INVESTING IN DISTRESSED SECURITIES
Post on 21-Jul-2016
Journal of Applied Corporate Finance S P R I N G 1 9 9 6 V O L U M E 9 . 1
Investing in Distressed Securities by Walter J. Bloomenthal,
BA Securities, Inc.
79JOURNAL OF APPLIED CORPORATE FINANCE
by Walter J. Bloomenthal,BA Securities, Inc.
79BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE
ways. It can be done in the workout areathat is, on the private side of the
information wallin which case banks may take advantage (legally) of the
nonpublic information available to them through their direct relationships with
issuers. Trading in bank loans on nonpublic information is legal because bank
loans are not securities (although recent increases in the liquidity of the
secondary loan market are rapidly making this distinction less important for all
but lawyers) and because the transaction is an over-the-counter, private
transaction between sophisticated financial institutions with full disclosure of all
Trading or investing in distressed assets can also be done on the public side
of the information wall, in which case investments can be made in all asset
classesnot only loans and trade claims, but notes, bonds, equities, warrants,
and options. To be permitted to engage in such public trading, however, traders
must have no access to nonpublic informationfor example, no communica-
tion with account officers or credit officers, and no access to credit files or
nonpublic offering circulars.
Banks, including Bank of America (BAC), engage in both types of distressed
debt investing through various holding company affiliates. In such cases, the
activities must be kept completely separate; for legal and regulatory purposes
they fall on different sides of the information wall. This article focuses on
distressed asset investing on the public side of the information wall. My aim in
the pages that follow is to comment on recent trends in distressed investing and,
in the process, to describe how we at BAC approach this business.
ommercial banks trade and invest in distressed assets primarily for
one reasonto earn high risk-adjusted returns. Distressed invest-
ing activity within banks is generally undertaken in one of two
80VOLUME 9 NUMBER 1 SPRING 1996
In March of 1995, BAC invested $19.4 millionin privately placed notes of a property securitycompany. We purchased slightly over 25% of theissue at a price just under 74% of the notes facevalue. Based on our previous experience in thisindustry, we saw what we took to be an under-valued situation as well as an opportunity toadd value through our own actions as a credi-tor (actions that I discuss later). Six monthsafter our initial investment, the company wasacquired, its debt was repaid in full, and wereceived full return of our investment as well asa $6.9 million profit (in the form of capitalappreciation and past due and accrued inter-est). The raw return on our investment was over35%, or about 70% on an annualized basis.
WHY THE HIGH EXPECTED RETURNS?
At BAC, our investments in distressed assets areconfined largely to debt claims. We define distressedassets as those claims trading at 95% of par or lowerprimarily because the issuer is experiencing somedegree of financial difficulty.
As mentioned above, the main attraction of thisbusiness for commercial banks is the potential toachieve superior risk-adjusted returns. Such returnsare likely to be available for two reasons: (1) thearbitrage opportunity created by the regulatory/accounting process, which in turn affects commer-cial banks decisions to hold or sell loans; and (2) thecomparative advantage of banks in analyzing andvaluing complicated debt claims.
Commercial banks are attracted to distressedassets in part because, unlike their standard businessof making new-issue loans, investing in distressed debthas upside potential. For example, bank loans tradingwell below face value have a reasonable chance toincrease in value, and thus the expected returns havea relatively normal, or two-tailed, distribution. Tradi-tional lending, by contrast, has a one-tailed distributionin the sense that the value of loans rarely increasesabove the issue price (par) and may decline signifi-cantly in response to negative information or a default.The only news that generally affects the value of atraditional loan is bad news; good news will not causethe price to increase much, if any, above par. In fact,because of the free option (the ability to prepay at anytime without penalty) built into almost all traditionalloans, good news is likely to cause the issuer tonegotiate a reduction in its interest spread or, at the veryleast, to prepay the loan.
Distressed asset investments are made at adiscount to par, and thus there is upside as well asdownside potential. In fact, because most of the badnews has probably already been disclosed (which iswhy the asset is distressed), there may well appearto be more potential upside than downside forinvestors in such deals. The size of the returnobviously depends on the price of the asset inrelation to its eventual value.
