Exchange Vet Returns To Changed Market

The last time James Schneider oversaw a debt exchange, Bill Clinton was still going through the rough spots of his first term as President, and students at the University of North Carolina were planning the first ever Internet radio broadcast. Circumstances have changed since Schneider's early retirement in 1994, but his experience with exchange offers could not be timelier. Last week, Morgan Joseph announced Schneider had joined the firm as a managing director of a special effort to manage exchange offers. While Schneider notes that there are many obstacles now facing companies hoping to do debt exchanges to avoid bankruptcy, he says that the debt markets are entering a new era of creativity and complexity.

Morgan Joseph's Fred Joseph recruited Schneider for Drexel Burnham Lambert in 1975. Schneider served as the head of Drexel's restructuring group from 1981 until 1991. His group was sold to Smith Barney, and he worked at Harris Upham & Co. before retiring in 1994.

The need for exchange offer specialists is greater today than it was when his Drexel group had an 80% market share on them, Schneider said. "When this financial downturn came, I said, 'Oh my goodness, I'm afraid I'm going to have to go back into business.' And my wife said, 'Well sure you've got to go back into business. Those people won't remember the 1990s or the '80s.' ... A lot of the younger people in the business don't remember tough times. And the last time was the early '90s and the last time before that was the early '80s."

And exchanges have taken off. Moody's Investors Service reports that there were 23 distressed exchanges on rated issues in 2008 affecting a total of $36.9 billion in debt. In 2007, there were four such exchanges affecting $920 million.

Dressed For Distressed

Schneider's addition to Morgan Joseph is a part of the firm's wider expansion effort into the distressed and restructuring arena. Last September, Morgan Joseph added a seven-person financial restructuring group from Alvarez & Marsal Corporate Finance. The group is led by James Decker, who was most recently national co-head of Alvarez & Marsal Corporate Finance. Schneider said that Decker's group is more focused on helping companies that are already in bankruptcy, and that his focus is more on companies trying to avoid it.

Schneider said his focus is about 50% on healthy companies and 50% on distressed companies. He said he tends to look not so much at the type of security offered, but rather the type of company to determine whether to propose a debt-for-equity exchange or a debt-for-debt exchange. He does have a rule of thumb. "You tend to use debt more the more troubled the company is, and you tend to try to use equity the healthier the company is," he said.

For Schneider, the biggest obstacle to getting debt exchange offers executed is the current tax law regarding taxable exchanges, which were different than they were when he was last in the business. Currently, companies must pay income tax on any savings or gains made in an exchange, unless the company is in bankruptcy. During Schneider's time at Drexel, the overwhelming majority of exchanges were tax free. "When you swap debt into equity you're probably doing a taxable transaction. Unless you have the right issuer and the right circumstances, that's going to be done much less outside of bankruptcy than inside of bankruptcy. ...There is a very, very narrow window of deals that you can do tax free. The bulk of exchange offers will be taxable," said Schneider. "And the taxability oftentimes changes the economics dramatically."

Currently, an effort in Congress is underway to allow issuers or the private equity firms buying their debt to defer these income taxes and pay them over eight years. The measure is a part of the larger stimulus bill, and this tax provision has been added in the Senate version of the bill.

But the differences in today's market for exchanges are not all bad, according to Schneider. "One of the improvements is that in the old days when you offered common stock for a particular security, the arbitragers could only sell on an uptick, and now the short sale rule has been changed so you can sell on downtick," he said. "That's actually an improvement in exchange offers from 20 years ago."