The Return of the Wall Street Vulture

Investors are risking billions to buy up the wreckage of the U.S. economic bust

On Aug. 16, bankrupt wireless startup NextWave Telecom Inc. held a hastily arranged news conference before a packed crowd in a ballroom near New York's Grand Central Station. The topic was its master plan to build a high-speed Internet network across the U.S. The plan had been stuck in neutral since the venture first won its most valuable asset--wireless spectrum licenses--five years ago.

Few people noticed one of the most important men in the room, Douglas P. Teitelbaum, seated quietly in the back row. The managing principal of Bay Harbour Management, a $700 million vulture fund, had just thrown the troubled wireless venture a lifeline. Despite the meltdown in telecom stocks and a nasty fight with the Federal Communications Commission to keep the licenses, Teitelbaum, already the company's largest investor with a 6% stake, decided to bet that NextWave would someday become a major wireless player. So he led a group, including other funds, UBS Warburg, and equipment maker Qualcomm Inc. (QCOM ), that sank another $5.5 billion into it.

Welcome to the Great American Fire Sale. Wall Street's vultures are buying companies and their assets at bargain prices on an unprecedented scale. Never before have so many troubled companies been on sale for so little. Nor have so many scavengers swooped in to take control of companies by snapping up bad loans and beaten-down bonds. Private equity firms, leveraged-buyout shops, vulture funds, hedge funds, and investment banks have a war chest of about $45 billion from the likes of private investors, pension funds, and college foundations to buy a chunk of the record $592 billion worth of distressed and defaulted bonds and bank loans now on sale for $360 billion, estimates Edward Altman at New York University's Stern School of Business (chart).

LITTLE LOVED. Unlike analysts and venture capitalists, who became media stars in the 1990s boom, Wall Street's vulture capitalists tend to shun publicity. Typically, they loathe discussing their investments for fear a rival might dive in and screw up a deal. And many hate being mentioned in articles like this. They're so shy because they know vultures are little loved. By reputation, they prey on corporate misery and wind up firing workers.

Their bad rap is often deserved. Some have shut businesses and liquidated entire companies just to collect the cash in the till. But the vultures have a crucial role in helping Corporate America recover from the excesses of the past decade. By providing shareholders and creditors with an exit from soured investments, they can set the stage for a new phase of economic growth. Using liquidity furnished by Fed Chairman Alan Greenspan's interest-rate cuts, they buy companies' assets at knocked-down prices. And that should allow an orderly liquidation of assets instead of a financial panic--or a freeze-up like Japan's, which has kept the world's second-largest economy in gridlock for more than a decade. "The whole bankruptcy system in the U.S. is designed to rehabilitate the corporation. You don't die for your mistakes. You get refinanced," says William C. Repko, head of J.P. Morgan Chase's restructuring group.

Not that the process is easy or without substantial risks. The last time the vultures were out in force, in the early 1990s, their big targets were busted real estate assets and ill-fated leveraged buyouts. Making money from them was a breeze compared with profitably cleaning up after last year's telecom meltdown--which has thrown up about half of the $37.6 billion of defaults in the public bond market so far this year, according to NYU's Altman. For starters, investing in telecoms means placing bets on fast-changing technologies.

Just how tough the going has become is reflected in the average recovery rate on defaulted telecom bonds. That has plummeted to a meager 12 cents on the dollar--less than half of last year's 25 cents. And even those levels could prove to be too high if the economy continues to stall. Indeed, some buyout artists are already seeing some of their investments plunge to as little as 2 cents. "It used to be that you got at least 50 cents," says Marc Lasry, senior managing director at broker Amroc Investments, which specializes in distressed companies.

Can the vultures beat these odds? Little academic study has been made of their impact. But Edith S. Hotchkiss, a finance professor at Boston College, found that companies taken over by vultures in the early 1990s performed better after they emerged from bankruptcy. "I expect the vultures' participation in governance [today] to be even more critical to the success of the reorganized companies," says Hotchkiss.

Already, the vultures' marauding is shaking up several industries. In telecom, Teitelbaum and others are stepping up pressure on wireless carriers such as Verizon Wireless Inc. by funding a rival--and keeping precious radio spectrum out of their hands. Reclusive Denver billionaire Philip Anschutz has gained sway over one out of five of America's 36,000 movie screens by buying up the debt of troubled cinema chains. And Thomas O. Hicks's leveraged-buyout shop Hicks, Muse, Tate & Furst Inc. is stitching together a string of bankrupt brands--Swanson, Open Pit barbecue sauce, Vlasic pickles--to build a new franchise, Pinnacle Foods Corp. (PFOD )

Still others are preparing to pounce. Henry Kravis' Kohlberg Kravis Roberts & Co. set up a venture with Accel Partners in July to buy out telecom players. Nelson Peltz, president of investment firm Triarc Companies Inc. (TRY ), who bought American Can in 1986 and distributes mugs in his office bearing his motto "cash is king," is once again shopping for cheap low-tech companies. Goldman, Sachs & Co. (GS ) has raised $1 billion for a private equity fund to acquire stakes in venture-capital and leveraged-buyout portfolios that investors desperately want to exit. And real estate titan Sam Zell, dubbed the "Grave Dancer," has started picking at distressed assets in telecom and elsewhere. "You have a lot of inefficient markets out there and a lot of companies reporting a lot of lousy numbers," says Zell. "That's creating opportunities to buy various kinds of paper at relatively attractive prices."

