouble, they have three main options available to them:

Option #1: Keep Fighting Outside Bankruptcy

Companies can try to survive by cutting costs, selling assets, or finding outside capital. These efforts sometimes work, depending on what caused the financial problems in the first place.

However, short-term fixes often damage long-term business value. Cutting inventory, stretching payments to suppliers, or reducing employee salaries might help survive a crisis, but these actions can hurt important relationships and reduce the company's future prospects.

Option #2: Propose an Exchange Offer

Companies can make exchange offers to replace their existing debt and preferred stock with new, less burdensome securities. This serves as an out-of-court reorganization, letting companies avoid bankruptcy by convincing creditors to accept less burdensome terms.

The Free-Rider Problem

The problem with exchange offers is that unlike stockholders, who can be compelled to accept merger terms if 50-67% of shareholders agree, bondholders cannot be forced to participate even when companies ask them to accept less than full value.

This creates a free-rider problem because the value of holding out usually exceeds the value of participating.

Individual bondholders might be willing to accept reduced payments to avoid the uncertainty and delays of bankruptcy proceedings. However, they worry that if they participate while others hold out, they will give up value while others receive full payment.

This collective action problem means each bondholder has an incentive to hold out for full payment, often causing the exchange to fail.

Prepackaged Bankruptcy Solution

One way around this problem involves prepackaged bankruptcy, where creditors agree to a reorganization plan before filing for bankruptcy.

The advantage is that bankruptcy law requires only a majority in number and two-thirds of the dollar amount of each creditor class to approve a plan. This means up to one-third can be compelled to go along with the other creditors, effectively eliminating the free-rider problem.

Option #3: File for Bankruptcy Protection

If other measures fail, companies can file for court protection under Chapter 11 and attempt to reorganize with a more sustainable capital structure. This remains a last resort due to the stigma still attached to bankruptcy.

Filing for bankruptcy creates immediate changes that often benefit the company's operations while creating investment opportunities:

Immediate Effects of Filing

Bankruptcy stops all creditor collection efforts. Companies suspend payments on most debt, trade creditors, and even employees, except for fully secured debt that must continue being paid.

Different creditor groups get addressed through reorganization plans that need approval from both the bankruptcy judge and a majority in number plus two-thirds in dollar amount of each creditor class.

Conflicting Interests

Companies and their creditors typically want different things during bankruptcy.

Companies want to emerge as financially strong as possible, which means keeping cash reserves high and debt levels low. They also want to spend money on capital improvements during the process.

Creditors prefer getting as much cash as possible distributed to them and often oppose what they see as excessive spending by the company.

Contract Rejection Powers

Bankruptcy gives companies the power to cancel leases and long-term contracts like supply arrangements. This ability to reject unfavorable contracts often lets bankrupt companies become low-cost competitors in their industries after reorganization.

These powers extend beyond contracts to physical operations. Companies can close unprofitable facilities, reduce above-market lease costs to current market rates, and write down overvalued assets to fair market value.

Cash Building During Bankruptcy

These cost-cutting abilities explain why bankrupt companies tend to build up substantial cash balances.

Cost reductions from contract rejections and normal cost-cutting boost cash flow. Companies also retain more cash flow since they no longer pay interest or dividends.

Moreover, many bankrupt companies have large tax loss carry-forwards that offset current taxes, further boosting cash. Since cash cannot be distributed until a reorganization plan gets approved, these balances grow from compound interest.

Bankruptcy investing differs significantly from normal stock and bond investing, creating several unique advantages:

Built-In Catalysts

The reorganization process provides a clear timeline for realizing value. Regular undervalued stocks can stay cheap indefinitely, and bonds may need to be held until distant maturity dates.

In contrast, bankrupt companies typically reorganize within 2-3 years of filing, creating a more predictable path to returns.

When companies emerge from bankruptcy, creditors receive their value through distributions of cash, new debt securities, or equity in the reorganized company.

Liquidity Enhancement

Bankruptcy emergence also improves liquidity for claimholders. Owners of small, illiquid trade claims or large amounts of bank debt see substantial improvements in how easily they can trade their holdings.

Even when distributions come as new debt or equity securities rather than cash, these typically trade much more easily than claims against bankrupt companies.

Market Independence

Bankrupt securities, especially senior ones, move largely independent of broader stock and bond market fluctuations.

Instead of tracking general market sentiment, these securities behave more like risk arbitrage investments. Their prices move based on reorganization progress rather than whether the S&P 500 goes up or down.

Three Stages of Opportunity

Michael Price, a well-known bankruptcy investor, describes three distinct stages of bankruptcy investing, each with different risk and return profiles.

• Stage #1: Occurs immediately after the Chapter 11 filing and offers the greatest uncertainty but also the biggest opportunities. Financial statements may be late or missing, hidden liabilities are not yet clear, and the underlying business may still be unstable. Many holders get forced to sell regardless of price, creating potential bargains.

• Stage #2: Involves negotiating the reorganization plan, starting anywhere from a few months to several years after filing. By this point, analysts have thoroughly examined the company and security prices reflect available information. However, significant uncertainty remains about the final plan and how different creditor classes will be treated.

• Stage #3: Runs from plan finalization to emergence from bankruptcy, usually taking three months to one year. This stage resembles risk arbitrage investing most closely, with the lowest but most predictable returns available once the reorganization plan becomes public.

The best bargains typically appear during the chaos and uncertainty of Stage #1, while the most predictable returns come in Stage #3 after the plan details are known.

