hawker beechcraft distressed debt investment … beechcraft distressed debt investment analysis case...

Copyright ©2012 by Stephen G. Moyer

Hawker Beechcraft Distressed Debt Investment Analysis

Case Study prepared by Stephen G. Moyer

Never had the investment committee of Arch Capitali (Arch) been as divided as it was on an otherwise

sunny afternoon in mid-town Manhattan. It was mid-March 2012 and the anticipated economic

turnaround that would lift the fortunes of its large investment in Hawker-Beechcraft Corporation

(Hawker), a premier business plane manufacturer located in Wichita KS, seemed a distant hope and the

investment was in a nose-dive.

Arch, which had deployed over $5 billion in distressed debt investments over the ten years of its

existence, viewed itself as one of the premier distressed investment funds in the world returning an

average net IRR to its investors of 16.8%. Rob Shapiro, CIO and a co-founder of Arch, was worried what

a serious debacle with Hawker, which had now been prominently associated with Arch because it was

well known that Arch was the largest secured debt holder, could portend for Arch. Arch had begun

marketing a new fund, to take advantage of the prospective European melt-down, and had found

significant investor resistance due to its lack of a European track-record. A high profile loss in Hawker

could jeopardize the success of European fund raising efforts. And, of course, Shapiro had over $50

million of his own net-worth in the fund which held the Hawker investment.

When Arch began accumulating the secured term loan of Hawker in the first-half of 2010, an economic

recovery, though modest, seemed in place—particularly in China and India which Arch was convinced

were poised for an explosion in private jet demand as a result of their poor domestic commercial airlines

and ballooning population of mega-millionaires. At that time Hank Hammer, the Arch partner that had

internally promoted the investment in Hawker, viewed Hawker’s secured term loan trading at 65 as an

attractive investment given the implied valuation where Arch was creating the company. Hammer, who

had attended the Air Force Academy, flown innumerable combat runs in Desert Storm, graduated as a

Baker Scholar from Harvard Business School and then enjoyed a meteoric rise to partner at Arch, was

aware of his potential bias toward aviation and had constantly fostered dissenting opinions as he made

the case for an investment in Hawker.

Hammer had been monitoring Hawker for more than a year before he decided to recommend

investment. Over the course of that time, market concerns over declining revenues had put Hawker into

an over-leveraged tail spin. During the first-half of 2009, Hawker, which was controlled by Goldman

Sachs, repurchased almost $500 million of its unsecured debt at a deep discount, which significantly

reduced leverage and shaved $45 million in annual interest expense. Hammer felt that while there were

certainly still some clear risks, that the strengthening economic outlook together with Hawker’s

improved balance sheet made the secured loan compelling. He also considered Hawker’s remaining

unsecured bonds, which were trading 30 – 40 points cheaper, but felt the better risk-adjusted return

was in the secured loan which he viewed as having minimal downside risk given the value of Hawker’s

core operations:


Hawker’s Beechcraft unit was the premier manufacturer of twin turboprop planes.

These aircraft had a defensible market niche because they were more economical than

jets to operate, were relatively fast, and had the ability to land and take-off on relatively

short, unpaved runways of the sort found in less-developed countries and remote parts

of developed countries where commodity and energy extraction activity was bolstering

demand.

Hawker had the largest network of dealers and related maintenance depots in the world

which generated consistent, high-margin revenue due to the need to regularly service

its 37,000+ in-service fleet.

Hawker’s small military related business which made single engine turboprops used as

jet-fighter training aircraft had a long-standing monopoly-like contract with an

additional 8 years of guaranteed plane sales and 20-years of guaranteed maintenance.

Hawker’s 750 – 900 family of business-jets (6-8 passenger) was well regarded, enjoyed

significant market share and had just been upgraded.

Of course, Hawker’s debt would not have been selling at significant discounts if there had been no

turbulence in the forecast. The biggest concern, in Hammer’s mind, was the introduction of the

Hawker’s newest jet—the mid-size (8 – 12 passenger) Hawker 4000. The Hawker 4000 was a great plane

with horrible timing. It had been introduced at the end of 2006 as the clear technical leader in the

category with a ground-breaking composite fuselage that permitted a more comfortable oblong (as

opposed to circular) cabin configuration (more shoulder and head room) and weight-related operating

efficiencies. The plane’s pre-delivery sales, which included an initial 50 plane order from NetJets, had

exceeded expectations. However, when the recession hit additional sales halted and NetJets had been

able to cancel its order with virtually no penalties. Hammer had retained an industry consultant to

independently analyze the Hawker 4000’s market viability and the conclusion had been that although

there were definitely competitors in the class, everyone had suffered a similar decline in sales and that

when the cyclical rebound in demand returned, the 4000 had sufficient brand-recognition and

demonstrable operating advantages that it should capture meaningful market share assuming

appropriate marketing and pricing. Hammer also took the time to personally pilot the 4000 as well as

several competitors to convince himself it was “best in class”.

Hammer’s other significant concern was Hawker’s unionized labor force. Almost all of Hawker’s

manufacturing operations were in the U.S. (85% by headcount in Wichita) and they were represented by

the International Association of Machinists and Aerospace Workers (IAMAW). Based on publically

available financial statements, which was all Hammer could review without becoming restricted and

thus unable to easily make an investment, it was difficult to analyze how Hawker’s labor and production

costs compared to its competitors. He assumed Hawker had higher costs than its Brazilian competitor

Embraer, but Embrear was a relative new-comer and only in the jet market. He also assumed that

Hawker probably had a less favorable collective bargaining agreement than Cessna, which was also

Wichita based. Based on his research, Cessna had a very constructive relationship with labor whereas

Hawker had been the subject of several strikes in the last ten years. In addition, Hawker’s underfunded

pension liability was $297 million at year-end 2009.