Of course, in a reasonably efficient market, theprice of a loan after the bad news is out should adjustso that new investors are promised only an adequate,or fair, rate of return on their investmentfair, thatis, for the level of the risk assumed. And in recentyears, the secondary market for distressed loans hasbecome somewhat more liquid and thus, presum-
ably, more efficient. But, at the same time, the levelof risk associated with distressed loans is likely to beconsiderably higher than the perceived risk ofhealthy loans, and the expected returns should becommensurately higher. (That is an important part ofthe definition of an efficient market.) And, as Idiscuss below, there are some reasons why commer-cial banks may have a comparative advantage bothin assessing and in managing such risks.
There are regulatory/accounting pressures oncommercial banks (and, to a lesser degree, insur-ance companies) that create opportunities for in-vestors to acquire distressed bank loans (and pri-vate placements) at attractive prices. Commercialbanking is, of course, a heavily regulated industry.And, when faced with the regulatory costs ofhaving large amounts of nonperforming or criti-cized loans, many banks find it preferable to sellthe loanseven at prices that reflect less than theexpected recovery. In fact, a quirk of regulatoryaccounting ensures that the only way for a bank toend regulatory scrutiny of a nonperforming loan isto sell it. For, even if a charge is taken against aloan and the loans value is written down, theremaining value (cost minus writedown) continuesto be classified as nonperforming.
Another reason banks often sell distressed assetsis lender fatigue in combination with the economics
81JOURNAL OF APPLIED CORPORATE FINANCE
of the workout process. In many cases, banks oftendecide it is not worth the cost of continuing the attemptto restructure a troubled loan, especially if the amountis relatively smallsay, less than $5 million.
Thus, as banks periodically come under pres-sure to clean up their balance sheets by reducingtheir levels of nonperforming and criticized assets,they have incentives to sell such assetsagain, atprices potentially below the present value of ex-pected interest and principal payments. In additionto this regulatory motive, U.S. tax laws encouragesuch sales by allowing banks to deduct their losseson such loans from ordinary operating income. Atthe same time, the buyers of such assets, whethercommercial banks or otherwise, will buy those assetssolely for economic reasons. And such buyers,including other commercial banks, will place theassets in a trading account. In contrast to bankregulatory accounting, assets carried in a tradingaccount are valued at market pricesthat is, thereare no nonperforming or criticized assets and noreserves to be held against them (that kind ofinformation about expected losses has already beenincorporated into the market price of the loans).
In sum, distressed assets are often sold by banksfor regulatory or accounting reasons and purchasedby investors for their economic value. And, becausethe regulatory stigma associated with nonperformingor criticized assets makes them worth less to theoriginating bank than an outside investor, there issome opportunity for arbitrage.
The Real Effects of Regulatory Accounting
In attempting to understand selling banks be-havior, it is also important to keep in mind thatregulatory accounting can have real effects. Thearbitrage opportunity in buying distressed debtstems not only from regulators and regulation, butalso from the ways in which the stock marketsevaluation of banks is affected by regulations andregulatory accounting. When regulators criticizeloans or classify them as nonperforming, thoseactions have the effect of reducing banks reportedearnings (by requiring higher levels of reserves) aswell as various credit performance ratios. Studies ofthe correlation between banks stock prices andreserve levels have shown that the market dislikesreserve levels that are either too high or too low. Theclear message here is that the market does not liketo be surprised!
The following scenario was played out repeat-edly during the early 90s: Bank ABC has set itsreserves at a certain level based on losses expectedin its credit portfolio, and has shared those expecta-tions with bank stock analysts. Enter the regulators,who in the name of conservatism classify a larger-than-expected percentage of ABCs loans asnonperforming (even though many of them may becurrent on their payments). As a consequence, ABCsquarterly earnings and credit performance ratiosdisappoint the analysts, and the banks stock pricedrops sharply. In response, the banks managementattempts as soon as possible to sell enough criticizedor nonperforming loans to get the portfolio back inline with expectations.
One might be tempted to blame the stockmarket for this seemingly shortsighted behavior bybanks. But the markets problem with underfunding(and overfunding) of reserves can be traced toinvestors lack of good information about bankassets. Commercial banks wholesale loan portfoliosare basically blind pools, which means that theidentity and value of individual assets that make upthe pool are not disclosed. And, since investorsunderstandably tend to discount asset values tocompensate for their own uncertainty, any surprisebrings home to them their informational disadvan-tageand the market reacts strongly and negatively.
