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Distress Investing: Principles and Technique


Praise for Distress Investing

"Marty Whitman has distilled decades of distressed investing experience into a text that is a must-read for everyone interested in the field, whether a student or a professional investor."
Wilbur L. Ross, Chairman and CEO, WL Ross & Co. LLC

"Distress Investing: Principles and Technique represents a detailed and unique perspective on an arcane arena of investment that is going to get a lot more attention. Marty Whitman is the master, and has set the standard for many years."
Sam Zell, Chairman, Equity Group Investments, LLC

"Martin Whitman and Professor Diz have produced a seminal work on the ins and outs of distressed investing for all distressed debt investors. It is jam-packed with information and guidance for the novice and the experienced. A must-read for anyone interested in distressed investing."
Lewis Kruger, Stroock & Stroock & Lavan LLP

"Marty Whitman, a legend in distress investing, packs decades of experience into these pages. The restructuring of the capital markets currently under way is sure to provide great distress investment opportunities, which this guide book can make count for you."
Bruce Flatt, Brookfield Asset Management Inc.

"The principles found in this book are those I used in the reorganization of my business from bankruptcy to an S&P 500 company with an investment grade rating and a multibillion-dollar market capitalization. An excellent premier by Marty Whitman and Professor Diz, integrating economic theory with real-world investment to help investors of all shapes and sizes understand and invest in distressed securities."
Gene Isenberg, Chairman and CEO, Nabors Industries, Inc.

"Marty Whitman, the unquestioned 'Dean' of active distressed investors, and Fernando Diz, one of the few academics specializing in distressed investing, have teamed up to provide perhaps the best and most comprehensive primer on distressed securities and markets. I learned so much from this remarkable volume."
Edward I. Altman, Max L. Heine Professor of Finance, NYU Stern School of Business, Director of credit and debt markets research at the NYU Salomon Center and adviser to several financial institutions including, Paulson & Co. and Concordia Advisers

Martin J. Whitman is Chairman and co-CIO of Third Avenue Management LLC. He has taught courses in value investing and distressed investing for the past thirty years at the Schools of Management at both Syracuse University and Yale University. Whitman is also the author of the Wiley titles Value Investing and The Aggressive Conservative Investor.

Fernando Diz is the Martin J. Whitman Associate Professor of Finance and Director of the Ballentine Investment Institute at Syracuse University. His research specialties are in the areas of trading, derivative securities, and value and distress investing. Diz has written for the Journal of Futures Markets, the Review of Financial Studies, and the Journal of Alternative Investments.

Foreword xiii

Preface xv

Acknowledgments xxii

PART ONE The General Landscape of Distress Investing

CHAPTER 1 The Changed Environment 3

Trends in Corporate Debt Growth and Leverage before the Financial Meltdown of 2007–2008 4

Junk Bonds and the Levering-Up Period 6

The Syndicated Loan Market and Leveraged Loans 12

Financial Meltdown of 2007–2008 16

Principal Provisions of the 2005 Bankruptcy Act as They Affect Chapter 11 Reorganizations of Businesses 22

CHAPTER 2 The Theoretical Underpinning 27

What Market? 27

Toward a General Theory of Market Efficiency 29

External Forces Influencing Markets Explained 32

What Risk? 34

Capital Structure and Credit Risk 38

Valuation 39

The Company as a Stand-Alone Entity 41

Control and Its Vital Importance 42

CHAPTER 3 The Causes of Financial Distress 43

Lack of Access to Capital Markets 44

Deterioration of Operating Performance 46

Deterioration of GAAP Performance 48

Large Off-Balance-Sheet Contingent Liabilities 51

CHAPTER 4 Deal Expenses and Who Bears Them 53

Attorneys and Financial Advisers' Compensation Structure and the Distribution of the Fee Pie 54

Time in Chapter 11 and Number of Legal Firms Retained 66

Determinants of Legal Fees and Expenses 67

Determinants of Financial Advisers’ Fees and Expenses 68

Can Professional Costs Be Excessive? 68

Appendix 69

CHAPTER 5 Other Important Issues 71

Management Compensation and Entrenchment 71

Tax and Political Disadvantages 73

CHAPTER 6 The Five Basic Truths of Distress Investing 77

Truth 1: No One Can Take Away a Corporate Creditor's Right to a Money Payment Outside of Chapter 11 or Chapter 7 78

Truth 2: Chapter 11 Rules Influence All Reorganizations 82

Truth 3: Substantive Characteristics of Securities 84

Truth 4: Restructurings Are Costly for Creditors 86

Truth 5: Creditors Have Only Contractual Rights 87

PART TWO Restructuring Troubled Issuers

CHAPTER 7 Voluntary Exchanges 91

Problems with Voluntary Exchanges 92

The Holdout Problem Illustrated 93

Making a Voluntary Exchange Work 94

Tax Disadvantages of a Voluntary Exchange versus Chapter 11 Reorganization 95

CHAPTER 8 A Brief Review of Chapter 11 99

Liquidations and Reorganizations 100

Starting a Case: Voluntary versus Involuntary Petitions 100

Forum Shopping 101

Parties in a Chapter 11 Case 101

Administration of a Chapter 11 Case 103

The Chapter 11 Plan 109

CHAPTER 9 The Workout Process 117

Parties and Their Differing Needs and Desires 117

Types of Chapter 11 Cases 120

Leverage Factors in Chapter 11 125

PART THREE The Investment Process

CHAPTER 10 How to Analyze: Valuation 133

Strict Going Concern Valuation 134

Resource Conversion Valuation 146

Liquidation Valuations 148

CHAPTER 11 Due Diligence for Distressed Issues 151

CHAPTER 12 Distress Investing Risks 157

Risks Associated with the Alteration of Priorities 158

Risks Associated with Collateral or Enterprise Valuation 165

Reorganization Risks 168

Other Risks 168

CHAPTER 13 Form of Consideration versus Amount of Consideration 171

PART FOUR Cases and Implications for Public Policy

CHAPTER 14 Brief Case Studies of Distressed Securities, 2008-2009 177

Performing Loans Likely to Remain Performing Loans 178

Small Cases 182

Large Cases 184

Capital Infusions into Troubled Companies 184

CHAPTER 15 A Small Case: Home Products International 187

The Early Years 188

Growth by Acquisitions 189

Retail Industry Woes 192

The Fight for Control 195

Amendment of Indenture and Event of Default 196

The Decision: Prepackaged Chapter 11 197

Treatment of Impaired Classes under the Plan 198

Financial Means for Implementation of the Plan 199

Going-Concern and Liquidation Valuations 199

CHAPTER 16 A Large Reorganization Case: Kmart Corporation 203

Landlords and Unexpired Leases 204

Vendors and Critical Vendor Motions 206

Management and KERPs Pre-2005 BAPCPA 208

Fraudulent Transfers 209

Subsidiary Guarantees and Substantive Consolidation 210

Chapter 11 Committees and Out-of-Control

Professional Costs 211

Blocking Positions 211

Buying Claims in Chapter 11 214

Debtor-in-Possession Financing 215

Kmart’s Plan of Reorganization and Plan Investors 218

Investment Performance 222

CHAPTER 17 An Ideal Restructuring System 225

Feasibility and Cash Bailouts 226

Good Enough Rather Than Ideal 226

Highly Beneficial Elements in the U.S. Restructuring System 226

Goals of an Ideal Restructuring System 228

Suggested Reforms 229

Notes 233

About the Authors 238

Index 239