CHAPTER 3
Looking for Prey
To enable the vulture to live, not only is it able to sustain a prolonged fast, but it is gifted with the power of discovering food at almost incredible distances. At early dawn, it rises in the air circling round and round until it is scarcely visible. From this enormous elevation it surveys the country for many miles around. Not even a lamb can die without being espied by a vulture.
—Reverend John George Wood, Birds and Beasts
We vultures are adaptable creatures. We’re happy to feed on almost any type of prey, and willing to try new hunting strategies. While the fulcrum security remains our basic tool, vultures have other ways to profit when a company goes under. We can lend money on very favorable terms to companies desperate for cash, or we can act like a private equity firm and use our newly acquired stock to gain control of the reorganized company. In both cases, the highest return comes from acquiring some or all of the equity.
Lending is an increasingly common strategy for vulture funds, particularly those that have longer-term lock-up provisions (which prevent investors from withdrawing at least some of their money for several years). Under this strategy, better known as loan-to-own, vultures lend to companies desperate for cash—desperate enough to consider deals they would never make otherwise. These high-interest loans generally include a primary lien on all the collateral and stringent provisions, such as a requirement that management sell the company within 30 or 60 days, or that it prove the company has enough cash flow to repay the fund.
If the company does manage to pay back the loan, it can be a big windfall for the vulture fund, but these companies rarely repay, so in most cases the loan underwriting is more like an acquisition that is essentially built into the loan-financing package from the beginning. If the company can’t pay, the loan converts into a proposed debtor-in-possession (DIP) financing, a type of loan made to a company in Chapter 11 bankruptcy proceedings to allow it to keep operating during the workout. A DIP loan takes priority over all other existing debt, equity, and all other claims, giving the DIP lender first crack at the company’s assets if something goes wrong.
Also, as a senior lender to the distressed or deteriorating business, the vulture fund gets special information rights, such as access to monthly or weekly financial reports. Similarly, the vulture fund will benefit by employing tight lending covenants that set financial measures, such as interest coverage minimums or debt-to-equity caps. These covenants might also dictate actions that an outsider normally could not influence, such as selling the business or a subsidiary, or preparing a detailed turnaround plan.
Loan-to-own can be a great way to buy companies on the cheap, but it’s a much less liquid form of investment than simply buying senior securities on the secondary market. You must be prepared for a long-term commitment to the company and the workout process, without seeing a return for a few years.
Since your success with this investment strategy depends on the quality of the underlying company, you have to do your homework thoroughly and make sure there is an adequate margin of safety built in from the start. The key thing to remember is that you are really buying the company on the day you fund the loan, so you need to get down to the nitty-gritty in your due diligence before you put up the money; by the time you actually take over, it may be too late.
One of the most difficult things about loan-to-own investment is sourcing the deals in the first place. Certainly you can just call up companies in distress and offer them financing, but you are much more likely to find borrowers through your network. If you are an active vulture investor, you will likely receive calls from bankers, brokers, or lawyers with whom you have worked in the past, looking to put you in touch with companies in desperate need of lenders. Of course once you do get the call, the situation may be so hopeless that it isn’t worth pursuing at all, so you should be prepared to walk away unless you have a real conviction that there is profit potential.
Tweeter Home Entertainment Group, Inc., a U.S. specialty retailer of consumer electronics, is an interesting example of a loan-to-own investment I made, even though it didn’t work out so well. Founded in 1972 by Sandy Bloomberg, Tweeter sold, installed, and repaired high-end home entertainment systems through a chain of retail stores. The company became very successful as demand increased for home theater and media rooms.
By 2005, Tweeter had grown from a single store into a publicly traded 150-plus-store chain with almost $800 million in revenues. It sold HDTV plasma, liquid crystal display (LCD) and rear-projection television sets, home theater video and audio solutions, home theater furniture, DVD players and recorders, surround-sound systems, audio components, digital video satellite systems, satellite radios, personal video recorders, and digital entertainment centers. A separate division provided design and in-home installation of home theater systems, satellite TV, Internet access systems, touch screen controls, and whole-house control systems.
But some two years later, the company began to bleed, wounded by intense competition, price fixing in the LCD monitor industry, excessive debt, and some strategic blunders. Tweeter’s management had opted for rapid growth through acquisitions, expanding its core northeastern market across the country, from Florida to California. As often happens, the company overpaid for these acquisitions with borrowed money, and ultimately found itself in a distressed situation.
The structure of Tweeter’s loans, although typical for retailers, compounded the company’s problems. In July 2005, Tweeter had entered into an asset-based revolving credit facility (ABL) with Bank of America, which served as agent for a syndicate of bank lenders. The ABL revolver, which was secured by nearly all of Tweeter’s assets, had a $90 million maximum in revolving credit loans that could include up to $15 million in letters of credit and $13 million in term loans.
