Asking a roomful of distressed specialists to define “control” is like asking a group of poets to define “beauty.” The divergent views are passionately and eloquently argued but, one senses, fundamentally similar.
That said, how a distressed debt fund manager feels about control essentially defines his or her approach to investing in this rarified market.
What got them started was Mark Patterson's seemingly straightforward assertion that “control” meant owning more than 50 percent of the stock in a company that has emerged from bankruptcy.
Glenn August suggested that control, in fact, is an outcome that can be acheived with less actual ownership. “If we can have significant influence, then we can achieve our objective,” he said. “Clearly, when you have 50.1 percent, you can generally affect both the board and the strategy. When you have less than that, it obviously is more challenging, but you can still affect a company's strategy with a much smaller percentage.”
Judy Mencher brought up what distressed debt pros commonly refer to as a “blocking position,” gained by owning at least a third of a company's debt. This, too, she argues, allows a significant degree of control. “Since it takes two thirds to approve a plan but one third to block it, a blocking position gives you more leverage in the restructuring process.”
Marc Lasry said that although his firm is an active investor and participates on creditor committees, it does not seek control of target investments. He argued the term “control” has been misunderstood by those outside the distressed asset class. “The problem is that in distressed, people will say that in essence they have control, but I don't think you've got control unless you've got what Mark [Patterson] said – you've got 50 percent and you've got the board. Within distressed, what you often have is influence. If you can block a plan, it doesn't mean you can control a process. You can't hire or fire people, but you've got a say in what's happening.”
Oak Hill's August again argued for the more expansive definition of the term: “In a number of situations that we've been involved with, we have affected who the CEO is and affected the company's strategy with materially less than a 50 percent interest.”
“Can I clarify the debate?” interjected Patterson. “In the purest sense, control is 50.1 or don't even have the conversation. Everything else is a variant, and it's weaker than absolute control. When three guys have 30 percent each, it's a disaster. Each guy wants his own CEO. But when you've got 30 or 40 percent and no one else has more than 3 percent, I think you're in a very different position.”
Richard Latto explained that for his firm's strategy, real control is more necessary, because “when you get involved in smaller companies, you have to create your own process for an exit strategy. In bigger companies, you can sell stock, you can refinance. There are a variety of options. In the companies we deal in, we bring in our own bankers to refinance the company, and if you don't have a preponderance of the securities, you lose momentum and can't dictate policy.”
Lasry again questioned whether the level of control within the distressed strategy has been overstated. “Let's be blunt,” he said. “Ask someone with a control-oriented fund how many investments they've made, and how many of those they ended up controlling.”
“It's the wrong question,” replied Patterson. “Ask them how many dollars end up in control deals. We initially misfire about 75 to 85 percent of the time. Who cares? Ultimately, 95 percent of our first fund ended up in control deals. We're willing to wake up in the morning and say, ‘Okay, we screwed up yesterday – we blew $5 million and we have to sell it for $8 million or $2 million. It's was wrong – we're not getting control.’ So get out of it, but keep our focus.”
Distressed opportunities tend to move cyclically, but the overall market has also matured considerably since the last big wave of defaults in the early 1990s. Mencher noted that a decade ago, “you had one-off distressed funds, and they did everything. They did trading, they did control, they did whatever they could and invested whatever money they had to put to work. As more and more money has come into the market, we've all had to become more and more specialised in how we approach distressed debt.”
Patterson added: “There's better knowledge out there on the buyside. LPs are much smarter about the matrix of choices between hedge, full control and everything in between.”
The most recent go-go days for distressed debt were the years 2001 to 2003, during which huge bankruptcies like WorldCom and Kmart captured the market's attention. Today, the panelists agreed, the US distressed market is more geared toward middle-market investing.
But for large firms like Avenue Capital and MatlinPatterson, the early 2000s yield fond memories. “In retrospect, they were phenomenal days,” said Patterson. “You go to the peach orchard and you've got watermelons hanging off the trees. That happens about once per decade. These were insanely large companies. We hadn't seen that since 1989, and I'm struggling to remember a $5 billion debt structure that fell over back then.”
In the past year, it has been the rapid about-face of the financial markets that has most startled the roundtable participants. Within a very brief period, the US market switched from record defaults to record new high-yield issuance. August predicted that today's robust lending market may mean another wave of defaults is on the horizon for 2006 or 2007.
This led to the inevitable question – are we in a credit bubble?
No, said August. “Even though you've got leverage ratios going back to the five-times level, based on lower interest rates the actual interest coverage is materially better,” he said. “In addition, the economy is in a better condition today than it was post-9/11.”
