Showing posts with label distressed companies. Show all posts
Showing posts with label distressed companies. Show all posts

Wednesday 28 December 2022

Understanding financially distressed and bankrupt companies.

Financially distressed and bankrupt securities are analytically complex and often illiquid.

The reorganization process is both tedious and highly uncertain. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity. 

In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, 
  • - the effect of financial distress on business results; 
  • - the availability of cash to meet upcoming debt-service requirements; and 
  • - likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 

Similarly, investors in bankrupt securities must develop a thorough understanding of the 
  • -  reorganization process in general as well as 
  • -  the specifics of each situation being analyzed.



Financially Distressed and Bankrupt Businesses

Companies get into financial trouble for at least one of three reasons: 
  • - operating problems, 
  • - legal problems, and/or 
  • - financial problems. 

A serious business deterioration can cause continuing operating losses and ultimately financial distress.

Unusually severe legal problems caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. 

Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.


Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations. 
  • -  When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
  • Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor’s woes. 
  • Customers dependent on an ongoing business relationship may stop buying
  • Employees may abandon ship for more secure or less stressful jobs.


Effect of financial distress vary from company to company

Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities. 

The operations of 
  • capital-intensive businesses are, over the long run, relatively immune from financial distress, while 
  • those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 

For some businesses the decline in operating results is limited to the period of financial distress. 
  • -  After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. 
  • -  Others, however, remain shadows of their former selves.  

The capital structure of a business also affects the degree to which operations are impacted by financial distress. 
  • -  For debtors with most or all of their obligations at a holding company one or more levels removed from the company’s primary assets, the impact of financial distress can be minimal. Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
  • -  Companies that incur debt at the operating-subsidiary level may face greater dislocations.


More often bankrupt enterprise continues in business under protection for some to return to financial health

The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate. Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 

Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 
  • -  As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
  • - Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
  • -  As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
  • - Cash usually starts to build (for a number of reasons). 
  • -  When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 

While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.

Wednesday 15 January 2020

Investing in Financially Distressed and Bankrupt Securities: Issuer Responses to Financial Distress

There are three principal alternatives for an issuer of debt securities that encounters financial distress:
  • continue to pay principal and interest when due
  • offer to exchange new securities for securities currently outstanding, or 
  • default and file for bankruptcy. 
A potential investor in distressed securities must consider each of these three possible scenarios before committing capital.

Financially troubled companies can try to survive outside bankruptcy by resorting to
  • cost cutting, 
  • asset sales, or 
  • an infusion of outside capital. 
Such efforts can be successful, depending on the precise cause of the debtor's woes.  Short-term palliatives, however, can contribute to the erosion of long-term business value.

Efforts to conserve cash by cutting back inventory, stretching out accounts payable, or reducing salaries, for example, can get a business through a short-term crisis, but in the long run some of these measures may hurt relationships with customers, suppliers, and employees and result in a diminution of business value. 

A second option for a company is to make an exchange offer to replace outstanding debt and, where relevant, preferred stock with new securities. The possibility of an exchange offer adds a strategic dimension to investing in financially distressed securities absent from most passive investments. An exchange offer is an attempt by a financially distressed issuer to stave off bankruptcy by offering new, less-onerous securities in exchange for some or all of those outstanding.

An exchange offer can serve as an out-of-court plan of reorganization. Sometimes an offer is made to exchange for only one security; perhaps the issuer needs only to extend an upcoming maturity. Other times most or all outstanding debt securities and, where relevant, preferred stock are offered the opportunity to exchange.

Exchange offers are difficult to complete. Typically they involve persuading debt holders (and preferred stockholders, if any) to accept less than one dollar's worth of new securities for each current dollar of claim against the debtor. The greatest difficulty in consummating an exchange offer is that, unlike stockholders, bondholders cannot be compelled to do anything. Depending on state law, a vote of 50 percent or 67 percent of the stockholders of a company is sufficient to approve a merger; the minority is compelled to go along. However, the majority of a class of bondholders cannot force the minority to accept an exchange offer. This results in a free-rider problem since the value of "holding out" is typically greater than the value of going along with a restructuring.

Suppose Company X needs to cut its debt from $100 million to $75 million and offers bondholders an opportunity to exchange their bonds, currently trading at fifty cents on the dollar, for new bonds of equal seniority valued at seventy-five. This offer may be acceptable to each holder; individually they would be willing to forego the full value of their claims in order to avoid the uncertainty and the delay of bankruptcy proceedings as well as the loss of the time-value of their money. They may be concerned, however, that if they agree to exchange while others do not, they will have sacrificed 25 percent of the value owed them when others have held out for full value. Moreover, if they make the sacrifice and others do not, the debtor may not be sufficiently benefitted and could fail anyway. In that event those who exchanged would be rendered worse off than those who did not because, by holding a lower face amount of securities, they would have a smaller claim in bankruptcy.