But as is usual with such asset-based facilities, the amount of money Tweeter could actually borrow depended on a formula based on its current eligible accounts receivable and inventory collateral. Moreover, it carried the customary covenants prohibiting the company from taking on any additional loans, disposing of assets without permission, paying out dividends, or agreeing to a merger or takeover. It also required minimum levels of cash flow and other financial indicators, reduced by a $5 million reserve, a portion of customer deposits, and outstanding letters of credit.
Unfortunately, like many companies that get into trouble, Tweeter had focused more on market share than on cash flow and profits. Even as its gross revenues increased from $764 million in 2002 to $795 million in 2005, Tweeter’s cash flow, as measured by earnings before interest, taxes, depreciation, and amortization (EBITDA), had dropped precipitously. From a peak of $47.4 million in 2002, its EBITDA plunged into negative territory: −$5.6 million in 2005. Under these circumstances, agreeing to the Bank of America facility’s harsh conditions seems crazy, but in the retail industry this kind of loan is fairly common, and Tweeter had few options to stave off insolvency.
Naturally, Tweeter’s poor cash flow meant the lenders tightened the availability of funds, forcing Tweeter to reduce inventory from $143.2 million in 2005 to just $81 million by March 2007. As a result, Tweeter’s accounts receivable declined from $28.5 million to $20.5 million over the same period. In Exhibit 3.1, note how the company’s balance sheet effectively shrinks by over 20 percent year by year.
EXHIBIT 3.1 Tweeter’s Assets
In effect, the lending facility created a self-perpetuating downward spiral: as the company liquidated its inventory to pay its lenders, its more thinly stocked stores lost sales. Consequently, the company’s fixed costs became a higher and higher percentage of its revenues.
The red ink ratcheted down its credit availability from the ABL revolver with each successive month. By the end of September 2006, Tweeter had only $16.5 million available for future borrowings, while it held $6.9 million as letters of credit. For a retailer approaching the Christmas season (its most important driver of sales), such a tightening credit cycle is a death sentence.
After bad holiday sales at the end of 2006, Tweeter found itself caught in a squeeze, unable to generate cash flow without funds to buy inventory, and unable to borrow these funds from its primary lender because its cash flow had slowed. At the end of March 2007, Tweeter reported a net loss from continuing operations of $35.2 million for the quarter and of $32.9 million for the fiscal half, despite a $13.9 million federal tax refund. Since Bank of America’s facility was its only source of outside funds, Tweeter’s management decided to pay down the revolver by rapidly reducing working capital and shrinking inventory, reducing the company’s long-term debt to just $38 million by March 2007, down from over $50 million five years earlier.
As part of its restructuring, Tweeter opted to close 49 stores and 2 regional facilities as it pulled back from several less-profitable regions of the country. But closing these underperforming stores further strained the company’s short-term cash position, since it had already paid out some $27 million to settle with landlords and employees and anticipated an additional $30 million to $35 million in restructuring costs for the year.
To get together enough cash to pay off these lump-sum settlements and continuing expenses, Tweeter looked into alternative financing sources. On March 21, Tweeter replaced the Bank of America facility with a similar ABL revolver through General Electric (GE) Capital Corporation, which offered a borrowing maximum of $75 million, including up to $20 million in letters of credit and a swing-line advance of $5 million. It immediately drew down $35.3 million.
As with the Bank of America facility, Tweeter had secured the GE revolver with substantially all of its assets, and it had to meet a variety of covenants and restrictions based on its inventory and receivables reduced by reserves for liabilities. Despite Tweeter’s deteriorating condition, GE wasn’t taking too much risk, since it would routinely convert the ABLs it extended to struggling retailers into new DIP loans if the company liquidated, which would make it first in line to collect. In fact, under its formula for availability, it always had a healthy cushion to make sure it wouldn’t take any major losses either as an ABL lender or as a DIP lender, if it should come to that.
Although Tweeter managed to remain in compliance with the GE facility covenants as of March 31—with $11.9 million available for future borrowings—changing lenders didn’t help matters for long. As it continued to hemorrhage cash, it couldn’t meet GE’s borrowing formulas and covenants either. To escape its credit death spiral and avoid having to liquidate all its assets under GE’s covenants, Tweeter desperately needed rescue financing, which made it attractive to vulture investors.
On June 11, 2007, Tweeter and all of its affiliates filed a voluntary petition for Chapter 11 bankruptcy in Delaware. After performing considerable due diligence and many days of negotiating, our funds extended a $10 million DIP loan to the company on June 27, 2007. We structured it as a loan-to-own financing so that it would take out GE, but also quickly convert into equity if Tweeter was unable to repay it within its (very short) maturity. This DIP loan would permit us to credit-bid the full loan value in exchange for ownership of the underlying business.
After several weeks in bankruptcy, our DIP-loan covenants allowed us to foreclose on our collateral—that is the Tweeter operating company—unless someone else came in and paid off our DIP loan in full. But taking possession wasn’t as easy as it sounds.
