An In Depth Book Review by Sam Spomer, Creighton School of Law
Vultures have a predilection for the dead and dying. As in the animal kingdom, investors circle struggling businesses like vultures. Although these vulture investors and other scavengers are needed to clean up failing businesses, these investors have gained a terrible reputation. Yet, according to author Hilary Rosenberg, the term “vulture investor” is a misnomer indicating selfishness of the worst kind. Instead of picking apart a dying business one piece at a time, vulture investors may allow the business a rebirth and a new opportunity at life.
Rosenberg seeks to take the reader through the tension of Chapter 11 reorganizations as vulture investors clash with other creditors, shareholders, unions, the debtor business and other vulture investors. The Vulture Investors reads more like a suspense novel than a bankruptcy textbook. Rosenberg does not cite any bankruptcy code sections or any case law. Alternatively, Rosenberg immerses the reader in the story surrounding seven case studies of companies ranging from a struggling nuclear power plant in New Hampshire to the manufacturer of Cabbage Patch dolls to Donald Trump’s Taj Mahal. Each case study is unique with an evolving cast of characters and a variety of challenges that must be overcome by all parties involved.
Each case study begins with a short summary of the major players and what circumstances led a company teetering on bankruptcy. Most of Rosenberg’s information is derived from interviews with the actual players. These interviews allow Rosenberg to provide insight into each player’s thought process and motives; information that would not be contained in popular news publications. Rosenberg focuses on how each vulture’s unique characteristics shape how that particular vulture attacks reorganization. Although each vulture has a unique back-story, almost all of them have a common tie to the reorganization of America’s railroads in the 20th century.
The Origins of Vulture Investing
Vulture investing rose like a phoenix from the rubble of the Great Depression. Bankruptcy investing grew as the number and the size of the bankruptcies grew. In turn, the number of vultures investing in them took off. During the late 1930s, a majority of the nation’s railroad companies were in bankruptcy. Investors realized that the railroads were making money but something needed to be done about their defaulted bonds. The small group of vultures that invested in the railroads in the early 1940s would eventually become the movers and shakers of the vulture investing community of the 1970s. Bankruptcy investing was ultimately popularized by the reorganization of Penn Central Railroad in the 1970s. Penn Central was the largest bankruptcy of its time and offered dozens of bond issues. A swarm of young vulture investors descended upon Penn Central and those vultures emerged as the leading players in the 1980s and 1990s.
The Modern Era of Vulture Investing
In the 1980s, the number of vulture investors grew substantially due to the downturns in certain sectors of the economy, including energy and steel, and because companies were struggling to realize that the 1978 revision of the bankruptcy code encouraged bankrupt companies to reorganize. At the same time, the number of vulture investors was increasing, driving the price of bonds upwards. Previously passive vultures began to try to outmaneuver other vultures by taking a very active role in the reorganization. The vulture investors played a growing role in the reorganization of corporations in the bankruptcy system by using the Chapter 11 system to their advantage.
By the end of the 1990s, the vulture market had matured and transitioned into a “much more efficient machine.” There is now a secondary market for distressed debt and it is much more common to see a bankruptcy without any of the original creditors. So-called “prepacked bankruptcies” are now the norm. In turn, companies are able to restructure much more quickly and resume life. Although vulture investors continue to earn enviable returns, shareholders are often left with little after the company reorganizes.
The Field Guide to Vulture Investing
Vulture investors seek out value that has gone unappreciated and unnoticed by the markets. They are not searching for dying businesses. Instead, vulture investors are seeking businesses that are in bankruptcy, close to bankruptcy or heading down the road to liquidation but have a chance to stabilize and thrive with the investor’s assistance. In essence, vulture investors look to provide liquidity to troubled businesses by buying debt and eliminating that debt by transferring the debt into equity through reorganization. It is that extra liquidity that allows the business to continue operations and achieve maximum value. According to the author, a successful investment strategy will earn higher than thirty percent returns. However, as shown in the case studies, one incorrect move and the investor can potentially lose the entire investment. The success of a vulture investor relies upon proper valuations, sufficient capital, timing, and expert-level understanding of bankruptcy. Luck doesn’t hurt either.
As a general strategy, vulture investors find undervalued companies that are currently illiquid and lead the company through restructuring, usually in the form of Chapter 11 bankruptcy. The first step is to value the company. Although Rosenberg does not discuss valuation in any depth, she does note that most vultures’ valuation is a result of “painstaking research and an encyclopedic knowledge of the bankruptcy code.” After the vulture has identified a proper target, the next step is timing the investment. Due to the target company’s illiquidity and the looming threat of bankruptcy, the company’s bonds and other debt should be selling for pennies on the dollar. However, if the investor is not patient, the investor may purchase at too high a price and lose substantial potential returns. Several of the book’s case studies show the consequences of purchasing debt at too high a price. A vulture’s next step depends upon the type of vulture investor.