Making matters worse for bankersand enlarg-ing the arbitrage opportunitywhen a Federal ReserveBoard regulator classifies as nonperforming a nationalloan held by an agent bank, it is automatically classi-fied at all of the banks in the bank group. Conse-quently, one sale by a bank will often lead to sales byseveral other members of the bank group. Thus,nonbank buyers of classified assets may have a poten-tial advantage over banks in that the classified des-ignation is of no consequence to such buyers.
We have also seen similar responses to regula-tory action by insurance companies, thus sometimescreating buying opportunities for distressed inves-tors in private placements. For example, our 35%return on the private placement issue mentionedearlier derived in part from our perception (whichturned out to be correct) that excessive regulatoryconcern by the NAIC had artificially depressed thevalue of the notes. As a general rule, however, theselling behavior of insurance companies is less drivenby regulation than that of commercial banks, and soopportunities for regulatory arbitrage in private place-ments have been fewer than in distressed bank loans.
The level of risk associated with distressed loans is likely to be considerably higherthan the perceived risk of healthy loans, and the expected returns should be
commensurately higher. And there are some reasons why commercial banks mayhave a comparative advantage both in assessing and in managing such risks.
82VOLUME 9 NUMBER 1 SPRING 1996
The regulatory arbitrage described above ap-plies only to bank loans and certain private place-ments. It does not apply to financial institutionsholdings of public bonds and equities, which areliquid, exchange-traded instruments that are gener-ally marked to market. If commercial banks have acomparative advantage in investing in distressedpublic bonds, that advantage can be expected tocome from bankers experience in assessing the risksof corporate debt claims and in analyzing the valueof a company in relation to its capital structure.
And, to the extent some banks do have anedge in valuing corporate debt of all kinds, thatcapability will come from three sources of humancapital that are consciously developed and culti-vated in large banks: (1) a large number of peopleand processes dedicated to determining whether ornot a company will be able to repay its debts (thecredit process); (2) a small, highly specializedgroup of people with a lot of experience withcomplicated out-of-court and Chapter 11 reorgani-zations (the workout or special asset area); and(3) a relatively small, moderately specialized groupof people with market knowledge and informationabout loans (the loan syndication/loan tradingarea). In some combination of people from thesethree disciplines lies the potential for a profitabledistressed trading/investing group. And if you addto the talents of these three groups the newlyacquired fixed-income research capabilities of manybanks Section 20 subs, you may have additionalsynergies for distressed investing.
Opportunities in Trading Distressed Debt,Public and Private
The relative advantage of banks over manynonbanks in analyzing and valuing distressed debtstems in large part from banks specialization in morecomplicated or smaller, typically unrated transac-tions. While rating agencies tend to concentrate onlarge companies whose long operating histories
have generated lots of publicly available informa-tion, banks are willing to lend to complicated andsmaller companies with little or no track record, inlarge part on the basis of expected future perfor-mance. Most bond rating agencies base as much as40% of their rating on a companys size, thusautomatically consigning even the most profitablesmaller firms (anything below about $200 million) tonon-investment-grade ratings. Banks have moretolerance for complexity and small size, and willaccordingly spend more time analyzing future cashflows, different capital structures, and various upsideand downside scenarios.
Banks take such pains because the relativescarcity of information about small companies gen-erally allows them to command higher yieldsor aliquidity premium, if you willwhen pricing theloans. Moreover, banks have ways of structuringtransactions to reduce their credit risk. For example,they routinely include various covenants in the loandocuments that increase their ability to monitor theloan and take action at the first sign of difficulty. Andthey often take collateral (whose value they are oftenable to readily assess and monitor), which increasesthe chance of a significant recovery in the event offinancial trouble.
