Twenty years ago this month, the Enron scandal came to light. It was one of the biggest falls from grace for a Wall Street darling in recent history. It was the largest bankruptcy at the time (2001). That is, until a year later when Worldcom filed and more recently with the financial crisis.
The fraud at Enron destroyed the accounting firm Arthur Andersen. It led to new regulations with Sarbanes-Oxley Act. A book, The Smartest Guys in the Room, was written about it (then made into a movie with the same name). But worst of all, the shareholders were wiped out.
If there is one lesson to take away from Enron’s collapse, it is the risk of having a huge chunk of your net worth tied to the existence of one company. A lot of decent shareholders, including employees, were completely oblivious to the fraud going on at the top. They were all wiped out!
Unfortunately, while bankruptcy often has a nasty ending for stockholders, it’s not the end of the story. Another world of investing exists around failing companies.
A bankrupt company still has assets, which are sold off to pay its creditors. Secured creditors, like bondholders, are paid first. Unsecured creditors, like banks, employees, and suppliers are next, if there’s any money left. The stockholders are always last and typically get nothing.
The general pattern around these types of events goes like this:
- The news comes out that a company is at risk
- The market overreacts to the news — the more complex the situation, the more uncertainty, the more likely stock and bondholders rush to sell
- The supply/demand imbalance from excessive selling pushes prices down
- The price action of that security is why almost everyone avoids it
- The rush to sell can spill over into an entire sector or market
- But falling prices create opportunities because a price exists for every security where even the most horrendous company becomes a steal
Enron’s downfall, and the complexity around it, created a unique opportunity for distressed debt investors. And Seth Klarman happened to be one of them.
Klarman once explained his investment thesis on Enron and how it fit his investment philosophy perfectly. He wasn’t alone either. Oaktree had one of the biggest positions at the time.
Distressed debt is not a typical topic here because the average investor doesn’t run around buying up distressed debt on the side. Nor do I. But it probably makes for a good case study for someone interested in the field and I found Klarman’s explanation interesting nonetheless.
Anyways, here’s Klarman’s take on Enron:
We went from probably owning 5% of our assets in distressed debt in 2001, to 55% in the summer or fall in 2002. What happened is Enron filed for bankruptcy in December 2001, Worldcom in June of 2002, and the world basically said, “Oh my god. If Enron and Worldcom can have fraudulent numbers, bad accounting. Who can trust these lying bastards running these companies. How many other companies in this space have these problems?”
In wasn’t just Enron. Dynegy started to admit problems. Other companies started to have problems. Other companies were teetering on the brink of bankruptcy. There was self-fulfilling prophecy at work as the capital markets closed to these people. As the “private market” type buyers that used to love paying ten times cash flow for these assets, all of a sudden weren’t there at five times. Which is one of the issues I have with private market value as a concept is it’s a nice concept but there’s a circularity to it. It only works when there’s optimism, financing available, etc. etc. When things go wrong, it’s not there.
So the market had suddenly gone from saying, “We love telecom. We love energy,” to every telecom and every energy company, “I don’t trust the numbers. They’re probably filing for bankruptcy. Let’s get out of all of them.” So summer of 2002, we are buying Enron debt at 15 and 10 cents on the dollar… So there could not have been a more tainted name in history.
Our analysis of Enron – and it is currently our biggest position, it has been bigger but they’ve been mailing back a bunch of money – is it’s our favorite kind of investment. It’s senior debt, in a bankruptcy, with a lot of hair, a lot of complexity, very hard to analyse, a lot of litigation, a lot of uncertainty, and so much stigma that everybody that owned Enron wanted out of it after it filed. That within that year, huge amounts – huge percentage of the claims – not only bonds, not only bank debt, but even company claims. Enron did a lot of energy trading. So there were major energy companies like Enron or Shell or I don’t know who or pipeline companies that were all selling claims against Enron at cents on the dollar. As I said, 15 cents even 10 cents on the dollar.
What’s really complicated about Enron – although it’s a characteristic of many bankruptcies — is the way to think about how you do in a bankruptcy, there are two sides. It’s very simple. There are assets and there are liabilities. That sounds like Accounting 101. In a bankruptcy the assets are fairly straightforward. Forget about what the balance sheet says. Just look at the assets. Either it’s cash. As is the case of Enron, a lot of the assets got sold or where trading claims like a brokerage firm might have and they collected a lot of it. So they had cash. They had some foreign energy businesses. They had a utility that at times they thought they were going to sell, at times they decided they couldn’t sell. And ultimately, over several years of liquidating assets, they ended up with $16 to $18 billion of assets – I don’t know the exact number – of which most was in cash and a bunch was also in the Portland, Oregon utility and some international energy assets. So call it $16 billion, maybe a little more.
Then they had liabilities. Liabilities were largely senior debt. The complication in Enron was there were, like, over 1,000 subsidiaries and you had to sort out which assets belonged to which subsidiary. Some subsidiaries had guaranteed the debt of others. That all had to be unravelled in court – very very complicated, hard to know. One of our people basically spent the better part of the last four years understanding what the unraveling was like, dealing with court proceedings, trying to meet with them even when they were all fired, incredibly complicated issues. But our bottom line was the company was lowballing the recoveries because they were highballing – overestimating – the claims. The company was, at various times, saying $50, $60, $80 billion of claims.
The simple math of a bankruptcy — forgetting about senior debt and subordinated debt — is your recovery on your debt is assets divided by liabilities. So if you have $16 billion of asset value and you have $50 billion of liabilities, you get 32 cents on the dollar. If you have $100 billion of liabilities, you get 16 cents on the dollar. If you have $25 billion of liabilities, you get 64 cents on the dollar.
That was the entire issue at Enron. That our feeling was, based on detailed analysis and corroboration from various things along the way, that the company was overestimating. And why would they do that?…When the people liquidating Enron wanted to tell the world how it turned out, they said, “Oh my god! It’s going to take forever. So much expense. So few recoveries. So many claims. We’ll be lucky to get 17 cents on the dollar.” And that was the first thing they filed in bankruptcy court — 17 cents. And the debt traded down to — it was already depressed, I think it got worse — down to 14 or 15 cents. And our analysis was always that the recoveries would be from the mid 30s to the mid 40s. Over time, we’ve actually gotten more optimistic and now think eventually the recoveries will be well over 50.
And so it’s been a complicated but wonderful process as things have gotten more clear of adding to the position and then holding it as it rallied a lot. It went from 10 or 15 cents on the dollar back then, eventually getting to 40 plus cents on the dollar. Which causes what was a 7% position when we first took it, to become a 16% position as of a month or two ago. And then we got a bunch of money back as they paid 12 or 13 cents April 1st.
Now, the other thing and this speaks to several aspects of our firm. First of all, our idea of the lowest possible risk type of position you can take is senior debt in a bankruptcy. We’re the only people in the country that think the safest thing we could do is put a huge chunk of your money into Enron debt. But that is, in fact, the case. That, I think I have given lots of reasons why the market figured to overreact to Enron, why few buyers figured to show up, why all the holders figured to sell.
Seth Klarman Lecture
This post was originally published on July 19, 2017.
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