Rosenberg classifies vulture investors as either Migratory Birds or Nest Builders. Migratory Birds are the traditional type of vultures who “dart in and out of securities looking for a good trade.” Speculators and traders are examples of Migratory Birds. Migratory Birds will usually see the company through restructuring but will quickly sell their interest once the company has regained its value. In contrast, Nest Builders stay with company for the long term, even after the company has regained its value after restructuring. Nest Builders attempt to acquire the whole company or a significant portion of the company’s debt, which will be exchanged for a large portion of the company’s new stock in reorganization. The Nest Builders will then run the company themselves or transition the company to a new management team.
Both Migratory Birds and Nest Builders have increasingly become activist vultures. Vulture investors will use numerous aggressive techniques to restructure the company and give themselves a substantial interest in the company. If the company enters bankruptcy, the vulture has to decide if the vulture is willing to join a creditor’s committee or if the vulture will remain independent from the creditor’s committee. The vulture will have greater liquidity if the vulture does not join a creditor’s committee because the vulture will not be prohibited from trading on his investment. Yet, that liquidity comes at a cost. If the vulture joins a creditor’s committee, the vulture will have inside information into the company’s reorganization and a greater ability to steer the reorganization plan that is most favorable for the vulture investor.
Once a vulture is classified as either a Migratory Bird or a Nest Builder, Rosenberg looks to whether the vulture investor is a Heavyweight. Heavyweights do not usually bother with committees because the Heavyweight’s size requires that the company deal with them on an individual basis. Heavyweights form their position by purchasing a large block of the company’s debt or equity to form a blocking position because every reorganization plan requires a majority of holders carrying two-thirds of the debt of each voting class of claims. The Heavyweight may simply threaten to block the reorganization. Although Heavyweight tactics can be highly effective, they are not recommended by all vulture investors. One Heavyweight’s blocking tactics may unnecessarily drag out reorganization for months beyond what is best for the company and the other creditors.
Once the vulture investor has a blocking position, the vulture investor must either work with the current management on a reorganization plan or the vulture may propose his own plan. Under the Bankruptcy Code, the company has the ability to propose a reorganization plan to creditors first for a specified amount of time. However, as shown by the case studies, vulture creditors usually have their own reorganization plan, called a “prepacked bankruptcy” or prepack, prior to investment. In several of the case studies, the vulture investors go to the bankruptcy judge and ask for the ability to propose their plan to the other creditors. Quite commonly, the vulture investor’s reorganization plan focused on a capital contribution by the vulture investor and a new stock distribution to both the vulture investor and the other creditors in satisfaction for the company’s obligations. At the end of the day, the company’s former shareholders are left holding the bag, with little or nothing to show for their previous investment in the company. If all goes according to plan, the company will have a fresh start and the vulture will have a tremendous return.
However, as shown by the case studies, the reorganization rarely goes according to the plan. The opportunity for extravagant returns will usually draw more vulture investors. When other vulture investors arrive, it becomes a battle in which all vultures attempt to persuade the creditors that their valuation and their reorganization plan are in the creditor’s best interest. These conflicts arise many times in the case studies and are rarely amicable. For example, in one case study, two vulture investors invest separately in a distressed company in two different creditor classes. The investors disagree as to the proper valuation of the company and one of the vultures blocks any reorganization plan that does not provide that vulture a specific level of return. These vultures have a multitude of tools at their disposal. First, the vultures can continue to block each other’s plans until one vulture becomes frustrated and sells his investment. However, this is a dangerous game to play and will hurt both vultures in the end. Instead, some vulture creditors will attempt to disqualify the other vulture’s creditor class from voting. By making this request to the bankruptcy judge, one vulture can effectively be removed from the reorganization process. Another option, and by far the most practical, is to negotiate a deal with the other vulture investor. All in all, the case studies show that the company’s management does not control the reorganization process. Instead, the vultures ultimately control the reorganization process.
As long as there are undervalued companies nearing reorganization, there will continue to be vulture investors. Rosenberg notes the field of potential vultures is expanding from small management firms to large investment firms such as Oppenheimer Fund and Fidelity Investments. Even with these large firms entering the reorganization market, there will still be a niche for the smaller management firms described in the book. The smaller firms will have to be more precise in their valuations and more selective in their targets, but they can still survive. After all, Rosenberg shows in The Investment Vultures that discount investing is not a science and a cookie-cutter approach will not work with all reorganizations. In fact, discount investing is an art that requires persistence, creative thinking and luck.
Sam Spomer is a Compliance Assistant at the University of Nebraska-Omaha and a 2012 J.D..