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A growing asset class in difficult times

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  1. A growing asset class in difficult times LIUC April 2009 Investing in High Yield and Distressed Debt

  2. AGENDA • Basics of Credit Investing • Investing in HY and Distress • Strategies and Trading Technicals • Current situation • Appendix

  3. Basics of Credit Investing A Focus on High Yield Bonds and Leverage Loans

  4. Credit Investing • Lending to corporations • a direct private financing contract (loan) • underwriting newly issued corporate bonds • private placement vs. public offerings • Secondary market investing in corporate bond • Publicly listed debt vs. OTC transactions • Return on credit investments • periodic interest payments until maturity • in cash vs. payment-in-kind (PIK loans) • Repayment of the principal (end of the game) • entirely at maturity (bonds, bullet loans) • according to a scheduled amortization (most loans) • Capped return on the investment

  5. Example of a PIK The KDG Case • Euro 400m Floating Rate Senior PIK Notes due 2014 of Kabel Deutschland Holding GmbH & Co. KG, issued on December 2004 • Issue price: 99% • Book runners: GS and DB • “Interest will be payable of additional notes, or cash if we so elect…”  in case the company elects to pay-in-kind (PIK), all the cash will be received at maturity by the noteholders • “The Notes will be senior obligations of the Issuer and will rank equal with all existing and future debt of the Issuer” (as a matter of fact, the notes are structurally subordinated to the operating assets)” • “We might redeem all or part of the Notes on December 2005” – technically called Non-Call 1 • “If we experience a Change of Control, we will be required to offer to repurchase the Notes at 101%” “Structurally” subordinated to the operating assets

  6. Assets Traded Type of Assets Asset Characteristic Typical Investors Investor Characteristic Senior secured, 1st lien and 2nd lien bank debt, DIP facilities, bridge financings, mezzanine debt, LCDS Greater security, stricter covenants, more rights. Assets are generally less volatile Commercial banks, CLOs, credit funds, mezzanine funds Low threshold for losses. As investor base shifts from traditional investors to CLOs and general credit funds, level of workout expertise is decreasing Bank Debt Secured bonds, unsecured bonds, subordinated bonds, convertible bonds, CDS Commonly traded instruments with high market correlation. Typically little covenant protection and limited rights in a workout High yield funds, CDOs and credit funds Higher threshold for losses relative to bank debt investors. Low expertise in workouts. CDOs may be forced sellers in defaulted situations Bonds Trade claims, pension deficit claims, vendor notes, intercompany claims, litigation claims Less liquid. Often possible to create claims at discount to market. Often provides a different or unique angle Trade suppliers, unions, employee pension trustees, vendors, insolvency practitioners Generally unsophisticated, or unable to exercise full rights. Look for liquidity Trade Claims and Other Debt Public and private equity, impaired equity, post reorganisation equity, convertible preferred or preferred equity, options Public securities have highest volatility of all assets. Private situations or structured deals are low volatility. Potential for new money deals Equity funds, special situation funds, private equity, families, governments, other equity investors More sophisticated, particularly if private equity. Relationships remain key. Event driven or special situation funds focused on opportunistic investing Special Situation Equity 6 Only Distress / Special Situation funds

  7. High Yield Bonds and Leverage Loans High Yield (HY) Bonds Leverage Loans Contract form Arranged by banks and mostly syndicated to the market Maturity typically 6, 7 and 8 years (1° lien tranche A, B, C, or 2° lien) Spreads range from 200bps to 400bps Most of times underwritten in LBOs, as high yield bonds Security over assets Can be first lien or second lien on assets • Bond / note / other securities • Sub-investment grade - Junk (mostly B- through CCC rating) • Typically 7-10 year maturity • Yield at issuance  8%-12% (Libor + 500/700 bps) • Mostly issued in the context of a leverage buyout (LBO) executed by a private equity firm • Usually unsecured and subordinated