In practice, every bank has its own view ofexpected losses in the event of defaultor, alterna-tively, of the percentage of the loans value thebank expects to recover if the borrower defaults.Banks expectations for recovery, moreover, oftendiffer greatly among individual transactions, basedon the parameters of a given deal and the banksexperience (and effectiveness) in working out badloans. While data on percentage recoveries is readilyavailable for bonds, such data is not generallyavailable for bank loans. Thus, banks greater abil-ity to assess recovery levels in a default situationmay represent an important comparative advantageover nonbanks in trading distressed bank loans.While this kind of expertise can be replicated tosome extent simply by hiring people from banks,the large and sophisticated (and expensive) infra-structure remains at the bank.1
1. There is a great deal of knowledge and experience that resides in acommercial bank. Much of it, moreover, is specific as opposed to generalknowledgethat is, the kind that cannot be reduced to a manual or transferred toothers with a computer program. It comes about from the credit process, as directedby the Chief Credit Officer and transmitted throughout the organization by thepolicies and actions of the Credit Policy Committee. While individuals may haveinformation or knowledge about certain individual transactions, it is the institution
that serves as the repository of the collective experience of its members. In thissense, the knowledge and experience of the institution is greater than the sum ofits parts. As just one example, commercial banks have a great deal of statisticalinformation about default rates, credit rating migration, and recoveries fromdefault. And, while individuals may possess some of this information, only theinstitution has access to the sum total of this kind of knowledge.
83JOURNAL OF APPLIED CORPORATE FINANCE
In general, then, the riskier a credit becomes,the more valuable is the kind of detailed creditanalysis performed by bankersespecially when setagainst the conventional rating analysis that reliesalmost entirely on public information and pastfinancial statements. At the point at which a loan orbond defaults, the public rating on that instrumentis probably of little value, and the information onwhich the rating is based is very likely to be stale. Forthis reason, bankers advantage in analyzing andvaluing smaller, more complicated transactions in-creases as the credits become more riskyandprobably reaches its peak when issuers default andconfusion reigns.
Opportunities in Trading Post-BankruptcyEquities
Because some distressed debt claims are satis-fied by the issuance of common or preferred stock,distressed asset groups will also, over time, gainexperience and information about equity invest-ments in distressed companies. And, to the extentsuch experience and knowledge is not widelyavailable in the broader market, there may beopportunities to invest profitably in such equities,particularly in those situations where the bankalready has a relationship.
Until recently, banks have typically sold anyequities they received in exchange for debt claims inbankruptcy, rather than holding in anticipation ofprice increases. Such sales have generally caused theprice of the equities to decline. And, because post-bankruptcy equities are initially not followed bymany equity analysts, the prices tend to remaindepressed for a time. In fact, these two factors seemto have worked together to create the followingpattern: The price of stock issued by post-bank-ruptcy companies, while declining shortly after thecompany emerges from Chapter 11, tends to riseover the next 12 months as the banks sell and thecompany begins to be followed by an increasingnumber of equity analysts. This patternwhich hasbeen observed by a number of investors (and hasbeen the subject of at least one article)2wouldappear to hold out a profitable trading opportunity.
Of course, once enough investors see thepattern and attempt to exploit it for gain, this kind
of trading rule tends to lose its effectiveness veryquickly. When that happens (and it likely alreadyhas), reliable opportunities for profit will becomerare. And, given that some percentage of thesefirms will wind up back in Chapter 11, investorsmust be highly selective in choosing among theequities of post-bankrupt companies. But it is insuch selective investingthat is, in being able todistinguish the eventual winners from the losersamong this group of firmsthat some banks arelikely to have an edge.
VALUING DISTRESSED SECURITIES
There are three basic methods of valuing acompany that are used by a distressed assetgroup, none of which are unfamiliar to commer-cial bankers or corporate finance specialists. Allthree methods have specific applications to indi-vidual situations.
One well-known method is to discount antici-pated net after-tax cash flows back to a net presentvalue (DCF) using an appropriately risk-adjusteddiscount rateone that reflects the issuers leverageratio as well as the risks of its business. The DCFmethod has long been the standard method forvaluing sub-investment grade loans, especially le-veraged or structured loansor at least those that arecurrently expected to meet their payments withoutmuch difficulty.
The DCF method, however, has one majorshortcoming: the valuation is only as good as theaccuracy of the assumed cash flows. Thus, if the cashflows used in the model are inaccurate, the valuationwill be wrong even though the model itself ismathematically correct. And this potential weaknessof DCF can be disastrous in cases of great uncer-tainty. For example, if you study those leveraged orhigh-yield transactions that failed (either defaultedor had to be significantly restructured), you will tendto find that the projected cash flows were excessivelyoptimistic, generally because volume or marginassumptions did not materialize.
For these reasons, DCF is much more likely tobe used for relatively less distressed situations andfor real estate transactionsboth cases in which theforecast of expected cash flows is likely to be fairlyreliable. Moreover, when banks do use DCF in more
2. See Herb Wagner, Mark Van De Voorde, Al Yoshimura, Luisa Longo, &Quinn Fanning, Post-Bankruptcy Equity Performance, Journal of Finance (1996).