Even with a DIP-loan foreclosure, a company operating in Chapter 11 must be auctioned to the highest bidder through the bankruptcy court, which typically notifies interested parties and gives them an opportunity to be heard or object to the transaction. For the Tweeter auction, a cadre of bankers, lawyers, lenders, potential bidders, and other interested hangers-on showed up at the auction, which was held at the New York offices of law firm Skadden, Arps, Slate, Meagher & Flom. In total, about 100 people packed into the huge Skadden conference room to bid.
With our DIP loan in the mix, we expected our offer would be the highest and best, since all other bidders would have to make us whole before they could have a crack at the company. In effect, our DIP loan would be the fulcrum security. This meant that I didn’t really need to make an appearance, and, since emotions often run high at these auctions, I probably should have stayed home.
I couldn’t help attending, though, just for the experience of taking over my first entire company through a bankruptcy transaction. I had seen tons of other cases at that stage in my career and was ready for this, but Tweeter would be the first one in which I would be appointed chairman of the board, with all the risks and responsibilities that come with the title.
Predictably, the proceedings turned heated, with me doing most of the shouting. Over the course of the next 20 or so hours, a variety of contenders tried to outbid us in a variety of ways during several auction rounds. I already knew that there was a group of professional liquidators, including representatives from Tiger Capital Group LLC, Great American Group Inc., and Hilco Trading, who showed up at nearly every retailer bankruptcy auction.
Like hyenas snatching any piece of meat they could scavenge, these firms made their livings by buying up expiring retailers’ remaining inventory, intellectual property, or other saleable scrap. Even though I had watched liquidators operate in many other cases, it was quite interesting to see how they tried to gain an edge in this auction by teaming up with each other while negotiating with all parties every step of the way.
In addition to the liquidators, a group of landlords or their attorneys would also show up at retailer auctions—and Tweeter’s was no exception. Some of the landlords stood to lose a lot of money if their stores went dark, since they wouldn’t be able to replace these retail tenants at the above-market rents the spaces had previously commanded. On the other hand, some landlords stood to gain a lot if they could maneuver out of below-market leases for stores that they could then re-rent for more. In Tweeter’s case, several people were bidding for one of the company’s leases in a desirable location in Georgia. Months later, we would sell this location for about $3 million.
After a long night in and out of the auction conference room, we came down to the last few rounds of negotiation the next morning. At that point, a new issue arose when the unsecured creditors threatened to enter an objection to our bid unless we agreed to pay them to go away. I considered this extortion, and told them (through our attorneys) to go pound sand.
Although I had excellent attorneys, the unsecured creditors’ attorney didn’t seem to get the message, so I wound up yelling at him directly to make the point that his clients would get nothing if he kept holding up the auction. Ultimately, we did pay them a token settlement amount—but only $200,000.
After this final settlement the auction was complete, and we were now able to exchange our DIP loan for all of the company’s newly issued equity without any further consideration. We renamed the company Tweeter Newco LLC; most of its operations continued after it emerged from reorganization. As with most acquisitions, the good news was that we now owned the asset—but that was also the bad news.
Right after the auction, we found out that the CEO who was running Tweeter had a major ethics issue. He disclosed to us in confidence during the auction that he had been moving inventory from closing stores to other stores without first getting proper lender consent. Moreover, he later denied authorship of the financial projections that he had given us as DIP lenders, insisting that the company’s financial advisers had sole responsibility for them. These were bad signs for things to come.
Unlike some companies emerging from corporate reorganization, which generate enough cash flow to allow some wiggle room for mistakes, Tweeter’s cash flow remained negative even after it shed its debt in the bankruptcy. That meant that even slight missteps had large consequences.
One thing we had relied upon in making the acquisition was the potential sale of a partly owned subsidiary, Tivoli Audio, which specialized in manufacturing and selling retro-designed transistor radios. We expected to get about $10 million from the sale, which would have reduced our net purchase cost for Tweeter substantially.
Although we did sell Tivoli less than 30 days after closing on Tweeter, we didn’t get the cash as a dividend. Instead, and without authorization, the CEO quickly spent the money to purchase new inventory for the remaining Tweeter stores. We eventually had to let the CEO go, as he consistently missed his own projected targets and made a difficult situation even worse. Moreover, Tweeter Newco was not immune from market and economic forces. A year later the new incarnation failed as well, during the 2008 credit tsunami that swallowed many businesses.
Nonetheless, I remain convinced that the basic principle of successfully originating loan-to-own financing made sense then and still makes sense today. I’ve invested in many other loan-to-own financings that worked out very well. Although we lost money in the Tweeter deal, the way it was structured helped reduce our risk substantially. We are still collecting on remaining liquidating assets that fell to us during Tweeter’s second bankruptcy and we continue to benefit from the original deal structuring.
In fact, these days, loan-to-own investing often is the shrewdest method of acquiring a company. Generally, the original lenders (with their loans and securities underwater), the subordinated bondholders, and the existing equity investors have little desire to supply additional capital to the failing business.