Hammer’s investment summary to the committee had been compelling:

Look, if we wait for a clear turn-around in plane sales Hawker’s debt will trade up and we will lose the

opportunity. That’s the same reason we’ve been investing in home-builders before a demonstrable

uptick in new home sales. We know corporations are sitting on record amounts of cash and that they

are way over due in upgrading their plane fleets. We know that the ranks of multi-millionaires in China

and India is mushrooming and that these people hate domestic commercial offerings as a practical

matter and yearn for the prestige of private plane ownership—these were the same guys buying Ferraris

when there were no roads to drive on. Further, based on discussions with the biggest trader, I believe

that Goldman has been in the market this month buying the unsecured notes—which are junior to the

secured loan I recommend we buy. If they see value in the unsecured notes, the secured loan has to be

money good.

We are basically buying the Toyota of the industry—Beechcraft is the always reliable Toyota workhorse

for mass-market everyday needs while Hawker is the Lexus of the private jet market. At a price of 65,

the yield to the 2014 maturity of the bank debt is 12%, which doesn’t suck and remember that Goldman

just bought a lot of unsecured bonds below us. If this thing turns around as we expect then the bank

debt should be at par by 2012 and our holding return will be 25%. If the worst case happens and we

own this thing, then we will have effectively purchased it for about $1 billon when Goldman paid $3.1

billion 3-years ago and I can’t believe there won’t be Chinese buyers of the IP implicit in a manufacturer

with internationally certified airframes.

As Hammer now gazed out the 47th floor window overlooking a frozen Central Park, he remembered

those words and wondered how it had gone so wrong. The Hawker 4000, which he had so much

enjoyed test flying, seemed an Albatross that could sink Hawker and potentially his career at Arch. In

2010 and 2011 Hawker reported a cumulative loss of $935 million. Instead of being a shinny Toyota,

Hawker now seemed more like the mud-brown Yugo that no-one would buy because they weren’t sure

the company would be there in future years to make spare parts. Backlog had plummeted and sub-

optimal production volumes were killing costs. Vendor’s had started to put the company on COD terms

and even after drawing the remaining availablity on its $240 million revolving credit facility in the fourth

quarter of 2011, Hawker was out of cash.

Goldman had hired Steve Miller, the vaunted turn-around artist, in February 2012 to assume control.

Miller had called Hammer yesterday to give Hammer an operational update and to ask for a $125 million

“rescue” loan. While Miller tried to project an aura of control, Hammer surmised that operations were

in free-fall. Miller was emphatic that the new funds were needed immediately. But he also did not

sugar coat the situation and made it clear that there were many challenges to confront and that an

additional financial restructuring and probably even a Chapter 11 bankruptcy were in Hawker’s future.

Hammer indicated it was unclear Arch was willing make the Rescue Loan, but it would be much easier if

Hawker immediately filed Chapter 11 and Arch lent the money on a preferred basis as a debtor-in-

possession (DIP) loan. Miller said they needed more time to arrange an organized “pre-pack” Chapter


11 that would project to the market that Hawker would quickly emerge as a healthy Phoenix; if it filed

now on a disorderly basis it would badly jeopardize its employee, dealer and customer loyalty. Miller

reminded Hammer that when GM was on the bankruptcy precipice many thought it would be forced to

liquidate had the government not assured the company’s quick exit from the bankruptcy process—

unfortunately, Kansas was not a swing state so there would be no help from Uncle Sam. Hawker’s

lawyers had figured out how to make the Rescue Loan safe for Arch, but it would mean undermining the

collateral support for the secured loan Arch currently owned. Miller said he thought it was in Arch’s

best interest to “prime” itself, but it they didn’t want to do it, he had a lot of phone numbers on his

speed dial.

Rob Shapiro listened to Hammer’s update and had many concerns:

Not only were they being coerced to make the new loan to “save” the existing investment, but

the new loan would itself undermine the quality of the existing loan.

At the time of investment Shapiro had been persuaded that owning Hawker for a $1 billion

valuation wasn’t such a bad worst-case scenario—now he wasn’t sure. Hawker was

hemorrhaging cash. The $125 million current ask was just the start—$300-500 million more

could easily be required to keep the company afloat.

Was the Hawker 4000 salvageable given its tarnished start. Sure it was leading edge in 2006

when launched, but now Embrear and Bombardier/Lear had launched updated offerings and

had deep pockets to weather a protracted pricing battle.

China, the hoped for source of demand, was experiencing a slowdown in growth and it was

quite clear the military was unlikely in the near-term to reform antiquated flight plan

authorization procedures that would make the convenience of a private jet realizable. Even

worse, a key potential fall-back buyer for Hawker—China Aircraft Corporation (CAC)—had just

entered into a business jet manufacturing joint-venture with Cessna.

Even if Shapiro could imagine Miller having the ability to brow-beat the other creditors into

agreeing to some type of pre-pack Chapter 11, what about the union. Chapter 11 was often a

great tool to force concessions out of unions but not if the process had to be completed

quickly—the law gave unions too many ways to stall. Hawker might be forced to just live with

the existing agreement—including the massive pension obligation (which at 12/31/11 stood at

$493 million).

Hammer acknowledged that these were legitimate concerns and that neither he, nor anyone else, had

good answers. But what did they want to do—refuse to make the Rescue Loan and worry that someone

like Carl Icahn would and potentially be in a superior position to them? Hammer’s gaze returned to

Central Park and the now setting sun wishing for some source of light. Shapiro also looked at Central

Park thinking, among many things, the London office lease he had just signed had been a bad idea. He

came back to the moment and told the group he needed the following to make a decision:

A. Rescue Loan: Should Arch make the loan? Was it “safe” as Miller purported? What pricing

could they demand?


B. The Existing Secured Loan Investment: They owned $400 million face of the secured loan and it

was trading at 70. How would the Rescue Loan impact the value? What were the likely

restructuring scenarios for Hawker and how would these impact value? What was the damn

loan worth and should Arch buy, sell or hold?

