THE BIG MONEY IN BUSTED BONDS Who would invest in the troubled utility that owns Seabrook? Specialists who recall that bankrupt Interstate Stores turned into highflying Toys ''R'' Us.
By Eugene Linden REPORTER ASSOCIATE Patricia A. Langan

(FORTUNE Magazine) – AS IT STRUGGLES to avert bankruptcy, Public Service of New Hampshire finds its fate largely in the hands of a small group of investors who were attracted to the company precisely because of its financial predicament. One of these investors, Martin J. Whitman of Whitman Heffernan & Rhein, a New York securities firm, controls so many Public Service senior bonds that he is a deciding factor in any plans the utility may have to restructure. Another speculator in the utility, which is best known for its troubled Seabrook nuclear power plant, is Randall Smith, head of R.D. Smith & Co. The brokerage firm controls a large amount of unsecured debt, figuring that it will appreciate as the Seabrook showdown nears. Whitman and Smith are leaders in the market for so-called distressed securities, issues driven far below true value by investor response to bad news. With so much bad news around since October 19, the market for distressed securities looks good. Specialists like Whitman and Smith sift through the rejects of the U.S. economy looking for what they consider relatively riskless investments. They sometimes put their money into the common stocks of ailing companies. But because returns on stocks are unpredictable, they more frequently invest in the bonds of companies on the brink of failure or already over the cliff. These bonds tend to trade at bargain prices, even though they retain claims on company assets. Meltdown Monday hurt the distressed market temporarily, but it has charged back. Since the crash, R.D. Smith's portfolio of recommended distressed securities has dramatically outperformed both the over-the-counter composite index and Standard & Poor's index of 500 stocks. Astute Wall Streeters have long seen the profit potential in disaster. Before and after World War II, speculators pounced on the underpriced wreckage of the Great Depression. In the 1970s those who took a flier on such bankrupt companies as Penn Central, the Chicago & Milwaukee Railroad, and Interstate Stores (now Toys ''R'' Us) reaped immense rewards. In recent years distressed situations were too few and too small to warrant a brokerage business all their own. But now bankruptcy is considered a normal business tool, and life- or-death financial restructurings -- proposals to swap debt for equity, to lower interest rates, or to stretch out payback times -- are commonplace. Last year was the best in the history of the distressed securities market, which could amount to $20 billion in 1988. Insiders say that no more than 100 professionals have the mix of nerve and knowledge to play this arcane game. Most specialists can be found at small entrepreneurial firms, but such Wall Street giants as Goldman Sachs and Salomon Brothers also have distressed securities operations. James D. Bennett, 33, chief operating officer of R.D. Smith, figures that of roughly 200 distressed companies that the firm follows at any time, only 20 promise real appreciation. Among them: Manville, Public Service of New Hampshire, Storage Technologies, and Texaco. The trick is not just to identify the company; the real talent lies in seeking out the security likely to make the most money. At Texaco he figures it's the 10% debentures; at Public Service it's 17.5% debentures. The distressed market is not for the faint of heart. For one thing, it requires players to put aside conventional measures of value. Says Bennett: ''Ordinary investors are guided by the size and predictability of future earnings. Huge losses, uncertainties involving unresolved legal issues, and the fluidity of events scare 99% away.'' Investors also tend to overreact to bad news, driving down prices. According to Edward I. Altman of New York University's Graduate School of Business Administration, the average stock loses about 40% of its value in the month after a bankruptcy is announced, and the average bond takes a 25% hit in the month following a default. But the prices tend to drift back as investors begin to trawl for bottom fish. Martin Whitman, like his fellows in the distressed market, counts institutional investors as his principal clients. He is currently raising money to start a new fund. Entrance fee: $5 million. THE DISTRESSED securities market is confoundedly complex. Analysts routinely wade through briefs filed in lawsuits, the fine print on bond indentures, and the footnotes to accounting statements. Says Whitman: ''The more you deal with a large number of variables that are hard to weigh, the more inefficient the market.'' Success depends on hawk-eyed research to spot the inefficiencies and speedy trading to take advantage of them. Highly specialized research can unearth gems. Take the case of Dome Petroleum, the Canadian company sent reeling by its bet that oil was heading for $100 a barrel. Yakil Polak, an analyst with R.D. Smith, saw that the fine print in one of Dome's many debt offerings -- unsecured 14.75% debentures due in 2006 for the driller's Hudson Bay unit -- stated that if any other Hudson Bay debt was secured, these bonds would become secured as well. Continuing the search, Polak found that a group of banks led by Citicorp had made the