Distressed Securities

Valuation

Copyright 2010 Investment Banking Institute

www.ibtraining.com
Table of Contents

I. Overview of Distressed Securities

II. Corporate Debt Pricing

III. How to get Control of a Distressed Asset

IV. Case Study - Samsonite

V. Financial Model

2
Distressed Securities

The year of the vulture

The private equity firms that will thrive in the year ahead
are those that know how to profit from others'
misfortunes

2007 was a tale of two halves

The first was ebullient: nine out of the ten biggest leveraged
buyouts ever, and Blackstone becoming a publicly traded
company
The second was one in which LBOs fell from almost 40% of the
dollar value of deals through July to a single-digit market share

May 15, 2008 Fortune Magazine

3
What Are Distressed Securities?
Distressed securities are securities of companies that are either
already in default, under bankruptcy protection, or in distress and
heading toward such a condition
Distressed fixed income securities are rated below investment grade
The most common types of distressed securities are bonds and bank debt
While there is no precise definition, fixed income instruments with a yield
to maturity in excess of 1,000 basis points over the risk-free rate of return
(e.g. Treasuries) are commonly thought of as being distressed
While sound methodologically, the absolute 1,000 basis-point
benchmark may not be appropriate in all market environments
Average credit risk spreads can fluctuate widely
A basis point (often denoted as bp, bps) is a unit that is equal to 1/100th
of a percentage point
As we will see later in the presentation, the market for distressed
securities is less efficient than other markets, enabling skilled
investors to earn superior risk-adjusted returns

4
10 Largest Bankruptcies in US 1980 - 2007

Company Date Assets

Worldcom 07/21/2002 $103,914

Enron Corp 12/21/2001 $63,392

Conseco, Inc. 12/18/2002 $61,392

Texaco, Inc. 4/12/1987 $35,892

Financial Corp of America 9/9/1988 $33,864

Refco Inc. 10/27/2005 $33,333

Global Crossing Ltd. 1/28/2002 $30,185

Pacific Gas and Electric 4/6/2001 $29,770

Company
UAL Corp 12/9/2002 $25,197
Delta Air Lines, Inc. 9/14/2005 $21,801
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What is Distressed Debt?

Most traditional way of S&P Moodys

categorizing debt is with reference
to the ratings systems of the most AAA AAA Investment
prominent debt ratings agencies: Grade
Moodys Investors Service (Moodys) AA Aa
and Standard & Poors (S&P)
A A
While these firms use slightly
different ratings notation, they
have a functionally similar 10-grade
BBB Baa
scheme ranging from AAA to D
BB Ba Speculative
A prominent dividing line is
Grade
between BBB and BB. BBB and B B
above is classified as investment
grade, while BB and below is CCC Caa
characterized as speculative grade
and was, during the 1980s, labeled CC Ca
junk
C C
Fitch also provides rating of bonds
D

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Description of Bond Ratings (S&P)
AAA highest rating assigned to a debt instrument, indicating
an extremely strong capacity to pay principal and interest.
Bonds in this category are often referred to as gilt edge
securities
AA high quality bonds by all standards with strong capacity to
pay principal and interest. These bonds are rated lower
primarily because the margin of protection are less strong than
those for AAA bonds
A these bonds possess many favorable investment attributes,
but elements may suggest a susceptibility to impairment given
adverse economic changes
Bonds are regarded as having adequate capacity to pay
principal and interest, but certain protective elements may be
lacking in the event of adverse economic conditions that could
lead to a weakened capacity for payment

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Description of Bond Ratings (S&P)
BB Bonds regarded as having only moderate protection of
principal and interest payments during both good times and
bad times
B Bonds that generally lack characteristics of other desirable
investments. Assurance of interest and principal over any long
period of time may be small
CCC Poor quality issues that may be in default or in danger of
default
CC Highly speculative issues that are often in default or
possess other marked shortcomings
C lowest class of bonds. These issues can be regarded as
extremely poor in investment quality
D Issues in default with principal or interest payments in
arrears. Such bonds are extremely speculative and should be
valued only on the basis of their value in liquidation or
reorganization

