February 18, 2016

U.S. and European distressed debt hedge fund manager

Applying Fundamental Analysis to Distressed Investing (Part 1 of 3)

As part of a strategy to diversify their portfolio, investors should consider an allocation to distressed funds. Historically, this asset class has performed extremely well through cycles, generating above average returns while providing a relatively low correlation to the broader markets. However, distressed investments often experience periods of reduced liquidity, which investors must be willing to accept and which require fund managers to actively manage asset and liability duration in their portfolios.

Additionally, distressed investing tends to be highly complex and requires financial and legal knowhow and experience in order to capitalize on the opportunity. Consequently, allocations to distressed situations should be entrusted to individuals and firms that specialize in this type of investing and have demonstrated an ability to invest in the asset class through a broader credit cycle.

This paper will provide an overview of the investment process in distressed corporate securities and bank debt and the opportunity to generate alpha through an allocation to this asset class. This paper is divided into three parts:

Part 1 will provide an overview of distressed investing and review various strategies for investing in this asset class.

Part 2 will begin a discussion of the distressed investing process and address both the sourcing of distressed opportunities as well as the financial and legal analysis necessary to make investments in distressed situations.

Part 3 will continue the review of the process of distressed investing and examine some of the characteristics inherent in investing in this asset class.

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Applying Fundamental Analysis to Distressed Investing

Part 1

Page

Applying Fundamental Analysis to Distressed Investing

Introd

tion

As part of a strategy to diversify

their

portfolio, investors should consider

an allocation

to distressed

funds

Historically, this

asset class has

performed

extremely

well through cycles, generating above

average returns

hile providing

relatively

low corre

lation to the broader markets

. However

istressed

investments

often experience periods of

reduced liquidity

, which investors must be willing to

and which require

fund managers

to actively

nage

asset and liability duration in their

portfolios. Additionally

distressed investing

tends to

highly

complex and requires

financial and le

gal

knowhow

and expe

rience

in order to capitalize on the opportunity

. Consequently,

allocations to

distressed

situation

should be entrusted to individuals and firms that

specialize in

this type of

investing

and

have demons

trated an ability to invest in the asset class

through a broader credit cycle.

This paper will

provide an overview of the invest

ment proces

in distressed corporate securities and

bank debt

and the opportunity to gene

rate alpha through

allocation to

this asset class.

This paper is divided into

three parts:

Part 1 will provide an overview of distressed investing and review various strategies for investing

in this asset class

Part 2 will begin a discussion of the distressed investing process and address both the sourcing

of distressed opportunit

ies as well as the financial and legal analysis

necessary to make

investments in distressed situations.

Part 3 will

continue the review of the process of distressed investing and examine some of the

characteristics inherent in investing in this asset class

Overview of

Distressed

Investing

Distressed investing involves investments in businesses that are experiencing financial distress

and

are

either

(i)

undergoing

a restructuring

, reorganization

or bankruptcy

(ii)

the market perceives a higher

probabili

ty that they will need to

do so

in the future

distress

is typically

caused by a deterioration

of cash flow relative to expectation

or an increase in liabilities

and the associated concerns regarding

liquidity or solvency

of the

business.

A wide variety of factors may lead to the distressed situations

including a failure of

the

manage

ment

team

to execute their business plan, loss of contracts

See “An Overview of Event

Driven Investing: Potential for Alpha and Lower Correlation”, Fidelity In

vestments,

December 2013. Also, of the 12 strategies that make up the Credit Suisse Hedge Fund Inde

xes, the Distressed

strategy had

the second highest aver

age annual returns and the highest Sharpe ratio during

the period from

January 1994 through September 2015

While there are other types of distressed assets, including distressed real estate, structured products

, portfolios,

sovereigns or municipalities,

this paper will deal primarily with investments in single name corporate

distressed

situations.

Applying Fundamental Analysis to Distressed Investing

Part 1

Page

competitive pressures,

cyclical or secular changes to an industry, litigation

the discovery

liabilities

the

increase in

pre

existing

liabilities (for example

environmental or pension

liabilities

Additionally, the risk of distress is

exacerbated

in situations

when

the company

heavily leveraged

a result, the

distressed cycle tend

to follow periods of easy

access to

capital,

after

corporations

have

take

advantage of lo

ser lending standards to fund buyouts,

capital expenditures,

acquisitions

dividends.