Despite attractive opportunities, distressed securities investing involves significant risks that must be carefully managed:

Patience and Discipline Required

This type of investing requires waiting for the right situation at the right price while sticking to value investing principles.

When done correctly, it can offer higher returns with potentially less risk than traditional investing.

When done poorly, the results can be disastrous, especially for junior securities that can get completely wiped out.

Market Characteristics

The market for distressed securities is highly illiquid, which creates both opportunities and dangers.

Sophisticated traders can take advantage of inexperienced investors, and quoted prices often bear little relationship to actual trading levels. In fact, distressed bond markets may have only a few buyers and sellers, sometimes just market makers.

In these conditions, transaction prices get determined more by participants' trading skills than by security analysis. Since most participants in this market are highly experienced professionals, individual investors need to be extremely cautious.

Timing Dependency

Returns in bankruptcy investing depend heavily on timing. Unsecured but "fully covered" claims essentially become zero-coupon bonds that pay face value when the reorganization completes.

Since returns depend on how long the bankruptcy process takes, an investor expecting a lengthy process would naturally pay less than someone anticipating a quick resolution to achieve the same return.

Risk Spectrum by Business Type

Risk levels vary dramatically based on the type of business and situation. The highest-risk investments include highly competitive or fashion-oriented businesses that depend on key personnel and own few tangible assets.

Companies selling customized products and financial firms that rely heavily on customer confidence also fall into this category.

Lower-risk opportunities typically involve overleveraged capital-intensive companies, especially those with monopoly or near-monopoly positions in their industries.

Deteriorating Business Warning

Investors should avoid securities of rapidly deteriorating businesses. Don't focus on asset values while ignoring negative operating cash flows.

When a business loses cash from operations even before paying interest, losses often accelerate, especially with high leverage. If a turnaround doesn't happen quickly, it may never come.

Successful investing in distressed securities requires a systematic approach focused on understanding both assets and liabilities:

Balance Sheet Focus

Analyzing distressed securities starts with the balance sheet. Understanding the amounts and priorities of a company's liabilities reveals how different security holders will likely be treated and how the financial distress will probably be resolved.

Asset Valuation

The first step involves valuing the debtor's assets. Once you know the size of the pie, you can figure out how it might be divided.

This requires splitting the debtor's assets into two categories: (1) assets of the ongoing business, and (2) assets available for distribution to creditors during reorganization, such as excess cash, assets held for sale, and investment securities.

Valuation Challenges

Valuing a business in Chapter 11 presents unique challenges since the company's situation constantly changes. The business may be unstable or struggling, and bankruptcy creates several financial distortions that complicate the process:

• Cash accumulation that won't continue after reorganization.

• Suspended interest payments that will resume after emergence.

• High legal and administrative fees that will disappear once the process ends.

These temporary changes mean investors must estimate what the company's normalized cash flows and expenses will look like after reorganization, requiring assumptions about operations without the bankruptcy effects.

Off-Balance-Sheet Items

Analysis must extend beyond what appears on the balance sheet. Hidden assets might include real estate carried below current value, overfunded pension plans, and valuable patents.

Hidden liabilities can include underfunded pension plans, government claims from tax, environmental, or regulatory agencies, and claims from rejected contracts and leases.

Liability Analysis

After valuing assets, investors should examine liabilities in descending order of seniority. Secured debt gets evaluated first. If the security's value equals or exceeds the claim amount, the debt is considered fully secured or oversecured.

Oversecured claims receive interest that accrued during bankruptcy proceedings. When secured debt exceeds the security's value, holders typically receive value equal to their security plus an unsecured claim for the shortfall.

Investment Opportunities by Seniority

Opportunities exist at every level of the debt hierarchy, each with different risk and return profiles:

Senior Securities

Risk-averse investors typically prefer senior securities. While potential returns are often lower than junior claims, risks are also much lower. Senior securities get paid first, and unless they receive full or nearly full repayment, junior classes typically get little value.

Fulcrum Securities

These securities fall in the middle of repayment priority, where asset values cover some but not all of their claims. Fulcrum securities benefit most directly from value increases and get hurt most by value decreases.

Junior Securities

These can provide spectacular returns but can also prove disastrous. They often function like out-of-the-money options, essentially betting on operating improvements or value increases.

Common Stock

Bankrupt company common stock frequently trades well above its reorganization value, which is often close to zero.

While occasional big wins occur, investors should generally avoid bankrupt company common stock at virtually any price. The risks are substantial and returns highly uncertain.

Negotiation Dynamics

Restructurings and bankruptcy reorganizations involve negotiated processes where outcomes depend on the relative bargaining power of different creditor classes, negotiator skills, and dollar amounts at stake.

A blocking position gives creditors significant negotiating power, especially in small, closely held debt issues.

This means owning one-third of the outstanding debt in a particular class, which is enough to block any reorganization plan since plans require approval from two-thirds of each creditor class by dollar amount.

Even holders of junior securities with blocking positions can delay the entire bankruptcy process until they receive better treatment. This leverage works because everyone wants to complete the reorganization quickly to avoid mounting legal fees and business uncertainty.

Blocking positions create hold-up value in two ways:

• Owners can hold up (delay) the bankruptcy process, which costs everyone time and money.

• They can hold up (rob) other creditor classes by threatening delays unless they receive better treatment than strict legal priority would provide.

Thus, the threat of delay becomes a valuable negotiating tool that can override strict legal priorities.