company a secured loan. Further research showed that the Hudson Bay debentures were backed by valuable assets and consequently were worth more than par. At the time Polak made the discovery, the bonds sold for 75 cents on the dollar. Smith & Co. bid on the bonds but never corralled the thinly traded issue. Now the secret is out, and the bonds are selling at par, a 53% return (profit plus accrued interest over a year) for nimble investors. Distressed market mavens watch the junk bond market closely. The case of Dart Drug shows why. In June 1984 the managers of the Washington pharmacy chain bought the company from its parent, the Dart Group, a large holding company controlled by the Haft family. The Hafts, who are not known for giving things away (FORTUNE, June 22, 1987), got $160 million for a company that then had a net worth of only $22 million. To finance the buyout, the managers issued 12.7% debentures, saddling themselves with heavy interest payments. Almost instantly Dart's big competitors launched a ruinous price war. Ten months after the buyout, the retailer faced the prospect of default and bankruptcy. By April 1987 its bond prices had fallen from 100 cents to 35 cents on the dollar. At that point bargain hunters got interested. ''This is wonderful,'' one remembers saying at the time. ''I'm going to get rich off Dart.'' The new investors bet that Dart bondholders would vote to restructure the company to avoid bankruptcy. They won the bet, but it was close. On the day before Dart was prepared to file for Chapter 11 last July, enough bondholders agreed to exchange their old securities for new ones to save the company. One investor delivered his bonds to the Washington trustee by radio cab from his summer home on Long Island. As part of the restructuring, the bondholders got securities worth 55 cents on the dollar. That was a big loss for the original purchasers, but a fantastic 57% gain for investors who bought the bonds at 35 cents three months earlier. Bennett expects to be looking at a lot more companies like Dart. Says he: ''Financially precarious companies are going to have a harder time doing junk bond financings after the crash, which means that a year from now we are likely to see a lot more restructurings.'' Skillful investors can find value even in basket cases like Crystal Oil. The combination of high debt and low oil prices forced Crystal into bankruptcy after it posted $232 million in losses against $51 million in revenues in 1986. The Shreveport, Louisiana, oil and gas company owed creditors over $400 million but had assets estimated at only $100 million. Still, some nimble distressed securities experts bought Crystal bonds at 4 cents on the dollar and got back 16 cents when the company emerged from bankruptcy. The company is now making money. EVEN THE DISTRESSED players sniff at Worlds of Wonder, the manufacturer with the hot products of Christmases past -- a talking bear named Teddy Ruxpin and a sci-fi gun set called Lazer Tag. The company filed for Chapter 11 before Santa packed up his 1987 sleigh. In spite of its early success, Worlds of Wonder could not keep up with the fickle tastes of children, and it never made even the first interest payment on junk bonds issued by Smith Barney last June. The bonds recently traded at 7.5 cents on the dollar. Some distressed players say they might consider WOW at a nickel. Betting on bankruptcies requires patient analysis. By contrast, betting on a restructuring plan to avoid bankruptcy requires a poker face and strong stomach. The drama comes when distressed investors wager how and when the other holders will play their hand. If the investors vote to reject the plan, the company goes into the tank. If the plan passes, two different things happen. The 85% or so of the holders who voted to accept the plan turn in their old securities for new ones. The remaining investors -- the ''holdouts'' -- end up with securities worth much more than those offered in the restructuring. That's because the company is obligated to honor the original terms of all outstanding securities. SPECIALISTS in the distressed market can play a restructuring in two ways: They can try to be holdouts or they can attempt to control the deal. In the free-for-all over hard-pressed Petro-Lewis, both strategies meant headaches for James R. ''Jim Bob'' Moffett, chief executive of Freeport-McMoRan, the New Orleans natural resource company trying to take over Petro-Lewis. To complete the acquisition, Moffett needed to get 90% of the bondholders to agree to a restructuring plan. Instead of agreeing, the junior bondholders figured they could make more money by holding out. At one point Moffett convened the 15 major holders of Petro junior bonds to force them to some consensus. According to a participant, one heavy hitter after another pretended not to have enough bonds to be of consequence. Moffett got so exasperated that he left the meeting, asking the group to choose a leader to represent them. He says: ''When I came back, they hadn't chosen a spokesman because each one wanted to be the last guy with bonds.'' Marty Whitman, who held highly secured senior bonds, was no holdout. Says he: ''Our basic business is to buy the most senior securities and to buy enough so that a deal can't go through without our consent.'' He developed this strategy in the late 1970s, when he realized that the bankruptcy reform act