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Bond Ratings of Companies
As of the spring of 2008, there were only six companies left with
"AAA" ratings from both S&P and Moody's. They are Automatic Data
Processing (ADP), Berkshire Hathaway (BRK), GE (GE), Johnson &
Johnson (JNJ), Exxon (XOM), and Toyota (TM) April 2008. In the late
seventies this number was 58 and in the nineties it was 22
Competition and willingness to take on more debt possible reasons
Rating agencies conduct a very thorough review of the companies
that they rate. There are numerous considerations that are weighed,
the most important of which is a companys cash flow
Basically, if a company is a cash cow, it is very likely to have a high credit rating.
Rating companies look closely at the source of a companys cash flow as well as its
variety, availability, and source
Companies with high credit ratings have quick-turning, high quality accounts
receivable, meaning that they are getting paid on time and getting all that they are
due. Rating agencies also consider it important that a company have the ability to
sustain their profitability
Aside from cash flows, rating agencies scrutinize a companys management for their
competence, structure, strategic planning, and composition. Other considerations
include scrutiny of a companys appetite for risk and competition
Rating agencies must always consider external factors such as the economic cycle
but the fundamentals of the companies that they rate always get first consideration
and have a far greater bearing on a companys overall rating
Nevertheless, rating agencies have increased their responsiveness to and consideration of the economic cycle in
recent years given the large impact that the economic cycle has on many companies

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Investing in Distressed Debt?
Distressed debt is not a particularly suitable or practical investment
for individual investors:
Significant risk of loss
Annual total market returns could vary dramatically
Professional participants in the market could have significant
information advantages
Distressed securities market is often fairly illiquid, which means
there can be very high transaction costs for individuals investing
on a modest scale
Transaction costs increase the relative risks and make it very difficult to earn appropriate risk
adjusted returns
Size of the average trading unit or block is so large that, except
for the most wealthy, it is difficult to have an adequately
diversified portfolio
Risk of this asset class is such that investing should generally be done on a diversified basis
Bank debt and corporate bonds generally trade in blocks of $5mm and $1mm respectively.
Though distressed securities may trade at significant discounts, this still implies that to own a
diversified portfolio of approximately 15 companies could require a significant amount of
capital

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How to look for Distressed Companies
Public Stock
Trading at 52-week/all-time low stock price
Bonds
Rating downgrade(s)
Sell-off in bonds
Distressed bond investors start accumulating bonds
Bank Debt
Liquidity crunch and concerns or ability to make coupon/amortization
payments
Reduced borrowing base and availability
Waivers or amendments
Internal Signals
Declining operating performance
Management turnover
Extensive and recurring restructuring charges/asset write downs
External Signals
Weak economy
Industry cyclical downturn

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Table of Contents

I. Overview of Distressed Securities

II. Corporate Debt Pricing

III. How to Get Control of a Distressed Asset

IV. Case Study Samsonite

V. Financial Model

12
Revolver, Term Loans and Bonds

Revolver Term loans Bonds

Claim on Senior Senior Subordinated

Assets
Collateral Secured Secured Mostly
Unsecured
Rate Floating Fixed Fixed
Principal Amortizing Amortizing On Maturity
Repayments
Covenant Restrictive Restrictive Less Restrictive
Package

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High Yield Debt
High-yield bonds are issued by organizations that do not qualify
for investment-grade ratings by one of the leading credit
rating agencies - Moodys Investors Service, Standard & Poors
Ratings Services and Fitch Ratings
High yield bond/non-investment grade bond/speculative grade
bond or junk bonds have a higher risk of default or other adverse
credit events, but typically pay higher yields than better quality
bonds in order to compensate for their added risk and make them
attractive to investors
Credit rating agencies evaluate issuers and assign ratings based
on their opinions of the issuers ability to pay interest and
principal as scheduled. Those issuers with a greater risk of
defaultnot paying interest or principal in a timely manner
are rated below investment grade
These issuers must pay a higher interest rate to attract investors
to buy their bonds and to compensate them for the risks
associated with investing in organizations of lower credit quality

