A growing asset class in difficult times LIUC April 2009 1 Investing in High Yield and Distressed Debt.

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  • Slide 1
  • A growing asset class in difficult times LIUC April 2009 1 Investing in High Yield and Distressed Debt
  • Slide 2
  • AGENDA Basics of Credit Investing Investing in HY and Distress Strategies and Trading Technicals Current situation Appendix 2
  • Slide 3
  • Basics of Credit Investing A Focus on High Yield Bonds and Leverage Loans 3
  • Slide 4
  • Credit Investing Lending to corporations a direct private financing contract (loan) underwriting newly issued corporate bonds private placement vs. public offerings Secondary market investing in corporate bond Publicly listed debt vs. OTC transactions Return on credit investments periodic interest payments until maturity in cash vs. payment-in-kind (PIK loans) Repayment of the principal (end of the game) entirely at maturity (bonds, bullet loans) according to a scheduled amortization (most loans) Capped return on the investment 4
  • Slide 5
  • Example of a PIK The KDG Case Euro 400m Floating Rate Senior PIK Notes due 2014 of Kabel Deutschland Holding GmbH & Co. KG, issued on December 2004 Issue price: 99% Book runners: GS and DB Interest will be payable of additional notes, or cash if we so elect in case the company elects to pay-in-kind (PIK), all the cash will be received at maturity by the noteholders The Notes will be senior obligations of the Issuer and will rank equal with all existing and future debt of the Issuer (as a matter of fact, the notes are structurally subordinated to the operating assets) We might redeem all or part of the Notes on December 2005 technically called Non-Call 1 If we experience a Change of Control, we will be required to offer to repurchase the Notes at 101% Structurally subordinated to the operating assets
  • Slide 6
  • Assets Traded Senior secured, 1 st lien and 2 nd lien bank debt, DIP facilities, bridge financings, mezzanine debt, LCDS Greater security, stricter covenants, more rights. Assets are generally less volatile Commercial banks, CLOs, credit funds, mezzanine funds Low threshold for losses. As investor base shifts from traditional investors to CLOs and general credit funds, level of workout expertise is decreasing Secured bonds, unsecured bonds, subordinated bonds, convertible bonds, CDS Commonly traded instruments with high market correlation. Typically little covenant protection and limited rights in a workout High yield funds, CDOs and credit funds Higher threshold for losses relative to bank debt investors. Low expertise in workouts. CDOs may be forced sellers in defaulted situations Trade claims, pension deficit claims, vendor notes, intercompany claims, litigation claims Less liquid. Often possible to create claims at discount to market. Often provides a different or unique angle Trade suppliers, unions, employee pension trustees, vendors, insolvency practitioners Generally unsophisticated, or unable to exercise full rights. Look for liquidity Public and private equity, impaired equity, post reorganisation equity, convertible preferred or preferred equity, options Public securities have highest volatility of all assets. Private situations or structured deals are low volatility. Potential for new money deals Equity funds, special situation funds, private equity, families, governments, other equity investors More sophisticated, particularly if private equity. Relationships remain key. Event driven or special situation funds focused on opportunistic investing Type of AssetsAsset CharacteristicTypical InvestorsInvestor Characteristic Bank Debt Bonds Trade Claims and Other Debt Special Situation Equity 6 Only Distress / Special Situation funds 6
  • Slide 7
  • High Yield Bonds and Leverage Loans High Yield (HY) Bonds Bond / note / other securities Sub-investment grade - Junk (mostly B- through CCC rating) Typically 7-10 year maturity Yield at issuance 8%-12% (Libor + 500/700 bps) Mostly issued in the context of a leverage buyout (LBO) executed by a private equity firm Usually unsecured and subordinated Leverage Loans Contract form Arranged by banks and mostly syndicated to the market Maturity typically 6, 7 and 8 years (1 lien tranche A, B, C, or 2 lien) Spreads range from 200bps to 400bps Most of times underwritten in LBOs, as high yield bonds Security over assets Can be first lien or second lien on assets 7
  • Slide 8
  • Where Do High-Yield, Distress Bonds & Loans Sit in the Capital Structure? private instrument / contract (typically negotiated by banks and then syndicated to the credit investors) first priority in reimbursement in case of liquidation rights typically protected by security over hard assets publicly listed instrument / note or bonds (typically underwritten by banks and then syndicated to the credit investors) Subordinated debt subordinated to senior credit loans or bonds, but senior to equity, in reimbursement in case of liquidation rights typically protected by a general guarantee of the issuer (no direct claim on the assets) Senior Secured Loans: Senior Unsecured Bonds: 8 CAPITAL STRUCTURE WATERFALL 8