C. Hawker Restructuring: If Hawker needs to go through a Chapter 11 bankruptcy, how much will

the business be harmed? Is it worth it to stay in Chapter 11 longer in order to terminate the

pension and redo the collective bargaining agreement? Should Hawker keep it current business

mix or discontinue or sell parts of it?

COMPANY HISTORY

Hawker traced its roots to Beech Aircraft Corporation founded in 1932 in Wichita KS. Raytheon

purchased Beech in 1980 to diversify its largely defense oriented operations into civilian aviation. In

1993, Raytheon acquired British Aerospace Corporate Jets (BACJ) from British Air and decided to

resurrect the Hawker brand used by certain of BACJs predecessors for its small to medium sized jets.

In March 2007, Raytheon sold its Raytheon Aircraft operations to Hawker Beechcraft Corporation (HBC),

a newly formed acquisition corporation controlled by GS Capital Partners VI, an affiliate of Goldman

Sachs, and Onex Partners II, an affiliate of Onex Corporation, for $3.3 billion, which was later adjusted to

$3.1 billion. The purchase price represented 8.1x trailing EBITDA. Raytheon recorded a pre-tax gain of

$1.6 billion on the sale. HBC financed the acquisition approximately as follows:

Hawker’s year-end balance sheet following the acquisition was as follows:

Secured Term Loan 1,300.0

8.50% Sr Notes 400.0

8.875/9.625 PIK Sr Notes 400.0

9.75 Sr Sub Notes 300.0

Total Debt 2,400.0

Equity Contribution 700.0

Total Purchase Financing 3,100.0

Summary Balance Sheet at 12/31/07

Cash 569.5 Advances 541.2

Accounts Receivable 80.1 Accounts Payable 323.6

Inventories 1,289.3 Current portion of LT Debt 69.6

Other Current Assets 121.0 Other Current Liab 257.7

Total Current Assets 2,059.9 Total Current Liab 1,192.1

PP&E 655.7 LT Debt 2,377.3

Intangible Assets 1,118.2 Pension & Benefit Oblig 16.4

Good Will 716.0 Other LT Liab 85.0

Other Assets 125.4 Total Liabilities 3,670.8

Equity 1,004.4

Total Assets 4,675.2 Total Liab & Equity 4,675.2


At the time of the acquisition, the future of private aviation seemed very promising. Deliveries for both

business jets and turboprops had been recovering strongly since a cyclical trough in 2003. Business Jet

demand in particular had been buoyed by the growth in factional ownership schemes that had

significant tax and regulatory advantages compared to the leasing market.

Hawker had just obtained FAA-type certification for the Hawker 4000 composite-body super-mid jet in

November 2006 and had an initial 50-plane order (worth over $1 billion) from NetJets.

OPERATIONS

Hawker has three reportable operating segments:

Business Aircraft: Hawker’s business aircraft segment combines both its jet and propeller

manufacturing activities. The business jet group targets three distinct segments of the business jet

market:

Super-Mid Jet: Hawker’s 4000 was arguably the technological leader in this category when

introduced in 2006. Jet’s in this class can carry 8-12 passengers with transcontinental range and

cost $20 – 25 million depending options.

Mid-size Jet: Hawker’s 750 – 900 family of jets based on a common airframe offered a suite of

options in this segment. Jet’s in this class can hold 4 – 6 passengers, have an effective range of

approximately 2,200 nautical miles (e.g. San Francisco – Chicago/New York – Dallas) and cost

$13 – 17 million. According to the General Aviation Manufacturing Association (GAMA), the

Hawker 750 – 900 family had approximately 33% market share in 2008.

Light Jet: Hawker’s Premier/400 family of light jets targeted this segment and according to

GAMA accounted for 20% of 2008 deliveries. Planes in this class hold up to 4 passengers, have

an effective range of approximately 1,500 nautical miles and cost $5 – 8 million.

0

200

400

600

800

1000

1200

2000 2001 2002 2003 2004 2005 2006 2007

Aircraft Delivery Trends

Turbo Prop Biz Jets


Business Jet operations were hard-hit during the recession, particularly the Hawker 4000 which suffered

the cancellation of the NetJets order. Besides the cyclical decline normally associated with a recession,

the O’bama administration’s high profile criticism of corporate excess tended to make corporations

more reticent to use business jets, particularly after the public tongue-lashing the Big 3 auto executives

received when each admitted to flying a private jet to appear at a Congressional hearing. Also

contributing to the sales decline was a particularly acute fall-off in used aircraft prices which made the

implied economics of new aircraft investment exceptionally unattractive. Compounding the macro

challenges, it now appeared that Hawker’s financial condition was hurting its competitiveness as in 2011

the primary rivals of its 750-900 mid-jets—the Lear Jet 45/60 family and the Cessna Citation XLS—

experienced upticks in deliveries whereas Hawker lost its category dominance.

Hawker’s competitiveness in the light-jet market was also under considerable pressure. However there

the biggest issue appeared to be new entrants. Embraer had entered the segment with the very

competitively priced Phenom 300. And although it had experienced several delays, Honda was

scheduling 2013 deliveries for its heavily promoted HA-420 and reputedly had a 65 plane backlog. In

December 2010, Hawker decided to curtail production of the Hawker 400 until inventory became

aligned with demand. In December 2011 Hawker took the further step of suspending development of

the new Hawker 200 (that would replace the prior Premier series) citing a weak outlook for the light jet

market.

