Disclosure: Short MOMENT 11.5% Senior Subordinated Notes (60877UAM9), Long MOMENT 10% 1.5 Lien Senior Secured Notes (60877UBA4).
The 1.5 Lien Notes last traded at 93. If they prevail at a hearing on September 9, noteholders will receive 104.17 in cash. If not, replacement notes are still unlikely to be worth less than current trading levels.
If you’ve gotten past the pun in the title and are still with me, read on for what I think is a compelling and actionable near-term opportunity in the Momentive Performance Materials (MPM) bankruptcy cases. Spending some quality time with the MPM docket has been a bright spot in an otherwise challenging quarter for Cable Car. Barring a successful appeal by the Subordinated Notes trustee, which I think unlikely, I’ll have the chance to discuss the success of my short position in the Subordinated Notes in Cable Car’s next quarterly letter. I have been following the case closely in support of that position, and in the process decided to invest in the Senior Secured Notes following the sell-off from last week’s make-whole decision. The remainder of this post discusses the 1.5 Lien Notes. A similar opportunity with slightly less appealing pricing (but more liquidity and lien priority1) exists in the 8.875% First Lien Senior Secured Notes (55336TAC9).
Cable Car focuses primarily on equity securities, but I occasionally find value elsewhere in the capital structure. For a number of structural reasons, reorganizations often present interesting opportunities to invest in debt securities. Institutional ownership restrictions, the prevalence of relative value frameworks, and legal complexity can often lead to mispricing. Distressed debt often has a potential return profile similar to equity (both long or short), even when it is not being explicitly equitized.
As a non-lawyer (though I am the proud son of a mediator!) and passive investor, I have a deliberately limited approach to bankruptcy cases. Unlike many specialist distressed debt investors, I will generally only even consider participating after a plan of reorganization has been proposed, which after some analysis I believe is likely to be confirmed. I am content to let larger players do the heavy lifting of negotiating a prepack or a restructuring support agreement, for which they are often well compensated by the right to provide exit financing on preferential terms. Even after a plan has been put forward and controversies have been fully briefed, securities prices may not yet reflect the proposed distributions under the plan, or the reasonable range of outcomes in the legal process (subject to interpretation, of course). I’m a firm believer that potential outcomes can be bounded and questions of interpretations assessed, even by the non-specialist. There’s something very appealing about quantifiable outcomes for value investors with a probabilistic approach. With extensive public bankruptcy docket updates nearly in real time, reorganizations present a rather delightful reading comprehension exercise—at least if there’s something wrong with you and, like me, you kind of enjoy poring over a bond indenture. From experience, I can say it at least beats reading critical theory.
In any case, all that is a very long-winded way of saying that while I think I have a handle on this situation, I am not a distressed debt expert. So if you are, and you’re reading this, please don’t be shy about pointing out where my analysis may be flawed. Or just say hello!
MPM is a quartz and silicones producer that was purchased for $3.8 billion in a leveraged buyout by Apollo in 2006. The bankruptcy proceedings formally value the enterprise at just $2.2 billion today. For a detailed discussion of the Debtor’s business and the proposed plan of reorganization, see the plan disclosure statement. The details of the operating business are not important to rehash here, except to note that MPM will benefit from restructuring. Although hopelessly overleveraged at 16x last year’s (possibly cyclically depressed2) EBITDA, MPM is a leader in its business and generates enough earnings to comfortably support a more realistic capital structure. The proposed plan reduces net debt by about $3.2 billion, including a $600 million equity injection. If confirmed, MPM will emerge with about $1.2 billion of net debt against $300 million in EBITDA. Using management’s 2015 EBITDA forecast, the pro forma entity would have about 4.5x Total Debt/EBITDA and 3.8x EBITDA/Interest coverage. These metrics are roughly consistent with an issuer rated BB or B.
Elements of the plan have been contentious. The First Lien and 1.5 Lien trustee unsuccessfully argued that the notes were due a significant make-whole payment in addition to the par value of the notes and accrued post-petition interest. Votes for or against the plan were due prior to the adjudication of the make-whole dispute, and they offered Senior Secured noteholders something of a Hobson’s choice: either vote to reject the plan and accept replacement notes with or without the make-whole, or vote to accept the plan and receive payment in cash, but give up the right to pursue the make-whole adversarial proceeding. Unsurprisingly, both classes of Senior Secured voted to reject the plan. I will come back to that decision in a moment.
In principle, any replacement notes should have a net present value equal to the value of the Senior Secured claim. In practice that is not such an easy number to pin down. The court heard testimony, unfortunately filed under seal, from fixed income experts who opined on the proper choice of discount rate. Depending on the terms of the new notes, prevailing market conditions could result in replacement notes having a market value other than the value of their claims. Indeed, after Judge Drain issued a bench ruling denying the make-whole claim, disappointed Senior Secured noteholders drove the price down to its current low 90s context.
If the plan is confirmed as currently proposed, then we can calculate exactly what the 1.5 Lien holders will receive. Assuming for convenience a September 15, 2014 effective date, the notes are due 5 months of post-petition interest, or about 4.17 cents on the dollar, which would be capitalized. The notes trade flat, so paying 93 points for 104.17 in principal is equivalent to buying 100 face value of the new bonds for 89.28. The new bonds have a proposed maturity of March 15, 2022 (7.5 years) and a coupon of 275 basis points above comparable Treasuries. The nearest Treasury maturity currently has a yield of about 2.2%, so the new bonds would carry a coupon of approximately 4.95%.