Bankers advantage in analyzing and valuing smaller, more complicated transactionsincreases as the credits become more riskyand probably reaches its peak when
issuers default and confusion reigns.
84VOLUME 9 NUMBER 1 SPRING 1996
distressed situations, they will often use a DCFanalysis that is modified to compensate for the lackof complete information about cash flows. Such amodified DCF involves bankers setting their bestguess of gross levels of cash flow available (operat-ing income plus asset sales) against their scheduleddebt obligations, and evaluating the probability ofrepayment on that basis.
Another valuation methodin some waysmore useful in distressed investing than DCFisto examine other instruments of the issuing com-pany, or comparable instruments issued by simi-lar companies, and to determine how and atwhat levels they trade (in terms of price, mul-tiples, ratios, expected recoveries from default,and so forth). In some cases, this comparison ofsimilars method may turn out to be less precisethan DCF (because no two companies are ex-actly alike), but it has the distinct advantage ofbeing very market-driven. If the method ofcomparables is not used as the first or mainapproach, it will usually be used to validate thevalue obtained by using one of the other twomethods. It is also useful for getting an approxi-mate value when there is less than completeinformation about the instrument in question.
A third method is to value a companys assetsat hammer prices and then compare those assetvalues with debt levels. While this method does notnecessarily provide an accurate ongoing businessevaluation, it does give a useful estimate of liquida-tion value. This is not very different from thevaluation methods used for secured loans, espe-cially business credit loans secured by inventoryand receivables.
In riskier and highly distressed credits, esti-mates of liquidation values together with the methodof comparables tend to provide the most reliablebasis for investment decisions. The modified DCFdescribed earlier can be used to supplement andprovide additional insights. But if there is a largediscrepancy between the results obtained with thedifferent valuation methods, we immediately re-spond by re-examining the cash flow assumptionsused in the DCF model. Because of the confusionand uncertainty in the bankruptcy/workout pro-cess, it is usually difficult to project cash flows withany degree of confidence. And, as a general rule,the closer a credit comes to failure, the less reliableis the information on which DCF estimates arebased.
AN EXAMPLE (Continued)
In the case of the security company discussedearlier, we valued the distressed notes of thesecurity company using both the market com-parable method and a modified DCF (or fun-damental analysis) technique. We reviewedthe operating history of the company and cameto some conclusions about future operatingcash flows. We then viewed the potential cashflows in the context of the companys capitalstructure and debt levels, and decided that wehad found an investment with superior relativevalue.
For this reason, then, the valuation of distressedassets tends to rely most heavily on marketcomparables and liquidation values. And, as sug-gested earlier, large commercial banks are likely tohave developed the capabilities for this kind ofanalysis. Distressed asset groups operating in largebanks may be able to rely on their workout orbusiness credit groups to help provide reliableestimates of asset values in the event of liquidation.They can also draw on their loan syndication andhigh-yield bond trading groups for the marketinformation necessary for identifying and pricingcomparable transactions, as well as their own expe-rience in such markets.
ACTIVE VS. PASSIVE INVESTING
Besides determining which assets and assetclasses to invest in, investors in distressed assets mustdecide what role they wish to play, if any, ininfluencing the outcome of their investments. Activeinvesting typically means negotiating directly withthe issuer and with various creditor groups. Andalthough active investing generally provides higherreturns, it also requires larger investments to have ameaningful position and say in the negotiations.
Although this is an oversimplification, let mestart by suggesting that there are two basic ap-proaches to active investing in distressed securities.The first approach involves participating in, and insome cases even initiating, a restructuring of claimsthat increases the probability of repayment bystrengthening the viability of the issuer. In so doing,it has at least the potential to increase the value of allcreditors claims. The second approach, sometimes
85JOURNAL OF APPLIED CORPORATE FINANCE
associated with the name vulture investing, at-tempts to profit primarily by transferring value fromother creditorsthat is, by maximizing the value ofone creditor class at the expense of other classes. Forexample, some investors purchase large enoughpositions in distressed situations to block reorgani-zation plans approved by other creditors, and thenuse their blocking power to hold out for better termsthat come at the expense of other creditors. Inanother strategy commonly used in the early 90s,vultures purchased public subordinated debt inhighly leveraged transactions, and then used chargesof fraudulent conveyance to attempt to gain conces-sions by senior creditors.
