The Hedge Fund Law Report - the definitive source of actionable intellige...

http://www.hflawreport.com/print/article/711

Vol. 3, No. 9

March 4, 2010

BANKRUPTCY

Due Diligence Considerations for Hedge Funds That Invest in the Equities of Bankrupt Companies: Lessons of the Energy Partners, Ltd. Bankruptcy
By Gregory C. White Hill Schwartz Spilker Keller LLC Hedge funds are recognizing with increasing frequency that the common stock of bankrupt companies or companies in the zone of insolvency may have post-reorganization value. See Interview with Mark Dalton, Alex Sorokin and Neil Wessan of Halsey Lane Holdings: Key Considerations for Distressed Debt Hedge Funds that become Unnatural Owners of Equity Following a Reorganization, The Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010). While investing in bankruptcy equities involves considerable risk notably, the tangible likelihood of a complete loss of value such investments also, in the right circumstances, offer the prospect of considerable upside. In particular, bankruptcy equities may be attractive in at least three circumstances: (1) where creditors undervalue the assets of the debtor; (2) when an event (such as a lawsuit in which the debtor is a plaintiff) can act as a catalyst for value creation; and (3) were conditions in the relevant industry or credit markets may enable a debtor to emerge from reorganization while its bankrupt competitors do not. See Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings, The Hedge Fund Law Report, Vol. 2, No. 27 (Jul 8, 2009). However, beyond the well-known financial risk of investing in bankruptcy equities, hedge funds should be cognizant of additional legal and structural risks that can adversely affect investment outcomes, or at least complicate the process of value creation. This article tells the story of hedge funds participation on the equity committee in the Chapter 11 bankruptcy of Energy Partners, Ltd. (EPL), a Louisiana-based exploration and production company. In particular, this article outlines the facts of the case as they relate to the equity committees involvement in the valuation of EPL, focusing on relevant terms of the debtors engagement letter with its financial adviser. The article then discusses two key lessons highlighted by the EPL case for hedge funds considering purchases of bankruptcy equities. Background of the EPL Bankruptcy In May of 2009, Louisiana-based exploration and production company Energy Partners, Ltd. (EPL or the Debtor) filed a petition in the United States Bankruptcy Court for the Southern District of Texas (Court) seeking relief under Chapter 11 of the United States Bankruptcy Code. The bankruptcy announcement instantly sent the price of EPLs common stock to record lows; the stock reached five cents per share as investors liquidated their holdings. As recently as September 30, 2008, EPL had one of the largest concentrations of hedge fund ownership

1 of 5

3/8/2010 10:13 AM

The Hedge Fund Law Report - the definitive source of actionable intellige...

http://www.hflawreport.com/print/article/711

relative to other companies in the energy sector, with 16 hedge funds accounting for nearly 30 percent of EPLs market capitalization, as illustrated in the following table:

Pre-Approved Restructuring In conjunction with the bankruptcy, EPL filed a pre-negotiated plan of reorganization (Plan) to: (1) convert all of its $473 million in senior notes (including accrued interest) outstanding into essentially 100 percent of new EPL common stock (New EPL Common Stock); and (2) wipe out all existing equity interests. Rather than receive any payment on account of their interests, holders of pre-petition EPL common stock would be given warrants granting them the option to purchase a maximum of 12.5 percent of the fully diluted New EPL Common Stock. Valuation Dispute In connection with the proposed Plan, the Debtors financial adviser (Debtors Adviser) determined the enterprise value of EPL for the purpose of estimating the total value potentially realizable by creditors and holders of equity interests. The valuation undertaken by the Debtors Adviser concluded that no residual value would be available for holders of equity interests. However, the valuation estimated an enterprise value realizable to EPLs creditors of $499 million, which implied that the senior creditors would be provided with an unexplained $26 million premium over their claims. Soon after the Plan was filed, representative EPL shareholders formed an official committee (Equity Committee), quickly objected to the proposed treatment of the common stock and disputed the valuation that was performed by the Debtors Adviser. By June 2009, the month following the filing, the Equity Committee consisted of three

2 of 5

3/8/2010 10:13 AM

The Hedge Fund Law Report - the definitive source of actionable intellige...

http://www.hflawreport.com/print/article/711

members. One of the members was Daniel Bletzman from hedge fund Birch Run Capital Partners, LP, who immediately expressed his disagreement with the results of the valuation and began pressing for a more favorable outcome for shareholders. Mr. Bletzman reviewed the initial valuation and noticed several material issues that significantly undervalued the Debtor, which he quickly escalated to the courts attention. The key issues identified by Mr. Bletzman included the following:

The valuation performed by the Debtors Adviser used hydrocarbon prices as of March 31, 2009. By early June 2009, the spot price for oil had increased approximately 38 percent, and forward price curves for both oil and natural gas had increased significantly. This fact alone, and without considering any of the other inputs and assumptions used in the discounted cash flow analysis performed by the Debtors Adviser, meant that the March 31, 2009 valuation was significantly lower than if it had been determined using more current (i.e., June 2009) market prices. The Debtors Advisers valuation also relied on a comparable public company method, again using comparable company stock prices as of March 31, 2009. Mr. Bletzman claimed that the dramatic increase in the stock prices of comparable companies from March 31, 2009 to June 8, 2009 had a direct and significant effect on the value of the Debtor and raised questions about the reasonableness and accuracy of the valuation performed by the Debtors Adviser.

