Procuring gems from bankruptcies

Investing in a firm facing bankruptcy presents significant opportunity for investors skilled at using fundamental analysis to identify hidden gems.

Contrary to the finality of the UK bankruptcy process, when a company files for US Chapter 11 status, it receives legal protection from creditors while a recovery plan is built. In such circum�stances, creditors must assess whether they have the time, understanding and inclination to retain the claims owed them by the bankrupt party.

By retaining their claims, creditors gamble on a successful recovery, but may not receive cash for years. Many, however, need an immediate payout in place of working through the arduous bankruptcy process.

Experienced distressed managers provide liquidity. Managers assess the company’s value and offer creditors the chance to sell-out at a discount, which compensates the manager for risk. The distressed strategy is executed using a multitude of products, including bank debt, corporate debt, unsecured creditor claims, leases, common stock, preferred stock and warrants.

Active approach

Some distressed investors take an active approach, becoming involved in restructuring. Others buy dis�counted distressed equity or debt and hold until it appreciates or is paid out according to resolution of a bankruptcy estate.

Over the past four years, distressed strategies have had significant success, especially when compared with other hedge funds. From January 1990 through August 2004, distressed strategies returned 15 per cent versus 9 per cent for equity market neutral funds, accord�ing to HFR. This success was par�tially driven by the economic downturn and subsequent rebound, as managers who purchased undervalued securities benefited when markets improved.

Although the success of distressed investing has made it syn�onymous with economic downturn, the strategy can generate above-average returns in most markets. Performance is not nec�essarily correlated to markets but to a manager’s fundamental research capabilities.

In spite of improved economic performance, numbers of Chapter 11 filings are poised to increase next year. Dr Edward Altman of the NYU Salomon Center estimates that the US distressed market will reach $318bn (E259bn) in 2004 and $328bn in 2005. This dwarfs estimated demand from dedicated distressed investors, placed at $80bn. While the days of high profile cases, such as Enron, have passed, another wave of filings is expected over the next two to three years, particularly among middle-tier companies.

Three primary events will lead to continued default: rising interest rates; a desire by companies to rid themselves of unwanted financial burdens and competition from overseas players.

The US is experiencing record levels of indebtedness across all levels of the economy, fuelled by low interest rates. As rates rise, debt refinancing is likely to become increasingly difficult. At the same time, an influx of cheap, mass produced, foreign goods has crippled

US steel and textile manufac�turers. Other industries are likely to experience the same competitive pressure from overseas, with a flood of bankruptcies likely to result.

Strategy, not stigma

Chapter 11 status no longer carries the stigma of the 1980s and early 1990s. Com��panies increasingly view bankruptcy as a strategic opportunity to rid them��selves of financial burdens, modify capital struc����������������ture, divest assets, reject burden��some leases or executory contracts and isolate legacy liabilities. Over the next three years, a trend may erupt where companies turn to bank�ruptcy to rid themselves of pension liabilities.

Distressed investors look for industry trends, whereby one or two major players attempt to force suppliers into financial difficulty, creating a domino effect. For example, the bankruptcy of United Airlines and US Airways has resulted in the weakened credit profile of airline industry suppliers.

Although a creditor could wait to see the outcome of a claim, a chain of debt could cause the creditor to seek immediate reimbursement at a lower cost or face liquidation. With interest rates rising, companies in industries such as automotive, healthcare and retail teeter on the brink of default.

Research is a critical component to this strategy. Not only must distressed investors understand the fundamental value of the asset in which they are investing but also, they must understand the financial profile of the creditor. Distressed strategies offer sophis�ticated investors the opportunity to diversify their existing portfolios and reduce their exposure to the cyclical nature of the global equities markets.

Bryan E. Gordon, chairman and managing director, Madison Capital Management, New York

Gordon: research a critical component