0

20

40

60

80

100

2006 2007 2008 2009 2010 2011

Hawker Business Jet Deliveries

Hawker 4000 Hawker 750 - 900 Hawker 400/Premier

0

20

40

60

80

100

2008 2009 2010 2011

Mid-Size Jet Delivery Trends

Lear 45/60 Hawker 750 - 900 Citation XLS

0

20

40

60

80

100

120

140

160

2008 2009 2010 2011

Light Jet Delivery Trends

Embraer Phenom 300 Citation CJ2/3 Hawker 400/Premier

430 441

309

238213

0

50

100

150

200

250

300

350

400

450

500

-

1,000.0

2,000.0

3,000.0

4,000.0

5,000.0

6,000.0

7,000.0

8,000.0

2007 2008 2009 2010 2011

D

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v

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r

i

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Business Jet Revenue & Backlog Trends

Total Deliveries Revenue Backlog


Propeller driven aircraft had always been the focus of the Beechcraft division. The core product group is

the King Air family of turboprops, which in 2008 controlled 42% of the passenger turboprop market.

Over its 25-year life, over 6,000 King Air’s had been sold, making it the largest selling business turboprop

in history. Beechcraft also manufactures and sells a variety of single and twin piston engine planes

primarily under the Bonanza brand. While Beechcraft’s deliveries had yet to rebound, in 2011 they were

relatively strong compared to the industry as a whole which experienced a 7.7% decline in turboprop

deliveries.

Bottomline, however, the business plane division was incurring massive losses even adjusting for non-

cash items such as asset impairment charges, that were flying Hawker into banrkuptcy

Trainer Aircraft—In 1995, Raytheon won a contract to provide pilot training aircraft to the U.S. Airforce

and Navy under the Joint Primary Aircraft Training System (JPATS). The contract was for the delivery of

approximately 800 aircraft, called the T-6, through 2018 and then service and support potentially

through 2050. The T-6 is a single-engine turboprop capable of flying 365 mph.

Almost immediately after the close of the LBO, serious production problems arose with the trainer due

to quality control issues associated with an essential vendor. These problems continued into 2008 but

Hawker was able to make some deliveries to the U.S. Air Force and to all of its foreign customers.

Deliveries spiked in 2009 as the supply issues were resolved.

0

20

40

60

80

100

120

140

160

180

200

2006 2007 2008 2009 2010 2011

Beechcraft Prop Delivery Trends

King Air Family Baron/Bonanza

(500.0)

(400.0)

(300.0)

(200.0)

(100.0)

0.0

100.0

200.0

0

500

1000

1500

2000

2500

3000

2005 2006 2007 2008 2009 2010 2011

O

p

e

r

I

n

c

.

Business Plane Rev & Adj* Oper Income

Oper Inc Revenue

**Adj to exclude impairment charges

0

62

25

36

109

80 82

0

20

40

60

80

100

120

0

200

400

600

800

1000

1200

2005 2006 2007 2008 2009 2010 2011

D

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Trainer Revenue & Backlog Trends

Trainer Aircraft deliveries Trainer/Attack Rev Trainer Backlog

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

-

20.0

40.0

60.0

80.0

100.0

2005 2006 2007 2008 2009 2010 2011

Trainer Operating Income Trends

Adj Operating Income Adj Operating Income %


In 2010, the U.S. Air Force began conducting final tests for a weaponized Light Air Support (LAS) air

plane that would be used primarily in Afghanistan by the Afghan military. Hawker developed a modified

version of the trainer, the AT-6, for consideration. The only other finalist was the “Super Tucano”

developed by Embraer. Embraer was a Brazilian aircraft manufacturer but said it would use U.S. based

Sierra Nevada Corp. as its prime contractor and build the planes in Jacksonville, FL almost entirely out of

U.S. supplied parts. In December 2011, a $355 million LAS contract was awarded to the Super Tucano.

Hawker immediately challenged the award in court and in February 2012 the Air Force withdrew the

contract with Sierra Nevada and agreed to re-evaluate the award decision.

Through 2011, approximately 600 T-6’s had been delivered under the JPATS contract and an additional

100 to other government’s including Canada, Greece and Israel. Trainer backlog at the end of 2011 was

down materially due to primarily to U.S. Defense department cutbacks.

Customer Support/Maintenance—With over 37,000 planes in service, Hawker has among the largest

installed fleets in the world, which it supports with the largest network of owned and/or authorized

service centers in the industry. Hawker has 11 owned service centers in the U.S., U.K. and Mexico and a

network of 95 authorized service centers in 27 countries which sell parts and provide regular

maintenance and upgrades.

The Support segment had been a strong and stable performer since the acquisition. Operating margins

had been significantly improved by a combination of tight expense control as well as expanded gross

margins on part sales. The modest revenue decline in 2009 was attributed to a customer deferrals of

certain maintenance processes that were subsequently completed in 2010.

-

20.0

40.0

60.0

80.0

100.0

120.0

200.0

250.0

300.0

350.0

400.0

450.0

500.0

550.0

600.0

2005 2006 2007 2008 2009 2010 2011

Customer Support SegementAdj Revenue and Oper Inc Trends

Adj Oper Inc Adj Customer Support Rev


2009 Financial Restructuring

In 2009, following a decline in profitability in 2008 coupled with the weak post-Lehman state of the

economy, investor’s were concerned about the Hawker’s viability. In the first quarter of 2009, Moody’s

Investors Service downgraded the rating of Hawker’s Senior Bonds from B2 to B3 with a negative

outlook. Prices of Hawker’s outstanding debt securities declined markedly.

Goldman Sachs, Hawker’s equity sponsor, recognized that these price declines represented a unique

opportunity to deleverage Hawker and save interest expense. Hawker had $531 million in cash at

December 31, 2008. During the first quarter of 2009, Hawker quietly entered the market and

repurchased $222 million face amount of its outstanding bonds for $41 million resulting in a recorded

gain, after various accounting adjustments, of $177 million. When these activities were reported at the

end of quarter, bond prices rose but Hawker continued its repurchases via a tender offer and retired an

additional $274.6 million for an aggregate cost of $96.1 million. Best of all, because in 2009 Hawker

recorded a pretax loss of over $500 million, it paid no tax on the approximately $300 million of

cancellation of indebtedness gain realized on these repurchases. Annual going-forward interest savings

were $44.5 million.

