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Investing in distressed companies can produce enormous gains. When the recovery is successful, it is not uncommon for the stock to produce multiples of the initial investment and for bonds to generate 50-100% gains along with often-generous interest income. However, not all distressed companies recover, and some decay into bankruptcy. What happens to your investment then?
In The Turnaround Letter’s continuing series on investing in distressed securities, we explore the downside if the recovery unravels.
- Your company’s recovery didn’t work, so it can try to work out the problems before filing for bankruptcy, or it can file for bankruptcy.
- Chapter 11 bankruptcy allows a company to continue to operate while it restructures its finances and operations.
- Reorganization plans generally follow the absolute priority of claims in distributing the firm’s value.
- Equity holders usually get wiped out, while bond holders may get a partial or full recovery.
Your analysis was solid and management did a valiant job of trying to turn around the company; but after two years, it just didn’t work. As Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” By some estimates, as many as two-thirds of distressed companies end up in bankruptcy, and your investment is looking like it will join them. How might this play out?
Management may first decide to work out the company’s financial problems with its debt holders (creditors) before it misses an interest payment or breaches a covenant. Creditors may agree to reduce the debt, or perhaps the company agrees to find a buyer and use the proceeds to repay the debt. Creditors may be satisfied with getting a partial return of their capital rather than going through the formal bankruptcy process, as bankruptcy is expensive and time-consuming for everyone.
Once a company misses an interest payment or breaches a covenant, creditors’ rights increase enough that they can force the company into bankruptcy. Management may decide to voluntarily file for bankruptcy to preserve more of their own rights. Bankruptcy allows a company to continue operating while working out a reorganization plan with its creditors.
When a company files for bankruptcy, it falls under the Bankruptcy Court’s formal jurisdiction. The court’s primary focus is to ensure a fair process for allocating value to the claimholders while they maximize the firm’s value. The company can continue to operate the business but significant decisions must get court approval.
An ironic feature of a bankrupt company is that banks will become eager to lend to it. These new lenders get first claim on any assets, along with hefty fees. The company (now the “debtor”) retains control of the business, so this funding is called Debtor-in-Possession, or DIP, financing. DIP financing helps the company operate while in bankruptcy. In our example, your company rounds up $35 million in DIP financing.
So, how will your security fare in bankruptcy? Compared to its scenario where the company rebounds (explored in our previous note), in this case its revenues and profits have declined further, and at a diminished 7x multiple the firm’s enterprise value is only $105 million:
Example: Bankrupt company valuation ($millions)
There $435 million in debt but only $180 million of value to be allocated ($105 million in Enterprise value plus $75 million in cash). Not everyone will get paid in full. In your company’s reorganization plan, following intense negotiations, the waterfall of claims will be paid based on their absolute priority. The most senior creditors get paid first, and only when they are paid in full does the next junior level get paid anything. Your company’s DIP lenders get first dibs, then secured creditors (who have collateral backing their claim), followed by unsecured creditors (bond holders), with equity holders getting whatever is left over.
The DIP financing and secured bank loans are paid in full. The unsecured creditors received 15 cents on the dollar. If you hold one of these bonds, you will receive 15 cents in principal plus two years of interest at 9%, totaling 33 cents in total proceeds per dollar of face value. If you paid only 30 cents, or 30% of par, for your bond, you will get a 10% return. Not a disaster, but not what you were hoping for.