Babson Capital White Paper from January 2010
As a fallout of the credit crisis of 2008/2009, there has been renewed interest in distressed debt in the capital markets. This White Paper discusses some fundamental concepts of distressed debt investing. It shows how debt can be defined as distressed based on spreads, prices and the difference between market trading levels and market participants’ expectations of future discounted cash flows. Regardless of the cause of distress, the investment opportunity arises when the market perceives that the company has insufficient cash flow to service its existing capital structure and there may be a need for an in-court or out-of-court restructuring. The White Paper describes the bankruptcy process, the role of debtor-in-possession (DIP) facilities and the importance of valuation in understanding the distressed debt investment opportunity. Finally, the three distressed debt investment strategies are outlined, based on the degree of investor involvement: discount value, activist and control.
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Defining Distressed Debt
Though there is no universally recognized definition of distressed debt, bonds are technically considered to be distressed when they trade 1,000 bps over similar duration Treasuries. Similarly, loans trading 1,000 bps over LIBOR or for less than 75 cents on the dollar are considered to be distressed. This debt could be private or public, senior or junior, secured or unsecured.
The market categorizes a company’s debt as distressed if it is perceived that the company will have or currently has insufficient cash flow to service its debt and a debt modification or restructuring appears imminent. This typically occurs when there is market consensus that a company will be unable to make a scheduled principal or interest payment in the near term. Even if a near-term payment default is not expected, debt can also be considered distressed if the company’s leverage ratio significantly exceeds that of its peers, or if there is a high likelihood that the company will violate its financial covenants.
In the investment community, the state of default broadly includes payment defaults, covenant defaults and bankruptcies. Figure 1 below shows the historical default rates and the volume of defaults thus defined. Default rates for this downturn have exceeded those of the last downturn with high yield bonds hitting 10.3% and high yield loans 12.6% in 2009, and 8.6% and 6.5%, respectively, for 2000/2001. Likewise, the total par value of distressed debt for 2009 (as of December 15, 2009) was $180 billion, up almost three times from the previous peak of $64 billion in 2001.
The technical definition of distressed debt essentially relies on the efficient functioning of the market – which is presumed to accurately discount all available credit information into prices. The problem with this assumption is that the 1,000 bps benchmark may not be appropriate for all market environments. For example, during the worst of the recent credit crisis, bond and loan prices dropped dramatically as significant technical pressure in the form of forced selling resulted in historically low prices for assets relative to their fundamental value and ultimate recovery values. Loan prices, in particular, had historically been very stable even through market troughs. Figure 2 illustrates how at the worst of the credit crisis at the end of 2008, 65% of all non-defaulted loans were trading below 70. This was not to say that more than 65% of issuers were then distressed, but market technicals were such that loan prices plunged to levels not seen before. Hence, it is important to note that the definition above is more appropriate for a normally functioning market, characterized by willing, not forced, buyers and sellers of assets.
Another way of looking at distressed debt is to consider the valuation of the company’s balance sheet. At the time the company is capitalized, whether it is via a private-equity sponsored leveraged buyout or a strategic acquisition by a competitor, the historical cost of acquisition is reflected in the company’s balance sheet.