By my math, that works out to a 6.8% yield to maturity. Even at the current ask of 96, the yield to maturity is 6.28%. While not very appealing in absolute terms—I wouldn’t be terribly excited to earn 6.8% in my portfolio for the next 7.5 years—it is an attractive yield on a relative basis. It is worth examining where similar securities currently trade. As everyone knows, “high” yield debt is not currently yielding very much right now.
The court’s choice of 4.95% is at least one view of the “right” yield for reorganized MPM notes. At the moment the market appears to disagree, but selling may have been exaggerated by disappointment over the make-whole ruling. Institutional buyers that are restricted from buying debt in bankruptcy may find the notes appealing after emergence.
While there isn’t a neat benchmark for 7.5-year senior secured industrial paper, there are a few comparisons that suggest the replacement notes should yield something less than 6.8%, and in any event not more. According to FactSet, as of September 4, a BAML index of B-rated industrials yields 4.935% with 5 years to maturity and 6.333% with 10 years to maturity. A 7.5-year MPM note could be reasonably interpolated somewhere in between. BB credits yield between 4.288-5.736%. Furthermore, the 1.5 Lien notes have the benefit of being partially collateralized by their junior security interest, while the index includes unsecured and subordinated debt. The notes would be the most senior part of the capital structure of reorganized MPM other than an undrawn ABL revolver. The nearest maturity, similarly structured bond I could find in a comparable industry is part of another Apollo LBO, Berry Plastics. BERRY 5.5% Second Lien Senior Secured Notes due May 15, 2022 (085790AX1) are B-/Caa1 rated and yielded 5.62% on their last trade.
I led with the relative value discussion because I think this is a situation with very limited downside risk. Because the coupon is based off a spread to Treasuries, there is no market interest rate risk until the plan is confirmed, after which of course a rise in market interest rates would be the most significant ongoing risk factor, barring an unexpected collapse of the entire restructuring process and forced liquidation. However, there are multiple ways in which an investment today could generate very attractive returns in a very short time frame:
- Most straightforwardly, if 4.95% is the correct market rate of interest for the bonds, they should trade to par after emergence.
- Alternatively, trading in line with the BERRY notes would result in a gain of about 7 points.
- If plan confirmation is delayed for any reason, the notes continue to accrue post-petition interest at 10%, increasing the eventual recovery.
- The Senior Secured trustee could appeal the make-whole decision and win (very unlikely).
- Apollo could call the replacement notes for cash as a goodwill gesture or if financing on better terms becomes available.
- The Senior Secured noteholders could prevail in their Rule 3018 motion to change their votes to accept the plan.
It is this last possibility that I think most interesting, and it is a key motivating factor for the investment. In conjunction with the plan confirmation hearing on September 9, a requisite majority of both classes of Senior Secured notes has petitioned to change their votes to accept the plan. The market is giving investors a free option on the success of the motion and setting up a compelling risk/reward tradeoff: if the motion succeeds, noteholders will be paid in full in cash, earning more than 11 points on their investment in 2 weeks. If the motion fails, investors are unlikely to lose much, if anything, if my reasoning above holds.
While, again, I am not a lawyer, I think there are reasons to believe the judge may be sympathetic to the motion. The legal standard for a 3018 motion is to show “cause,” which commentators have suggested is a lower standard than “good cause.” To change its vote, a party in theory needs to persuade a judge only that doing so would not result in a harmful outcome. I think it will be difficult for the Debtors to argue that in this case, confirmation of the plan as written is harmful to the Debtors. They are left with a public interest argument that allowing a change of votes would somehow constitute a “do over” that might unfairly prejudice future restructuring processes. Given the unappealing voting options available to the Senior Secured classes, I’m skeptical of that argument. Past cases have hinged on whether or not the goal of the party trying to change its vote was to unfairly benefit its own interests by blocking confirmation of the plan. Although the Senior Secured creditors opposed confirmation of the plan as written, they are not attempting to block plan confirmation through the change of votes. In this case, changing votes to accept the plan would result in the acceptance of the plan as it was first proposed.
Here I would like to take a moment to pick on a stranger on Twitter. I joined “Finance Twitter” only a couple months ago, but I already have found it indispensable in at least one regard. For bench rulings, and in particular the Momentive ruling, two excellent reporters provided breaking news on Twitter. Their quick takes actually preceded newswire headlines on the rulings, which was pretty cool.
Nevertheless, I think Maria has it wrong when she writes:
During the last confirmation hearing, Judge Robert Drain expressed frustration that the parties had not come to a negotiated settlement, stopping the proceedings several times to encourage Apollo and the Senior Secured holders to settle the make-whole dispute. Prior to ruling, Judge Drain was quoted by Bloomberg as saying: “This is a bunch of lawyers standing around avoiding an obvious solution [...] You know most people when offered payment in cash take it.” That is just what the Senior Secured noteholders are now trying to do. Judge Drain demonstrated a strong preference for a consensual solution to the restructuring process. Denying the Rule 3018 motion could motivate the Senior Secured noteholders to appeal, lengthening the restructuring process and adding costs to the Debtors.
I think there’s a good chance the motion is granted and noteholders recover in full in cash. I would welcome your thoughts.
1 If you’ve been following the case, you’ll understand why I specifically wrote lien priority, as opposed to seniority in right of payment!
2 A more nuanced view of the silicones cycle is necessary to evaluate the Second Lien notes, which will receive equity in the reorganized entity. Some commentators have suggested that the current level of earnings represents a cyclical trough and Apollo put together a sweetheart deal. That may be true: I have not done more than the superficial analysis needed to give myself comfort that the business is at least not falling off a cliff.