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Table of Contents
I. Overview of Distressed Securities II. Corporate Debt Pricing III. How to get Control of a Distressed Asset IV. Case Study - Samsonite V. Financial Model
Distressed Securities
The year of the vulture
The private equity firms that will thrive in the year ahead are those that know how to profit from others' misfortunes 2007 was a tale of two halves
The first was ebullient: nine out of the ten biggest leveraged buyouts ever, and Blackstone becoming a publicly traded company The second was one in which LBOs fell from almost 40% of the dollar value of deals through July to a single-digit market share May 15, 2008 Fortune Magazine
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While sound methodologically, the absolute 1,000 basis-point benchmark may not be appropriate in all market environments
Average credit risk spreads can fluctuate widely
A basis point (often denoted as bp, bps) is a unit that is equal to 1/100th
of a percentage point
As we will see later in the presentation, the market for distressed securities is less efficient than other markets, enabling skilled investors to earn superior risk-adjusted returns
A prominent dividing line is between BBB and BB. BBB and above is classified as investment grade, while BB and below is characterized as speculative grade and was, during the 1980s, labeled junk Fitch also provides rating of bonds
Rating agencies conduct a very thorough review of the companies that they rate. There are numerous considerations that are weighed, the most important of which is a companys cash flow
Basically, if a company is a cash cow, it is very likely to have a high credit rating. Rating companies look closely at the source of a companys cash flow as well as its variety, availability, and source Companies with high credit ratings have quick-turning, high quality accounts receivable, meaning that they are getting paid on time and getting all that they are due. Rating agencies also consider it important that a company have the ability to sustain their profitability Aside from cash flows, rating agencies scrutinize a companys management for their competence, structure, strategic planning, and composition. Other considerations include scrutiny of a companys appetite for risk and competition Rating agencies must always consider external factors such as the economic cycle but the fundamentals of the companies that they rate always get first consideration and have a far greater bearing on a companys overall rating
Nevertheless, rating agencies have increased their responsiveness to and consideration of the economic cycle in recent years given the large impact that the economic cycle has on many companies
Professional participants in the market could have significant information advantages Distressed securities market is often fairly illiquid, which means there can be very high transaction costs for individuals investing on a modest scale
Transaction costs increase the relative risks and make it very difficult to earn appropriate risk adjusted returns
Size of the average trading unit or block is so large that, except for the most wealthy, it is difficult to have an adequately diversified portfolio
Risk of this asset class is such that investing should generally be done on a diversified basis Bank debt and corporate bonds generally trade in blocks of $5mm and $1mm respectively. Though distressed securities may trade at significant discounts, this still implies that to own a diversified portfolio of approximately 15 companies could require a significant amount of capital
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Bonds
Rating downgrade(s) Sell-off in bonds Distressed bond investors start accumulating bonds
Bank Debt
Liquidity crunch and concerns or ability to make coupon/amortization payments Reduced borrowing base and availability Waivers or amendments
Internal Signals
Declining operating performance Management turnover Extensive and recurring restructuring charges/asset write downs
External Signals
Weak economy Industry cyclical downturn
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Table of Contents
I. Overview of Distressed Securities II. Corporate Debt Pricing III. How to Get Control of a Distressed Asset IV. Case Study Samsonite V. Financial Model
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Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuers ability to pay interest and principal as scheduled. Those issuers with a greater risk of defaultnot paying interest or principal in a timely manner are rated below investment grade
These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality
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More than one in 10 of the borrowers to which Moody's assigns ratings are treated as distressed by bond traders, the highest proportion since global defaults reached 10.5 percent in 2002
At that time, bondholders charged as much as 11.4 percentage points of extra yield to buy high-risk, high- yield debt rather than government bonds, double the current spread of 5.73 percentage points, according to Merrill Lynch & Co. indexes
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Further decline in bond price with stop at around 50 (estimated) dependent on size and condition of the shorts Bond price settles between 25-40 as mutual funds continue to exit credit and distressed buyers evaluate the opportunity Distressed buyers that started work on the credit early in the process dominate volume and may accumulate a control position OR The Company may report an improvement in operations and securities trend towards 75-90 takes 2 quarters of continued steady / improvement in operations
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Free fall Chapter 11 will lead to chaos and lack of disclosure pushing bonds to 15-25
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Table of Contents
I. Overview of Distressed Securities Valuation Overview II. Corporate Debt Pricing III. How to Get Control of a Distressed Asset IV. Case Study Samsonite V. Financial Model