In the fourth quarter of 2009, Hawker was in default of various secured loan covenants. As part of the

resolution of these defaults, various covenants were adjusted and availability under the $400 million

revolver was reduced to $240 million. In addition, on November 25, 2009 the Term Loan lenders

extended a new $200 million Incremental Term Loan due at the March 26, 2014 maturity of the original

Term Loan. Compared to the LIBOR +200 b.p. pricing on the Term Loan, the Incremental Term Loan paid

LIBOR +850 b.p. and was issued with 6% original issue discount. Proceeds of the Incremental Term Loan

were used to pay-down the revolver. Arch, which by this time had accumulated over 25% of the Term

Loan, actively participated in the negotiations and took a pro-rata participation in the Incremental Term

Loan.

1H09 Debt Repurchase Activities

12/31/08 1Q Repuch 3/31/09 Tender 6/28/09

8.50% Sr Notes 400.0 (128.0) 272.0 (89.1) 182.9

8.875/9.625 PIK Sr Notes 400.0 (14.6) 385.4 (110.0) 275.4

9.75 Sr Sub Notes 300.0 (79.4) 220.6 (75.5) 145.1

1,100.0 (222.0) 878.0 (274.6) 603.4

Cash Spent (41.0) (96.1)

Avg Price 18.5% 35.0%

Gain Reported, Net 177.0 175.0


Emergency Cash Needs

During Miller’s initial update call with Hammer, he explained that for the last several quarters operating

losses combined with vendor concerns over Hawker’s viability had caused an increase in working capital

that had drained liquidity and now threatened to halt operations. At the beginning of 2011, Hawker had

$310 million in cash and all $240 million available on its working capital revolver. During the fourth

quarter Hawker fully drew down the revolver (then $190 million available) as a defensive maneuver

anticipating it would be in covenant default at year-end and wanted to maximize liquidity before the

facility was frozen.

As of March, Hawker was getting low on cash and needed additional capital immediately or it would be

unable to pay for essential components to keep production lines running. Miller realized that given the

high probability of a bankruptcy, prospective lenders at this point would prefer to lend the company

money after the formal filing of a bankruptcy petition so that the loan could be structured as a debtor-

in-possession facility (DIP) and receive preferred recovery status under Bankruptcy Code (BRC) §503.

Essentially, under BRC §503 any liability incurred by the debtor after the filing of the bankruptcy petition

is deemed an administrative expense and given a recovery priority over any pre-petition liability—unless

such liability was effectively elevated to the status of an administrative expense by the terms of §503

itself.

Miller and his legal team at Kirkland & Ellis recognized that there were two problems with trying

to raise capital for Hawker pursuant to a DIP. The first was timing. Strategically, Miller, who

had only been on the job for only five weeks, wanted to at least attempt to see if a voluntary

restructuring was feasible and avoid a Chapter 11 altogether. Hawker’s marketing group had

been adamant that its financial condition was making it difficult to sell planes now and it would

be impossible to make any sales if Hawker was in bankruptcy. Miller realized a voluntary deal

was a long shot given the complexity of the capital structure and the challenges facing Hawker,

but felt the upside in-terms of preserving Hawker’s brand image justified the effort. If the

consensual restructuring proved infeasible, then he felt it was imperative that when Hawker filed

for Chapter 11 to effect the restructuring that it do so on a pre-agreed basis with the support of

the major creditor constituencies so that Hawker could enter the process with a clear road-map

to the future so that employees, vendors and, most importantly, prospective customers would

believe in Hawker’s long-term viability. Miller said he needed at least 60 days to organize the

creditors, attempt to negotiate a voluntary deal and, failing that, prepare all the paperwork

needed for a pre-arranged Chapter 11.

The second issue was collateral. Even though BRC §503 provides for a priority recovery for

post-petition creditors over pre-petition unsecured creditors, it did not affect the preferential

position of existing secured creditors to their collateral. As part of the $1.7 billion secured

financing facility (i.e. Revolver, Term Loan & Incremental Term Loan), Hawker had ostensibly

granted the lenders broad liens on all of its tangible and intangible assets—basically the whole

company. The fact that the secured debt and senior unsecured notes were trading at 70 and 25,

respectively, implied that the market was concerned that the company might not be worth the

face amount of the secured debt and that there was likely little value for the unsecured creditors.


Accordingly, even with the priority of §503, no one would want to lend to Hawker on an

unsecured basis. And with the secured debt trading at a significant discount, it was very

unlikely Hawker could argue that the collateral could be “shared” with a new secured lender

without impairing the existing secured lenders.

Miller told Kirkland’s lawyers to start earning their exorbitant fees and come up with an angle.

Kirkland’s lead bankruptcy lawyer on the case called his partner in charge of aircraft

securitization to see if he had any ideas. As a matter of fact….he did. The perfection of security

interests in newly manufactured aircraft actually had some nuances that very seldom came up

in the financing context relative to the process of perfecting a security interest in existing aircraft.

In simple terms, Federal Law requires a lien filing (usually documented as a mortgage lien) with

the Federal Aviation Administration (FAA) to perfect a security interest in an aircraft—this is in

contrast to county (e.g. Sedgwick County, Kansas) level Uniform Commercial Code filings that

would typically be used to perfect work-in-process inventory during the manufacturing phase.

The general rationale for the FAA filing requirement is that a mobile plane is not associated with

a specific location and thus a prospective creditor would not know where to look for notice of a

prior lien if geographical filings were deemed sufficient. Under the terms of the secured loan,

the debtor was not required to file “lien documents” on completed aircraft for upto 180-days

following the receipt of an airworthiness certificate. The reason for this grace period,

presumably, was that once the aircraft was certified as airworthy, Hawker would immediately

want to deliver it to the customer so that a completion payment could be collected. The grace-

period avoided the expense of making mortgage filings that would immediately need to be

redone once the customer took possession.