This means vulture lenders can pretty much name their own terms, structuring loans to carry heavy additional incentives such as penny warrants or other equity kickers, high interest rates, and concrete milestones for strategic actions (such as selling or otherwise closing an unprofitable division, or negotiating a more advantageous agreement with unions). Junior lenders or equity holders may not like the transaction, but they have little leverage, since loan-to-own lenders can threaten to foreclose on the business once their loan matures unless they are paid in full in cash.
While loan-to-own investing can be an important part of a vulture’s toolbox, these loans carry some significant risks. It is inherently risky to make an illiquid loan that cannot be easily valued using current market prices or sold expeditiously if something goes wrong.
On top of that, loan-to-own deals involve some regulatory and legal risks. Depending on how it originates its loans, a vulture fund could be recategorized as a lending institution under U.S. federal banking and tax laws. This could be disastrous for its offshore investors, which would then be subject to U.S. taxes and possibly U.S. banking regulations.
Similarly, too much interference with management of a distressed enterprise can lead to endless litigation over creditor priorities, breaches of fiduciary duty, or even possible employer liability claims. To keep such risks to a minimum, a vulture needs some experience in these kinds of transactions and the advice of specialized counsel.
Although sometimes short-term investing in a troubled company’s stock can be a good tactic, in most distressed situations a successful vulture has to be patient—taking the long view can be crucial, since you often find yourself involved in lengthy, messy bankruptcy proceedings before you see that big payoff.
But what I call the private-equity approach to vulture investing requires even more patience. In some instances, a fund can partially or completely take over a distressed company and dig in for the long haul, using its control of the board to reorganize and turn around a company that needs a lot of work, doing so out of the public eye.
Advocates of private-equity strategies claim that private companies can save a lot in costs by avoiding the kind of disclosure and regulatory reporting required in the public markets. Since the company no longer needs to court public shareholders, sell-side analysts, or even regulators, management can, in theory, save time and money. In my experience, however, it’s not a great idea simply to turn off these investor and public relations functions, because once the company goes public again, it can be very expensive to restart them.
Private-equity strategy proponents also suggest that since they don’t have the same pressure to show quarterly earnings improvements, it’s easier to make the big changes a turnaround strategy might require. But I’m not sure that any savings or improvements make up for what you lose by giving up a liquid public market for the stock. Even if the newly emergent company doesn’t trade on a large exchange, those smaller transactions can be surprisingly profitable.
To do this kind of investing, it helps to have at least part of your assets in a long-term “lock-up” structure like that of a true private equity fund, with the flexibility to buy claims anywhere in the capital structure. These might include bank loans, bonds, or sometimes equity. But the traditional vulture method is to buy up a bankrupt company’s pre-petition loans at a big discount—such as 30 to 50 cents on the dollar—and then fight for a reorganization plan that would give holders equity.
In many cases, the restructured company can issue new equity as it emerges from bankruptcy, which in my view is the best outcome—it’s always better to have a liquid investment. Moreover, companies coming out of a Chapter 11 reorganization benefit from a general exemption from all the normal SEC registration requirements for issuing new stock, sparing lenders who become new owners a lot of hassle and cost. The devil is in the details, however, so it’s important to work closely with experienced counsel to know for certain what exemptions are available in each deal.
Sometimes with this strategy other investors might end up in control of the deal, opting to take the company private, with you as a co-owner. In the case of the ladder manufacturer Werner Co., we now own 14 percent of the company, with four or five other investment funds controlling the balance, rather like a private equity syndicate. In this kind of transaction, the entire group or syndicate will typically be locked up until it sells the company to another private buyer or does an initial public offering.
Often these situations work out reasonably well, particularly if the other owners are also vulture investors with a similar outlook. But sometimes, each investor has its own strategy—and its own views on how to make the company profitable, when to sell it, and for how much. The worst situation is when too many of the new equity holders are the original pre-petition lenders that bought the debt securities at par, or full face value. Since they have a totally different cost basis than vultures who bought in at a big discount, the result is an inherent conflict over whether or not to sell the company, and at what valuation.
Let’s say five siblings bought a house together for $100,000 each, then after a big fall in the real estate market, one brother moved away, selling his share to a cousin for $50,000. When it came time to sell the house, the five probably wouldn’t be able to agree on a price—the cousin might be willing to sell his share for $60,000 or $70,000, but the others wouldn’t want to take the loss. And while the cousin might be willing to spend money to make repairs or redecorate to attract buyers, the original four siblings wouldn’t want to burn any more of their cash.
Like this dysfunctional family, the old lenders are often unwilling to put money into the company to improve its performance and make it more saleable, seeing any additional investment as throwing good money after bad. The result can be a board in constant conflict, sending mixed messages to management, and perhaps a sale at the wrong time for the wrong price.
