Let Us Prey


Day after day, company after company files for protection under the bankruptcy laws—the amount of assets is greater now than at any time since 1991, and is expected to keep growing. A sorry situation for corporate America but an opportunity for vulture investors. These players seek tasty morsels amid the carnage; that is, buying distressed debt securities they hope will pay off big when a company is reorganized, either in bankruptcy court or to forestall Chapter 11.

While there's no accurate beak count, more vultures than ever are plying this trade, from grizzled veterans like Carl Icahn to canny hotshots like David Matlin. And it's a more sophisticated, dangerous game than ever. To illustrate how dangerous, check out these two tales of toppled telecommunications ventures:

•When ICO Global Communications (otc: IGJA - news - people) filed for Chapter 11 in 1999, the future looked bleak for the mobile-phone satellite system. Enter telecom guru Craig McCaw, who last May orchestrated a $1.2 billion bailout of ICO and folded it into Teledesic, his own satellite company. Vulture investors profited outrageously. They had purchased their securities at 20 cents on the dollar and got back 50 cents six months later.

•Iridium (otc: IRIDQ - news - people), an ICO competitor with $5 billion in debt, had filed for bankruptcy just two weeks before ICO did. McCaw got involved this time, too, but he didn't have the same acquisitive appetite for Iridium as he did for ICO. ICO had the advantage that its satellites had not been launched, allowing McCaw to refashion them for Teledesic's purposes. Iridium's fleet was already aloft.

He merely lent Iridium $2.5 million to tide it over, so-called debtor-in-possession financing, in which the most recent lender goes to the head of the line in the reorganization. Some vultures pounced on the news of McCaw's arrival. They picked up Iridium bonds for 30 cents on the dollar. But McCaw chose not to rescue Iridium, and the bonds were wiped out.

In the last recession there were great companies with bad balance sheets. In this economic slowdown you see a lot of bad companies with bad balance sheets. "This isn't the kind of merchandise that was available in the early 1990s," says Lorraine Spurge, chief executive of Los Angeles-based financial advisory firm Spurge Ink.

If you're an individual investor without the resources and savvy of an Icahn, should you invest? Only if you understand you're at the whim of, among a host of other things, the big players like Icahn who control the reorganization process. Even the smaller-time vultures, with $50 million to $100 million under management, have to focus on a smaller number of opportunities, says Jeffrey Altman, senior vice president of Franklin Mutual Advisors, which has $2 billion invested in distressed securities.

Should you have some mad money and insist on playing, however, we have a list of pros' picks you might try, in hopes you won't be Iridiumed. They're either in Chapter 11 or are otherwise hurting, but offer at least the prospect of a big payday, (see table).

What about mutual funds? A few, like Third Avenue Value (TAVFX) and Fidelity Capital & Income (FAGIX) , have been known to dabble in defaulted bonds, but only have tiny portions of their portfolios there. (Altman's distressed investments are only about 10% of Franklin's total.) Most of the players, like Oaktree Capital Management, cater to pension fund and endowment clients. There are also a raft of hedge funds scoping for prey, like Angelo, Gordon, with its $1.4 billion earmarked for distressed investments. These take wealthy individuals as clients. Other players include funds of funds, such as the portfolio being assembled by Edward Bowman for clients of PNC Bank.

Leon Black, the onetime Drexel banker who made his name and fortune in distressed securities, is rumored to be reentering the market, raising a new $3.5 billion fund. Wilbur Ross, best known as an investment banker in the early-1990s, has gotten into the vulture investing business and is raising money a second time for U.S. and Asia deals. Entirely new players, like LBO funds, are sniffing, too.

But the money flowing in is still just a small fraction of the distressed debt out there to look at: $650 billion, face value, of distressed debts. (An IOU is defined as distressed if it's trading at more than 1,000 basis points over Treasurys.) This sickly paper is selling at a combined market value of $400 billion. That's twice the value of the bad debt up for grabs in the 1990 vulture-fest, (see chart, p. 141).

The buzzards' bounty should increase because of the huge amount of junk issued in the 1990s that is due to mature soon: $28 billion this year, $53 billion in 2002 and $66 billion in 2003. Problems paying off the principal or refinancing the debt could produce delicious disasters that vultures can exploit.

It seems at first blush that bargains abound. Defaulted bonds traditionally traded at 30 to 45 cents on the dollar. Lately, says distressed-securities expert Professor Edward Altman of the Stern School of Business at New York University, it's around 20 cents. Busted bank loans, which only institutions are allowed to buy, have sold historically for 65 to 75 cents on the dollar; today a 55-cent price is common.

But even at those prices, there's no assurance that vulture investors will get a repeat of the early 1990s, whenreturns ran as high as 40% annually. "It's not even close," says Samuel Zell, the Chicago financier and veteran vulture known as "The Grave Dancer." Recent buyers, meanwhile, have some catching up to do just to break even. The average distressed fund lost 33% last year.

With a weakening economy, there are horror stories for speculators holding subordinated debt (that is, creditors behind senior debt in a bankruptcy). Take the recent implosion of the AMF Bowling (otc: AMBW - news - people) leveraged buyout, which Goldman Sachs did in 1996 for $1.4 billion, or 8.5 times pro forma operating income (net before depreciation, interest and taxes). AMF, the nation's largest bowling chain, took out $515 million in bank loans and $500 million in bond debt. Goldman and partners put up $400 million in equity.

