Whether it’s the tightening of the credit markets, a regulatory shift, margin erosion due to influx of competition, or structural changes such as in the retail industry as of late: there are plenty of reasons that get companies into deep water and create opportunities for distressed debt investing in Canada. The more difficult question is how to identify, evaluate and capitalize on companies in distress.
Indicators of financial distress
The most obvious indicator of financial distress, at least in the public markets, lies in market trading prices. A distressed company will typically trade at below $1 per share with bond prices discounted by 20 to 50% depending on the severity of the situation. Another clue is the deterioration in the credit rating of a company; however, rating agencies tend to be slow in adjusting a rating due to the company’s financial circumstances. It is also important to note that a given rating is essentially the rating agency’s best estimate of the probability of default but says nothing about the relative value of the security. Lastly, the computation of Edward Altman’s Z-Score, a combination of five weighted business ratios that is used to estimate the likelihood of financial distress, is instructive. A score of below 1.81 has been shown as highly predictive of bankruptcy as long as 2 years out.
Reasons for distress
Of course, the mere identification of distress is not sufficient to make an investment decision. Rather, the investor must evaluate whether the market mispriced the distressed company’s securities. Prior to jumping into valuation, it is crucial to understand the cause of distress to formulate an appropriate investment strategy. For example, if the distressed company sells an uncompetitive product or has unrealistic business plan, the likelihood of a successful restructuring decreases and the investor may only evaluate the opportunity from the perspective of liquidation. On the other hand, if the company is simply overleveraged and in need of a balance sheet restructuring but is otherwise healthy, a successful turnaround may be feasible and the investor can use its valuation skills and experience in the insolvency process to generate a return.
Valuation
With regards to relative valuation, the EV/EBITDA ratio as compared to similar companies in the industry is generally a good starting point, albeit with some adjustment. For example, when computing enterprise value, the market value of debt can be used instead of the book value, as the market value for comparable healthy companies generally equals book value. Another possibility is to use forward multiples discounted to the present, assuming a successful turnaround of the company. If the company’s EBITDA is negative, revenue multiples are a good alternative.
Intrinsic valuation is challenging as a discounted cash flow valuation (DCF) in a distressed situation often yields a negative equity value. Nevertheless, if the investor believes the company will successfully re-emerge from insolvency as going concern, a DCF is a crucial step to model through the restructuring process. Note that substantial adjustments have to be made in the model. Just to list a few, the working capital needs have to be propped up due disrupted supplier relationships. Sales, general & administrative expenses may decrease due to possible layoffs but increase due to key employee retention plans (KERP), often used in restructuring situations to keep the incumbent management team intact. The long-term reputational damage of bankruptcy has to be taken into account softening any future growth prospects. In addition, it is prudent to compute the liquidation value and its probability, as sometimes companies attempt but ultimately fail to restructure, as is the case of Sears Canada for example.
Evaluation of debt tranches
If the investor determines that the debt of the company is undervalued, the next step is to choose the appropriate level of the capital structure to invest in. It is crucial to understand the subordination and security of various debt instruments. Note that irrespective of whether debt is called “subordinated”, “junior” or “unsecured”, debt is only subordinated to another tranche or debt instrument if it says so explicitly in the trust indenture or other such governing document. Security on a loan is only uncontestable if the security was properly perfected. Lastly, understanding the corporate structure of the distressed company is crucial to identify any structural subordination, by which debt that is lower in the capital structure may trump debt in the parent company. Ultimately, the more confident the investor is in the company’s ability to repay all of its obligations upon conclusion of its diligence process, the more junior and discounted the target investment debt tranche can be to maximize value.
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