This is exactly what happened with Breed Technologies, Inc., a private-equity deal in which we invested. Breed, the first company to create air bags for automobiles, fell into distress in 2000, by which point it was the largest steering wheel manufacturer in the world and the third largest supplier of airbags and automotive safety systems. Its customers included most major automobile original-equipment manufacturers.
Breed had about $1.4 billion in revenues during 2000, with EBITDA cash flow of about $116 million. Nonetheless, the company got into trouble because of its ballooning debt obligations. The company made a number of overpriced acquisitions and literally used its credit card to do so. By the time we started looking at Breed, it had over $1.1 billion in liabilities—including over $600 million in bank loans in a syndicate organized by Bank of America, $330 million in 9.25 percent junk bonds, and about $133 million in trade claims and underfunded pension obligations (all shown in Exhibit 3.2).
EXHIBIT 3.2 Breed’s Capital Structure
| Amount | Book | |
| Capital as of October 2000 | Outstanding | Value |
| ($ millions) | ||
| Debt and other liabilities | ||
| DIP loan ($125m maximum, Bank of America) | $35.0 | $35.0 |
| Bank of America loans | ||
| Term Loan A, maximum $325m | $209.6 | $218.2 |
| Term Loan B, maximum $200m | $134.1 | $139.9 |
| Designated post-petition loans | $175.0 | $175.0 |
| Revolving credit facility | $85.8 | $85.8 |
| Letters of Credit | $2.5 | $2.5 |
| Swingline facility | $0.1 | $0.1 |
| Unsecured senior subordinated notes 9.25%, due 4/2008 | $330.0 | $345.3 |
| Trade claims | $125.2 | $125.2 |
| Underfunded pensions | $7.3 | $7.3 |
| TOTAL | $1,104.6 | $1,134.2 |
| (Less Cash) | ($14.4) | ($14.4) |
| NET DEBT | $1,090.2 | $1,119.8 |
| Source: Company reports and Schultze Asset Management estimates | ||
The company opted to do a voluntary restructuring, converting its senior bank loans, including bank debt I owned, into private equity. Although Breed managed to reduce its debt to just $151 million, its new private stockholders—chiefly former lenders GE Capital and Van Kampen Funds, Inc.—were clearly not interested in holding it for the long-term. Since they held the majority of the private equity, GE and Van Kampen pushed through a quick sale of the company to The Carlyle Group in March 2003 for a price that I thought was far too low for a profitable and largely debt-free auto supplier.
As a result, the other private stockholders and I received $12.25 per share in cash in exchange for our shares. This amount represented a TEV/EBITDA multiple of just 4.77×, somewhat lower than the average multiple of other similarly positioned automobile suppliers, which was 5.01×.
In fact, it became clear from the proxy statement for the transaction that Delphi Corporation had offered about $18 per share to buy the company, but since it included many more contingencies than Carlyle’s offer, Breed rejected it. Admittedly, I was somewhat at fault for the result since I had appointed one of the members (Gene Stohler) to Breed’s board of directors, and I hadn’t kept in close enough contact with him during the process.
My experiences with both Breed and Tweeter have taught me to think long and hard before getting into future private equity deals. Although I still sometimes use this strategy, on the whole I prefer more-liquid investments, wherever possible. Even so, if the potential reward of going into a less-liquid private-equity-type investment outweighs the inherent risk, it can be an excellent way for a vulture to succeed. In fact, sometimes the least-liquid investments present the best potential return since inexperienced investors usually avoid these deals.
In recent years, a number of vulture funds have begun using financial derivatives to express an opinion on a company’s value. This strategy includes the use of credit default swaps (CDS) to take a big bet on a company without actually buying its underlying bonds or bank loans. As with most derivatives, the idea is to use this kind of “leverage” to make large profits from a relatively small investment.
Although I have dabbled a bit in this relatively newfangled approach to vulture investing, for the most part I have steered clear. That’s because derivative instruments ratchet up the risks as well as the potential profits. Your bet is not only on the company’s ability to pay its debts, but also on that of your counterparty. This counterparty risk can be hard to quantify, particularly since hedge funds, one of the main users of CDS for speculation, continually trade the contracts among themselves. Until recently—after regulators insisted—they often didn’t bother to notify the original buyer or seller that its counterparty had changed.
During the financial crisis of 2008 and 2009, these risks became all too clear, making “derivatives” something of a dirty word. When Lehman Brothers collapsed, so did many funds that had bought derivatives from the firm to express an opinion on distressed securities; some didn’t even know they had been dealing with Lehman or other counterparties that, in hindsight, proved questionable.
More recently in 2011, with Greece on the verge of default, the International Swaps and Derivatives Association (ISDA) issued an opinion stating that a proposed plan to exchange Greek sovereign debt for new debt at a 50 percent “haircut”(that is, worth half as much) would not be a default under CDS contracts. Thus, the whole purpose of owning CDS insurance is called into question—if the insurance doesn’t pay out when you take a big loss, why would you ever want to buy it in the first place?