Inevitably

, the market realizes that many

of these companies were inappropri

ately

capitalized

and cannot support their balance sheet

. As Warren Buffet said, “only when the tide goes out

do you discover who’s been swimming naked.”

Irrespective of the reasons for the financial distress

once it occurs

(

once

the market recognizes

the

increased risk of it occurring

)

the company’s fixed income securities, bank debt and other claims will

trade down to a level that the market perceives

to be

the

present value of their

recovery in a

restructuring

or reorganization

process or to a level that provides a yield

commensurate

with the

increased risk.

However, there are times when Mr. Market gets it wrong, when fear outweighs greed

and the various assets trade at deep discounts to recovery value or provide outsized yield

s relative to

the risk. A distressed investor’s ultimate goal is to identify

those

situations when Mr. Market errs

and to

capitalize on what they believe

to be

an asymmetric risk / reward situation

by investing

with a margin of

safety

Although

all

asset

classes

trade below intrinsic value

from time to time

(

and value investors’ goals are

always

to identify those opportunities

)

the

securities and loans

of distressed companies tend to have a

higher propensity

to be mispriced relative to fundamental value

n other

investment

assets

There

are a number of reasons for this



istressed situations occur because

of some aberration

relative

to expectations

financial

forecasts were not

realized, liabilities are greater than

previously

assumed

industries

experiencing

cycles

secular

change

hen things go wrong

(

and there is a lack of

understanding as to what occurred

and how it will be resolved

)

fear and panic

can guide

investment decisions and result in selling.



Some

investors are precluded by their investment mandate from owning assets that fall

below a certain credit rating

or other investment criteria

forcing them to sell



Recent regulations, including Dodd

Frank and Basel III have put pressure on b

anks to sell

istressed assets as a means of improving their capital

adequacy

ratios.



Investors

with

highly

diversified portfolios

may

lack the internal resources necessary

analyze

the

distressed situation

and

assess

the

recovery

and

prefer

to “just get out.”



any investors lack either the

infrastructure or

expertise necessary to

engage in

restructurings

Debt is typically considered distressed when it trades at

an option adjusted spread of at least

1,000 basis points

above the risk

free rate.

Applying Fundamental Analysis to Distressed Investing

Part 1

Page



The timeframe to work through a restructuring and the liquidity profile of the assets during

the restructuring may cause an asset / liability duration mismatch

in the investors’ portfolio

forcing them to sell



Some investors may be prohibited from owning post

reorganization securities or lack the

ability to provide fresh capital to the company.

The result is that there is a

strong

bias for investors to sell as t

he market perceives the financial distress

and this

may

result in assets trading below

their

intrinsic value.

Consequently

, distressed investors

nature, must be contrarian a

willing to

step into situations

when the herd is running in the other

direc

tion.

While

investments in distressed situations are typically

expressed

through secondary trades of the

companies’ debt or trade claims

at significant

discounts to par, distressed investment professionals

generally

preserve wide latitude

to opportunistically inves

t across the capital structure

to make direct

investments into the business.

Often in distressed situations,

the equity will trade as an inexpensive

option on the survival of the business. If the

investor deems that the marke

t is wrong about the risk of a

restructuring or the recoveries, he or she may be able to buy the equity at values that provide a very

asymmetric risk / reward.

Additionally, investors may have the opportunity to

directly

invest in the business.

Such inve

stments

may include



apital to fund an operational restructuring



apital

for the company to

bid for its own securities at a discount or to provide a cash

element

an exchange offering



debtor in possession

loan

(DIP)

in a bankruptcy



orking or growth

apital

subsequent to a restructuring or reorganization

The injection of capital

prior to or during a restructuring

or reorganization

typically

invested

at a super

senior level

with

priority over

preexisting debt.

In order to exploit the opportunitie

s to provide

additional capital

distressed investors

will often

maintain some dry powder

Distressed Investing Strategies

There are two basic strategies for distressed

investing

: a trading strategy and an active management

strategy.

