Valuing claims and estimating recoveries during a complicated bankruptcy process can be extremely time consuming and difficult. However, the more complex and opaque the situation is, the more mispriced assets can become leading to excellent risk/reward conditions to deploy capital.
From Seth Klarman’s 2005 Investor Letter:
For us, analytically complex, litigious, stigmatized, and shunned situations bought at the right price form the backbone of a limited risk portfolio of opportunity.”
First, it is important to understand how intercompany claims and double-dips work in a bankruptcy proceeding. The term “double-dip” is used too loosely in the restructuring world in my opinion, similar to how “convexity” is used in the bond trading world. A double-dip gives creditors at one entity a higher recovery by allowing a claim against another entity / other entities.
In a very simplistic bankruptcy, lets assume ABC Co. has $100mm in assets and $200mm in liabilities. ABC Co. creditors would receive a recovery of 50 cents on the dollar (50%). Unfortunately, no bankruptcy is this simple.
Let’s look at a more realistic example with two entities, Hold Co. and Op. Co (advanced note: this structure actually resembles more of a Fin co / Parent structure but the result is the same):
Both entities have issued debt, however Hold Co. has guaranteed the $200mm of bonds issued at Op. Co. Additionally Op. Co has upstreamed the bond proceeds to Hold Co., this intercompany loan is held on Op. Co’s balance sheet as an asset. Recoveries at Hold Co. are fairly straightforward, there are assets of $100mm, and liabilities of $500mm due to the $200mm guarantee and intercompany loan.
Recoveries at Op. Co show how the double-dip comes into play. Total assets are: the $50mm at Op. Co, a 20% recovery on the intercompany claim of $200mm, and a 20% recovery on the $200mm bond guarantee provided by Hold. Co, giving a total Op. Co recovery of 65 cents (65%). This may seem counter-intuitive so let’s look at another example where the proceeds from the bond issuance are transferred to a non-guarantor entity:
In this example, each entity, Hold Co., Op. Co, and Other Co. each have their own debt, and Hold Co. still guarantees Op. Co bonds, however Op. Co transfers bond proceeds to Other Co. and has a $200mm intercompany claim to Other Co. Op Co. recovery is now 57.5% ($50mm in assets + 12.5% recovery on $200mm intercompany with Other Co. + 20% recovery on $200mm guarantee by Hold Co. / $200mm in liabilities).
These examples are obviously very simplistic, in the real world there are many different classes of creditors, more complex entities, difficult to value assets, and various legal issues.
For example, below is a snapshot of the Eastman Kodak (EK) Org Chart provided in First Day Motions by Antoinette McCorvey, CFO of EK, on 1/19/2012:
EK was an interesting case because the company filed with roughly a billion dollars in cash. However, it was difficult to know where this cash was located (in the United States, China, etc) as EK financials were consolidated. The company on the top right is named “Eastman Kodak Holdings BV”, and is a dutch holding company, whose subsidiaries include most of EK’s Chinese companies, refer to the zoomed in org chart below:
Unlike in the United States, the Dutch Chamber of Commerce requires all registered Dutch companies file annual reports which are publicly accessible. Anyone can purchase the financial information of “Eastman Kodak Holdings BV”, for 9.50 euro. This report (in Dutch) displays balance sheet information and basic financials for a few years prior. In this particular case it was important to see how much cash this entity held, as most was from China and would not be recoverable and therefore a prudent analyst should not include the China cash number in a recovery analysis, or at least haircut the number drastically. The Dutch Chamber of Commerce website is a very valuable and underutilized asset in the bankruptcy research process.
Another complex example involves Section 135 of the 1900 Nova Scotia Companies Act, which states a Canadian Unlimited Liability Company’s (ULC) equity owners are obligated to pay the debts of its subsidiaries:
135 In the event of a company being wound up, every present and past member shall, subject to this Section, be liable to contribute to the assets of the company to an amount sufficient for payment of its debts and liabilities and the costs, charges, and expenses of the winding up and for the adjustments of the rights of the contributories among themselves, with the qualifications following:
In the General Motors (GM) case, the company issued unsecured bonds from a Canadian subsidiary, General Motors Nova Scotia Finance Co. These bonds traded in line with other unsecured GM bonds before 2008 and smart funds starting buying these bonds and hedged with matched CDS after discovering General Motors Nova Scotia Finance upstreamed the bond proceeds to its parent (GM) and the 1900 Nova Scotia Companies Act could allow General Motors Nova Scotia Finance a claim at GM. Owning these bonds against CDS is an amazing trade and would give an investor an immense amount of jump-to-default (JTD) protection (similar to a secured-unsecured trade), allowing an investor to take even more risk in the structure, regardless of credit view.
In general it is amazing how close in spread unsecured bonds trade for a credit which are issued at different boxes when everything is fine. However, in almost every credit which becomes distressed, there is a period of time in which bonds from one remote box finally trade at the correct risk adjusted level - SVU/ABS, MGM 2013, GM, GMAC/RESCAP, to name a few.
In very complex cases with cross-ownership between different creditors and classes, such as in the Lehman Bankruptcy, creditors will usually negotiate these guarantee claims and file competing plans. LBHI creditors filed a liquidation plan on December 15th, 2010 which suggested consolidating all affiliates assets which would eliminate guarantee claims, giving more value to LBHI creditors. Ultimately in the MODIFIED THIRD AMENDED JOINT CHAPTER 11 PLAN OF LEHMAN BROTHERS HOLDINGS INC. AND ITS AFFILIATED DEBTORS, intercompany guarantee claims were reduced between the main entities:
LBHI Senior Third-Party Guarantee Claims - 20%
Affiliate Claims of Participating Subsidiary Debtors against LCPI - 20%
Affiliate Claims of Participating Subsidiary Debtors against LBCS - 20%
Affiliate Claims of Participating Subsidiary Debtors against LBSF - 20%
Affiliate Claims of Participating Subsidiary Debtors against LBOTC - 20%
Affiliate Claims of Participating Subsidiary Debtors against LBCC - 20%
The point is, recovery analysis is never as clear cut as the initial examples provided, but understanding how intercompany claims work is important in security analysis and allows a diligent analyst to potentially unlock hidden value. As a side note, it is interesting to see what recoveries look like at the different Lehman boxes as of the 10th distribution
At Volmanac we do not only use data science and analysis to gain an edge, we try to find helpful data sources that will be valuable in the next complex situation. The market now knows about the 1900 Nova Scotia Companies Act, but far fewer market participants are aware of other resources such as the Dutch Chamber of Commerce website.
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