14
High Yield Debt Levels and Default Rates
Moodys said in a December 2007 report that Defaults by
speculative-grade companies will quadruple next year as the
era of easy credit comes to an end and economic growth
slows
The global default rate will rise to 4.2 percent by November from
1 percent now, the lowest since 1981
Forecast is based on an assumption that the U.S. economy slows
without falling into recession. In a recession, defaults may
approach 10 per cent
More than one in 10 of the borrowers to which Moody's assigns
ratings are treated as distressed by bond traders, the highest
proportion since global defaults reached 10.5 percent in 2002
At that time, bondholders charged as much as 11.4 percentage
points of extra yield to buy high-risk, high- yield debt rather than
government bonds, double the current spread of 5.73 percentage
points, according to Merrill Lynch & Co. indexes

15
Credit Deterioration - Phase 1 and Phase 2

Phase 1: New High Yield Debt Issued

$150 million of XYZ Corp 13% Senior Notes due 1/15/2017
Purchased by traditional new issue buyers
Standard credit profile and ratios Debt/EBITDA of 3.5x-4.0x,
EBITDA/Interest 1.8x-2.2x, bond price $100
Initially highly liquid and price driven by market fluctuations and demand
for offering
Liquidity deteriorates within 6 months because outperformance of
Company financials results in few sellers and underperformance results in
few buyers
Phase 2: Company files 10-K or 10-Q
Hosts management conference call and discloses a deterioration in
operating performance and short term outlook not promising
Immediate dislocation in market with bond price range typically from 75-
90 and issue supported by anchor buyers who put in lot of work in
understanding the Company
Price and credit deterioration trigger credit focus screens among
distressed investors which may lead to short positions being established
and further price pressure towards lower end of range

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Credit Deterioration - Phase 3
Phase 3: Company files subsequent 10-Q
Disclosure of further credit deterioration which may include
Violation of senior secured credit facility
Total Debt/EBITDA increases above 8x
EBITDA/Interest falls below 1x
Further decline in bond price with stop at around 50 (estimated) -
dependent on size and condition of the shorts
Bond price settles between 25-40 as mutual funds continue to exit
credit and distressed buyers evaluate the opportunity
Distressed buyers that started work on the credit early in the
process dominate volume and may accumulate a control position
OR
The Company may report an improvement in operations and
securities trend towards 75-90 takes 2 quarters of continued
steady / improvement in operations

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Credit Deterioration - Phase 4
Phase 4: Further material adverse credit event
Event of default under indenture but no Chapter 11 filing
Bonds prices trend flat and trend towards approximately 20, material
downward asset re-valuation which may result in almost zero value for
unsecured creditors
Voluntary Chapter 11 filing which could be a prepackaged or a
prearranged deal
Reorganization Plan and disclosure statement make recovery analysis
clearer
Prices dependent on asset valuation, capital structure and timing of
emergence
Free fall Chapter 11 will lead to chaos and lack of disclosure
pushing bonds to 15-25

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Recovery and Restructuring Phases 5, 6, 7

Phase 5: Emergence
Court approval of plan, NewCompany capital structure
becomes effective
Pricing of old debt securities contingent on equity and or
debt prices of NewCo securities
Phase 6: Post restructuring
First 4 quarters of stronger operating statistics therefore
credit profile improves and equity value increases
Phase 7: Post restructuring
NewCompany experiences 6-8 quarters of steady operating
performance
Process of refinancing restructured debt securities begins
Newco seeks access to new issuance market

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Table of Contents

I. Overview of Distressed Securities Valuation Overview

II. Corporate Debt Pricing

III. How to Get Control of a Distressed Asset

IV. Case Study Samsonite

V. Financial Model

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Current Situation
Companies are coming under increasing pressure from lenders
at an earlier stage than before
Banks have a large number of distressed credits in their loan
portfolio
The leveraged loan market has experienced a sharp
contraction
Banks no longer have patience with troubled companies
Less willing to extend waivers indefinitely
Demanding more in fees and amendments
Banks are forcing more companies to go to auction or sell
assets quickly
Relationship lending is not as prevalent
Presents an opportunity for creative investors