Favorable Settlement for EPL Shareholders For the two reasons cited above, the Equity Committee withheld its approval of the Plan, claiming that the Debtors Advisers valuation undervalued the Debtor. Shortly thereafter, the Equity Committee and the holders of notes issued by the Debtor held discussions regarding the valuation of EPL. Within a few weeks, the Equity Committee successfully negotiating a more favorable settlement with the Debtor and its Senior Creditors that allowed the equity holders to retain five percent of the New EPL Common Stock (equivalent to approximately $30 million). Practical Considerations As the number of corporate bankruptcy cases continue to rise, hedge funds are likely to play increasingly prominent and varying roles in the corporate reorganization process. In particular, beyond their historic role as members of official or ad hoc creditor committees, hedge funds are likely to play increasingly salient role on equity committees. With regard to equity committee participation, several observations can be drawn from the EPL case:

It is important to consider the motivation and incentive of each equity committee member. While creditors and equity owners in EPL bankruptcy knew that there were three members of the equity committee in the EPL case, each members individual stake in EPLs common stock was not made public. Hedge fund managers that serve on equity committees should be aware of what other members stand to gain or lose in a potential settlement. In many cases, equity committee members are mutual funds or

3 of 5

3/8/2010 10:13 AM

The Hedge Fund Law Report - the definitive source of actionable intellige...

http://www.hflawreport.com/print/article/711

other large institutional investors that have held the debtors stock for several years and are usually at risk of experiencing a complete investment loss. Hedge funds typically find themselves on the other side of the spectrum by purchasing the debtors stock at already distressed levels. This frequent difference in basis implies that the motivations and incentives of equity committee members may diverge. In particular, parties with lower bases may be amenable to lower settlements. On the topic of disclosure of information with respect to the timing, quantity and other data on distressed debt purchases in bankruptcies, see Bankruptcy Court Denies Philadelphia Newspapers Motion to Force Disclosure from Steering Group Pursuant to Rule 2019, The Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010); Delaware Bankruptcy Court Bars Ad Hoc Noteholder Group from Participating in Accuride Chapter 11 Proceedings Until the Group Complies with Rule 2019, The Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010); Delaware Bankruptcy Court Disagrees with WaMu Decision, Finding that Rule 2019 Does Not Apply to Ad Hoc Committees in Six Flags Chapter 11 Proceeding, The Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010). The decision to invest in the equity segment of a bankrupt debtors capital structure is difficult and subject to a high degree of risk. While rigorous valuation techniques may enable a manager to quantify and evaluate potential reorganization value, careful attention must also be given to how a debtor has determined its own reorganization value. According to the disclosure statement filed by EPL, the Debtors Adviser was engaged to estimate the enterprise value of the reorganized Debtor. The engagement letter between the Debtor and the Debtors Adviser, an energy investment banking firm based in Houston, stated that in connection with any restructuring transaction (a defined term in the engagement letter), the Debtors Adviser would receive a cash fee equivalent to $2 million. At least in this case, and probably others in which debtors financial advisers are engaged on similar terms, it may reasonably be presumed that the debtors adviser has an incentive to enable the debtor consummate an exit from bankruptcy or other restructuring transaction. Generally, a lower or more conservative valuation of a debtor is more appealing to creditors (especially senior creditors) because the dollar amounts of creditors claims will convert into higher percentages of equity the reorganized debtors with lower valuations. By contrast, in the presence of a low valuation, there may be no post-reorganization equity left over for pre-organization equity holders. Accordingly, analysis of the terms of the engagement between a debtor and its financial adviser may be a relevant to diligence item for a hedge fund contemplating an investment in the equity of a debtor or company in the zone of insolvency.

Gregory C. White is an Associate in the Valuation Group in the Dallas office of business valuation and litigation consulting firm Hill Schwartz Spilker Keller LLC. His background includes serving as the primary contact for large institutional and corporate trust relationships with total assets in excess of $30 billion. His clients have included public and corporate pensions, foundations, endowments, investment managers, fund of funds and investment consultants. 2008 - 2010 The Hedge Fund Law Report. All rights reserved.

4 of 5

3/8/2010 10:13 AM