But the bowling business stagnated. And AMF's costly expansion at home and in Asia, during that region's financial crisis, was monumentally ill-timed. Operating income, projected to hit $350 million by 1999, reached only $130 million. A year ago vulture investors bought what appeared to be a conservative business at a conservative price, 40 cents on the dollar. But with the operating income sliding fast, the bonds kept sliding, too, all the way to 5. (They now trade at 10.)

Investing in bank debt has also become a real jungle. This endeavor was a less riskyproposition in the early 1990s because banks had required that the loans be secured by corporate assets. You'd buy at 60 cents on the dollar and bet the bonds would return to par.

No more. Although most syndicated loans in the late 1990s were conservative—they extended less debt as a percentage of the company's total valuation—a lot of them were unsecured.

Note what happened with Owens Corning's (nyse: OWC - news - people) unsecured bank debt, which traded at 80 cents on the dollar when the company reported increased asbestos-liability exposure last year. Vultures flocked, presuming the bank debt would be renegotiated to give it collateral and a senior position. Didn't happen. When instead the building-materials maker filed for bankruptcy in October, the debt slumped to 30 cents because it was on equal footing with other claims.

Tough terrain. Which speculators are best able to navigate it? Icahn is one. Of late he has purchased debt of TWA, docked in Chapter 11. He must know what he is getting into; he controlled the airline in the 1980s. He has also bought bonds and bank debt of Reliance Group Holdings, once the insurance empire of Saul Steinberg.

The name on everyone's lips these days is David Matlin, the swashbuckling manager of a $2 billion house portfolio at Credit Suisse First Boston (nyse: DIR - news - people). Matlin takes large positions in many junior unsecured bonds hoping a few will pay off big to compensate for the losers. Competitors say Matlin never pays more than 25 cents on the dollar.

One of Matlin's biggest scores was his 1999 purchase of junior bonds of the failing paging service provider PageNet at about 25 cents on the dollar. Its bonds rebounded to 80 cents only months later. "Dave is the Babe Ruth of the game. Ruth was the home-run leader and the strikeout leader in the same year," says restructuring adviser Barry Ridings at Lazard Frères.

Another vulture all-star is Cerberus Partners' Stephen Feinberg, who has been managing distressed funds since 1985. He now runs a dozen different funds and separate accounts, and a finance company that all together have $7 billion in their coffers. During the mid- and late-1990s, when the U.S. vulture business dried up, he looked for flotsam washing up in Asia at 5 and 10 cents on the dollar. His annual returns there, according to competitors, were more than 30%. Last year he targeted collapsed department store operator Nagasakiya.

Some pros aim to trade their bonds for equity in a reorganized company. No small feat: All the holders of different levels of debt must agree to the terms. If even one class dissents, the player that holds at least a 33% position in one particular debt class can block a recovery plan negotiated by the rest. In a stalemate, a federal bankruptcy judge carves up the carcass.

No wonder these workouts are often combative affairs, with members duking it out over nickels and dimes. Add Icahn to the mix and workouts become Jacobean dramas. Take Marvel Entertainment Group (nyse: MVL - news - people), which was controlled by another hard case, billionaire Ronald Perelman. Perelman, who has scooped up his share of troubled securities, is a formidable dealmaker. But his skills as a business builder are questionable. Marvel, maker of Spider-Man and Captain America comic books, had lost its way under Perelman; with the comics suffering from poor art and stories, readers were deserting.

In 1996 Perelman put the company in Chapter 11 and tried to merge it with Toy Biz, a highly profitable toy company. Then Icahn bought up Marvel bonds for a reported $70 million, tried to scotch the Toy Biz deal and take over Marvel himself.

Rancor was so intense, various parties would sometimes negotiate from different board rooms. "They just did not trust one another," recalls Chaim Fortgang, a lawyer representing the bank creditors. In late 1997 a fed-up judge created a mechanism that left Toy Biz the owner of an almost defunct company. Perelman lost his equity interest, and Icahn's bonds were wiped out.

More broadly, Icahn's Marvel misadventure illustrates how the level of play has escalated over the past decade. Sharp elbows are the norm in bankruptcy court. Take United Companies, a home equity lender that went into bankruptcy in March 1999. Matlin held half the subordinated debt, and Farallon Partners, a San Francisco-based hedge fund, owned the bank debt. Farallon negotiated a tidy recovery for the bank debt, but, under the plan, Matlin's investment would have evaporated. Matlin vowed to block the deal until he got a cut of the action. He made out with $2.5 million, but far less than the $10 million or so he wanted.

Even those investors who don't want equity must be willing to commit intense efforts to squeezing whatever value they can out of the troubled securities they own. As the market has become more sophisticated, vulture investing has developed a permanent support industry. Aleading adviser to bondholders is the boutique firm Chanin Capital Partners. Anticipating bankruptcies among overbuilt cinema chains, it hired the former president of AMC theaters to help. It has since been part of four cinema bankruptcies, including those of Regal Cinemas and Loews.

One strategy that heavy hitters don't bother with, but smaller funds do: shorting a wobbly company's bonds. Some wise investors did that in December for crisis-ridden Pacific Gas & Electric (nyse: PCG - news - people) and Southern California Edison (nyse: EIX - news - people) at prices in the mid-90-cent range. At the time, it was received wisdom that utilities just don't go bankrupt. The California utility bonds slipped to the low 50s before the state government stepped in.

Will the future bring more vultures? Certainly. More merchandise? Absolutely. Better merchandise? Unlikely.



Tables
Risky Business
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Charts
Debt Meat
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