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How to Get Control of Distressed Asset
Out of Court
Purchase bonds and exchange for equity in a privately negotiated
transaction
Exchange offer to completely recapitalize the Company
In Court
Formal process of a Chapter 11 reorganization
Chapter 7 liquidation

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Advantages and Disadvantages of In Court and Out-of
Court for Distressed Investor
In Court Advantages
Can acquire assets free and clear of liabilities and encumbrances
In Court Disadvantages
Transaction costs associated with bankruptcy proceeding
Potential for competing bidders and plans as part of the bankruptcy
process
Higher and Better offers
Out of Court Advantages
Can avoid competing bidders in open auction process
Avoid bankruptcy costs
Can privately negotiate a debt for equity swap that creates the right
capital structure
Out of Court Disadvantages
Possibility of acquiring hidden liabilities
May be stuck with acquired securities if situation deteriorates further

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Debt for Equity Swaps
Buying bonds at a discount and swapping into equity through a
privately negotiated transaction with the company
Can approach the original equity sponsor before buying the bonds to
ensure a friendly transaction and potentially access detailed due
diligence information
Acquire enough of the bonds so that a swap will engineer the best
capital structure for the company
Exchange the bonds for most of the equity
Leave original sponsor with a stub equity portion (5%-15%), warrants or
other consideration
More favorable than a long drawn out restructuring
Other bondholders remain in place
Now have par paper
Senior lenders should be more comfortable and willing to stay committed to the
credit
Must get in early and exploit the situation before the credit is too
distressed

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Exchange Offers
A more comprehensive approach could involve the combination
of an exchange offer and new money investment
Combines the restructuring of the old debt with a change of
control
Can often prove the most efficient method to gain control in
the public forum
Accomplished relatively quickly
Low transaction costs compared to bankruptcy
Avoid large number of competing bids
Difficult to accomplish in complex situations
Large vendor listings
Publicly listed equity
Diverse group of bondholders

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Chapter 7 vs. Chapter 11
Distressed opportunity typically arises when a company, unable to
meet all its debts, files for Chapter 11 (reorganization) or Chapter 7
(liquidation) bankruptcy
Chapter 7 involves shutting a companys doors and parceling out its
assets to its creditors
Chapter 11 gives the company legal protection to continue operating
while working out a repayment plan, known as a plan for
reorganization, with a committee of its major creditors
These creditors can be banks whove made loans, utilities and other
vendors owed for their goods and services, and investors who own bonds
Stock holders are also among the constituents, though when it comes to
dividing up the assets of the company they are paid back last and usually
very little, if anything
If in a bankruptcy, a company does not have sufficient assets to repay all claims,
the stock holders will get wiped out as they are last in line to receive any of the
proceeds from the liquidation or reorganization

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Chapter 11
Equity nearly always wiped out
Intense pressure to sell the Company
Most restructuring advisors are bankruptcy or M&A specialists
High risk of change of management
Lawyers control process with constant court appearances
Most restructuring advisors are bankruptcy or M&A specialists
Average time in Chapter 11 is over 12 months
Extremely costly in fees with $3 mm to $10 mm in fees for
lawyers and advisors in large assets

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Table of Contents

I. Overview of Distressed Securities

II. Corporate Debt Pricing

III. How to get Control of a Distressed Asset

IV. Case Study Samsonite

V. Financial Model

28
Company Overview
Samsonite is the worlds largest designer and manufacturer
and distributor of luggage products
Only global luggage brand
Approximately 31% market share in Europe and 19% in US in 2002
Competed in a highly fragmented market against much smaller
regional companies
Products marketed under Samsonite and American Tourister
brands - 90% brand recognition in the U.S. and over 70% in
Europe; 80% American Tourister brand recognition in U.S.
Expanded product line to include casual bags and computer cases
Europe market share 31% in 2002 CAGR of 11% growth in sales
since 1996
Asia sales growing at CAGR of 19% from fiscal 1997 to 2002
US market share fell from 30% in 1996 to 17% in 1999 due to
product and marketing, strategic decisions taken by management
Recovered to 18% in fiscal 2001 under new CEO