An exchange offer is somewhat like the Prisoner's Dilemma. In this paradigm two prisoners, held incommunicado, are asked to confess to a crime. If neither confesses, they both go free. If both confess, they incur a severe punishment but not a lethal one. If one confesses and the other holds out, however, the holdout will be executed. If they could collude, both prisoners would hold out and go free; held in isolation, each fears that the other might confess.

The Prisoner's Dilemma is directly applicable to the bondholders in an exchange offer. Each might be willing to go along if he or she could be certain that other holders would also, but since no bondholder could be certain of others' cooperation, each has a financial incentive to hold out. Exchange offers often require a very high acceptance rate in order to mitigate this problem. If all bondholders could be brought together, there might be a chance to achieve voluntary cooperation. Historically, however, bondholders have been a disparate group, not always even identifiable by the debtor and hard to bring together for negotiations.

One way to overcome the free-rider problem is a technique known as a prepackaged bankruptcy, in which creditors agree to a plan of reorganization prior to the bankruptcy filing. Because negotiations have already been completed, a prepackaged bankruptcy is reasonably expected to be dispatched in months rather than years; the duration is not much greater than the time involved in completing an exchange offer. The advantage of a prepackaged bankruptcy over an exchange offer is that since a majority in number and two-thirds of the dollar amount of each creditor class must approve a bankruptcy plan, up to one-third of the dollar amount of a class can be compelled to go along with the other creditors, effectively eliminating the freerider problem. It seems likely that there will be increased use of the prepackaged bankruptcy in future efforts to restructure overleveraged companies in order to expedite the reorganization process, avoid the high administrative costs of a traditional Chapter 11 filing, and circumvent the free-rider problem.


If measures to keep the patient alive prove unsuccessful, the third option is to file for court protection under Chapter 11 of the federal bankruptcy code and attempt to reorganize the debtor with a more viable capital structure. This is typically a last resort, however, for there is still considerable stigma attached to bankruptcy.

Monday 13 January 2020

Investing in Financially Distressed and Bankrupt Securities

Financially Distressed and Bankrupt Businesses 

Companies get into financial trouble for at least one of three reasons: 

  • operating problems, 
  • legal problems, and/or 
  • financial problems. 
A serious business deterioration can cause continuing operating losses and ultimately financial distress. Unusually severe legal problems, such as those that plagued Johns Manville, Texaco, and A. H. Robins, caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.



Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations.


  • When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
  • Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor's woes. 
  • Customers dependent on an ongoing business relationship may stop buying. 
  • Employees may abandon ship for more secure or less stressful jobs. 


Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities.

  • The operations of capital-intensive businesses are, over the long run, relatively immune from financial distress, while those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 
  • For some businesses the decline in operating results is limited to the period of financial distress. 
  • After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. Others, however, remain shadows of their former selves. 


The capital structure of a business also affects the degree to which operations are impacted by financial distress.

  • For debtors with most or all of their obligations at a holding company one or more levels removed from the company's primary assets, the impact of financial distress can be minimal. 
  • Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
  • Companies that incur debt at the operating-subsidiary level may face greater dislocations. 


The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate.

  • Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 
  • Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 
  • As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
  • Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
  • As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
  • Cash usually starts to build (for a number of reasons). 
  • When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 
  • While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.

The Value Investing Process: Investing in Financially Distressed and Bankrupt Securities


As we have learned from the history of the junk-bond market, investors have traditionally attached a stigma to the securities of financially distressed companies, perceiving them as highly risky and therefore imprudent. 

Financially distressed and bankrupt securities are analytically complex and often illiquid.

  • The reorganization process is both tedious and highly uncertain. 
  • Identifying attractive opportunities requires painstaking analysis; investors may evaluate dozens of situations to uncover a single worthwhile opportunity. 


Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity.

  • In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, the effect of financial distress on business results; the availability of cash to meet upcoming debt-service requirements; and likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 
  • Similarly, investors in bankrupt securities must develop a thorough understanding of the reorganization process in general as well as the specifics of each situation being analyzed. 


Because most investors are unable to analyze these securities and unwilling to invest in them, the securities of financially distressed and bankrupt companies can provide attractive value investment opportunities. Unlike newly issued junk bonds, these securities sell considerably below par value where the risk/reward ratio can be attractive for knowledgeable and patient investors.

Sunday 15 January 2017

Value Investor's Opportunities in Distressed Securities

Some of the risks and opportunities associated with investing in distressed securities. 


While regular value investing involves dealing with a wide number of unknowns, distressed securities represent particularly complex situations. 

Because most investors are unwilling to put in the time and effort involved with analysing such securities; for some, the opportunities are plentiful in this realm.