  • Slide 9
  • Credit Investing Risk-Reward Profile RISK REWARD / IRR Risk-free rate US Italy Government Debt Enel TI Corporate Debt Investment Grade Seat IT Holding Corporate Debt High Yield / Junk Geox Alitalia Equities and Distressed Debt Indicative spreads to Risk-free rate: 15%-25% 4%-15% 1%-4% 0%-1% High yield debt becomes distressed when it trades in the secondary market below 70-80% of face value This is the main focus of todays lecture ! [Risk can be defined as VAR, volatility, illiquidity, tail risk, gap risk,...] 9
  • Slide 10
  • Risk / Reward: Cutting To The Core RISK REWARD / IRR Attractive Risk / Reward Unattractive Risk / Reward 10 Risk premium line riskfree
  • Slide 11
  • Treasury Yield Curve 11
  • Slide 12
  • Credit Spreads
  • Slide 13
  • Default Rates Long-term Avg Previous peak points Historical Max
  • Slide 14
  • Ratings & Default Rates
  • Slide 15
  • Risk Event: Migration
  • Slide 16
  • Default Rates vs. High Yield Spreads (US) 16
  • Slide 17
  • Default Rate vs. Leveraged Loan Spread
  • Slide 18
  • Estimated Recovery Rate
  • Slide 19
  • Final Recovery Rate
  • Slide 20
  • Recovery Rates (US)
  • Slide 21
  • Default Rates & Recovery Rates
  • Slide 22
  • Default Loss
  • Slide 23
  • Corporate Credit Spreads Indexes The latest release of the HY index is the Itraxx S9 Xover (maturity March 2013) The Itraxx Europe index is a reference for investment grade companies The Itraxx Finl Sen and Sub represent senior and subordinated credit risk of financial institutions Itraxx Generic represents a blend of the various series releases (indexes roll every 6 months into a new release with new constituents) 23
  • Slide 24
  • Itraxx Generic Xover Index 24
  • Slide 25
  • Liquid vs Illiquid Investments / Trades Typically a bond or a loan which is traded by brokers Bid / Ask spread ranging from 0.25% to 2% Broker willing to trade a size of at least Euro 2mln to Euro 10mln Many market participants focus on liquid investments due to: mandate they have from their investors Capability to exit Lower gap risk Capability to improve returns by trading around positions, hence benefitting from volatility Typically forgotten bonds or loans by brokers, small sized deals, whose syndication went to just a few market participants, or directly sourced investments (where there isnt a standard process by which banks first underwrite the deals) No market making by brokers Trading might happen based on individual negotiations Impossibility to exit, to trade around, etc Typically only funds which have a lock- up period and who target a return premium for the illiquidity LIQUIDILLIQUID 25
  • Slide 26
  • The Extra Premium for Illiquidity Extra spread demanded by deals smaller than $500 million (proxy of definition of illiquidity) 26
  • Slide 27
  • Credit Derivatives (CDS or LCDS) 27
  • Slide 28
  • Importance of Derivatives for the Asset Class Hedging If you are long a single name credit risk, you can hedge the trade without going through the process of selling the underlying cash asset buying a CDS on that name If you are long market credit risk, you may buy credit index protection to hedge the exposure to the market (i.e. Itraxx) Capability to have additional liquidity in the market Capability to deploy curve and basis trades relative value market neutral 28
  • Slide 29
  • Invest in HY and Distress Evolving Asset Class by the Day 29
  • Slide 30
  • Investing in HY is Cyclical 30
  • Slide 31
  • The Difference Between a Trade and an Investment Short Term Potentially look at arbitrage opportunities Trade based on trading technicals Medium-Long Term Take a view on market/sector/company Investment based mostly on analysis and macro view TRADEINVESTMENT 31
  • Slide 32
  • Investment Process Overview Identify investment opportunities internally and from other sources Monitor stressed credits, industry sector trends, news and research reports Monitor market trends and review deals in the credit and equity markets Active dialogue with desks, investment management community, restructuring professionals, industry experts and other relationships Maintain key relationships with funds, desks and professionals and industrial players Identify the edge Conduct full financial analysis, including valuation, debt capacity and liquidity analysis Evaluate process risk by analysing legal issues, jurisdiction, capital structure, indentures, legal agreements, stakeholder interests, etc talk to key players management, existing investors, professional advisors, and interested investors