Settlement rules have been another problem with the CDS market. Although it is now possible for dealers to settle the contracts with cash instead of delivering the underlying bonds, this only came about after enormous confusion reigned during a couple of big bankruptcies in 2005 and 2006—including auto-parts maker Delphi Automotive and Northwest Airlines. This delivery requirement led to some pretty bizarre results.
Before 2005, when a company defaulted on its debt or otherwise declared bankruptcy, the market would generally hammer its debt securities. Then, as the CDS market ballooned, the derivatives “tail” started wagging the bond market “dog.”
When a “credit event” (such as a bankruptcy filing) triggered the CDS contracts—which are essentially default insurance on the bond issuer—buyers had to settle the contracts by physically delivering the underlying bonds to get the CDS payout, which was full face value on the bonds. Since the pool of derivatives written on the bonds was much bigger than the actual supply, the filing created massive demand for these securities, jacking up prices even for junior, out-of-the-money bonds.
As a result, I had to explain to our investors why we lost money on our short positions in the junior bonds of Northwest Airlines, Delphi Automotive, and Collins & Aikman, another auto-parts supplier. I had expected these bonds to end up worthless when the companies went bankrupt, because there simply wasn’t enough value to distribute down to junior creditors. Although I was right in anticipating the bankruptcies in these cases, I hadn’t foreseen how the physical derivatives settlement would drive appreciation in the underlying securities, which otherwise made no economic sense.
In Delphi’s bankruptcy, for example, more than $5 billion in CDS contracts had been written on only about $1 billion worth of actual bonds. So as dealers scrambled to get those bonds to deliver, the value of the soon-to-be-worthless securities jumped from 30 cents on the dollar to 80 or 90 cents. To prevent total chaos, dealers had to make special arrangements to waive contract requirements for settlement in securities and take cash instead. Cash settlement later became the norm.
This sudden change in settlement rules after more than a decade is one reason that I keep out of this market—it’s not really mature yet. When taking a long-term fundamental view on a company, it’s better to stick to securities rather than use derivatives, which are still not fully tested and not fully developed. In fact, after the financial crisis of the last few years, regulators clamped down further on the derivatives market, making their use even more dangerous for distressed-securities investing.
Finally, although derivatives can be a powerful instrument for gaining leverage (in the financial sense) most true vultures shy away from leverage since they know that’s usually what causes companies to get into distress in the first place.
Another approach in distressed-securities investing is using combined long/short trades. Under this strategy, an investor will typically buy (“go long”) the senior securities of an issuer while hedging the downside risk by shorting more-junior securities. The goal is to make consistent profits with relatively little downside risk.
Many investors over the years took this approach a step further by adding leverage to increase the returns. Unfortunately, leverage often doesn’t work out as expected—the road to success is littered with the remains of vulture investors who overleveraged their long/short distressed-securities portfolios. In fact, during the credit crisis in 2008, the SEC even made it illegal to short many companies, albeit temporarily.
My preference is therefore to steer clear of combined long/short trades altogether. I would rather take an outright long or an outright short position without pretending that somehow my primary position is hedged and therefore eligible for leverage. Instead, I manage the risk of portfolio volatility by controlling the size of my positions.
Whatever their strategy, vultures are generally activist investors—they rarely just sit back and wait for developments. In fact, activism can be a strategy in itself. Generally, a distressed company’s creditors will form a committee to represent their interests during a bankruptcy. But these interests will vary considerably among holders of different asset classes. Banks, bond investors, and syndicated-loan investors will fight to get the best repayment deal.
If you own 34 percent of the securities in a particular creditor class—or form a syndicate with enough like-minded investors—you can achieve a “blocking position” under the bankruptcy code, which gives you leverage (in the power sense) when negotiating a plan of reorganization with the debtor.
With the power this blocking position confers, you can contest any plan you don’t approve. Even better is acquiring more than two-thirds of the outstanding securities in that class, which gives you control and lets you force your views on other creditors regarding payouts or debt-to-equity conversions.
Activism isn’t confined to bankruptcy negotiations among creditors, however. You can also use your holdings, no matter how small, in a post-bankruptcy stock to influence the newly reorganized company through its board or otherwise. Since the market usually continues to punish the stock for some time after its reemergence, and it may take a while for analysts who dropped coverage after the bankruptcy filing to pick it up again, the new equity may be undervalued, thereby enabling you to build a substantial position cheaply.
In the best case, after a company goes through bankruptcy reorganization, it has wiped out all its old debt and has decent cash flow, giving it a comfortably flexible balance sheet. It may even have managed to carry forward its pre-bankruptcy net operating losses for tax purposes, which means it won’t be paying taxes for at least a few years (and in some cases, for more than a decade).
As an activist, your aim is to prod the company into taking steps to raise the stock price, using proxy fights or stockholder proposals. You might encourage the management and the board of directors to pay a special dividend, to buy back stock, or even to liquidate or sell the company. Since most people overlook these opportunities, they can be among the more exciting and lucrative. Over the years we have been fairly successful with this strategy, but this success has not always come easily—company managers tend to resist, using means both fair and foul.