Three Reasons for financial distress

There are three reasons a company might run into financial distress: 
  • operating issues, 
  • legal issues, and/or 
  • financial issues



Responses to financial distress and the implications to the investment

Issuers can respond to such situations in one of three ways: 
  • continue to pay obligations, 
  • attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or 
  • default and declare bankruptcy. 


Investors must understand the implications to their investments as the above scenarios play out. 

Investors must also: 
  • understand how other stakeholders will react to such situations, and 
  • understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).


Investing Opportunities in Bankruptcies

While bankruptcies are often complex and difficult to analyse.

Investors who know what they are doing usually have tremendous opportunities for returns with very little risk. 

At the same time, someone who doesn't know what he's doing risks losing his entire investment.

The process of analysing financially distressed securities starts at the balance sheet. 
  • Assets should be valued so that the size of the pie can be estimated. 
  • Obligations should then be subtracted from this amount. 
  • This task is much more difficult than it appears, however. 
  • For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. 
  • Furthermore, off-balance sheet liabilities must also be considered.

In bankruptcies, mis-pricing can occur which allow the enterprising value investors the opportunity for excellent returns.





Read also:

Monday 5 December 2011

Characteristics of Declining Companies and their Value Drivers


Characteristics of Declining Companies

            In this section, we will look at characteristics that declining companies tend to share, with an eye towards the problems that they create for analysts trying to value these firms. Note again that not every declining company possesses all of these characteristics but they do share enough of them to make these generalizations.

1.     Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and can thus be fixed by bringing in a new management team).
2.     Shrinking or negative margins:  The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.
3.     Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.
4.     Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cashflows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.
5.     Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many declining firms face debt burdens that are overwhelming. Note that much of this debt was probably acquired when the firm was in a healthier phase of the life cycle and at terms that cannot be matched today. In addition to difficulties these firms face in meeting the obligations that they have committed to meet, they will face additional trouble in refinancing the debt, since lenders will demand more stringent terms.



Declining companies: Value Drivers

Going concern value

To value a firm as a going concern, we consider only those scenarios where the firm survives. The expected cash flow is estimated only across these scenarios and thus should be higher than the expected cash flow estimated in the modified discounted cash flow model. When estimating discount rates, we make the assumption that debt ratios will, in fact, decrease over time, if the firm is over levered, and that the firm will derive tax benefits from debt as it turns the corner on profitability. This is consistent with the assumption that the firm will remain a going concern. Most discounted cash flow valuations that we observe in practice are going concern valuations, though they may not come with the tag attached.
            A less precise albeit easier alternative is to value the company as if it were a healthy company today. This would require estimating the cashflows that the firm would have generated if it were a healthy firm, a task most easily accomplished by replacing the firm's operating margin by the average operating margin of healthy firms in the business. The cost of capital for the distressed firm can be set to the average cost of capital for the industry and the value of the firm can be computed. The danger with this approach is that it will overstate firm value by assuming that the return to financial health is both painless and imminent.