In general, then, this second kind of distressedinvesting aims primarily to increase the investorsreturns at the expense of other creditorsand, insome cases, to the detriment of the debtor firm.Because of the negative publicity that comes withthis approach, commercial banks tend to avoid it.Vulture investors thus tend to be independent orunaffiliated advisors or agents (including mutualfunds) that use other investors funds. To the extentthey place a great deal of value on their relationshipswith their corporate clients, banks are usually reluc-tant to put themselves into a contentious position vis--vis any debtor corporation (unless, as discussedbelow, they are the original lenders and the debtorfiles Chapter 11). For, even if a bank did not have arelationship with the issuer of a distressed debtclaim, it might have a relationship with companies inthe same industry (or a member of the distressedfirms board of directors might be a senior executiveof an actual or prospective client).
Besides preserving their reputations as relation-ship bankers, commercial banks are also concernedabout how regulators and other banks would viewthem if they were to participate too aggressively ina bankruptcy or workout process in which they werean investor as opposed to an original lender. Bankstend to see each other time and again in differentworkout situations, and the value of maintaining areputation as a reasonable player also helps ensurethat a bank will not generally attempt to run orinfluence a workout solely for its own gain.
This is not to suggest, however, that banks donot act vigorously to protect their own interests,particularly when they are part of the original lendergroup and the debtor has filed for Chapter 11. As ageneral rule, banks are easier to deal with thanbondholders outside of Chapter 11 because banks
can generally amend a loan much more easily thanan indenture trustee can amend a bond. But, once adebtor files, the original banks may in fact be lesswilling than some bondholders to make any conces-sions because the banks carry the loan at cost andwant to be repaid in full. By contrast, owners ofbonds carry the securities at market, the bonds arerelatively liquid, and bondholders are generallymore apt to strike a deal at market prices.
For this reason, then, a distressed companyprobably has a better chance of striking a workabledeal in a bankruptcy situation with a group of banksthat are distressed investors than with either unaffili-ated vultures or the original lenders. As investors indistressed situations, banks will negotiate directlywith issuers and other investors provided it can bedone in a constructive, non-confrontational way.
AN EXAMPLE (Continued)
In the case of the security alarm companydescribed above, we were able to increase ourgain through active negotiation with the obligorand other parties in the workout process. Nego-tiations on our part allowed all the noteholdersto secure a $7.7 million make-whole payment(our share $2 million) that was destined forforgiveness prior to our involvement. Becausethe notes were fixed rate, there was an addi-tional source of value from the reductions ininterest rates that occurred after the issuer sus-pended payments but prior to our purchase.Although this may seem like a fairly obviousbargaining point, the negotiations that tookplace prior to our purchase had not focused onthis source of added valueperhaps because ofa highly fragmented creditor group that ourpresence helped to unite.
CONTROLS AND HEDGING
Once a distressed trading/investing group hasbeen formed, tactics and strategies have been de-veloped, and valuation methods have been deter-mined, it is also important to set portfolio guide-lines and limits. Traditional concentration limitsfor example, no more than 5-10% in any singletransaction, and no more than 10-20% in any oneasset group or industryshould be strictly en-forced. Management might also want to require
In riskier and highly distressed credits, estimates of liquidation values together withthe method of comparables tend to provide the most reliable basis for investment
decisions. The modified DCF described earlier can be used to supplement andprovide additional insights.
86VOLUME 9 NUMBER 1 SPRING 1996
that at least 50% of par fixed-rate assets be hedgedagainst interest rate risk.
In terms of asset classes, bank debt is generallyless liquid than securities (bonds and equities), butits value is also less volatile, and so less vulnerableto market movements. Because of its floating-ratenature, bank debt also generally doesnt have to behedged against interest rate risk. Bonds, by contrast,face interest rate risk that should be at least partiallyhedged (depending, as I discuss below, on thepurchase price and debt rating). Bonds are moreliquid and more volatile than bank debt, and they canbe easily purchased in smaller dollar amounts (lessthan $5MM). Public equities are usually very liquid,are also more volatile than bank debt, and can bepurchased directly or through the use of options.
