value and opportunity

It is quite interesting to read the comments to my latest IVG post and elsewhere. The overall sentiment seems to be quite negative. I think this is also partly due to some recent bankruptcies in Germany’s fledgling “Mittelstand” corporate bond market, where a couple of companies with really bad balance sheets issued bonds and defaulted quite soon afterwords. Very often, recovery rates were low double digits or even single digits.

Investing and evaluating bankruptcy situations is very complex. You have to figure out two things in order to come up with a value:

1. The probability of the company going bankrupt
2. The recovery in case of bancruptcy

The valuation of the bond is then pretty straight forward. However, before going there, maybe we should take step back and

Why do companies go bankrupt ?

In general, companies do not go bankrupt voluntarily because first and foremost the equity holders and owners will object strongly. Once a company is in bankruptcy, the game is over for equity owners, however as long as the company “lives” there is always a chance (or technically the option) that things turn around. So an equity holder will always try to stay in business.

Also management usually has not a lot to gain from bankruptcy and will try to hang on as long as they can to their posts and receive salaries. This is also one of the reasons why in many jurisdictions, not filing for bankruptcy although you are in a unsolvable position is considered a crime. In German, this for instance would be called “Insolvenzverschleppung”.

Usually, it is creditors who “pull the plug”, either by not rolling debt or by enforcing covenants which usually are part of standard bank loans. “Normal creditors” like banks and normal bond holders also don’t really like bankruptcies, they prefer their bonds being paid or rolled over. For a normal bank for instance, there is no upside to simply enforce a loan covenant if there is still a high chance that the company can survive. Enforcing a covenant for a normal bank usually means that they have to swap their loan into an asset with a much higher capital requirement.

So what banks normally do is that they will press for more equity and/or a higher coupon but normally they prefer the company to stay in business because seizing the assets does not provide a lot of upside, as the bank at max gets its notional back.

However “normal” creditors get nervous if a debtor is loosing money and the underlying assets pool is shrinking fast. If a bankruptcy is more or less unavoidable and the asset pool is shrinking, than the logical way is to press for bankruptcy as fast as possible in order to protect the downside.

Introducing the “predators”

However there is also another group of creditors: So called “vulture funds”. Those guy usually come in if a company is in some kind of trouble, but there is still enough collateral.

Their strategy is quite simple: They try to enter the capital structure at the most senior level at a discount. Those discounts often appear, if for example a bad bank is set up and people want to dispose legacy assets as soon as possible.

Example:

Assume, secured loans of a troubled company with a maturity of 5 years are sold to a “distressed debt” fund at 60% of nominal. The interest rate is 5%. By holding it until maturity, the fund will earn 13.7% p.a. if everything goes OK. This is nice, however distressed debt claims to earn as their Private equity investors more like 20-30% ROEs.

So how can they increase their annual returns ? The answer is simple: Try to enforce bankruptcy as quickly as possible and sell the collateral. So for the example from above I made two further scenarios: either bankruptcy after one year or direct bankruptcy.

Period	0	1	2	3	4	5
HTM	-70	5	5	5	5	105
IRR	13.7%
Bankruptcy after 1 year	-70	5	0	100
IRR	15.1%
Direct bankruptcy	-70	0	100
IRR	19.5%

So in this simple example, the principle is quite easy to see: For a “distressed secured” buyer, the earlier the bankruptcy, the higher the returns.

How can a predator enforce bankruptcy ?

The usual way to do this is to enforce “broken” loan covenants. Normal bank loans contain certain minimum thresholds, often with regard to debt/equity or debt/asset ratios as well as interest/income. If those thresholds are not met anymore, usually the debtor has a certain “cure period” to fix things. Otherwise, the loans will become “due”. In normal cases, banks will not have an incentive to enforce the covenant. So they will renegotiate the covenants but demand extra collateral and/or a higher coupon.

A “predator” however, wil try to enforce the covenant in order to get his hands on the collateral.

In general, syndicated loans (i.e. a big loan which has been split up between a group of banks) will require a majority vote to actually renegotiate loan covenants. And that is where it gets interesting.

“Distressed debt” funds normally apply 2 strategies to accelerate their returns:

1) Enforcing bankruptcy
2) Blackmailing the loan syndicate

The second strategy is basically a game theory thing. If you have enough share of a syndicate to block decisions, sometimes those creditors who cannot afford a bankruptcy process will buy off th “predators”. This is often even better than going through the liquidation process.

Back to IVG: What does it mean here ?

Well, that’s easy: Look out for the predators !!!

As those guys smell the blood quite early, they have of course already arrived, at least according to this interesting piece of news from Reuters:

German property company IVG Immobilien is attracting attention from distressed debt investors as some lenders seek to cut their exposure to avoid potential heavy losses in a restructuring of its 4 billion euro ($5.3 billion) debts.

Between 400 million euros and 500 million in loans have been sold in three trades recently by banks looking to reduce or exit their positions in IVG and more trades are expected to occur in the coming weeks, bankers said on Friday.

And even more interesting:

IVG was not immediately available to comment.

The loans were sold to investors at around mid-80 percent of face value, a level considered to be distressed in Europe’s secondary loan market, bankers added.

IVG had outstanding debt of almost 4 billion euros at the end of 2012, comprising mostly bank loans, 3.16 billion euros of which are due to be refinanced by the end of 2014. IVG is close to breaching covenants on its debts.

So the predators are there, time to panic and sell the convertible ?

Not so fast. In my opinion there are 4 reasons why one should not panic:

1. The covenants are not broken yet, so there is no way to enforce the covenant here and now.
2. The price levels mentioned here does not justify a liquidation in my opinion. If you buy at 85% and you liquidate, then you will get money only within 2-3 years. This would be a single digit return at this levels
3. The amount traded does not provide a majority in any of the loan tranches.
4. There is a lot of money in the market chasing “high yield” paper, therefore improving IVG’s chance for refinancing

So for me it looks at the moment rather like a blackmailing strategy as discussed above, where the syndicate banks shall be forced to buy out the predators. Even if the predators go for liquidation, the question is how quickly they will be able to enforce the covenants.

Sometimes, “predators” run even more sophisticated schemes errrh strategies. One strategy for example would be Blackmailing as described above plus then investing in other parts of the capital structure at even more distressed prices. So the funds mentioned above could threaten the company and hold up the negotiation process only to purchase for instance the convertible at a very low price. At the last moment, they could then agree to a restructuring (or sell to the other banks) and harvesting the upside on the convertible.

Summary:

With the arrival of the “predators”, renegotiation for IVG will become more difficult. For the time being, it rather looks like a typical distressed debt “blackmailing” strategy, aimed at the other consortium banks. However this could change.

On the other hand, at current levels (66%-67%), a lot of bad news seems to be priced in, giving convertible holders an upside of > 50% in less than a year if the convertible gets paid in full.

Even in a liquidation scenario, I do not believe that we see such low recoveries as in other German cases in the recent past.

So for the time being, I am considering if I add carefully to my position if the (expected) bad news arrives. I am pretty sure the next call with management will be a disaster, so this could be a good entry point.