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MANAGING HEDGE FUND RISK
AMF Bowling
AMF Bowling provides a good example of how we seek to mitigate risk in
our analysis of individual investments, and how we choose the investments
we think are the most appropriate fit for the firms risk-reward profile.
AMF is not only the leading bowling alley operator in the United States,
but also manufactures and sells bowling alley equipment. The company
was acquired in a leveraged buyout transaction in 1996. The managements
objective was to pursue a roll-up strategy by acquiring smaller bowling
centre operators, achieving operating synergies and eventually realising
a higher valuation on a larger business than the multiples of cashflow
paid. However, two negative developments impacted AMF: (1) the com-
pany was unable to achieve some of the operating synergies originally
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anticipated, and (2) the market for bowling alley products fell off precipi-
tously during 199798, when the Asian economies experienced severe
difficulties. Sales in Asia had been a major contributor to the companys
cashflow until that point, so the decline in Asian business weakened
AMFs financial condition, as it was highly leveraged from the original
leveraged buyout (LBO) and the acquisitions completed.
Murray Capital first analysed a potential investment in AMF Bowling in
1998. There were a number of different debt securities in the companys
capital structure available for investment, but we were primarily interested
in evaluating a potential investment in the bank debt and the senior subor-
dinated notes, which represent an unsecured debt obligation where the
rights to payment come after that of the senior lenders. In evaluating the
bank debt, we noted its senior position in the capital structure and the fact
that it was secured by all the companys assets. The financial leverage
through the bank debt was approximately 4.3 times cashflow, a level we
found reasonable, as we believed that the business was worth at least that
multiple, while the cashflow was not in a steep decline. We also performed
a liquidation analysis on the company to determine what cash value the
assets would generate in a straight liquidation. We determined that the
bank debt would be covered by approximately 90% in such an event. We
then performed an evaluation of the senior subordinated notes. The notes
ranked below the bank debt in priority, and the leverage through these
notes was approximately 6.7 times cashflow, materially higher than the
multiple through the bank debt. We also noted that in the event of a liqui-
dation, the senior subordinated notes would get a recovery of zero.
The results of our upside, base case and downside scenarios is outlined
in Panel 1. We viewed the potential bank debt investment as having a rela-
tively attractive upside of approximately 21% with a downside of +1%
return. The notes indicate a better upside of approximately 30%, but with a
much greater downside at 38%. Our view was that the bank debt was the
better investment of the two and that it was, in fact, an appropriate invest-
ment for our portfolio. We were comfortable with the return scenarios and
felt we had a reasonable chance of achieving the upside because of solid
management at the company, a strong equity sponsor, and AMFs leading
market position in the bowling centre business, which, although not a
growth industry, was regarded as being stable. While the senior subordi-
nated notes would do very well if we were right about AMFs prospects,
the cost of being wrong was too great in our judgement, with potential
exposure to a 38% loss of capital.
Consequently, we held our bank debt position for a number of months
and made a small profit in it. Over time, however, we became concerned
about the companys lack of progress in increasing its cashflow, and felt
that the risk of a restructuring was intensifying, meaning that it was
becoming less likely that we would achieve our full upside. As a result, we
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PANEL 1.
AMF Bowling: Bank Debt versus Bonds
Bond Investment:
Description: Senior Subordinated Notes due 2006, 10.875%
coupon, rated B3/CCC+
Leverage through Senior Subordinated Notes: 6.7x LTM EBITDA
of US$130MM
Liquidation analysis indicates zero value for the Senior
Subordinated Notes
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decided to exit the position. After we had exited, the financial performance
of AMF moved sideways for a time, neither improving nor deteriorating
dramatically. Nevertheless, due to the passage of time and looming debt
obligations, the company announced that it would need to restructure its
balance sheet. Since this announcement, the bank debt has traded to the
downside price we had originally anticipated in our analysis of 1987, while
the bonds traded to the downside we had anticipated. In fact, while the
bank debt held up quite well in the face of an actual downside scenario, the
bonds did not.