One of our current plays, Winn-Dixie Stores, Inc., is a case in point. The company, a major supermarket chain based in the Southeast, emerged from bankruptcy in 2006 after eliminating about $900 million in debt, while former bondholders received the company’s newly issued stock. At the time, management had developed a good business plan for transforming the chain after it emerged from reorganization. The plan centered on a new campaign for reinvesting in the existing store base. But that plan did not change when the economy changed.
Winn-Dixie has nearly a century of history, dating back to 1913 when two of its founders, Carl Davis and his brother William Milton, began working at the Clark Mercantile general store. The following year, William Milton bought the store and subsequently acquired or opened numerous stores throughout Florida. In 1944, after acquiring 73 stores from Winn & Lovett, the company took on that name; in 1952, it listed on the New York Stock Exchange. In 1955, after it bought 117 Dixie Home Stores, the company was renamed Winn-Dixie Stores, Inc. By 1969, Winn-Dixie operated 715 stores, and by 2003, that had grown to 1,073 stores in the southeastern United States and the Bahamas.
Two years later, however, the usual suspects in retail bankruptcies—tight liquidity and excessive debt—struck again. On February 21, 2005, Winn-Dixie and its 23 then-existing subsidiaries filed for reorganization. The company argued that its long-term liquidity constraints had prevented it from consistently remodeling its stores and opening new ones, putting it at a competitive disadvantage.
In June 2005, the company announced plans to restructure operations by reducing its “footprint” by 325 stores, closing three distribution centers, and cutting its workforce by 22,000, or 28 percent. On November 21, 2006, the company emerged from bankruptcy proceedings with a substantially de-leveraged balance sheet. Under its reorganization plan, Winn-Dixie distributed 54 million shares of new common stock to creditors and listed the stock on Nasdaq. I got more actively involved with the company several years later.
Winn-Dixie focused its post-reorganization strategy on remodeling its existing store base, at a significant cost. Since it began in fiscal 2007, the company has remodeled about half (250) of its locations to bring a “fresh and local” theme to these markets. For the five fiscal years ended June 30, 2011, Winn-Dixie invested over $825 million in capital expenditures on this initiative. The remodeled stores, with clean, modern, and attractive décor and more efficient layouts, have increased traffic and revenues significantly.
EXHIBIT 3.3 Winn-Dixie Historic Financials
Nonetheless, the increased sales did not improve Winn-Dixie’s historically low cash flow. As you can see from Exhibit 3.3, the company had decent “run rate” revenues—nearly $7 billion per annum. However, if you look at its relatively low EBITDA margins, you can see that the company only generated 1.7 cents of cash flow for each dollar of revenue it took in over that period. Although supermarkets are notoriously low-margin businesses, there was definitely room for improvement, since comparable companies generate EBITDA margins of closer to 4 percent on average.
Even after the recession began in 2008, Winn-Dixie management continued with its remodeling plan, but by September 2010 it had to cut back. It announced a reorganization plan to close 30 stores and lay off about 120 employees. As of June 2011, it had approximately 484 stores in the Southeast, plus 75 liquor stores, 6 distribution centers, 1 beverage manufacturing facility, and its own insurance company. Its 2011 workforce stood at about 47,000 employees, 56 percent part-time and 44 percent full-time.
By November 2009, after the company’s post-reorganization revenues had sharply improved, I began pressing the company to issue a special dividend or buy back a significant amount of stock so that the remaining shareholders would benefit from the value of its higher earnings.
Although company executives and board members met with me and my associates, they initially pooh-poohed our suggestions and bridled at our tough questions about management pay ($15 million in 2008) and perks, which included a private jet for CEO Peter Lynch (whose family collected a further $500,000 per year for space rented to the company). In fact, Larry Appel, the company’s then-general counsel, looked ready to explode when I asked him directly about Lynch’s use of the jet at the annual shareholder meeting.
After I made my stock buyback recommendation public, management organized a conference call for shareholders and analysts. I was on the call, waiting my turn to ask a question. Mysteriously, however, my name just never seemed to come up in the queue—although several others were able to ask multiple questions.
When the same thing happened during another call when management presented 2010’s third-quarter results, I checked with the teleconference operator (the system was working perfectly) and compared notes with another major shareholder who had a similar experience. We concluded that the company executives had—cravenly—opted to mute the lines of shareholders with dissenting opinions.
Winn-Dixie management likewise tried to repress dissension at its 2010 annual shareholder’s meeting at their headquarters in Florida. The police car stationed out front certainly set the tone. We had managed to get a say-on-pay shareholder proposal (to give shareholders influence over the remuneration of executives) on the proxy, after the SEC turned down the company’s request to drop it. Then management tried to pull a fast one by substituting its own watered-down version on the annual meeting agenda, without informing board members.