However, during the downturn, Hawker had continued to manufacture aircraft, in particular the

Hawker 4000, even though it had no binding contract with an end customer. As of March 2012,

Hawker had 18 fully completed aircraft for which airworthiness certificates had been granted

and 31 additional aircraft that were fully assembled and capable of flight. To supplement its

UCC filings, in the ordinary course Hawker had made “N Registration” filings with the FAA when

each new plane was started, but such registration filings were not “lien” filings. None of these

completed aircraft were subject to Mortgage Lien filings with the FAA thus the Kirkland legal

team concluded that these assets could be pledged to a new lender who could properly perfect

its security interest.

The Kirkland team had found Miller the collateral he needed to raise new money. Hawker

needed at least $125 million to fund itself until it could complete a consensual restructuring or

prepare a pre-pack. Miller believed that the finished plane inventory might conservatively be

worth $600 million, providing significant over-collateralization for a prospective new loan with the

excess value being an unsecured asset of the company that would benefit the unsecured

bonds. Consistent with the market rumor Hammer had heard when he recommended

investment, it was subsequently disclosed that in 2010 an affiliate of GS and Onex had

purchased approximately $160 million face, or 35%, of the remaining senior notes. So not only

had Kirkland found Miller the collateral he needed to raise capital, they had also potentially

found a way for GS and Onex, whose original equity investment was clearly worthless, to

continue to participate in the restructuring process and potentially retain a stake in Hawker.


The Outlook for the Restructuring.

As Hammer left the Investment Committee meeting he tried to methodically start analyzing the

restructuring options, but soon recognized there were significantly more variables and

uncertainties than typically confronted a distressed investor. Arch’s decision to remain public on

the investment so that it could freely trade its position, meant that Hammer had only Hawker’s

public financials for his analysis. If Arch decided to move forward with the Rescue Loan, then

they would certainly demand to see non-public operating data and projections, but doing so

would cause Arch to become “restricted” and it would t not be able to either add-to or sell its

existing position. Before they made the decision to get restricted, Hammer would have to do his

best with the available information.

Usually the methodology for estimating the recoveries from a distressed investment was fairly

straight forward:

1. Estimate the value of the debtor at the end of the restructuring process.

2. Determine the size and waterfall priority of creditor claims, and compare this to the

estimated valuation to derive expected recoveries.

3. Consider the most appropriate capital structure for the reorganized debtor and how this

could impact the form of recovery.

Estimating the potential value of Hawker:

How was Hammer to value a business that was hemorrhaging cash, was potentially in the process of

badly damaging its brand, and had ongoing weakness in its primary markets? Hammer was also worried

about management. Miller was the king of turnarounds, but what about the team that got Hawker in

this mess—assuming Hawker survived, wouldn’t they still be there making the day-to-day decisions.

Hammer was also worried that Miller had been essentially hired by Goldman, whose economic stake

was it’s out of the money equity investment and the senior notes it had purchased at a discount in 2010.

To deliver any value to these investments might require Miller to take more risk—sometimes associated

with the baseball phrase “swing for the fences”—than a strategy that would attempt to maximize the

expected recovery to the secured debt.

Hammer decided that a sum-of-the-parts approach would be the best methodology to try and estimate

the value of Hawker’s various pieces.

Customer Support/Maintenance: Hammer decided to start with what seemed like the easiest piece

first. Hawker clearly had a large installed fleet of planes and no matter what else happened these would

continue to need periodic maintenance and spare parts. While the division was not completely immune

to cyclical swings, revenue contraction at the 2009 trough had been much less than in the

manufacturing divisions and the margins had also shown resilience. The strong revenue rebound in

2010 suggested that the 2009 slowdown was largely a short-term deferral of maintenance that

eventually had to be completed in 2010 and 2011. Since the 2007 LBO, margins had improved but were

probably as good as they were going to get. Hammer assumed that the business required minimal

capital expenditures itself, although it was unclear what was required on the manufacturing side to


continue to produce parts. In fact, this was among Hammer’s biggest concerns—what would happen to

the service business if there was a curtailment in the supply of parts?

Trainer Business: The Trainer business should theoretically also be stable, although its growth

prospects were clearly uncertain. Hammer knew there was a lot of “noise” in the numbers that made an

overly precise analysis impossible. Quality control issues with key vendors curtailed deliveries in both

2007 and 2008 followed by a surge in 2009. There had also been adjustments to most of the periods

primarily related to intangible write-offs and cost-of-completion accounting “catch-up” adjustments.

Hammer felt this was likely a 9-10% margin business, but there was significant uncertainty on the

revenue side. Approximately 75% of deliveries under the JPATS contract had been made. There had

been some success in marketing the plane to other countries, but the year-end back log figure was very

unsettling. Hammer did not know how to handicap the issue of the lost LAS attack aircraft contract. On

the one hand he felt that Hawker probably had more political clout than Embraer/Sierra Nevada

(although it was not lost on him that they had chosen Florida for their primary manufacturing facility);

but he was worried that the T-6 airframe might be at an inherent disadvantage compared to the Super

Tucano for applications that involved heavier weapons payloads and wondered how Hawker’s financial

circumstances might impact the ultimate decision.

