19 Risk Management for a Distressed Securities Portfolio Marti P. Murray Murray Capital Management, Inc Murray Capital invests in the debt claims of troubled companies. The investments are primarily in distressed bonds and bank debt of companies undergoing financial difficulties because of underlying operational issues or serious and material litigation matters, such as product liability disputes. The investment objective is to maximise total return by identifying securi- ties that are undervalued due to market inefficiencies. Our goal is to identify opportunities that will increase in value over time as the troubled company pursues a restructuring, either in the context of a chapter 111 bankruptcy or through an out-of-court restructuring, thus restoring financial health. While maximising total return is our foremost objective, we seek to do so in a controlled, risk-averse manner. There are three areas in which we seek to control risk: managing the risk of the underlying investments, managing the risk of our portfolio overall, and managing the potential risk posed by general market dislocations where trading liquidity might become an issue. MANAGING RISK IN INDIVIDUAL INVESTMENTS The best way to begin the risk management process in distressed securities investing is to carefully do the homework. By this, we mean that invest- ment decisions should be subject to a rigorous analytical process that has clearly identified the potential rewards and risks of the investment. Third party research is a useful analytical tool, but should always be supple- mented with independent analysis. Buying securities in a rush increases risk. At Murray Capital, we prefer to follow the progress of situations for a significant amount of time before committing capital. This careful approach allows problems to be uncovered so they may be properly evaluated. 231 MANAGING HEDGE FUND RISK Access to management is also an important risk reduction technique. We prefer to invest in situations where we can have a dialogue with manage- ment and visit with them at their offices. This allows us to get much closer to the investment and develop a better understanding of the situation than would be possible through simply looking at papers and speaking to peo- ple on the telephone. We are wary of companies that do not talk to the investment community. Our research process on a potential investment begins by identifying the key drivers that will make an investment either a success or a failure. Once these issues have been identified, they are then analysed. The variables will be different for each investment – sometimes we may be analysing a legal claim or entitlement, sometimes we may be evaluating a company’s ability to improve its cashflow or maintain its credit rating. In all cases we are evaluating the quality of management as well as their objectives. Once we are confident that the key drivers have been properly identified and analysed, we then put together three scenarios for how we believe the investment might perform on a going-forward basis. These three scenarios are the upside, the base case and the downside. In the upside case, we are evaluating what our potential return will be if the outcome of our key vari- ables is favourable. In the base case, we determine how our upside will be impacted if, for example, timing is delayed or valuations are lower than in our upside. In the downside scenario, we evaluate what our risk is if things do not go our way – in other words, how much money will we make or, conversely, how much money might we lose? It is the outcome in the downside scenario that actually eliminates from consideration most of the investments we look at. If we find that we could potentially lose a material amount of money in an investment, we will eliminate it from consideration regardless of the upside. We would always prefer to be in a series of invest- ments where the upside is attractive and the potential downside is extremely limited, than in a group of investments with double the upside yet bearing significant risk of major capital loss. AMF Bowling AMF Bowling provides a good example of how we seek to mitigate risk in our analysis of individual investments, and how we choose the investments we think are the most appropriate fit for the firm’s risk-reward profile. AMF is not only the leading bowling alley operator in the United States, but also manufactures and sells bowling alley equipment. The company was acquired in a leveraged buyout transaction in 1996. The management’s objective was to pursue a “roll-up” strategy by acquiring smaller bowling centre operators, achieving operating synergies and eventually realising ahighervaluationonalargerbusinessthanthemultiplesofcashflow paid. However, two negative developments impacted AMF: (1) the com- pany was unable to achieve some of the operating synergies