An Economy Mired in Debt
Investors Swoop In to Buy Up Pile of Troubled Loans, Bonds
By MICHAEL STREMFEL
Staff Reporter
An unprecedented glut of troubled debt now hitting U.S. markets is driving down values for commercial paper, bonds and other debt-related assets, unleashing an investment frenzy among L.A.-area investors.
Distress-oriented L.A. investment shops, as well as prominent out-of-town firms, are snapping up soured bank debt and troubled bonds, often at steep discounts.
“There are more distressed deals right now than at any time during the ’90s,” said Andrew Miller, managing director at Houlihan Lokey Howard & Zukin, an investment firm in Los Angeles.
Actually, there’s more distressed and defaulted U.S. debt right now than at any other time in history, said Edward Altman, a professor at New York University’s Stern School of Business who tracks such statistics.
“The numbers are absolutely staggering. There has never been anything like this,” he said.
Specifically, $720 billion of U.S. debt is either in payment default or “distressed,” which Altman defines as selling at a yield of at least 1,000 basis points over U.S. Treasury notes. That’s more than twice the $300 billion level of sour debt during the 1990 recession. And the amount is growing fast. U.S. borrowers defaulted on $60 billion in debt in 2001 a new record, and roughly twice the previous record amount in 2000.
That sour-debt tsunami is sinking loan and bond values to bargain-basement levels, sending distressed-debt investors on shopping sprees.
“They have more (deals) than they can handle they’re salivating,” said Altman, who is invested in a few of the distressed-debt investment funds now popping up around the country.
The emerging distressed-debt investing frenzy comes at a time when traditional dealmaking mergers and acquisitions, bank lending, initial public offerings, venture investing has come to a relative standstill.
Volcanic deal flow
Distressed-debt investors find themselves in a similar situation to that of venture capitalists a few years ago. But rather than being inundated with dot-com business plans, today’s frenzied investors are deluged with debt deals.
The last investment craze involved early-stage equity deals. This one involves various types of later-stage debt deals.
“The companies facing financial distress today are of a much higher quality they’re not venture-stage outfits with flawed business plans,” said Josh Friedman, managing partner at Canyon Capital Advisors LLC in Beverly Hills. “When times were good, these companies had access to all kinds of alternatives in the capital markets.”
Not anymore.
So they’re turning to alternative sources of capital, or vice versa. Some of the deals involve investors buying beaten-down debt securities on the public markets. Others involve investors buying bank debt on the secondary market. Still others involve investors lending troubled companies new debt, at higher interest rates.
A good example is Burke Industries of Santa Fe Springs, a leading supplier of specialty rubber products everything from office wall baseboards to radar-deflecting tape used on B-2 Bomber wings.
When Burke hit turbulence last year and filed for Chapter 11 bankruptcy protection, its bank lender, Bank of America, was eager to cut bait. Waiting in the wings was Cerberus Capital Management, a New York investment firm with $7.5 billion under management.
“We issued Burke a $30 million letter of credit, and (Burke) drew down $20 million of that to (pay off) BofA in November,” said Kevin Genda, a Cerberus managing director.
Ownership change
Meanwhile, Burke’s $100 million in outstanding junk bonds (face value) had deteriorated to between 20 and 30 cents on the dollar, at which point Greenwich Street Capital Partners of New York, bought them up.
GSC Partners is now evaluating its options, with the most likely being that it will convert its bonds to a controlling equity stake and install a new management team, said Genda and Ted Clark, Burke’s president for the past two years.
“That is clearly one outcome that’s the most likely to happen,” Clark confirmed. “But we haven’t actually filed a reorganization plan yet, so it’s not anything that has been fully agreed to by the creditors’ committee.”
Burke, founded in 1942, is typical of the companies being targeted by distressed-debt investors. It has 1,000 employees at six plants, generating about $110 million in annual sales.
“These are established companies with good, solid business models and strong revenues whose capital structure and balance sheet just happen to be messed up,” said Lisa Goldman, managing director in the West L.A. office of investment bank Goldsmith-Agio-Helms.
While such companies are not confined to any particular sector, they are more heavily concentrated in areas hit hard by the economic downturn. Among those are leisure, apparel, textile and telecom companies. With a skyrocketing number of such companies falling into technical or payment default on their loans, banks are refusing to cut them much slack, even at higher interest rates.
“Most (bank) lenders are not in the business of lending at very high interest rates,” said Canyon Capital’s Friedman. “If risks become higher than a certain level, they will withdraw rather than assume that risk, so that creates an opportunity for alternative lenders like us.”
While distressed-debt deals are riskier and pay higher returns than traditional bank loans, they are not as far out on the risk/return spectrum as venture deals. While venture firms typically target annual yields of 30 to 50 percent, distressed-debt investors aim for 25 to 30 percent. Most of that yield comes from interest payments on the debt, with the rest coming from various “yield-enhancing features,” such as warrants or profit participation.
While VCs attain their yields with a few home runs that more than offset their multitude of strikeouts, distressed-debt investors tend to rely on a steadier stream of less-spectacular deals.
“If you can consistently hit doubles, those doubles eventually add up to home runs,” said Rob Deutschman, president of Capello Investment Partners in Santa Monica.
Even hitting doubles in the distressed-debt arena can be tough, however. “Guys who will do well are those with a history of restructuring who aren’t scared off by bankruptcy or someone threatening to file,” said Deutschman. “They’ll just say, ‘Go ahead and file. I know what the rules are and I can deal with that.'”