I stood up to ask a question pointing out this flagrant breach of corporate governance rules, but was told I had only two minutes to speak. Finally, a member of the board’s compensation committee, noting the interest of reporters in this unseemly proceeding, insisted that I be allowed to continue. Shareholders voted overwhelmingly for our corporate governance proposal despite management’s stealthy efforts to quash it.
Later at the same meeting, I grilled the CEO about the value of the stock, which had dropped by more than 50 percent in 2010 after the company’s bankruptcy trust distributed another 6.5 million shares to creditors—setting off a rush to sell by former lenders. Lynch reddened and visibly squirmed in his shoes as he claimed to have no opinion on whether the stock, at $6.50, was fairly priced. At that point, it was trading at the ridiculously low price-to-cash flow ratio of under two, while other grocery-chain stocks fetched five to six times cash flow.
Although my initial efforts were somewhat futile, I did succeed in one area—getting management and the board to refocus on the company’s capital expenditures. As a result of my firm’s activist campaign, Winn-Dixie’s management reduced its planned capital budget by tens of millions of dollars.
Moreover, in late 2011, the company finally announced a sale to BI-LO, a competing grocery chain owned by a private equity group, Lone Star Funds, at a 75 percent premium to Winn-Dixie’s then-current trading price. Although this was a good start, I was not entirely satisfied with the $560 million sales price, so my firm filed a shareholder class-action lawsuit against Winn-Dixie and its board alleging a too-hasty sale for less than the company’s true value, a breach of fiduciary duty.1
The suit claimed an unfair sales process and self-dealing, resulting in an inadequate sales price of $9.50 in cash per share of Winn-Dixie common stock. In my view, the true premium was much lower than the 75 percent the company claimed. For starters, the company’s reported book value at the time of the sale was $14.98 per share, and the shares had traded as high as $10.08 in July 2011. Meanwhile, several equity analysts had set a price target of $11.00 for Winn-Dixie shares.
Moreover, basic principles of business valuation strongly suggested that Winn-Dixie was worth much more than $9.50 per share. The sale valued Winn-Dixie at 2.75 times EBITDA, a fraction of the 6.58 average EBITDA multiple for Winn-Dixie’s competitors in 2011. Between 2000 and 2011, the median multiple for supermarket merger and acquisition deals globally was 7.9 times EBITDA.
In addition, the Winn-Dixie board agreed to burdensome deal protection provisions that I believed would deter or otherwise preclude superior offers for the company, including a $19.6 million termination fee that Winn-Dixie would have to pay BI-LO if it accepted another proposal. The board also agreed to inform BI-LO of competing offers and allow it to make a counteroffer. Even worse, the merger agreement included a “no-shop” provision, barring Winn-Dixie from initiating, soliciting, or encouraging superior proposals.
The proposed deal not only favored BI-LO at the expense of public shareholders, but also a number of Winn-Dixie management insiders. That’s where the self-dealing came in: the sale would trigger change-of-control provisions in top managers’ employment agreements that would hand these insiders millions of dollars in windfall payments. Although that would be the case in any sale, the price paid to shareholders would make no difference to the insider payments, giving Winn-Dixie managers an incentive to take the money and run.
Meanwhile, Winn-Dixie’s sole financial adviser in the sale turned out to be Goldman Sachs, which had represented Lone Star in several transactions and which participated as an investor in some Lone Star funds. This created further conflicts of interest.
My firm’s lawsuit sought an injunction to prevent the sale from going through and to force Winn-Dixie’s board to put the company back on the market for a better price designed to maximize shareholder value. The suit also sought more disclosure to shareholders so they could have enough information to decide how to vote their shares. Although Winn-Dixie ultimately did change the proxy disclosure substantially and the deal did close, at the time of this writing, our suit is still pending.
To succeed with an activist strategy, you can’t be active just for the sake of it. The key is finding, through painstaking fundamental research and analysis, something that should be changed to increase value for the class of securities you own. As an extension of your due diligence, you must then persuade others that you are right, bringing in financial advisers and legal counsel, as appropriate.
If you know the company well, you can be strong and confident enough to critique selfish or incompetent managers and board members, making an effective case for change to even a large group of pessimists. But whether you are participating on a creditor committee, engaging in proxy maneuvers, or communicating with a company’s management, you need to have done your homework.
While distressed investing can involve a variety of complicated and exotic strategies, I believe that simplicity is a vulture’s best friend. By its very nature, investing in distressed companies is already a complex and risky process that usually ends up in bankruptcy court. Remember, distressed companies are always distressed for a reason—even if that reason was just that they took on too much debt.
Since your goal is to maximize your opportunity for success while minimizing the inherent risks, the simpler your approach, the better. If possible, stick to the most liquid and plain vanilla investments. That way, you’ll have the flexibility to change course and go on to better opportunities when the winds shift against you or when the hyenas arrive to eat your lunch.
1A copy of the full complaint is included in Appendix 4.