By  on May 19, 2008

The distressed debt investors are starting to smell blood on the streets.

"Debt trading in some sectors is starting to look distressed," said one institutional trader, who noted that the bonds for one particular retailer are now trading at around 80 cents on the dollar. "Generally it would be considered distressed when the bonds start hitting around the 70s."

He said the easy lending of the past, the subprime debacle and the anticipation of more bad news to come are what's bringing distressed investing back to the forefront. "At some point, the writing will be on the wall. Maybe [retailers will] get through another Christmas," the trader said.

So exactly just how easy was it for companies to borrow money in the past few years?

"We witnessed an unprecedented period of lending, where lenders were willing to extend credit on terms far more liberal than before. Covenant-lite loans [those with few or no requirements], low fees and rates, payment-in-kind and toggle options and few or no collateral requirements defined a true 'borrower's market,'" said William R. Wagner, a financial restructuring partner at the Baker & McKenzie law firm.

Wagner said that, due to the subprime meltdown and subsequent general liquidity squeeze, "many companies that enjoyed borrowing at low rates and on liberal terms now face much less attractive refinancing alternatives, especially if they have liquidity issues of their own. Now they're coming to market looking for loans where banks are again demanding collateral and traditional covenant protection."

He noted that some of the overhang connected to the subprime debacle may not have hit the market yet, as corporate default rates are still relatively low and many investors believe the market still isn't at or even near the bottom.

With the era of easy money gone, some investors are eyeing distressed investing as the next phase, during which they can score some big bucks.

Often referred to as vulture investors, those that focus on the debt of distressed firms have been around for years. They emerged from obscurity during the junk bond era of the late Eighties, which created a slew of large retail bankruptcies burdened by an overload of debt.

Also known as the bottom-fishers of the investment community, their modus operandi is to buy at discount, in hopes of turning a quick profit should a piece of good news hike the price back up. Although most are speculators at heart, some provide financing to distressed firms and in turn take an equity position in hopes of future appreciation.

With so much money still floating around, don't expect the next group of vultures to behave in the same way as their predecessors.

Wagner noted there's been, and still is, a significant amount of fund-raising in the hedge fund community, some with the designated purpose of providing financing to, or making strategic investments in, troubled companies. What's potentially significant about the distressed investing side from the last bankruptcy wave in retail and apparel may be the type of players who trade and invest in bank debt. According to Wagner, many of these funds also have become the new lenders. Today's hedge funds aren't only well equipped to provide financing to companies in financial distress, they're also skillful in navigating the restructuring process.

So far 2008 has seen only a handful of bankruptcies: Friedman's Inc., Fortunoff, Lillian Vernon, Linens-N-Things and Sharper Image.

One fund manager in the retail and apparel sector said it could take another six to 12 months for both the remaining subprime overhang to work its way through the financial system and to see the impact of the Federal Reserve's attempt to navigate a soft landing. The fund manager isn't optimistic due to current weakness on the consumer side. "When the bankruptcy wave hits, I expect it'll be very bad for several years," the individual predicted.

In that scenario, there could be a lot of pain ahead.

Bankruptcies, should they become the mainstay of headline news, will no longer hang around in the court system for years and years. One example is general merchandiser McCrory Corp. McCrory filed for Chapter 11 bankruptcy court protection in February 1992, and operated stores under the nameplates McCrory, J.J. Newberry and S.H. Kress, to name a few. Its remaining assets after a six-year tour of bankruptcy court were finally sold in October 1997. Administrative creditors received 18 cents on the dollar, while unsecured creditors received nothing on their claims, which totaled $516 million.
Two major changes to the bankruptcy laws in 2005 impact how business bankruptcies are now handled by the courts.

"One change in the 2005 amendments impacting business bankruptcies concerns the time in which debtors have the exclusive right to file a plan of reorganization. Debtors still have the same initial 120-day period, but now it can only be extended, for cause, through 18 months from the filing of the Chapter 11 petition," said Joseph Samet, a partner specializing in bankruptcy at Baker & McKenzie.

Samet noted another change that impacts business debtors, which is the time to decide whether to assume or reject nonresidential real estate leases. "The debtor generally has 120 days but can obtain an extension for only another 90 days for cause. The total number of days, 210, is not supposed to be extended unless the landlord approves in writing," the attorney said.

The impact of the latter change means "retailers no longer have the luxury of two Christmas seasons to pick out which stores to close," said Bradley I. Dietz, managing director and co-head of the restructuring department at investment banking firm Peter J. Solomon Inc.

While investing firms may be anticipating the next big investment phase, Dietz is quick to note, "Not so fast."

The banker believes it's still too early to tell which way the wind will blow. "Two years ago attorneys started moving to different firms, and bankers are now on the move, some starting restructuring advisory businesses. However, there's still too much capacity in the market. It has been the [mantra] from the [restructuring] industry's lips to God's ears that it'll be the next six months, but they've been in that mode for the last two years," he said.

While Dietz does expect there will be some uptick in bankruptcy filings, he also believes apparel firms are less leveraged than in previous years. As for retailers and distressed firms in general, he observed that many of the companies entering bankruptcy proceedings are likely to be more highly leveraged than in the past, with assets "hocked to lenders so that there are fewer assets available for collateral when companies try to get new loans."
Peter J. Solomon, namesake of his eponymous banking firm, said that so far retailers are doing three things: evaluating store opening programs, figuring out how to weather the projected increase in the slowdown of consumer spending and determining how to get earnings per share growth, whether that includes using balance sheets to repurchase stock or make acquisitions.

For now, he too believes there might be a lull before anyone actually sees a wave of bankruptcy filings. "What's different between now and before are the covenant lites and the easy credit terms. The pressure is not from the financial players, the bond holders, but from vendors. As credit becomes constrained, it puts pressure on vendors to get paid. As vendors tighten up, that puts pressure on everybody," Solomon said.

As for the credit markets, who knows when that will ease up.

"There is no sense of when. Anyone who says they can tell you is a fool. No one has the foggiest idea," said Solomon, who advised that six months after the "last financial institution raises money via preferred stock" might be the time to take a look at the crystal ball.

Meanwhile, some deals are still getting done.

The ones that Allan Ellinger, of investment banking firm Marketing Management Group, sees being completed are smaller transactions where it can be easier to obtain financing.

And while many expect strategic players to have a bigger role on the mergers and acquisitions front than before, when it was a financial buyers' market, don't count anyone out yet.

Financial buyers are still sniffing around for deals. Last week, Windsong Brands, which earlier this year co-led a team of investors to buy Ellen Tracy from Liz Claiborne Inc., was part of a team of investors that included Hilco Consumer Capital, GB Brands and Crystal Capital that became the court-approved stalking horse bidder for certain assets of bankrupt Sharper Image.

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