entirely changed the game for investors. The act has provisions that allow the ailing company and the creditors to work out a settlement, which is then more or less rubber-stamped by the bankruptcy court. By essentially eliminating the Securities and Exchange Commission as an active protector of shareholder interests and greatly reducing the role of the bankruptcy judge, the act left the passive investor unprotected. But it opened the field for the active one. Whitman (with a little help from Smith and friends) eventually forced Moffett to pay about $70 million more than he originally offered for Petro. The experience left Moffett no fan of this new breed of distressed investor. Says he: ''On several occasions I considered putting Petro in Chapter 11, because that seemed the only way you can get people to act rationally.'' Other chief executives, however, are happy to have a few skillful, intelligent investors -- as opposed to thousands of shareholders -- helping them in times of distress. Says Steve Hansbrough, former chief executive of Dart Drug: ''It helps to have a small number of influential players to deal with.'' THE INFLUENTIAL PLAYERS have trained their sights on Public Service of New Hampshire (PSNH). The future of this woebegone utility depends on legal fights over rate increases, politics in New Hampshire and Massachusetts, and the good will of its large customers -- 8% of them have run out of patience and gone off the system. The distressed brokers still find something to love in Public Service: about $1.3 billion in debt securities that trade below even the most pessimistic estimates of bankruptcy prices. To invest in Public Service, Whitman and his partners, C. Kirk Rhein Jr. and James P. Heffernan, formed a group called Consolidated Utilities & Communications (CUC). Characteristically, Whitman looked for bonds that would put his group in a position to control the reorganization. He wanted senior bonds, but not those too senior. He passed up first mortgage bonds and other top-notch issues because they were so well secured that their holders would get their money back without having to participate in the restructuring plan. Eventually he acquired 40% of the 13.75% and 10.5% third mortgage bonds -- at bargain prices, of course. When Public Service tried to restructure by exchanging the third mortgages for ones that would pay interest in stock rather than cash, Whitman refused, saying the terms of the indenturement entitled him to a cash payment. That response killed the plan Public Service had paid Drexel Burnham Lambert and Merrill Lynch $4 million to develop. Whitman counterproposed his own reorganization plan. He proposed freezing rates and splitting Public Service of New Hampshire into two companies: a new PSNH utility and Seabrook Inc., which would take over a 35.6% interest in the still uncertified nuke. Whitman would give the utility to himself and the other holders of the three senior secured bonds and stick Seabrook on the remaining creditors and stockholders. If Seabrook goes on line, holders of $800 million in unsecured debentures would receive roughly 60 cents on the dollar; if Seabrook does not fire up, they would get only about 10 cents. Whitman and other senior bondholders, however, would get value equal to par, plus accrued interest. Not surprisingly, unsecured creditors are less than thrilled with Whitman's plan. R.D. Smith and its clients are major holders of the unsecured debentures, and Bennett says that ''there is no way debenture holders will agree to this with its present allocation.'' Under Whitman's plan his bonds ultimately would convert to equity in a nuke-free utility, and Bennett figures their eventual yield at 200 cents on the dollar. Distressed market watchers figure Whitman paid from 65 cents to 75 cents. Whitman's plan hit a roadblock in mid-December, when Midlantic National Bank of Edison, New Jersey, the trustee for the $425 million issue of 17.5% debentures due 2004, demanded immediate repayment of the issue. Since PSNH had already defaulted on the debenture, and six other public issues, it was unlikely to come up with the money. The first major utility bankruptcy in 46 years seemed imminent. Ironically, the group most outraged by Midlantic's move were the other major holders of the debentures in default. They had hoped to keep the possibility of restructuring alive. Once Midlantic Bank moved for immediate payment, it set in motion a sequence of events that is difficult to reverse. Two other trustees have called for repayment of their loans. PUBLIC SERVICE, meanwhile, has announced that it is working on a revised restructuring plan. If adopted, the new plan would neutralize Whitman by paying him and all other senior bondholders the full value of their debt. Since Whitman bought his bonds at fire-sale prices, he stands to make tens of millions on the deal. The plan would give control of the company, including its Seabrook power plant, to unsecured debt holders. As much as bondholders like the concept, its success depends on Public Service receiving an emergency rate increase of 15%, a question currently being decided in court. Whether Public Service of New Hampshire follows this restructuring plan, declares bankruptcy, or comes up with some new survival scheme, one thing is certain: The distressed investors will be there, not only looking for value, but fighting like pit bulls for it.