Beechcraft Business: Within the business plane division, Hammer felt it should be feasible to separate

the Beechcraft prop operation from the Hawker Jet business. As the only separate information

disclosed about the two operations were deliveries, any estimate involved a tremendous amount of

Analysis of Support Segment 2005 2006 2007 2008 2009 2010 2011

Customer Support--Rev 579.5 551.0 535.0 522.8 438.3 544.6 562.2

Rev of Sold Fuel Line Biz--Est* (83.0) (83.0) (83.0) (48.5)

Adj Customer Support Rev 496.5 468.0 452.0 474.3 438.3 544.6 562.2

Rept'd Customer Support Op Inc 12.0 30.6 55.6 82.5 44.1 97.5 95.3

Adj for Inventory writedown 0 0 0 0 31.5 0 0

Adj Oper Inc 12.0 30.6 55.6 82.5 75.6 97.5 95.3

Rept'd Operating %/Total 2.1% 5.6% 10.4% 15.8% 10.1% 17.9% 17.0%

Rept'd Oper %/Adj Rev 2.4% 6.5% 12.3% 17.4% 10.1% 17.9% 17.0%

Adj Oper %/Adj Rev 2.4% 6.5% 12.3% 17.4% 17.2% 17.9% 17.0%

*Fuel supply business sold in 3Q08. 2005 & 2006 Revenue contribution estimated.

Trainer Data 2005 2006 2007 2008 2009 2010 2011

Trainer Aircraft deliveries 62 25 36 109 80 82

Trainer/Attack Rev 422.9 420.0 357.0 338.2 531.3 681.1 649.4

Reported Oper Inc 68.6 52.0 26.3 28.2 45.5 95.7 25.3

One-time adjustments 12.0 3.8 (2.9) (25.2) 66.0

Adj Oper Inc 68.6 52.0 38.3 32.0 42.6 70.5 91.3

Oper Inc % 16.2% 12.4% 10.7% 9.5% 8.0% 10.3% 14.1%

Trainer Backlog 809.0 1,112.0 625.2 359.4


guess work. Hammer knew selling prices and then assumed based on the Trainer business and due

diligence inquiries that the businesses should generate at least 10% operating margins. He felt this was

conservative and would effectively factor in some capital expenditure needs since planes constantly

needed updating. His diligence investigations had convinced him that there would always be a market

for the King Air turboprop and piston engines but it was obvious that volumes had declined materially

since the recession and had yet to show any signs of rebounding.

Hawker Jet Business: Although he recognized it was essentially an exercise in fiction, Hammer used the

same methodology on the Jet business. Looking at the data he smiled at how easy it was to make things

work on paper but difficult in practice—after all, from 2008 thru 2011 the actual reported cumulative

operating loss from Hawker’s Business Plane segment had been $1.7 billion. Given the state of the

disastrous launch of the Hawker 4000 and the recent decision to shut down light jet production,

Hammer wondered if the range of offerings could be permanently downsized. Was it necessary to have

offerings in multiple classes. Almost all the established competitors used this strategy. But Honda was

entering the light-jet business and they were only going to offer one plane (at least initially).

If there was a decision to discontinue some lines, what would be the shut down costs? The unfolding

Hawker 4000 disaster was not unprecedented. After Raytheon purchased Beech it invested in a

futuristic successor to the King Air called the Starship. It was an engineering marvel but was launched

just as the 1988 recession hit. Only 11 Starships were sold in the first three years. Production was

halted in 1995 with only 53 produced and Beech began aggressively swapping customers into new jets

so they could take the Starships out of service and scrap them—a process completed around 2003. An

uncomfortably similar 52 Hawker 4000s had been produced, what should they do? The light jet

segment had too large an installed base to attempt a decommissioning so Hawker would probably have

to continue supporting these planes. Could it do so profitably?

Beechcraft Data 2005 2006 2007 2008 2009 2010 2011

King Air Deliveries 142 157 178 155 114 107

Avg Price 5.75 5.75 5.75 5.75 5.75 5.75

Est Revenue 816.5 902.8 1023.5 891.3 655.5 615.3

Est Operating Inc OM%= 10% 81.7 90.3 102.4 89.1 65.6 61.5

Baron/Bonanza Deliveries 118 111 103 56 51 54

Avg Price 0.8 0.8 0.8 0.8 0.8 0.8

Est Revenue 94.4 88.8 82.4 44.8 40.8 43.2


Total Operating Income--Est 91.1 99.2 110.6 93.6 69.6 65.8


Analyze the Waterfall of Claims.

With the basic pieces of the valuation developed, Hammer next considered what claims would be made

against the estate and what the payment priority of these claims would be relative to the secured debt

claim Arch owned. Generally this analysis was usually fairly straight forward. As a secured creditor,

Arch would have a preferred claim for the lesser of the face amount of its claim or the value of its

collateral. However, since it appeared there were going to be challenges on the perfection of parts of

the collateral package, Hammer began to consider what would happen if the loan was deemed

undersecured. In general, an undersecured loan (i.e. collateral value < loan amount) was broken into

two parts: a secured claim up to the value of the collateral and an unsecured “deficiency” claim for the

amount of the claim in excess of the value of the collateral. The deficiency claim would be treated like a

general unsecured prepetition claim which would be pari passu in priority with the senior debt, general

unsecured creditor claims, pension obligations, etc. However, it would be junior to post-petition

administrative claims. In other words, every penny that Hawker incurred as an expense or liability after

filing the Chapter 11 petition would be senior to any pre-petition unsecured claim. Hammer shivered at

the thought of how horrifically Hawker’s operations were consuming cash even before the extra costs of

all the bankruptcy lawyers and other professionals started to be piled on. All this negative cash flow

would need to be financed by the DIP and effectively be senior to Arch’s potential deficiency claim.

Hammer reviewed the capital structure and started thinking about the implications of the subordinated

senior notes. Under the bankruptcy code, a subordinated note was a general unsecured claim for

purposes of determining classes. What made it unique was a contractual provision, which was specific

to each indenture, that generally provided that to the extent a subordinated note received any recovery

that it would “turn-over” the recovery to any “senior claims” until the senior claim was paid in full.

Hammer was pretty sure the standard provision would benefit the two senior bond issues, but he wasn’t

sure whether a deficiency claim would fall within the typical definition of a senior claim. He made a

note to have the lawyers look at the subordinated note indenture.

