PPM Finance: Take Control and Write the Rules
August 30, 1999
For most firms the size of PPM Finance, a special investment group that buys distressed debt, building a large staff isn't a top priority.
But despite its portfolio of $1.4 billion, Chicago-based PPM has 25 professionals overseeing its assets. By contrast, parent PPM America has about $45 billion in assets and a comparatively low 125 professionals.
According to John Stark III, PPM Finance executive vice president and general counsel, this heavy personnel ratio is necessary when considering the intense focus each debt issuer receives.
"We're not only very collateral-oriented, but also very management-fixated," Stark said. "It all comes down to the people."
Spread over distressed funds, two collateralized loan portfolios, and asset-based and debtor-in-possession loans made directly to companies, the investment group acts more like an equity fund in terms of analysis and returns. "It's private equity type of opportunities at a discount," Stark said.
PPM is perhaps best known for leading the charge on a number of bondholder disputes with management and has a track record of getting more money for debt investors. A notable example was Hills Stores Co., a discount retailer, and its acquisition by Ames Department Stores. PPM owned some of Hills' 12.5% notes and strongly objected to the acquisition because of the tender offer of 55 cents on the dollar.
The notes were actually trading below 55 at the time, but there was still, as usual, a 101 change-of-control option, and Stark personally wrote a letter to management decrying the deal. PPM demanded par value, and the two sides finally settled on a price of 70. PPM said it earned a 19% annualized return on that investment.
Another case that PPM cites as an "acquire and operate" case study involved a six-year saga with Carolina Steel Corp.
PPM led the filing of an involuntary Chapter 11 bankruptcy petition against the company in 1993 and two months later bought the controlling share of a $37 million debt issue for about $3.5 million, a little under 10 cents on the dollar. As part of the subsequent bankruptcy, PPM's client ended up with 95% of the equity of the company.
After emerging from bankruptcy, the company increased cash flow to $11 million in 1998 from $4 million in 1994, and also sold off its stressed concrete and service center business, which decreased the debt load significantly. By this year, PPM had realized a 31.4% annualized return from the initial investment it made in Carolina Steel in 1991.
Big Fish In A Small Pond
So how does an investor managing less than $2 billion wield enough power to make such demands and realize the bounty?
Basically, it tries to be the big fish in small ponds. By avoiding comparative oceans like Nextel or Qwest, it looks at smaller issuers, or at least smaller tranches of big issues, and tries to take a large stake, or what Stark calls a control position.
If possible, PPM looks to take a 33% share of each investment, thus giving it enough pull with management to make demands when necessary. If it can't get 33%, PPM at least tries to get a bigger share than anybody else, Stark said. And it doesn't hesitate to use its influence, negotiating for more in takeover situations and even replacing management when necessary.
While many investors avoid such a strategy because it cuts down on liquidity when any one fund holds a huge majority, Stark said that finding a buyer for his paper is not the primary concern. PPM's time frame is longer than many distressed investors, so when Stark buys, he's not looking to sell next week or next month to generate quick returns.
"We assume we'll hold investments for about two years and we assume we'll end up owning the company," he said. It does not always work out to such a drastic end, and indeed if a given investment does not require a lot of meddling, Stark chalks it up to a pleasant surprise. But he goes in assuming he's in for the long haul.
PPM also has taken seats on the board of directors of issuers in the past when the situation warrants that level of involvement.
The second primary thrust of PPM's investment strategy, odd as it may sound, is to avoid risk. "We're very risk averse," Stark said. "That may sound strange [coming] from a distressed investor, but we focus on collateral to minimize downside risk."
Focusing on collateral still leaves a wide range of possible investments, he said, and it becomes a case-by-case analysis of the issuers. Even retailers, which are popular right now with distressed investors, have collateral in the way of inventory and stores.
Rising Defaults No Problem
So what's the outlook for a distressed investors like PPM?
Pretty good, to hear Stark talk. His company's distressed investments have maintained a 20% return over the past couple of years, and he expects to maintain that level if not increase it over the next year.
The classic perception, Stark said, is that when the economy is booming, distressed investors get poor returns, but with the default rate starting to increase, he said there will continue to be buying opportunities regardless of how well the overall economy is doing.
The biggest challenge, not surprisingly, is to avoid taking a ride on the clunkers that come along. But when you have the control position of the debt, it makes things much easier when things get ugly and negotiations begin, he stressed.
"You may begin negotiating a nine in the morning and go past midnight, and everybody's mad at everybody else... but when you're writing the rules, you'll win a lot of the times," Stark added.