Will Distressed Debt Investments Boom by iht11609


									This article originally appeared in slightly different form in the February 13, 2008 issue of

Will Distressed Debt Investments
                                                                                                 Dr. Dennis Heuer
Dr. Dennis Heuer and Daniel Baierlein                                                                 Local Partner
White & Case LLP, Frankfurt

“Buy low - sell high”. Financial                       strongly exposed to the risk of
investors have shown again and                         insolvency. The relevant indicators
again how profitable this strategy                     will be lower ratings for these
can be. The main reason for this is                    borrowers, which can be observed
that successful financial investors                    even now in some cases although
have the ability to invest in assets                   the current general economic               Daniel Baierlein
with    a    potential     for  high                   situation is probably not (yet)                   Associate
appreciation at the right time.                        responsible for this. Another factor
                                                       is that bridging and restructuring
It is generally expected that in                       loans will no longer be available to
2008 distressed debt investors                         the same extent as the financial
could profit from the current                          crisis continues.
volatility on financial markets and
existing     business    conditions.                   The expected appreciation of
Lucrative and “bargain” asset                          portfolios of structured securities is,
classes could particularly be                          however, dependent on the
leverage loans, i.e. loans extended                    underlying       assets      of   these
to companies with a complex                            securities. The default rates for
equity structure and high leverage,                    securities based on US subprime
and some portfolios of structured                      loans for residences (residential
securities which have been given                       mortgage backed securities) have
much attention in the press since                      significantly increased, and market
August 2007.                                           observers believe that this trend
                                                       will continue. The write-offs of
The reason given for the expected                      several billions reported by the
downturn of certain leverage loans                     worldwide banking community to
is that the default rates of German                    date must, based on a cautious
and European borrowers, currently                      evaluation, be seen as indicators in
at a historically low point, could rise                this direction. The situation for
significantly as a result of the                       European residential mortgage
economic slowdown and ongoing                          backed securities in countries with
volatility on financial markets. In                    strong price increases over the
particular, borrowers with high                        past years, such as the United
borrowings and complex financing                       Kingdom or Spain, could also
structures consisting of short-term                    become        worse.      As    regards
loans subject to early violations of                   structured securities based on
covenants could be expected to                         European commercial mortgage
run into financial difficulties in this                backed securities as underlying
environment and would thus be                          assets, it is likely that some of the

WHITE & CASE LLP      FEB 2008                                                                                        1
Will Distressed Debt Investments Boom?

(deeply indebted) borrowers will run into            On 29 November 2007 an investment
payment difficulties as a result of facing           agreement was made between the Citadel
refinancing      problems.       The     same        investor group and E*Trade. Citadel
considerations apply to structured securities        purchased from E*Trade a securities portfolio
which are based on leverage loans extended           with a nominal value of three billion US dollar
to German or European companies. The                 containing collateralized debt obligations and
default rates for structured debt instruments        secondary       collateral  from      mortgage
based on other asset classes, such as car            investments on the US subprime market for a
loans or leasing, are currently not higher than      purchase price of 800 million US dollar (27 %
expected. As a result of the financial crisis        of the nominal amount). In addition, the
these debt instruments are, however, also            investors granted E*Trade capital in a total
under pressure and cannot be traded on the           amount of 1,75 billion US dollar in
secondary market or can only be traded at a          consideration of common stock and
discount.                                            unsecured bonds at an interest rate of
                                                     12.5%. Based on this agreement, the
It is likely that institutional investors, such as   investors will hold 19.9% of the common
banks and insurers, holding substantial              stock of E*Trade and will be given a seat on
investments in these critical asset classes          the supervisory board. Additionally, E*Trade
will think about divesting these positions so        has agreed not to take up further debt higher
as to reduce their market risks and,                 or equal ranking or to enter into any other
consequently, their potential write-offs. At the     transactions affecting the interests of the
same time, specialized distressed debt               bondholders. It was further agreed that the
investors are able to generate above-                new bonds will be served with priority after
average returns if attractive purchase prices        certain old bonds have been repaid and that
can be realized.                                     other old bonds will be subordinated. This
                                                     example shows how distressed debt
Before starting to buy leverage loans, a             investors can successfully implement a
commercial due diligence of the companies            purchase of a structured portfolio based on a
involved should be conducted to determine            combination of equity capital, debt capital
whether the prospects of the business of             and control through a seat on the board of
each of the borrowers are solid. A due               directors of the company.
diligence review of structured portfolios will
focus on what asset classes are included in          From a legal point of view it will have to be
the portfolio and whether a positive forecast        reviewed whether the restructuring strategies
can be made for the performance of the               pursued by distressed debt investors can be
portfolio.                                           implemented in the view of existing creditor
                                                     rights against the assets. If for instance a
An example for a spectacular deal is the             hedge fund is not only interested in making a
investment by the hedge fund Citadel                 quick profit, without implementing any
Investment Group and other investors in the          restructuring strategies, but intends to take
online bank E*Trade Financial Corp. E*Trade          an active or passive influence on the
ran into financial difficulties as a result of       restructuring process or to convert debt into
unfortunate investments made on the US               equity, the critical issue is whether the hedge
subprime market. Following a report of a             fund can, as a distressed debt investor, exert
Citigroup analyst last October who estimated         any influence on the restructuring process
a 15 % likelihood of insolvency, customers           based on the debt instruments or by taking
terminated their investments which further           accompanying measures or can block
aggravated the financial situation of the            measures in such process.

Will Distressed Debt Investments Boom?

In the context of frequently highly complex
capital structures it is crucial for distressed   Dr. Dennis Heuer is Local Partner in the Frankfurt office of
debt investors to understand the position and     White & Case. He specializes in structured finance,
rights of the holders of the debt instruments     securitization and distressed debt.
and their collateralization. For this purpose
the legal relationships between these             Daniel Baierlein is Associate in the Frankfurt office of White &
creditors will have to be reviewed on the         Case. He specializes in structured finance, securitization and
                                                  distressed debt.
basis of typically complex inter-creditor
agreements and financing documentations           The information in this article is for educational purposes only;
strongly influenced by the Anglo-Saxon legal      it should not be construed as legal advice.
system. It is therefore recommended to
conduct a review of the assets before starting
the actual restructuring work. This is already
standard practice when purchasing certain
subordinated positions and also appropriate
or even required for refinancing the
purchase. It therefore appears likely that
there will be a greater need for legal advice
in the interface between structured finance
and financial restructuring & insolvency in the


To top