  8. Where Do High-Yield, Distress Bonds & Loans Sit in the Capital Structure? Senior Secured Loans: • private instrument / contract (typically negotiated by banks and then syndicated to the credit investors) • first priority in reimbursement in case of liquidation • rights typically protected by security over hard assets Senior Unsecured Bonds: • publicly listed instrument / note or bonds (typically underwritten by banks and then syndicated to the credit investors) Subordinated debt • subordinated to senior credit loans or bonds, but senior to equity, in reimbursement in case of liquidation • rights typically protected by a general guarantee of the issuer (no direct claim on the assets) CAPITAL STRUCTURE “WATERFALL” 8

  9. Credit Investing Risk-Reward Profile REWARD / IRR Indicative spreads to Risk-free rate: Alitalia 15%-25% Geox IT Holding Equities and Distressed Debt 4%-15% Seat TI 1%-4% Corporate Debt High Yield / Junk Enel Italy 0%-1% Corporate Debt Investment Grade US Risk-free rate Government Debt RISK [Risk can be defined as VAR, volatility, illiquidity, tail risk, gap risk,...] • High yield debt becomes distressed when it trades in the secondary market below 70-80% of face value • This is the main focus of today‘s lecture !

  10. Risk / Reward: Cutting To The Core Risk premium line REWARD / IRR Attractive Risk / Reward Unattractive Risk / Reward riskfree RISK

  11. Treasury Yield Curve

  12. Credit Spreads

  13. Default Rates Historical Max Previous peak points Long-term Avg

  14. Ratings & Default Rates

  15. Risk Event: Migration

  16. Default Rates vs. High Yield Spreads (US)

  17. Default Rate vs. Leveraged Loan Spread

  18. Estimated Recovery Rate

  19. Final Recovery Rate

  20. Recovery Rates (US)

  21. Default Rates & Recovery Rates

  22. Default Loss

  23. Corporate Credit Spreads’ Indexes • The latest release of the HY index is the Itraxx S9 Xover (maturity March 2013) • The Itraxx Europe index is a reference for investment grade companies The Itraxx Finl Sen and Sub represent senior and subordinated credit risk of financial institutions • Itraxx Generic represents a blend of the various series’ releases (indexes roll every 6 months into a new release with new constituents)

  24. Itraxx Generic Xover Index

  25. Liquid vs Illiquid Investments / Trades LIQUID ILLIQUID • Typically “forgotten” bonds or loans by brokers, small sized deals, whose syndication went to just a few market participants, or directly sourced investments (where there isn’t a standard process by which banks first underwrite the deals) • No market making by brokers • Trading might happen based on individual negotiations • Impossibility to “exit”, to “trade around”, etc • Typically only funds which have a lock-up period and who target a return premium for the illiquidity • Typically a bond or a loan which is traded by brokers • Bid / Ask spread ranging from 0.25% to 2% • Broker willing to trade a size of at least Euro 2mln to Euro 10mln • Many market participants focus on liquid investments due to: • mandate they have from their investors • Capability to “exit” • Lower gap risk • Capability to improve returns by “trading around positions”, hence benefitting from volatility 25

  26. The Extra Premium for Illiquidity Extra spread demanded by deals smaller than $500 million (proxy of definition of illiquidity) 26

  27. Credit Derivatives (CDS or LCDS) 27

  28. Importance of Derivatives for the Asset Class • Hedging • If you are “long” a single name credit risk, you can hedge the trade without going through the process of selling the underlying cash asset buying a CDS on that name • If you are “long” market credit risk, you may buy credit index protection to hedge the exposure to the market (i.e. Itraxx) • Capability to have additional liquidity in the market • Capability to deploy curve and basis trades • relative value • market neutral 28

  29. Invest in HY and Distress Evolving Asset Class by the Day 29

  30. Investing in HY is Cyclical 30

  31. The Difference Between a Trade and an Investment TRADE INVESTMENT • Medium-Long Term • Take a view on market/sector/company • Investment based mostly on analysis and macro view • Short Term • Potentially look at arbitrage opportunities • Trade based on trading technicals 31