and buyers Conduct industry and sector analysis Perform scenario analysis to determine upside/downside cases Identify events and timing to events Focus on capital preservation and low volatility Identify opportunities with down side of debt and upside of equity Assess and understand liquidity of the investment and exit Review the entire capital structure to determine where to invest and identify intra capital structure plays Determine opportunities to create / offer a new security Understand which security has negotiating leverage, and assess stakeholder interests Determine size, liquidity and overall fit with portfolio Monitor all positions for news, data and events in real time Mark positions monthly based on bid-ask market Sell discipline focused on exit: sell when event happens; sell on price appreciation; sell if situation or event changes negatively Talk continuously to key players and contacts to keep ahead of the information flow Review all positions weekly Revisit scenarios constantly Advisory panel input during portfolio review process Structure hedges IDEA GENERATIONSCREENING ANALYSISSTRUCTURING MANAGING POSITIONS 32
  • Slide 33
  • Managing the Process (Special Situations) INITIAL ASSESSMENT Opportunity assessed against our investment criteria Immediate feedback we will only work on deals we believe we can execute Experienced analyst allocated to complete financial analysis Founding partners involved from the outset to make an assessment of the risk/reward dynamics Information request provided focusing on the key facts we need to make an investment decision 24/48 hours REACHING AGREEMENT Key commercial issues identified and put on the table Meet and develop relationship with management Initial terms proposed and negotiated Flexible and pragmatic approach to other stakeholders Ongoing honest feedback provided throughout Upside/downside scenario analysis Timeline to completion established 2-5 days EXECUTION Experienced structuring team dedicated delivering the agreed deal Creative deal structuring using both financial, legal and industry angles Streamlined documentation requirements, borne out of years of experience of what is key in distressed and special situations Founding Partners involved throughout leveraging their relationships to bring other stakeholders on board 5+ days From identifying an opportunity to executing on it, we closely manage the process every step 33
  • Slide 34
  • Managing the Trade Price (% of Par) 100 75 25 0 50 Time Early identification of potential opportunities. Identify capital structure weak points and likely outcome of inter-creditor negotiations Refine understanding of the investment rationale, build the position, drive the process Constantly reassess investment rationale, valuation parameters, and trading flows throughout the restructuring process Efficiently trade throughout the restructuring period, have the best information, look to create the trade in other ways Maximise value through recovery and turnaround phase Distressed and special situations require early identification, efficient trading and quick, decisive decision making. For this reason, our founding partners are involved in every stage of the investment process to ensure we can take full advantage of the different stages of a companys restructuring and turnaround 34
  • Slide 35
  • Risk return profile for an HY manager Target return: 15%-20% IRR 10%-15% volatility Key risk measures: DIV01 = change of the underlying security value to a change of 1bps in credit curve; also indicative of the duration of a security. Example: For a bond with 5y duration, if the credit curve widens by 20bps, its value decreases by 1% (20bps * duration of 5). Leverage VAR
  • Slide 36
  • Making an Investment Recommendation Market screening Building an investment idea Sector analysis Company analysis Equity and credit comps Assessing risk-reward profile Degree of conviction The investment recommendation 36
  • Slide 37
  • Market Screening Scouting for companies with traded debt securities Take a look at sectors we deem to be attractive Take a look at bonds/loans deeply discounted to par value A HY investor restrict himself to names offering a potential levered return of at least Libor+600 bps Brokers or research analysts might suggest ideas, companies and situations to look at Who is focused on distressed looks at firms with an important credit event (imminently due or just past) bankruptcy process, like Alitalia or Lehman Brothers downgrades 37
  • Slide 38
  • Market Screening: example #1 38
  • Slide 39
  • Market Screening: example #2 39
  • Slide 40
  • Building an Investment Idea Choose the right sector Choose a company with a very good management team in that sector Pick cheap debt securities of that company in relative value terms 40
  • Slide 41
  • (1) Sector Analysis Most of our ac...