As the name implies

a trading strategy

involves investing in situations where the investor

generates alpha through

appreciat

ion of the securities and loans purchased

, and then sell

those assets

in the market

These distressed

investors

may

vest in situations where they

believe the market has

overestimated the risk of a restructuring

and once that risk is mitigated the assets will trade up to

intrinsic value.

Alternatively

, i

during a

restructuring

process

the market receive

s greater clarity on the

recovery and timing,

assets may appreciate allowing investors the ability

realize profits

The key to a

trading strategy is that managers

generally

are not

directly

involved in the restructuring process and

tend to invest in situations that they believe will remain liquid.

Applying Fundamental Analysis to Distressed Investing

Part 1

Page

n a

ctive management

strategy,

on the other hand,

involves

investments in situations where the

manager believes he

or she

can

create value through managing a restructuring

reorganization

process. In an active situation a

lpha

can be generated a few d

ifferent ways.



In a negotiated restructuring

or waiver

alpha can be generated by providing the holders

higher income (consent fees,

increased

interest payments

etc.

) or greater rights (enhanced

security

, guarantees

equity

options

), which result in the

appreciation of the underlying

asset



In a reorganization of company’s balance sheet

returns are generated through the

distribution of

new financial

assets

(post reorganization securities)

which subsequently

trade at a premium to

the

cost of the pre reorganization assets



Additionally, active managers may have the ability to provide direct investments to the

company at attractive ter

as a way

of enhancing

returns on the underlying investment

Some of the managers

who

employ an activ

e management strategy are doing so with the intent to take

control of the company in the process. Traditional private equity firms have used this process as a

means for acquiring

businesses

through the debt.

The process for an actively managed

investment

tends to

take

longer th

n for an investment that the

manager can trade in and out of.

Active managers will typically sit o

creditor committees

, hire financial

and legal advisors

and

be invo

lved in the negotiation process

. Often

during

restructuring

e assets

will become illiquid and

they trade

typically do so with

very wide bid / offer spread.

ecurities and

bank debt of

a business

engaged in

a restructuring will

often

trade with a J

Curve

, requiring active

managers to take a

temporary

“paper

loss”

Additionally, active

managers may

be presented with the

opportunity to make further investments in the underlying enterprise, which can enhance returns, and

therefore

they must

maintain

dry powder.

As a result

, managers who

invest in situations t

hat are going

ough restructurings

will

need to assess the timing of

an exit or liquidity event in order to match asset

and liability duration in the portfolio

Consequently this strategy tends to require patient capital.

Most

distressed fund managers

will try

engage in a combination of trading and active management

Occasionally the situation changes during the investment process and situations that the manager

expected to provide trading opportunities turn into restructuri

ngs

or vice versa. Consequently,

investors

should

analyze both possibilities prior to the investment. D

ue to the

need

of managers

to match asset

and liability duration within their funds, some managers may need to limit the amount of active

restructuring

s they are involved in

[

Part 2 will begin a discussion of the distressed investing process and address both the sourcing of

distressed opportunit

ies as well as the financial and legal analysis

necessary to make investments in

distressed situations.

]

Applying Fundamental Analysis to Distressed Investing

Part 1

Page

Twelve Lions Capital is an investment management firm focused on investing in distressed, stressed and

undervalued corporate securities and bank debt in North America and Europe. The firm employs a

fundamental bottom

up valuation approach to investing and

invests across the capital structure in

special situations where it believes it is creating the investment cheap to fundamental value and with

the expectation of creating alpha through either a restructuring or reorganization process or asset

appreciation.

Twelve Lions Capital is led by Marc Schneider, an investment professional who brings over twenty years

of relevant experience. Prior to forming Twelve Lions, Mr. Schneider was a senior investment

professional at Avenue Capital where he had a highly suc

cessful track record of investing in distressed

situations. Mr. Schneider also has experience as a Wall Street lawyer and investment banker.

For more information, please see our website or contact Marc Schneider:

www.twelvelionscapital.com

mschneider@twelvelionscapital.com

Twelve Lions Capital.

whole or in part, withou

t the prior written permission of Twelve Lions Capital. Unauthorized reproduction

of this work may be subject to civil and criminal penalties.

Marc Schneider, Twelve Lions Capital

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