originally 232 RISK MANAGEMENT FOR A DISTRESSED SECURITIES PORTFOLIO anticipated, and (2) the market for bowling alley products fell off precipi- tously during 1997–98, when the Asian economies experienced severe difficulties. Sales in Asia had been a major contributor to the company’s cashflow until that point, so the decline in Asian business weakened AMF’s financial condition, as it was highly leveraged from the original leveraged buyout (LBO) and the acquisitions completed. Murray Capital first analysed a potential investment in AMF Bowling in 1998. There were a number of different debt securities in the company’s capital structure available for investment, but we were primarily interested in evaluating a potential investment in the bank debt and the senior subor- dinated notes, which represent an unsecured debt obligation where the rights to payment come after that of the senior lenders. In evaluating the bank debt, we noted its senior position in the capital structure and the fact that it was secured by all the company’s assets. The financial leverage through the bank debt was approximately 4.3 times cashflow, a level we found reasonable, as we believed that the business was worth at least that multiple, while the cashflow was not in a steep decline. We also performed a liquidation analysis on the company to determine what cash value the assets would generate in a straight liquidation. We determined that the bank debt would be covered by approximately 90% in such an event. We then performed an evaluation of the senior subordinated notes. The notes ranked below the bank debt in priority, and the leverage through these notes was approximately 6.7 times cashflow, materially higher than the multiple through the bank debt. We also noted that in the event of a liqui- dation, the senior subordinated notes would get a recovery of zero. The results of our upside, base case and downside scenarios is outlined in Panel 1. We viewed the potential bank debt investment as having a rela- tively attractive upside of approximately 21% with a downside of +1% return. The notes indicate a better upside of approximately 30%, but with a much greater downside at –38%. Our view was that the bank debt was the better investment of the two and that it was, in fact, an appropriate invest- ment for our portfolio. We were comfortable with the return scenarios and felt we had a reasonable chance of achieving the upside because of solid management at the company, a strong equity sponsor, and AMF’s leading market position in the bowling centre business, which, although not a growth industry, was regarded as being stable. While the senior subordi- nated notes would do very well if we were right about AMF’s prospects, the cost of being wrong was too great in our judgement, with potential exposure to a 38% loss of capital. Consequently, we held our bank debt position for a number of months and made a small profit in it. Over time, however, we became concerned about the company’s lack of progress in increasing its cashflow, and felt that the risk of a restructuring was intensifying, meaning that it was becoming less likely that we would achieve our full upside. As a result, we 233 MANAGING HEDGE FUND RISK PANEL 1. AMF Bowling: Bank Debt versus Bonds Bank Debt investment: ❏ Description: Senior Secured Bank Debt due 2002, L+225 coupon, rated B1/B ❏ Leverage through Bank Debt: 4.3x latest twelve months (LTM) EBITDA of US$130MM ❏ Liquidation analysis indicates that Bank Debt is 90% covered by hard assets Downside Base case Upside Assumptions Debt is purchased Debt is purchased Debt is purchased @ 90.75; trades to @ 90.75; trades to @ 90.75; trades to 87 (4.3x projected 96 (360 bp off vs. 96 in 6 months; downside EBITDA current spread of earns interest and of US$120MM – 570 bp off) in 12 capital 8% lower than months; earns appreciation LTM) in 6 months; interest and earns interest capital appreciation Return (annualised) +1.0% +14.9% +20.7% Bond Investment: ❏ Description: Senior Subordinated Notes due 2006, 10.875% coupon, rated B3/CCC+ ❏ Leverage through Senior Subordinated Notes: 6.7x LTM EBITDA of US$130MM ❏ Liquidation analysis indicates zero value for the Senior Subordinated Notes Downside Base case Upside Assumptions Bonds are Bonds are Bonds are purchased @ 83; purchased @ 83; purchaed @ 83; trade to 46 (6.7x trade to 90 (800 bp trade to 90 in six projected off versus current months; earn downside EBITDA spread of 950 bp interest and of US$120MM off) in 12 months; capital –8% lower than earn interest and appreciation LTM) in six capital months; earn appreciation interest Return (annualised) –38.0% +20.9% +29.5% 234 RISK MANAGEMENT FOR A DISTRESSED SECURITIES PORTFOLIO decided to exit the position. After we had exited, the financial performance of AMF moved sideways for a time, neither improving nor deteriorating dramatically.