The Financially Distressed and Bankrupt Security Investing Process

Investors in financially distressed and bankrupt securities must concentrate on the corporate balance sheet. Like knowing the opposing lineups at a baseball game, understanding the amounts and priorities of a company's liabilities can tell investors a great deal not only about how the various security holders are likely to be treated but also how the financial distress is likely to be resolved.

The first step is to value the assets of the debtor. Once the size of the pie is known, it is possible to consider how it may be divided. To facilitate this process, an investor must divide the debtor's assets into two parts: the assets of the ongoing business; and the assets available for distribution to creditors upon reorganization, such as excess cash, assets held for sale, and investment securities. Investors in AM International, Inc., senior claims received substantial amounts of AM's excess cash upon reorganization; investors in Braniff Airlines' first bankruptcy in 1983 received liquidating trust certificates backed by a direct interest in aircraft assets.

In valuing an ongoing business operating in Chapter 11, investors should employ each of the valuation methodologies described in chapter 8. In many instances the investor is in the difficult position of analyzing a moving target since the business of the debtor is unstable, if not in turmoil. It is essential that investors take into account any income statement and cash flow distortions caused by the Chapter 11 process itself. Interest earned on excess cash that builds up during bankruptcy, for example, will not be a source of income for the reorganized company. Similarly, interest expense on reinstated debt, which does not accrue during bankruptcy, will once again accrue. Then, again, the high investment banking, legal, and administrative costs of a Chapter 11 proceeding, often cumulatively totaling several percent or more of the value of the debtor's estate, will cease upon emergence from bankruptcy. Bankrupt companies may even intentionally "uglify" their financial statements (for example, by expensing rather than capitalizing certain expenses or by building excessive balance sheet reserves) in order to minimize the assets apparently available for distribution to creditors. This value is ultimately revealed after reorganization, but by then insiders have picked up cheap stock or options.

Analysis of the assets and liabilities of financially distressed or bankrupt companies must extend beyond the balance sheet however. Off-balance-sheet assets may include real estate carried below current value, an overfunded pension plan, patents owned, and the like. Off-balance-sheet liabilities may include underfunded pension plans, Internal Revenue Service, Environmental Protection Agency, Pension Benefit Guaranty Corporation (PBGC), and other governmental claims, and claims resulting from rejected executory contracts and leases. In recent steel industry bankruptcies, for example, Wheeling Pittsburgh Steel and LTV Corporation transferred their underfunded pension plans to the PBGC, resulting in a bankruptcy claim by the PBGC against Wheeling and protracted litigation between the PBGC and LTV.

Once a debtor's assets have been valued, investors should turn their attention to the liability side of the balance sheet. The liabilities of a bankrupt company are best evaluated in descending order of seniority. Secured debt should be evaluated first. If the value of the security interest is determined, whether through negotiation or a valuation proceeding, to be equal to or greater than the amount of claim, the claim is said to be fully secured or oversecured. An oversecured claim entitles the holder to postpetition accrued interest (interest that would have accrued during the bankruptcy proceeding) to the extent of the amount of oversecurity. If secured debt is determined to be less than fully secured, holders will typically receive value equal to the extent of their security plus a senior but unsecured claim against the debtor for the amount of the undersecurity.

There may be some investment opportunities in distressed securities at every rank in the debt hierarchy. Risk-averse investors will generally prefer to hold senior securities; the potential return from senior securities is frequently less than that available from junior claims, but the risk is also much lower. Senior securities are first in priority, and unless they are fully or almost fully repaid, junior classes are unlikely to receive significant value.

"Fulcrum securities"—the class of securities partly but not fully covered by asset value—can also be attractive investments at the right price, ranking midway on the risk spectrum. Fulcrum securities benefit most directly from value increases and likewise are most directly impaired by any value diminution.

Investing in junior securities can provide spectacular returns but can also prove disastrous. These securities often serve as out-of-the-money options—effectively, bets—on an improvement in operating results or an increase in value.

The common stock of bankrupt companies frequently trades considerably above its reorganization value, which is often close to zero. While there may be an occasional home run, as a rule investors should avoid the common stock of bankrupt entities at virtually any price; the risks are great and the returns very uncertain. Unsophisticated investors have lost a great deal of money buying the overpriced common stock of bankrupt companies, even after the unfavorable terms of the reorganization plan have been widely disseminated.

It is worth remembering that restructurings and bankruptcy reorganizations are negotiated processes. Negotiations can be affected by the relative bargaining strengths and weaknesses of the different classes of creditors, the skills of the negotiators, and the dollar amounts at stake.

By way of example, Ron Labow headed an investor group that bought up most of Wheeling Pittsburgh Steel's bank debt and dictated a reorganization plan that left him in control of the reorganized company. A blocking position—one-third of the outstanding amount of debt—in a small, closely held debt issue may enable that class to obtain better treatment than similar but more widely held debt issues. The holder of a blocking position in even the most junior bankrupt security, because of his or her ability to delay the debtor's emergence from bankruptcy, may gain far better treatment for his or her class than allowed by any allocation made strictly according to priority ranking. A blocking position is said to have "hold-up" value in two senses: the owner can hold up (delay) the bankruptcy process as well as hold up (rob) other classes of creditors, extracting nuisance value from what might otherwise be a nearly worthless claim.

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

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