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Background and Situation in Late 2002/early
2003
Companys capital structure has had many issues:
Company stock was virtually illiquid at the end of 2002
Traded an average of under $5,000 per day and the bid ask spread is
approximately 65% of the bid price
Absence of institutional support/coverage for common stock
Total obligations (debt and preferred stock) senior to the
common stock have a face value of approximately $800 mm
Existing preferred is increasing through PIK dividends at such a
high rate that it grows by approximately $50 mm per year
Onerous terms of the Existing Preferred Stock increasingly
causing significant earnings dilution for common shareholders and
could precipitate a Company-sponsored exchange offer or
bankruptcy
Overall leverage is too high
1. Lack of financial flexibility to mitigate potential shortfall in earnings
performance
2. High risk/low probability of execution of Companys five year
business pan and forecast without a de-leveraging event

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Background and Situation Assessment
Balance Sheet and the reported financial statement losses continued
to affect Companys business and relationships with the Companys
suppliers, vendors and other constituencies
Management stock option plan is not able to provide incentive to
management in a way to benefit common shareholders
The impact of the downturn in the economy and the Companys
industry
Companys revenues and EBITDA were highly dependent upon performance of
international operations and global travel industry
Current geopolitical and economic climate puts downward pressure on tourism
and travel related industries, and adds uncertainty to the Companys business
model and operating forecast going forward
US war with Iraq
Terrorism concerns and is effect on international travel
Spread of SARS virus
Continued global economic softness

These issues have led to another significant decline in travel

beginning in early 2003, which have impacted the Company beginning
in February-March 2003

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Objectives of the Recapitalization Transaction

Recapitalization Transaction incorporates a financial

restructuring which accomplishes the three principal
objectives set by the Company to reduce total debt and
preferred stock of the Company
Convert preferred stock into common or convertible securities
Reduce leverage through issuance of equity securities
Address senior debt, particularly with respect to maturity as the
Companys existing senior credit facility matures in June 2003

32
Summary of the Recapitalization Transaction

Equitization of the balance sheet - $160 million Convertible

Preferred Stock
$106 mm of new equity investment in cash
$35.3 million contribution by Bain Capital
$35.3 million contributed by OTPP
$54 million of additional New Preferred Stock via conversion by
Existing Preferred Stockholders
Terms of New Preferred Stock
Dividends: 8% (PIK option) compounded quarterly, with upward or
downward adjustments after year 8 depending on control issues
Conversion Price: $0.42 per common share
Senior Debt
Approximately $60 mm of new revolver availability
103/4% Senior Subordinated Notes due 2008
$323.4 million of Existing Notes remain outstanding after the
recapitalization transaction

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Summary of the Recapitalization Transaction

137/8% Senior Redeemable Exchangeable Preferred Stock (Existing

Preferred Stock)
$320.3 million face value of Existing Preferred Stock with liquidation
value of $333.5 million as of March 15, 2003
Holders will elect to exchange their Existing Preferred Stock for either
New Preferred Sock or common stock or a combination of both, subject to
a proration in the event that he holders of Existing Preferred Sock
collectively elect to receive more than $54 million in New Preferred Stock
$129 mm converted into $54 million face value of New Preferred Stock
Valued at 41.9% of liquidation preference ($54 million/$129 million)
Remaining $204.9 million of Existing Preferred Stock converted to
common stock at $1.00 per share (equivalent number of shares to valuing
at 41.9% of face and converting into common stock at $0.42 per share)
Aggregate implied valuation of Existing Preferred Stock is $140.1 million
Common Stock
Proposal involves a conversion of the New Preferred Stock into common
stock at a conversion price of $0.42 per share
Common shareholders would initially own approximately 3.3% of the
Company pro forma the proposed Recapitalization Transaction
New investors have the right to elect five out of the nine Board Members

