Vulture Investing

Money managers are snapping up the debt of bankrupt telecom companies

Looking for bargains in the New Economy's wasteland? Forget foraging among the obliterated stocks. The smart money is picking over the debt of the beleaguered or even bankrupt companies. "I just don't do common stock of troubled companies," says veteran "vulture" fund manager Martin Whitman of the Third Avenue Value Fund.

And there's plenty to pick over. Another ex-highflier seems to go bankrupt every day, from dot-commers, such as eToys and Webvan Group Inc.--whose business plans proved far too ambitious--to telecom upstarts, such as Winstar Communications Inc., which borrowed billions it hasn't a prayer of paying back. According to Moody's Investors Service, defaulted telecom debt increased 89%, to $6.5 billion in 2000, and will continue to be the largest defaulting sector in 2001.

In bankruptcy, assets are sold off to pay debt-holders. Bank loans and mortgage bonds get their money first, then corporate bonds, convertible bonds, and so on down the balance sheet to the lowest rung--common stock, which usually gets nothing. If the company reorganizes instead of liquidates, debt holders are paid off in stock in the restructured company. They become the new stockholders.

While e-tailer bankruptcies abound, most money managers are sticking with distressed networking and telecom companies. After all, these companies have tangible assets, such as fiber-optic cables, switching centers, and even satellites. Whitman says he is actively buying defaulted telecom debt, although he won't disclose which companies.

Some likely targets could be debt of ICG Communications (ICGXQ ), PSInet (PSIX ), and Winstar Communications. George Putnam III, publisher of, says these companies have the greatest allure for vulture investors. ICG, a large Internet service provider, is becoming profitable since filing for bankruptcy last November. PSInet, also an ISP and a Web hoster, has assets other telecoms might want. The vultures are snapping up the bank debt of Winstar, a large competitive local exchange carrier (CLEC). The company owes so much to its bankers that there's probably little or nothing left for bondholders.

There are also opportunities in the down-but-not-yet-out companies. George Putnam suggests McLeodUSA (MCLD ), one of the few CLECs that's close to the point where it will generate more cash than it consumes. That means it should cover its future expenses without taking on more debt, which is hard to come by anyway. Not everyone agrees with Putnam's assessment. McLeod bonds trade at 53% of their par value, or 53 cents for every dollar in face value. That yields a huge 26%, evidence that the pros think McLeodUSA could default.

Other very high yielders include the bonds of Web-hosting companies Exodus Communications Inc. (EXDS ) and Level 3 Communications Inc. (LVLT ) These are trading at just 30 cents to 40 cents on the dollar. Renowned value investor William H. Miller III of Legg Mason Value Trust owns bonds from both companies.

BATTLES. Vulture investing is trickier than traditional stockpicking. It requires a thorough knowledge of bankruptcy law and strategy, and the securities themselves may not be readily available to individual investors. Battles also erupt between creditors over who has claim to the assets during a liquidation. The smallest and weakest investors lose out.

That's why a smart way to profit in the cleanup of the New Economy bust is to invest in a mutual fund that practices vulture investing (table). Such funds include Whitman's Third Avenue Value Fund, Fidelity Capital & Income, UAM FPA Crescent, and any of Franklin's Mutual Series funds. For investors dealing with large sums, there are hedge funds, such as Cerberus Partners. The site has a list of such investment pools.

Although distressed debt is risky, it's far less so than distressed stocks. Better to have a claim on real assets than one on thin air.

By Lewis Braham

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