I would not expect to see more than 10% ofequities in our distressed asset portfolio, and thepercentage of bonds should tend to average about50% to 60%. To the extent that hedges are called for,they can be accomplished with interest rate swaps ona portfolio or gap basis. As assets become moredistressed, however, their values become moretransaction-sensitive and less market or interest-rate sensitive. (And, thus, because co-variance analy-sis doesnt work very well, the standard market andinterest rate hedging techniques become less usefulin such cases.) For this reason, the rule of thumbwithin the industry is that any bond that trades at 85or lower probably does not need to be hedgedagainst interest-rate movements.
In sum, there is no specific portfolio model thatseems to work particularly well for distressed assets.Common sense (which plays a key role in managingthis business) suggests that the best policy is to avoidexcess concentration in any one area and to spreadinvestments among various industries, asset classes,price ranges, and maturities. Timing can also be animportant factor in the following sense: Distressedbonds often exhibit increased price volatility in thefourth quarter, as investors attempt to lock-in theirprofits for the year and fix their year-end balancesheets. Consequently, some investors will consciouslyreduce their bond portfolios prior to the fourthquarter, while other investors look for buying oppor-tunities on price dips.
COMPENSATION POLICY AS CONTROL
Besides guidelines and monitoring, anotherimportant source of control and accountability (as
well as motivation) in a distressed trading assetgroup is compensation policy. Since distressed assetinvesting is a transaction-oriented activity, with aprimary object of achieving attractive returns, thecompensation policy for the group can be especiallyimportant. The goals of any compensation policy fordistressed asset traders should be as follows: (1) toset the expected level of pay in such a way that it bothrewards superior performance and avoids turnoverof key people; and (2) to align the individualincentives of the traders as closely as possible withthe interests of the banks shareholders by makingthe actual level of pay vary as directly as possiblewith performance.
It is often easier for a bank to establish a specificcompensation plan for a distressed trading groupthan for other areas of the bank because distressedtrading operates largely independently of otherareas of the bank. Although most of the traders inBAC have been trained at Bank of Americaandthough we regularly draw on the banks store ofexperience in matters such as recovery rates andcurrent loan pricingthe main asset a commercialbank provides its distressed trading group is capital.And, because the revenues and expenses of adistressed trading operation can be readily identified(and its assets are regularly marked to market),measuring performance is fairly straightforward.
How does compensation function as a controldevice? Consider the hypothetical case of a dis-tressed trading group operating with a budget, butno well-defined compensation plan. Without such aplan, distressed asset traders are likely to allow theirinvestment decisions to be influenced by how thegroup is doing vis--vis budget. For example, if thegroup is well below budget, traders may chooseseveral high-risk investments in an effort to make upthe shortfall in a hurryand the result could well beexcessive risk-taking (also known as Alpha error).Alternatively, if the group is well above budget, thentraders are likely to be prone to the opposite errorexcessive conservatism, a failure to seize profitableopportunities (Beta error)because they dontshare in the upside.
To control both excessive and less-than-optimalrisk-taking, a logical compensation plan wouldsimply pay distressed asset traders a percentage oftheir operating income (net of cost to carry and anymarket adjustments). The percentages should bebased on a knowledge of the market compensa-tion for tradersand they should probably increase
87JOURNAL OF APPLIED CORPORATE FINANCE
with higher levels of operating income and return.Also, based on the market timing and price volatilitypattern just noted, a compensation plan based on aSeptember 30 year end would give the traders apotential advantage to make attractive investmentsduring the fourth quarter.
Another potentially useful feature of the plan isto defer payment of a portion (say, 20%) of theannual incentive bonus payment over a two- orthree-year period. By deferring part of the currentbonus and making payout depend on continuedemploymentand perhaps combining this featurewith options or co-investment by the tradersthecompensation plan would help give traders a longer-term perspective and reward them for consistency aswell as current levels of performance.
Commercial banks trade/invest in distressedassets in order to generate attractive risk-adjustedreturns. Superior returns are the result of the upsidepotential inherent in distressed assets, a regulatory/accounting arbitrage that exists for bank loans, andbanks comparative advantage in valuing compli-cated debt claims. The arbitrage exists becausebanks can eliminate nonperforming or criticizedassets by selling them to investors that are either notbanks and/or carry the assets in a trading account;in either case the nonperforming or criticized natureof the asset is no longer relevant.