  32. Investment Process Overview MANAGING POSITIONS IDEA GENERATION SCREENING ANALYSIS STRUCTURING • Identify investment opportunities internally and from other sources • Monitor “stressed credits”, industry sector trends, news and research reports • Monitor market trends and review deals in the credit and equity markets • Active dialogue with desks, investment management community, restructuring professionals, industry experts and other relationships • Maintain key relationships with funds, desks and professionals and industrial players • Identify the edge • Conduct full financial analysis, including valuation, debt capacity and liquidity analysis • Evaluate process risk by analysing legal issues, jurisdiction, capital structure, indentures, legal agreements, stakeholder interests, etc • talk to key players – management, existing investors, professional advisors, and interested investors and buyers • Conduct industry and sector analysis • Perform scenario analysis to determine upside/downside cases • Identify events and timing to events • Focus on capital preservation and low volatility • Identify opportunities with down side of debt and upside of equity • Assess and understand liquidity of the investment and exit • Review the entire capital structure to determine where to invest and identify intra capital structure plays • Determine opportunities to create / offer a new security • Understand which security has negotiating leverage, and assess stakeholder interests • Determine size, liquidity and overall fit with portfolio • Monitor all positions for news, data and events in real time • Mark positions monthly based on bid-ask market • Sell discipline focused on exit: sell when event happens; sell on price appreciation; sell if situation or event changes negatively • Talk continuously to key players and contacts to keep ahead of the information flow • Review all positions weekly • Revisit scenarios constantly • Advisory panel input during portfolio review process • Structure hedges 32

  33. Managing the Process (Special Situations) From identifying an opportunity to executing on it, we closely manage the process every step INITIAL ASSESSMENT REACHING AGREEMENT EXECUTION • Opportunity assessed against our investment criteria • Immediate feedback – we will only work on deals we believe we can execute • Experienced analyst allocated to complete financial analysis • Founding partners involved from the outset to make an assessment of the risk/reward dynamics • Information request provided focusing on the key facts we need to make an investment decision • Key commercial issues identified and put on the table • Meet and develop relationship with management • Initial terms proposed and negotiated • Flexible and pragmatic approach to other stakeholders • Ongoing honest feedback provided throughout • Upside/downside scenario analysis • Timeline to completion established • Experienced structuring team dedicated delivering the agreed deal • Creative deal structuring using both financial, legal and industry angles • Streamlined documentation requirements, borne out of years of experience of what is key in distressed and special situations • Founding Partners involved throughout – leveraging their relationships to bring other stakeholders on board 24/48 hours 2-5 days 5+ days 33

  34. Managing the Trade Distressed and special situations require early identification, efficient trading and quick, decisive decision making. For this reason, our founding partners are involved in every stage of the investment process to ensure we can take full advantage of the different stages of a company’s restructuring and turnaround Price (% of Par) Efficiently trade throughout the restructuring period, have the best information, look to create the trade in other ways Refine understanding of the investment rationale, build the position, drive the process 100 Constantly reassess investment rationale, valuation parameters, and trading flows throughout the restructuring process 75 Early identification of potential opportunities. Identify capital structure weak points and likely outcome of inter-creditor negotiations 50 Maximise value through recovery and turnaround phase 25 0 Time 34

  35. Risk return profile for an HY manager • Target return: 15%-20% IRR • 10%-15% volatility • Key risk measures: • DIV01 = change of the underlying security value to a change of 1bps in credit curve; also indicative of the duration of a security. • Example: For a bond with 5y duration, if the credit curve widens by 20bps, its value decreases by 1% (20bps * duration of 5). • Leverage • VAR

  36. Making an Investment Recommendation • Market screening • Building an investment idea • Sector analysis • Company analysis • Equity and credit comps • Assessing risk-reward profile • Degree of conviction • The investment recommendation

  37. Market Screening • Scouting for companies with traded debt securities • Take a look at sectors we deem to be attractive • Take a look at bonds/loans deeply discounted to par value • A HY investor restrict himself to names offering a potential levered return of at least Libor+600 bps • Brokers or research analysts might suggest ideas, companies and situations to look at • Who is focused on distressed looks at firms with an important credit event (imminently due or just past) • bankruptcy process, like Alitalia or Lehman Brothers • downgrades