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Current Situation
Companies are coming under increasing pressure from lenders at an earlier stage than before Banks have a large number of distressed credits in their loan portfolio The leveraged loan market has experienced a sharp contraction Banks no longer have patience with troubled companies
Less willing to extend waivers indefinitely Demanding more in fees and amendments
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In Court
Formal process of a Chapter 11 reorganization Chapter 7 liquidation
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Advantages and Disadvantages of In Court and Out-of Court for Distressed Investor
In Court Advantages
Can acquire assets free and clear of liabilities and encumbrances
In Court Disadvantages
Transaction costs associated with bankruptcy proceeding Potential for competing bidders and plans as part of the bankruptcy process Higher and Better offers
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Must get in early and exploit the situation before the credit is too distressed
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Exchange Offers
A more comprehensive approach could involve the combination of an exchange offer and new money investment Combines the restructuring of the old debt with a change of control Can often prove the most efficient method to gain control in the public forum
Accomplished relatively quickly Low transaction costs compared to bankruptcy Avoid large number of competing bids
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Chapter 11
Equity nearly always wiped out Intense pressure to sell the Company
Most restructuring advisors are bankruptcy or M&A specialists
High risk of change of management Lawyers control process with constant court appearances
Most restructuring advisors are bankruptcy or M&A specialists
Average time in Chapter 11 is over 12 months Extremely costly in fees with $3 mm to $10 mm in fees for lawyers and advisors in large assets
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Table of Contents
I. Overview of Distressed Securities II. Corporate Debt Pricing III. How to get Control of a Distressed Asset IV. Case Study Samsonite V. Financial Model
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Company Overview
Samsonite is the worlds largest designer and manufacturer and distributor of luggage products
Only global luggage brand Approximately 31% market share in Europe and 19% in US in 2002 Competed in a highly fragmented market against much smaller regional companies
Products marketed under Samsonite and American Tourister brands - 90% brand recognition in the U.S. and over 70% in Europe; 80% American Tourister brand recognition in U.S.
Expanded product line to include casual bags and computer cases
Europe market share 31% in 2002 CAGR of 11% growth in sales since 1996
Asia sales growing at CAGR of 19% from fiscal 1997 to 2002 US market share fell from 30% in 1996 to 17% in 1999 due to product and marketing, strategic decisions taken by management
Recovered to 18% in fiscal 2001 under new CEO
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Total obligations (debt and preferred stock) senior to the common stock have a face value of approximately $800 mm Existing preferred is increasing through PIK dividends at such a high rate that it grows by approximately $50 mm per year Onerous terms of the Existing Preferred Stock increasingly causing significant earnings dilution for common shareholders and could precipitate a Company-sponsored exchange offer or bankruptcy Overall leverage is too high
1. Lack of financial flexibility to mitigate potential shortfall in earnings performance 2. High risk/low probability of execution of Companys five year business pan and forecast without a de-leveraging event
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These issues have led to another significant decline in travel beginning in early 2003, which have impacted the Company beginning in February-March 2003
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Senior Debt
Approximately $60 mm of new revolver availability
Remaining $204.9 million of Existing Preferred Stock converted to common stock at $1.00 per share (equivalent number of shares to valuing at 41.9% of face and converting into common stock at $0.42 per share) Aggregate implied valuation of Existing Preferred Stock is $140.1 million
Common Stock
Proposal involves a conversion of the New Preferred Stock into common stock at a conversion price of $0.42 per share Common shareholders would initially own approximately 3.3% of the Company pro forma the proposed Recapitalization Transaction New investors have the right to elect five out of the nine Board Members
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Alternates to Recapitalization
Issues with status quo with new senior credit facility
Management issues Capital structure issues Refinancing difficulties of new facility
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Table of Contents
I. Overview of Distressed Securities II. Corporate Debt Pricing III. How to get Control of a Distressed Asset IV. Case Study Samsonite V. Financial Model
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Valuation Analysis
We did a valuation analysis to see how much would Samsonite common shareholders and preferred shareholders get in the current company without the recapitalization Comparable Company looked at other brands challenging to find appropriate comps to Samsonite Comps included apparel companies like Nike, Ralph Lauren as one group and luxury groups like Coach, Gucci and Waterford Comparable Transaction challenging to find appropriate comparable transactions also Antler was sold to an investor group etc Discounted Cash Flow Analysis - forecast free cash flow for 5 years, terminal multiple of 7.0x-8.0x and discount rate of approx 10%-14% We see that common shareholders get zero in most of the scenarios
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