In July 2012, Cengage Learning (TLACQ) was able to ammend-and-extend its Term Loan, as well as exchange some Jan-2015 10.5% senior unsecured bonds into 12% second lien bonds due in 2019.

Cengage extended maturities on $1.3 billion of its bank debt in March, lengthening the term of the debt by three years in exchange for paying 3.25 percentage points extra interest. The so-called amend-to-extend transaction and last week’s bond exchange will add $120 million in annual interest expense, according to a July 6 research report from KDP. The amend-to-extend deal will be reversed if Cengage fails to reduce the amount of 10.5 percent senior notes outstanding to below $350 million by October 2014, three months after the extended portion of the debt comes due, as well as reducing other debt maturities, said John Puchalla, an analyst at Moody’s.[1]

“Adjusted EBITDA” was roughly $750mm on $5.3bn on debt, with interest expenses rising substantially - a very dangerous situation for a declining publishing business, but at least maturities were able to be extended giving the company some breathing room.

In early 2013, the whole capital structure was stressed and it looked as if the company could file for bankruptcy. Trailing 6 Month Revenues ending Dec31 2012 were $945MM as compared to $1,148MM a year earlier, and cash had dwindled to $33MM.

As one might guess, the second-lien bonds were trading higher than the unsecured 10.5% bonds as they were higher in the capital structure. However, companies cannot stay in stressed situations forever - they generally will either recover and the entire cap structure will rally, or they will file for bankruptcy. Below is a snapshot of Cengage’s capital structure at the end of 2012:


The remaining 10.5% bonds ($477mm before the DEC31 filing) were trading around 25, whereas the second-liens were trading at 39. I felt as though the senior bonds should potentially be trading higher than the second liens as they had more leverage being a shorter maturity and recoveries could be similar in a filing scenario given declining EBITDA (they both could be a zero).

I wanted to buy the senior 10.5% and short the 12% second-liens at a 2:3 ratio, shorting more of the second-liens as a filing seemed more likely. There was almost no scenario in which the loans would extend past the 2019 maturity in the short term - the 12% seconds were the worst part of the cap structure to be in at these prices in my opinion. I also felt that they were trading higher technically as there were 2-3 large holders who refused to trade them. Two possible outcomes were:

  1. In a filing scenario, with revenues declining tremendously, both bonds could end up with the same recovery (close to zero), and therefore the convergence trade would be profitable. However, there was a case in which the seconds potentially could end up being worth much more than the unsecureds after a long bankruptcy process (not in the near term as the bonds were trading at a very impaired level of 39). In order to reduce this risk, I would have to take off the trade near the filing date. There was also a chance that in a valuation dispute, the small tranche of unsecured creditors could carve out some value laying claims to some assets - especially if the first liens were impaired.
  2. In the case of a turnaround or another exogenous event such as the sponsor injecting equity (there were rumors they were in the market purchasing bonds), the 10.5% bonds would rally much more than the 12%, as the 12% had been extended past most maturities (duration is generally not important in very distressed bonds) as the company was incentivized to deal with the 10.5% bonds or the ammend-and-extend would be reversed. In this scenario the 10.5%s could trade potentially 50 points higher than the seconds.

Cengage did end up filing for bankruptcy, and the 10.5% / 12% spread went from 14 pts to roughly 5pts near the filing date and bonds fell 15 points. Later, unsecured creditors did fight for value and the unsecureds actually rallied 10-15 points higher than the seconds:

The plan filed in October 2013 pegged total second-lien recoveries at 5.5% of allowed claims of about $753 million, while senior notes would recover 8% of $306 million of allowed claims. However, the potential recovery would be funded from a pool of assets comprised of $265 million of disputed cash held by the company in an investment account that Cengage contends does not comprise collateral for the first-lien debt [2].

The primary disputes among the creditors involve the company’s enterprise valuation; the value of and the validity of liens allegedly held by first-lien lenders in at least 16,000, but potentially all, of the company’s copyrights; whether $248 million of disputed cash the company obtained by drawing down its first-lien revolver prior to the Chapter 11 filings is unencumbered, or alternatively, subject to first lender liens; and the value of the company’s unencumbered interest in foreign subsidiaries.

In essence, the junior creditors contend the company’s newly proposed unsecured escrow structure, which is intended to allow Cengage to emerge from Chapter 11 early next year even if the disputed issues are not resolved, is so flawed that it renders the proposed reorganization plan unconfirmable.[3]

In February 2014, creditors reached an agreement which provided the $1.3bn of junior creditors a share of $225 million in cash or stock[4].

While this trade had many factors that I did not anticipate (ie. unsecured being able to fight for more cash), when you create an asymmetric risk profile often exogenous factors will end up being positive catalysts. While it would have been more profitable if the company had recovered, it is possible to construct trades when pairs of securities are relatively mispriced which allows an investor to profit without taking a real credit view.