In the investing process, it is critical to have a point of view about out-
comes. In the case of AMF, we believed that the company would most
likely do well and that we would achieve our upside or close to it. From a
risk management perspective, however, the important question for the
portfolio manager is, What happens if Im wrong?. It is this question that
we attempt to address as we perform our analysis of the downside. Many
strategies and portfolio managers employ an expected return methodol-
ogy, in which various potential outcomes are assigned probabilities and a
weighted average expected return is calculated. If we had employed this
methodology in the case of AMF, the results might have been as follows:
From this analysis, we might conclude that the senior subordinated notes
are a good investment and are in fact, superior to the bank debt because the
expected return is in excess of 20%, while the expected return of the bank
debt is 17%. This conclusion would have been a big mistake and would
have led to a loss of capital for the investing portfolio. While we at Murray
Capital employ expected return methodologies in our analysis of invest-
ments, we add another simple layer of analysis: what is the expected return
and is it attractive? And what does the downside scenario show (just in
case we are wrong)? If the bank debt investment had indicated that we had
more than an acceptable level of downside, we would have eliminated the
investment from consideration, regardless of any upside or attractive
expected return that might have been calculated using the technique
described. The second level of analysis, in which we methodically remove
investments from consideration where the downside is significant, is criti-
cal to our risk management function.
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Limited downside
The fundamental analysis performed indicates not only an attractive
expected return but also limited downside.
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dealer community. We would look back over the trading history for secu-
rities to determine whether they have historically been more or less
tradeable, and at what types of bid-ask spreads.
It has been our experience that in the distressed debt sector, flight-to-
quality investments will hold their value better and recover more quickly
than other potential investments which do not fit the criteria as outlined. In
a severe market downturn where participants are faced with an intense
liquidity squeeze, it may be that flight-to-quality investments are the only
securities in the sector that are saleable, because bids may completely dis-
appear for earlier-stage and more risky investments. It is possible to see
prices drop for flight-to-quality names as severely tested managers look to
liquify their portfolios. While it may appear as though the flight-to-quality
investments are actually underperforming the rest of the sector during
these periods, this is clearly an illusion, as these investments will generally
be the only securities where a bid is readily available. The cause of the illu-
sory underperformance is more a function of pricing issues for the riskier
paper than actual valuations. Such discrepancies tend to be resolved over
a period of weeks as markets either stabilise (in which case the flight-to-
quality names tend to bounce back more quickly), or get worse (where
portfolio managers are forced to move into the riskier parts of their portfo-
lio and unload positions at truly fire sale prices).
Use of leverage
Clearly, the use of leverage in a distressed securities portfolio will enhance
returns in the upside but it also increases risk, particularly during market
dislocations. At Murray Capital, we have historically avoided the use of
leverage to enhance returns as it does not fit with our risk-return profile. In
distressed debt investing, there are several forms of leverage that may be
employed by the portfolio manager. The first is typical margin borrowing
from a broker or dealer who will lend against a portfolio of securities or dis-
tressed bank debt.
The second form of leverage are derivatives transactions known as total
return swaps. In a total return swap, the portfolio manager essentially
makes an investment equal to 20% of the purchase price for a given debt
instrument, borrows 80% and pays interest on 100% as though the invest-
ment has been fully financed. In exchange, the portfolio manager receives
the economics on 100%, even though his initial investment was only 20%.
Essentially, in this example, it is a purchase of the underlying securities
using 4/1 leverage. The portfolio manager does not own the underlying
securities, but the portfolio receives the economics of the bonds or bank
debt as though it were a regular long position. What the portfolio man-
ager actually owns is a swap. In some cases, these swap positions can be
rather difficult to manage during periods of market dislocation. A typical
downside scenario might be where liquidity dries up in the securities
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underlying the swap and the counterparty calls for more collateral, citing a
value for the underlying securities which is at odds with the portfolio man-
agers perception of value. Resulting pricing issues or the desire to unwind
the swap may ensue. In these situations, owning a swap (as opposed to just
being long the underlying securities) can turn into a disadvantage. The
swap may not be readily saleable to an interested third party, whereas the
underlying securities might be more saleable and more liquid. Total return
swaps can be beneficial for enhancing total returns, but they must be man-
aged and monitored with extreme caution.
It is clear that different portfolio managers in the distressed debt invest-
ing community have varying styles and approaches to maximising return
and minimising risk. As a result, equally gifted managers may have very
different return patterns with varying levels of return, volatility and corre-
lation. Murray Capital takes a balanced approach in which we seek to
maximise return, but in a way that clearly takes into account minimising
volatility, correlation and risk in a turbulent market environment. Our
techniques, while certainly not the only way to manage risk in a distressed
debt portfolio, have the benefit of history. We have been through many
market cycles and have been able to observe and learn how different types
of securities tend to react. We therefore attempt to continuously incorpo-
rate and leverage off what we have learned from past investments in our
approach to making new investments and managing the portfolio.
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