I Want to Learn About Distressed Debt Investing
I'm interested in learning about distressed corporate debt investing (like what Howard Marks does at Oaktree Capital).
Can anybody direct me to any resources that go over the process in identifying, analyzing, purchasing and profiting from such investments?
Distressed Debt Investing (Real Estate) (Originally Posted: 09/19/2015)
Using debt to invest in real estate has evolved over the last 30 years, and significantly changed after the subprime mortgage crisis, when more stringent regulations were introduced into the system. Looking back at different WSO Real Estate topics, there are a lot of posts regarding financing, debt strategy teams, functions, other general questions. I thought it would be helpful to share my perspective on distressed debt and open it up for others that probably know more about it than I do.
Distressed debt investing is basically filling a gap in the capital structure, typically in a time-sensitive environment. The reasons for this can vary, but the simplest example would be a loan maturation, where ownership is unable to do a standard refinancing. It gets significantly more complicated at a portfolio/company level, so I detailed out a single-asset investment example below.
Our friend Gob buys an Orange County office building for $20 million in 2007 and obtains a 70% LTV financing from Banana Stand Bank (BSB), interest only, for 5 years. In 2012, the $14 million note is due but thanks to increased vacancy and arson in the area, the office building is only worth $15 million now. He’s made a huge mistake.
The proposed refinancing from BSB is capped at 60% LTV of the new value, or $9 million, meaning he would need another $5 million to pay the original loan maturing. This is the gap in the capital structure we’ll need to fill.
One option is that Gob could sell the property for $15 million, pay back BSB the $14 million he owes, and take a $5 million loss on his equity. No Bueno. This equates into thousands of tricks turned by Franklin, or even more trips to people’s cars.
There are a few options to fill the gap between the loan coming due ($14 MM) and the offered refinancing ($9 MM), ranging from equity (riskiest) to an A/B note (least risky)
Equity: A capital contribution to the borrower (Gob) in exchange for an equity share in the borrowing entity, which could be a single-purchase-entity (referred to as a SPE) or part a larger company. Because this is the “riskiest” type of capital provided, the returns (IRR) should reflect that being higher. The upside for equity is effectively unlimited, because one would participate in all future appreciation. The equity also receives excess cash flow after paying the debt service. In our example, Lindsay gives Gob $1 million for 30% of the equity ownership. Lindsay would get 30% of extra cash from the property, and 30% of the resale value, after loan payments. Note this is still a good deal for Gob, as he only has $1 million of equity in the office building, BSB owns 14 out of the 15 million in existing value. Nice math, Lindsay.
Preferred Equity: Pref Equity receives cash flow before Common Equity (Lindsay) until the equity is repaid plus an agreed upon return, but Pref Equity holders typically do not have voting rights. We’ll make this simpler for our example. Tobias gets a severance package from the Blue Man Group for $1 million, which he gives to Gob for 20% of the ownership, in addition to a 5% annual dividend on his investment. The 5% payment would be senior to Lindsay and Gob's equity share of the cash flow. Tobias also would receive 20% of the available cash flows after debt service, similar to Lindsay’s 30%.
Mezzanine: Effectively a blend of equity and debt, this is loan that can be converted to equity in the event of a default, and potentially take control of the property. The fine print is very important here to avoid punitive covenants. Lucille ponies up $1 million in the form of a mezzanine note and prepares for future blunders. As this is still a risky investment, Lucille’s interest rate charged is 15%, or $150K per year. Because Lucille has never cared for Gob, she includes language that the interest accrued of $150K per year can be added into the principal ($1.0 MM), and a clause that stipulates full equity ownership transfer in a default, or if the principal reaches $2.5 MM (arbitrary example). If Gob choose to pay Lucille annually, she will receive her $150K annual payment before Tobias and Lindsay.
A/B Notes: For anyone familiar with first mortgages, or standard financing, this is similar, but divided into two, sometimes three, tranches, with the B-Note subordinate to the A-Note (i.e., the A-Note is paid first). As the B-Note has lower priority, it is a more risky investment than A, and will command a higher interest rate. Similar to a first mortgage, A notes are secured against the office building, and has the highest payment priority if Gob defaults. Michael is aware of Gob’s ineptitude, but needs a place to hide the funds from Saddam, so he loans Gob the remaining $2 million needed to maintain ownership of the office building. For his trouble, Michael receives 7% per year, interest-only. What have we always said comes first? Family. Except for this one time. Michael’s 7% interest gets paid before anyone else in the Bluth capital stack.
For this example we’ll leave out CMBS/Conduits as it would quickly get messy. But imagine if Michael sold his 7% annuity to an investment bank, the IB turns and partitions it out to different investors based on risk/return, thus removing it from the balance sheet.
To sum up- Banana Stand Bank, Original Loan: $14 million owed – Gob needs this amount or he’ll have to sell the property at a loss.
Available Refinance from BSB: $9 million (same bank will give another loan, but only at 60% of the property’s current value) Equity: $1 million from Lindsay Preferred Equity: $1 million from Tobias Mezzanine Debt: $1 million from Lucille A-Note: $2 million from Michael
Gob takes the $5 million from his functional, loving family and refinances from BSB to pay the maturing note of $14 million. Three years later in 2015, the office market in the OC (don’t call it that), has fully rebounded. Occupancy and rents have never been higher and Gob sells the building for $30 million.
Who gets paid what, and in what order?
We’ve now repaid all the debt service – the bank note, A-Loan, and Mezzanine – for a total of $13 million, leaving $17 million in profit for the equity holders.
Hope this was helpful. I spent way more time thinking about different Arrested jokes so let me know if my math/calcs are off. All this is just from my limited experience, so definitely interested in other perspectives.
GP