Commercial banks ability to value distressedassets is based on three of the basic strengths of theirbusiness: (1) the credit process; (2) the workoutprocess; and (3) the syndication and loan tradingprocess. Although discounted cash flow (DCF) tech-niques are used in some instances, the most commonmethods used to analyze distressed asset invest-ments are asset liquidation valuation and marketprice comparisons of similar instruments.
Having chosen what securities or loans inwhich to invest, banks can pursue one or more ofthree basic approaches to monitoring and other-wise influencing investment outcomes. The first is
passive investingidentify potential bargains andsit back and watch. The second may be described asvalue-increasing active investingimprove the ef-ficiency with which the company is run, or at leastwork to reduce conflicts among creditors and inves-tors, so as to ensure that more is left over forcreditors (and shareholders) to divide at the end ofthe negotiating process. Third is value-transferring,or vulture investingusing inefficiencies in thebankruptcy law and reorganization process to en-large ones own slice of the pie at the expense ofother creditors and investors.
As original lenders, banks can be very difficultto negotiate with after a company files Chapter 11.Regulatory procedures and accounting, combinedwith the inefficiency of the Chapter 11 process, makebanks unlikely to accept any concessions that wouldweaken their security in such circumstances. Out-side of Chapter 11, however, or as investors indistressed securities (as opposed to original lend-ers), commercial banks interest in preserving theirreputations as relationship bankers tends to leadthem either to be passive investors or to play agenerally constructive role in reorganizations. As ageneral rulebut by no means, of course, in allcasesbankers tend to favor negotiations in whichall (or most) parties to the transaction benefit be-cause of their general relationship orientation.
As distressed asset investing continues toexpand at banks and other financial institutions,the growth will increasingly be in other assetclasses, such as equities, trade claims, and evenoptions. Once their track record in such invest-ing becomes established, banks will eventuallyseek funds from external investors to manage,either side-by-side with their own investments orindependently of them.
With more investors and capital moving intothe markets for distressed trading, the marketsthemselves can be expected to become more liquidand efficient. And such increases in liquidity andefficiency will ultimately mean an easier time forthose companies seeking to work out of financialdifficulty in the future.
is Senior Managing Director of BA Securities, Inc. and runsBASIs Distressed Asset Trading group.
Banks tend to see each other time and again in different workout situations, and thevalue of maintaining a reputation as a reasonable player also helps ensure that a
bank will not generally attempt to run or influence a workout solely for its own gain.
Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with ofces at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775, or e-mail: email@example.com.
Information For Subscribers For new orders, renewals, sample copy re-quests, claims, changes of address, and all other subscription correspon-dence, please contact the Customer Service Department at your nearest Blackwell ofce.
Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas $330, Rest of World 201; Commercial Company Pre-mium Rate, The Americas $440, Rest of World 268; Individual Rate, The Americas $95, Rest of World 70, 105; Students**, The Americas $50, Rest of World 28, 42.
*Includes print plus premium online access to the current and all available backles. Print and online-only rates are also available (see below).
Customers in Canada should add 7% GST or provide evidence of entitlement to exemption Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitle-ment to exemption
** Students must present a copy of their student ID card to receive this rate.
For more information about Blackwell Publishing journals, including online ac-cess information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our customer service department, tel: (800) 835-6770 or +44 1865 778315 (UK ofce).
Back Issues Back issues are available from the publisher at the current single- issue rate.
Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail-ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.
Journal of Applied Corporate Finance is available online through Synergy, Blackwells online journal service which allows you to: Browse tables of contents and abstracts from over 290 professional,
science, social science, and medical journals Create your own Personal Homepage from which you can access your
personal subscriptions, set up e-mail table of contents alerts and run saved searches
Perform detailed searches across our database of titles and save the search criteria for future use
Link to and from bibliographic databases such as ISI.Sign up for free today at http://www.blackwell-synergy.com.
Disclaimer The Publisher, Morgan Stanley, its afliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its afliates, and Editor, neither does the publication of advertisements con-stitute any endorsement by the Publisher, Morgan Stanley, its afliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal.
Morgan Stanley is a full service nancial services company active in the securi-ties, investment management and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal.
Copyright 2004 Morgan Stanley. All rights reserved. No part of this publi-cation may be reproduced, stored or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specic clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertis-ing or promotional purposes, for creating new collective works or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: firstname.lastname@example.org.