Hawker Data 2005 2006 2007 2008 2009 2010 2011

Hawker 4000 Deliveries 0 0 6 20 16 10

Avg Price 22.5 22.5 22.5 22.5 22.5 22.5

Est Revenue 0 0 135 450 360 225


Hawker 750-900 Deliveries 64 67 88 51 34 30

Avg Price 13.0 13.0 13.0 13.0 13.0 13.0

Est Revenue 832 871 1,144 663 442 390


Hawker 400 & Premier Deliveries 76 95 66 27 23 12

Avg Price 6.0 6.0 6.0 6.0 6.0 6.0

Est Revenue 456 570 396 162 138 72


Total Potential Operating Inc--Est 128.8 144.1 167.5 127.5 94.0 68.7


Hammer assumed the $125 million Rescue Loan would be made….by someone. If Arch made the loan

Hammer would insist that it be repaid from the proceeds of the DIP that was put in place after the

probable Chapter 11 filing. That way even if Arch participated in the DIP loan, the claim status of the

Rescue Loan would effectively be elevated to a post-petition claim with the same collateral.

The pension liability would also need careful analysis. As of December 31, 2011 the underfunded

amount was $493 million and growing. The treatment of this liability would depend on what strategy

Hawker took with respect to the existing collective bargaining agreement (CBA) it had with the IAMAW.

Like all executory contracts, Hawker had the option to reject the contract with the result that the

counter-party would be entitled to a pre-petition unsecured claim in the amount of its damages. The

problem was that BRC §1113 provided unions with many protections that effectively made it very

difficult to reject such contracts. Among other things, §1113 required “good-faith bargaining” which

was essentially code for “long and drawn out”. If Hawker made the effort it would still be up to the

bankruptcy Judge to make a determination that a successful restructuring was infeasible with the

existing CBA before allowing termination. Assuming Hawker needed to meaningfully downsize, rejecting

the CBA would probably be feasible, but pursuing the strategy could take at least a year and might

permanently damage Hawker’s business because it was very unlikely that there would be any new

aircraft sales during the bankruptcy. But the potential benefits of terminating the CBA were material.

First, in addition to lower wage costs and no efficiency stifling “work rules”, further liability under the

defined benefit plan would be assumed by the Pension Benefit Guarantee Corporation (PBGC). The

PBGC would have the right to assert the current underfunding as a claim, but it would have the status of

pre-petition unsecured claim. One downside from this scenario was that the PBGC claim would be pari

passu with whatever amount of the secured loan was characterized as a deficiency claim and thus

reduce recoveries. If Hawker viewed the potential injury to the business as to grave and did not reject

the CBA, then the CBA and the related pension underfunding would be assumed by Hawker going

forward and continue to be a loadstone for it to carry.

Hammer needed to run some numbers. He needed to finalize his valuation and then start figuring out

which of the many claims against Hawker would recover value. Repaying the DIP and any unpaid

administrative expenses would clearly get the first chunk of value. Given the way Hawker was burning

cash he would have to consider budgeting $300 - 500 million for these claims. Then what ever amount

of the pre-petition secured debt was deemed adequately collateralized would be next. But after that

there would really be a food-fight among all the unsecured claims and it was unclear how much if any

scraps there would be to fight over.


Consider the Form of Recovery:

Finally Hammer started thinking about the likely form of Arch’s recovery. Even if his computer told him

Arch was going to receive something, it almost certainly was not going to be cash. He remembered how

two years ago he had flippantly said that it would be great if they ended up “stealing” the equity away

from Goldman at a discount. Now that didn’t seem like quite the lay-up it had back then. In a

restructuring scenario there were usually only two ways to recover value: the debt of the debtor or

equity of the debtor. Given Hawker would need to project financial strength when it exited, it was

unlikely there would be more than a minimal amount of debt at the exit. Normally, Arch strove to

acquire the post-reorganization equity on the grounds that it usually had unusual optionality. However,

if Hawker ended up having to forgo dealing with its Unions in an effort to minimize its time in Chapter

11, or had enormous costs associated with shutting down certain operations how much business risk

would this add? If Hawker ended up filing again in a few years (euphemistically referred to as a Chapter

22), then the post-reorg equity received this time around would be worthless. And Hammer recognized

that if they did control the equity they would likely be subject to a lock-up agreement that would force

them to hold the equity for as long as three years in order to not limit the ability to utilize Hawker’s

$600 million and growing net operating loss carry-forwards.

Hawker Claim Summary*

Secured Debt

Revolver 240.0

75MM Synthetic LC 40.0

Term Loan 1,225.0

Incremental Term Loan 195.0

Total Sr. Secured 1,700.0

Unsecured Debt

8.50% Sr Notes 182.0

8.875 Sr Notes 303.0

Total Senior 485.0

9.75 Sr Sub Notes 145.0

Total Unsecured 630.0

Total Debt 2,330.0

Other Potential Claims

General Unsecured Claims

Pension Obligation

Administrative Expenses

Rescue Loan

Potential DIP Loan

*Amounts differ from actual to simplify.


Then Hammer had a thought. Maybe the best course for Hawker would be a partial break-up. Would it

make sense for Arch to consider negotiating to have its debt holdings essentially swapped for the service

business? Or maybe the Trainer business? Arch owned some other companies in the defense sector—

there wouldn’t be any potential for operating synergies but they had substantial experience with the

contract bidding process. In fact, maybe there was a path to a cash recovery if all of Hawker were sold.

Hammer had noticed that every one of Hawkers competitors was part of much larger conglomerates.

Perhaps there was just too much inherent cyclicality in the business aircraft market for stand-alone

players to be competitive.

It was now 11PM and Hammer was getting a headache. He was close to coming up with the numbers,

but he wasn’t sure he had any answers for Shapiro. Tomorrow’s investment committee meeting was

going to be a long one and the best he could hope for was to avoid a crash landing.

i Arch Capital and all discussion of its personnel, strategy, decision making process, and investment activity are completely fictional.

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