34
Alternates to Recapitalization
Issues with status quo with new senior credit facility
Management issues
Capital structure issues
Refinancing difficulties of new facility

Issues with sale process with other parties

Prior sale process yielded no or low interest
Effect on business while conducting sale
Management issues will still remain
Capital structure issues buyer will not be comfortable

35
Table of Contents

I. Overview of Distressed Securities

II. Corporate Debt Pricing

III. How to get Control of a Distressed Asset

IV. Case Study Samsonite

V. Financial Model

36
IS, BS and Old Capital Structure
Let us model the historical income statement and balance sheet for
year ended January 31, 2001, 2002 and 2003
Information is available in Samsonite 10K for January 31, 2002
and 2003
Make sure we check our data after we complete the income
statement
Net Income ties in to the NI from Income Statement barring any
unusual or non-recurring items we took out
Assets = Liabilities + Shareholders Equity
Income Statement
Observe the drop in revenues and EBITDA in 2002 vs. 2001
See how the Preferred Stock dividends (37.5 mm dividend in 2002
are impacting the Companys Net Loss every year
Balance Sheet
Observe how the redeemable preferred is increasing from $240.0
mm to $320.3 mm from 2001 to 2003 as it is PIK interest (paid in
kind a type of bond that pays interest in additional bonds or
interest is added to the principal, as opposed to cash payouts )

37
Sources and Uses
Let us prepare sources and uses for the recapitalization
transaction
Pay down old term loan and revolver
Fees paid to bankers, lawyers and miscellaneous expenses
is $20mm
$106 mm of new preferred equity is being put in by private
equity investors
Use the January 31, 2003 numbers
Keep the cash balance the same as before at $22.7mm
Sources equal uses and the balance will be the new
revolver balance

38
Pro Forma Balance Sheet and Capitalization

Let us make a pro forma balance sheet for January 31, 2003
incorporating the sources and uses for the recapitalization
Capitalize $5 mm of the $20 mm of fees and the other $15 mm
get expensed
Uses the sources and uses table to make the adjustments
In the pro forma capitalization see how the following ratios
change as a result of the recapitalization look at these ratios
before the recap and after the recap
Total Debt to EBITDA
(Total Debt + Preferred Stock) / EBITDA

39
Pro Forma Ownership
What % of the Company do the Existing Common Shareholders
and the Preferred Stockholders get after the recapitalization?
Conversion price of preferred shares to common stock is $0.42 per
share
Find the current common shares outstanding for Samsonite from
the most recent 10K or 10Q (January 31, 2003)
Find out how many shares and % of the Company the common and
preferred shareholders get (Old preferred and new preferred
shareholders)
The private equity investors end up owning more than 50% of the
Company after the recapitalization for the $106 mm equity
investment they made as they owned some of the old Preferred
also (41.7% as the result of the $106 mm investment and over 10%
from the Old Preferred shares)

40
Valuation Analysis
We did a valuation analysis to see how much would Samsonite
common shareholders and preferred shareholders get in the
current company without the recapitalization
Comparable Company looked at other brands challenging to
find appropriate comps to Samsonite Comps included apparel
companies like Nike, Ralph Lauren as one group and luxury
groups like Coach, Gucci and Waterford
Comparable Transaction challenging to find appropriate
comparable transactions also Antler was sold to an investor
group etc
Discounted Cash Flow Analysis - forecast free cash flow for 5
years, terminal multiple of 7.0x-8.0x and discount rate of
approx 10%-14%
We see that common shareholders get zero in most of the
scenarios

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Implied Enterprise Value

We calculate the implied EV of the Company of the

recapitalization
Existing debt of $423.2 mm
Preferred stock is valued at 140.1 mm
333.5 mm of liquidation preference of preferred valued at
$.42 per share
Equity is valued at 8.4 mm
19.9 mm common shares valued at $.42 per share

42