No. of Recommendations: 4
I recently wrote a review of Marty Whitman's Distressed Investing. I thought some members of the board would appreciate it...

The collapse of many of Wall Street’s longstanding icons during the recent credit crisis perhaps presaged a new era in global financial markets. While the implosion seemed instantaneous, with the value of publicly traded instruments dropping often by double-digit percentages in a single day, the meltdown was long in the making. Since shortly after World War II, nonfinancial U.S. corporate credit market debt has grown by 4.1% annually while GDP has only managed to grow by 2.7% over that period. This growth was facilitated by the cheaper capital found in ever-expanding credit markets. Companies’ election to leverage up balance sheets, deteriorating underwriting standards, and the creation of increasingly esoteric financial instruments would ultimately lead to a financial meltdown not witnessed the Great Depression. Surely, many fortunes were lost during this epic meltdown but perhaps equally as many were made. Distressed investors have frequented the financial news, often with reports of their enormous, unprecedented compensation packages exceeding one billion dollars annually.
“Very little in distress investing lends itself to certainty…rather, the investor always deals in probabilities,” writes seminal value investor Marty Whitman in his recently published book Distress Investing. Whitman, the Chairman of Third Avenue Management, has made a fortune investing in distressed markets, and his thoughtful work reflects his extensive experience. “The theme of this book is that Chapter 11 bankruptcy is not the end of the game but the beginning of the game,” writes Whitman. A Chapter 11 filing is viewed as a worst-case scenario and any resolution of a distressed resolution, either in or out of court, will be influenced by Chapter 11’s rules.
Companies become distressed when they are not expected to be able to meet current or future financial obligations, which can take the form of interest or principal repayments, refinancings, or insurance or tort claims, among others. This typically occurs when companies have no or limited access to capital markets, the value of the company’s assets is materially impaired, or the company’s liabilities increase dramatically. The reason behind a company’s filing for bankruptcy has bearing on a distressed investor. Companies that are operationally strong albeit poorly capitalized are sound reorganization candidates.
Whitman devotes significant text to the deal expenses involved in a reorganization as “uncontrolled professional costs can materially detract from unsecured creditor recoveries and in extreme cases might detract from the feasibility of the debtor as a going concern.” His research concludes that the duration of a case is a primary determinant to the total amount of expenses and fees paid out of the bankruptcy estate. Notably, the 2005 bankruptcy amendments put a ceiling on the amount of time a debtor has to propose a plan of reorganization, and preliminary research of cases filed after the amendments show that the cases are in fact of shorter duration. The book is packed with research on this subject, including hourly rates for different professionals in different Chapter 11 cases, retention summaries for financial advisors where there is a monthly fee involved, bonus potential for financial professionals, and the average and median duration of Chapter 11 cases.
Distress investing turns on happens after a money default occurs. Creditors will either be reinstated, participate in a reorganization, receiving a bundle of securities to satisfy their claims, or suffer complete loss. Whitman stresses five basic truths of distressed investing: a corporate creditor’s right to a money payment cannot be taken away outside of a court proceeding; all reorganizations are influenced by Chapter 11 rules; securities enjoy substantive characteristics which afford their holder certain legal and contractual rights; restructurings involve significant costs; and creditors have contractual, not residual or “ownership” rights.
The book details the costs and benefits of traditional Chapter 11 against both prepackaged filings and voluntary exchanges. Invoking game theory, the author spends a chapter discussing why the latter usually fail, due to the classic “holdout” situation where certain creditors do not tender their instruments as they anticipate becoming credit enhanced in the event of a successful exchange in which they do not participate.
One of the book’s strongest attributes is its overview of Chapter 11, including the changes wrought by the 2005 amendments. Whitman discusses in great detail the parties involved and their varying interests, including the concepts of forum shopping, asset sales, executory contracts, avoidance powers, priority and nonpriority claims, subordination agreements, debtor-in-possession financing, the exclusivity period, plan acceptance and confirmation, the best interests test, cramdown, and critical vendor payments, among other topics. The book’s discussion of nonresidential real estate leases is one compelling example of the text’s valuable, up-to-date content. Unlike law before the amendments, debtor’s now have 210 days to assume nonresidential real property unexpired leases. The debtor can assume or assign those leases that are beneficial to the estate while rejecting those which are not. Damages for rejecting these leases are limited to the greater of one year’s rent or 15% of the remainder of the lease, up to a maximum of three year’s rent. The value of such leases is elucidated in one of the book’s case students, where the author notes Kmart elected to assign below-market leases for a payment of $50 million, ultimately inuring to the benefit of the company’s creditors. The Kmart cases study was one of two in the book, and provided a valuable glimpse into the real-world execution of distress investing.
Importantly, the book highlights the disparate needs of parties involved in Chapter 11 cases. Upon filing, because management continues to run the business under court supervision, Whitman is wary of management who have often used their exclusivity period to exert substantial control over the reorganization process, including efforts designed to protect their own interests. Secured creditors, such as banks, accordingly, are mindful of their own interests, which is usually a preference for cash, while trade vendors are usually overly concerned with the feasibility of the debtor as a going concern in order to keep their own often financially dependent business solvent. Similarly, control and non-control investors have divergent relationships with the debtor as the former strive to make the company feasible while the latter are concerned strictly with the market prices of the securities they hold.
The behavior of these creditors is ultimately dependent on current or prospective value of the credit instruments they hold. Several valuation methodologies are discussed, including cash flow based, comparable company analysis, and liquidation value. Issues such as depreciation, capital expenditures, GAAP treatment of restructuring and asset impairment charges, net operating losses and interest and rent expenses are discussed. While synthesizing the information included in these areas requires the reader have a preexisting basic understanding of them, their discussion was lucid enough to provide the reader a starting point from which he or she could research further.
Warren Buffett’s “Rule Number One” is “don’t lose money” and the author heeds this timeless advice given his significant discussion of risks attending distressed investing. Discussing the risk associated with in-depth legal and financial concepts such as equitable subordination, substantive consolidation, intercorporate credit support, critical vendor payments, security interest imperfections, collateral valuation, and cram down, this section of text merited several reads which was well worth the effort. These risks were discussed in the impact they would have on various holders of securities instruments and how courts have treated these issues in the past.
Distress Investing deserves a place on any serious investor’s bookshelf. Whitman astutely points out in the preface “understanding distress investing is extremely helpful to analysts deciding to focus on common stock value investing…it is essential when investing in common stocks to learn to benefit from the use of disclosure documents, to understand capitalizations, and to appreciate that fact that…common stocks can have little value regardless of price if they are issued by companies that are not creditworthy.” Mark Twain once said “The past does not repeat itself but it rhymes.” In the past few years, the global financial markets have witnessed continuous shocks resulting in the significant deterioration of asset values, and to believe such will not happen again is perhaps an irrational conviction not rooted in history or logic. With a fundamental understanding of the basic principles enumerated in this book, any investor will be better equipped to handle the inevitable turbulent markets of the future.
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