  38. Market Screening: example #1

  39. Market Screening: example #2

  40. Building an Investment Idea • Choose the right sector • Choose a company with a very good management team in that sector • Pick cheap debt securities of that company in relative value terms

  41. (1) Sector Analysis • Most of our actual return on capital depends on the sector we invest in • A deep understanding of all the challenges faced by the companies in the sector are facing is then of paramount importance • e.g. raw material price increases, price pressure, intense competition,… • To gain an educated view on the company sector condition and outlook • look at the competitors/peers in terms of their operating and financial stats (sales growth, EBITDA margin, leverage, cashflow conversion, etc) • when a listed competitor / peer reports its quarterly numbers, we might find a lot of information from its reports and subsequent brokers’ analysis • In the current context (recession) we • favor sectors like utilities, telecom, healthcare, aerospace, niche technologies (“defensive” sectors, uncorrelated with economic cycles) • avoid retail, fashion and luxury, financials, automotive and related, airlines, consumer goods (“cyclical” sector, highly correlated with the economic environment)

  42. (2) Company Analysis • Review of • Financial accounts (annual reports, quarterly financials statements) • Sell side research (equity and credit analyst research) • Interviews to suppliers, customers, peers, etc. • Aim to gain a deep knowledge of: • firm’s business model and business plan • firm’s financial structure • firm’s traded debt securities or loans • The end product is an excel-based output, including a granular operating and financial model of the company

  43. (3) Equity and Credit Comps • Need to understand if the debt securities we are considering investing in are “cheap” or “expensive” - compared to the securities of other companies in the same sector or with similar leverage • Especially true if we are trying to deploy a relative value investment strategy to isolate the “ALFA” • One of the key features to make money over time is to invest in cheap securities • Often we find better investment opportunities (better risk/reward and better companies) in comps/peers we look at • By analyzing comps’ securities as well, we might find a better way to express our views by combining together various trades

  44. Equity and Credit Comps: Example #1 Selected equity automotive components trading multiples Looking at equity comps is the most immediate - and frequently the most effective - way to form a view on the Enterprise Value of our target company

  45. Example (yes / no) KAMPS: NO – too much leverage due to operating underperformance GROHE: YES – quite leveraged, but high potential for cost savings and plenty of liquidity

  46. Equity and Credit Comps: Example # 2

  47. Assessing Risk-Reward • To measure the risk/reward we need to look at the unit of reward we are getting for a unit of risk we are undertaking • One possible risk-reward measure can be spread / leverage turns • Example: • An investment in a senior secured loan purchased at discount (80-85 cents) where there is a likely event of refinancing in 1-2 years and an almost nil probability of default potentially represents a good risk/reward investment (low default risk of senior secured loans and 15-20% equity-like potential return over the investment horizon) A debt security which yields 1000bps over Euribor and “sits” at 5x EBITDA leverage, has a ratio of “spread per turn of leverage” equal to 200bps – the higher the ratio, the higher their are paying us for a unit of risk, where the proxy for the unit of risk is the EBITDA leverage

  48. Risk / Reward Moving Up and Down the Capital Structure Example Intra Capital Structure: Moving Lower – from Senior to Subordinated – Risk is More and More Rewarded with Extra Spreads Spread / Leverage (Sub Debt) Incremental Spread / Leverage per additional leverage to go from Senior to Sub Spread / Leverage (Senior Debt) A B C D A/C B/D (B-A) / (D-C)

  49. Degree of Conviction • The degree of conviction represents how comfortable we are in the numbers and in the judgment calls at the basis of our analysis • Having a high degree of conviction in high yield and distress investing is of paramount importance since • the loss can be huge • Exit may be difficult

  50. Degree of Conviction: Examples • Situations where we might have a high degree of conviction: • We have been studying the company for a long time and we have had the chance to verify that our financial model works well in terms of forecasting • We have a good relationship with the CEO or CFO of the target company and we feel we have a better understanding of their body language • We know the sector well because we have been investing in it for a long time • We have already invested in the company • Situations where we might NOT have a high degree of conviction: • It is the first time we are looking at the sector of our target company • We have little historical financial information on the target company • Earnings have historically proven to be very volatile • The sector is going through a transformational period