“When you look at historical credit spread levels, it's hard to draw the conclusion that the credit markets are overpriced today,” agreed Michael Weinstock. “However, I do see some warning signs on the horizon. The kinds of warning signs I look for are – are there a lot of payment-in-kind deals or discount note deals? Are there a lot of small new issue deals? And are there equity take-out deals, where money is being raised to pay one-time dividends to private equity sponsors? We're seeing more of all of these.”
“The ability to do all of these refinancings came out of nowhere,” said Lasry, “And that's what saved a lot of companies and made our cycle so much shorter. In ‘02, the view was that this was going to take two to four years to work itself out.”
Latto described the current lending environment in the middle-market as aggressive. “For the refinancings that we're seeing, the room for error is much smaller than we saw five or six years ago,” he said. “Everybody's refinancing their companies at very low interest rates. As rates go up, I think you're going to see people hit bumps in the road much sooner.”
Lasry agreed: “What's turned this whole market around? It's liquidity. It's the first thing that's going to turn it right off again. Once this liquidity starts slowing down, you're going to have the opportunities.”
DO BORDERS MATTER?
Patterson asserted that his firm will consider investing in almost any country across the globe. Asked how his firm coped with the relatively higher risk of investing in certain geographies, Lasry spoke up: “We've got $2.5 billion in Asia. The reason we've got that much money out there has to do with price. If we can create a company here in the US at five or six times, surely you're not going to go and try to create it at the same price out in Asia. But in Asia, if you can create a company at two or three times, you'll buy it. Yes, you have to take into consideration the legal system, but if you're buying at a big enough discount, it's worth it.”
Specifically, certain countries in which Avenue Capital and MatlinPatterson have invested are not known for their advanced legal systems. While Lasry and Patterson ranked the legal systems of the UK, Switzerland, the Nordic countries and German highly, Thailand and Malaysia appear somewhere lower down the list.
Lasry said this, too, is factored into the investment analysis: “There's no point in saying, “Okay I'm going try to take control of the process and use the legal system,” because you don't want to use the legal system. You want to invest toward the end after a deal has already been cut.”
Patterson said that “trying to enforce a claim against highly connected people in these various counties is naïve.”
Lasry seconded this point with a war story: “In Indonesia, there was a state owned entity selling off debt. It ended up auctioning off a billion dollars of the debt. There were two bidders – ourselves and a family. We substantially outbid the family. We found out there was another auction. On the second auction, we outbid the family, and were told there was a third auction. On the third auction, we again outbid, and the family was given the debt.”
Weinstock noted that many restructurings outside of the US are done out of court. “In a lot of countries, the legal system is as bad for the company as it is for the creditors; it's mutually assured destruction. So long as there's a well established processes in the country and you see that out-of-court deals get done, we take a certain amount of comfort.”
August said he saw a great future for distressed investing in Europe. “Given the enormous buyout and private equity capital that's been amassed there, come '06, '07, you're going to have traditional, corporate US-style distressed opportunities,” he said.
OPERATIONS VS. CREDIT
One major way that distressed debt firms position themselves within an increasingly competitive market has to do with the notion of adding value. Does the firm endeavour to affect the growth of a company's bottom line, or is its value-add knowing where to buy at an unnaturally low price, from which the securities naturally appreciate in price on their own?
For his money, August said the latter strategy is “easy money – what we call the “revaluation trade,” which, for the time being, is pretty much behind us.” Today, said August, distressed debt investors must cultivate management teams and help grow the portfolio company's cash flow, not simply “benefit from multiple or valuation arbitrage.”
Lasry, the non-control investor, countered that control-oriented funds have the luxury of more time spent working with management teams. Avenue Capital does the bulk of its work before an investment is made on intense credit-oriented due diligence. “Everything always comes down to credit,” Lasry said. “Everyone within our firm needs to have extremely strong credit skills.”
Mencher said that operating talent, if needed, could be hired. “We're financial engineers,” she said. “If a portfolio company needs it, we bring in a new CEO, new COO or CFO. If I'm going to bring somebody into one of my companies, I want them to have an expertise in that industry. And we invest across a bunch of different industries. I don't want to have all those people on my payroll.”
While Longroad doesn't employ operating partners, said Latto, it maintains close relationships with professionals who systematically put in place systems to help portfolio companies save money. “In addition to providing operational resources, we bring in IT and insurance specialists that can save our companies several million dollars per year.”
Oak Hill and Quadrangle are similar in that both distressed debt teams are housed in a firm that also has a private equity team. August and Weinstock highlighted the benefits of this system. “Our fund has made five or six joint investments with Quadrangle's private equity team, and having people inhouse who are experts in control is very important,” said Weinstock.
All participants agreed that distressed investing involves working with an inferior set of information than is typically provided to M&A buyers. One said it was not unusual for the management of distressed companies to provide inaccurate or false information.
“That reminds me of something else we look for in our people,” added Patterson with a smile. “A very high level of cynicism.”