Likelihood of Distress

A key input to this approach is the estimate of the cumulative probability of distress over the valuation period. In this section, we will consider three ways in which we can estimate this probability. The first is a statistical approach, where we relate the probability of distress to a firm's observable characteristics – firm size, leverage and profitability, for instance – by contrasting firms that have gone bankrupt in prior years with firms that did not. The second is a less data intensive approach, where we use the bond rating for a firm, and the empirical default rates of firms in that rating class to estimate the probability of distress. The third is to use the prices of corporate bonds issued by the firm to back out the probability of distress.
a. Statistical Approaches: The fact that hundreds of firms go bankrupt every year provides us with a rich database that can be examined to evaluate both why bankruptcy occurs and how to predict the likelihood of future bankruptcy. One of the earliest studies that used this approach was by Altman (1968), where he used linear discriminant analysis to arrive at a measure that he called the Z score. In this first paper, that he has since updated several times, the Z score was a function of five ratios:
Z = 0.012 (Working capital/ Total Assets) + 0.014 (Retained Earnings/ Total Assets) + 0.033 (EBIT/ Total Assets) + 0.006 (Market value of equity/ Book value of total liabilities) + 0.999 (Sales/ Total Assets)
Altman argued that we could compute the Z scores for firms and use them to forecast which firms would go bankrupt, and he provided evidence to back up his claim. Since his study, both academics and practitioners have developed their own versions of these credit scores.  Notwithstanding its usefulness in predicting bankruptcy, linear discriminant analysis does not provide a probability of bankruptcy.
b. Based upon Bond Rating: Many firms, especially in the United States, have bonds that are rated for default risk by the ratings agencies. These bond ratings not only convey information about default risk (or at least the ratings agency's perception of default risk) but they come with a rich history. Since bonds have been rated for decades, we can look at the default experience of bonds in each ratings class. Assuming that the ratings agencies have not significantly altered their ratings standards, we can use these default probabilities as inputs into discounted cash flow valuation models. What are the limitations of this approach? The first is that we are delegating the responsibility of estimating default probabilities to the ratings agencies and we assume that they do it well. The second is that we are assuming that the ratings standards do not shift over time. The third is that table measures the likelihood of default on a bond, but it does not indicate whether the defaulting firm goes out of business. Many firms continue to operate as going concerns after default. 
c. Based upon Bond Price: The conventional approach to valuing bonds discounts promised cash flows back at a cost of debt that incorporates a default spread to come up with a price. Consider an alternative approach. We could discount the expected cash flows on the bond, which would be lower than the promised cash flows because of the possibility of default, at the riskfree rate to price the bond. If we assume that a constant annual probability of default, we can write the bond price as follows for a bond with fixed coupon maturing in N years.
Bond Price = 
This equation can now be used, in conjunction with the price on a traded corporate bond to back out the probability of default. We are solving for an annualized probability of default over the life of the bond, and ignoring the reality that the annualized probability of default will be higher in the earlier years and decline in the later years. While this approach has the attraction of being a simple one, we would hasten to add the following caveats in using it. First, note that we not only need to find a straight bond issued by the company – special features such as convertibility will render the approach unusable – but the bond price has to be available. If the corporate bond issue is privately placed, this will not be feasible. Second, the probabilities that are estimated may be different for different bonds issued by the same firm. Some of these differences can be traced to the assumption we have made that the annual probability of default remains constant and others can be traced to the mispricing of bonds. Third, as with the previous approach, failure to make debt payments does not always result in the cessation of operations. Finally, we are assuming that the coupon is either fully paid or not at all; if there is a partial payment of either the coupon or the face value in default, we will over estimate the probabilities of default using this approach.

Consequences of Distress

Once we have estimated the probability that the firm will be unable to make its debt payments and cease to exist, we have to consider the logical follow-up question. What happens then? As noted earlier in the chapter, it is not distress per se that is the problem but the fact that firms in distress have to sell their assets for less than the present value of the expected future cash flows from existing assets and expected future investments. Often, they may be unable to claim even the present value of the cash flows generated even by existing investments. Consequently, a key input that we need to estimate is the expected proceeds in the event of a distress sale. We have three choices:
1.     Estimate the present value of the expected cash flows in a discounted cash flow model, and assume that the distress sale will generate only a percentage (less than 100%) of this value. Thus, if the discounted cash flow valuation yields $ 5 billion as the value of the assets, we may assume that the value will only be $ 3 billion in the event of a distress sale.
2.     Estimate the present value of expected cash flows only from existing investments as the distress sale value. Essentially, we are assuming that a buyer will not pay for future investments in a distress sale. In practical terms, we would estimate the distress sale value by considering the cash flows from assets in place as a perpetuity (with no growth).
3.     The most practical way of estimating distress sale proceeds is to consider the distress sale proceeds as a percent of book value of assets, based upon the experience of other distressed firms.
Note that many of the issues that come up when estimating distress sale proceeds – the need to sell at below fair value, the urgency of the need to sell – are issues that are relevant when estimating liquidation value.


Ref:
The Little Book of Valuation
Aswath Damodaran

Friday 9 April 2010

Warren Buffett: Distressed Assets a Great Investment



October 27, 2008 — Warren Buffett says that distressed assets are a great investment in an interview with Charlie Rose. He talks about Mortgage-Backed Securities, the government bailout. He says if you buy distressed assets at distressed prices, you will make money. He also mentions his confidence in the US economy over time, and closes with his classic quote: "You want to be greedy when others are fearful, you want to be fearful when others are greedy."

Friday 12 June 2009

Distressed Firms and Superior Returns

Despite the higher returns provided by value-based firms, there is one class of stocks, those of distressed firms, that has achieved some fo the highest returns of all.

Many distressed firms have negative earnings and zero or negative book value and pay no dividends.

Research has shown that as the ratio of book value/price or earnings/price declines, so does the return. However, when book value or earnings turn negative, the price of the stock becomes so depressed that the future returns soar.

This same discontinuity is also found with dividend yields. The higher the dividend yield, the higher is the subsequent return. However, firms that pay no dividend at all have among the highist subsequent returns.

Research revealed that most stocks that have negative earnings or negative book values have experienced very adverse financial developments and have become severely depressed. Many investors are quick to dump these stocks when the news get very bad. This often drives the price down below the value justified by future prospects. Few investors seem able to see the light at the end of the tunnel or cannot justify - to themselves or to their clients - the purchase of such stocks under such adverse circumstances.




(Note: Tongher)