The predators don't all work in the same way. Some snap up debt and restructure companies just enough to sell their stakes at a profit. Call them the Fast-Buck Vultures (even though some turnarounds take several years). Others, the Baron Vultures, patiently create new empires. Then come the passive mutual funds, pension funds, and hedge funds that are stuck with soured bets in their portfolios. These Last-Hope Vultures must metamorphose into marauders to recover at least a portion of their investments--and avoid becoming bait themselves.

Serving them are the Hired Guns: traders who charge a fee to buy and sell the debt of troubled companies, crisis managers, restructuring advisers--financial repo men hired by banks to fetch a company's assets after it goes under--and bankruptcy lawyers. These days, they're in huge demand. While bankers are getting pink slips, many of the Hired Guns will get 20% pay hikes this year, according to compensation consultant Johnson Associates.

Here's how they work:

THE BARON VULTURES

Billionaire Anschutz, who started in the oil business, has remade himself into a movie tycoon in a year. He has been buying up the debt of troubled movie-theater chains such as United Artists Theatre Circuits and Edwards Theatres for as little as 60 cents on the dollar and swapping it for equity. Currently, he's locked in a battle with KKR and Hicks Muse for control of the nation's largest theater chain, Regal Cinemas.

So far, Anschutz has used his new clout to cut a deal with creditors to get United Artists in and out of bankruptcy. Next, media experts expect him to retool his theaters to show digital movies and host concerts. Anschutz, who declined to be interviewed, has a proven track record of striking gold in insolvent franchises. In the 1980s, he bought decrepit Southern Pacific Railroad and later used its rights of way to lay fiber-optic lines for his $19 billion Qwest Communications International Inc. (Q )

Bay Harbour's Teitelbaum already sits on the board of a dynasty he helped rescue from bankruptcy--Barneys New York Inc. (BNNY ) Teitelbaum first got involved with NextWave in 1996, when he lent it $1 million. He then plowed in more money to keep it from going bankrupt. Once NextWave did go belly up, he bought its debt for as little as 20 cents on the dollar, bringing his total investment to about $20 million as he fought the FCC for the company's right to keep its airwaves. "[Wireless data technology] is the brightest ray of hope for the telecom industry," he says. Teitelbaum figures NextWave eventually could be worth $45 billion--quintupling the value of his stake to $1.35 billion. Perhaps, but, warns one analyst, "that's a tough value proposition."

Money managers aren't alone in aspiring to become Barons. Entrepreneur John J. McDonnell Jr. joined with five other executives and private equity firm GTCR Golder Rauner LLC in April to buy back his brainchild from bankrupt dot-com PSINet Inc. (PSIX ) for $285 million. In 1999, the high-flying Internet startup paid $720 million for McDonnell's credit-card-processing business, Transaction Network Solutions. "It was like getting a car back with a few dents on it," says McDonnell. When the market improves, he wants to take TNS public. Andrew "Flip" Filipowski, chairman of Internet software and consulting firm divine Inc., is also buying battered pieces of dot-coms--considered the most treacherous area for vultures. In April, he bought parts of now-bankrupt marchFIRST Inc., whose chairman, Robert Bernard, was once a divine board member.

The Barons' strategy is spawning other imitators. Some big companies have started acting like vultures by bidding for bankrupt rivals at auction, accelerating consolidation. AMR Corp. (AMR ) bought TWA Airlines LLC in April. And Hewlett-Packard Co. (HWP ) is considering buying bankrupt Comdisco Inc. (CDO ) "Companies are increasingly interested in picking up bankrupt companies," says Henry A. Miller, head of the restructuring group at Dresdner Kleinwort Wasserstein. "Before, they were worried about touching them."

THE FAST-BUCK VULTURES

Howard Marks, chairman of $20 billion vulture fund Oaktree Capital Management LLC, has no interest in gaining control of companies for the long run. He aims to earn a big payoff as fast as possible by buying the troubled loans of debt-plagued companies such as insurer Conseco Inc. (CNC ) and lender Finova at sizable discounts. "We are trying to buy a dollar for 50 cents," says Marks, who operates from an immaculate white-marbled office overlooking downtown Los Angeles. "If you want cheap, you have to find it on the slag heap."

He's finding plenty of junk on corporate trash piles. Marks reckons that Oaktree is now the country's largest buyer of troubled bank loans, with $2 billion in its portfolio. He's careful to spread his bets: Oaktree won't invest more than 5% of its funds in any one company. Marks also sticks to senior debt--bank loans and bonds that have the strongest claim to repayment--so he'll have a say in turnaround strategies and in how the assets are divvied up. This cautious strategy has racked up a 10% return so far this year, vs. a 12.6% loss for the Standard & Poor's 500-stock index. But, warns Marks, "this is not like buying a stock. Once you get in, it's very difficult to get out. You negotiate. You reorganize. The process takes a few years. And no matter how good you are, you will have some go bad."

More concentrated bets can yield richer rewards. New York's Angelo Gordon & Co. will use $2.4 billion earmarked for distressed investments to buy up to a third of troubled companies' bond or bank debt to gain clout in allocating assets after they file for bankruptcy. "We try to use the restructuring process to help us get the biggest piece of the pie," says managing director Jeffrey Aronson. The firm then either cashes out or trades the paper to another player looking for a safer bet once the target has emerged from bankruptcy.

Martin Sass of investment firm M.D. Sass prefers to play a grim waiting game. To earn at least four times his investors' money over several years, his $1.4 billion fund goes in after other investors have completely lost hope that a company will ever be solvent. "We find that deals run into more problems than people expect," he says. "That's the optimal time to buy."

Some bottom-fishers just dig very deep in the trenches for a higher return. David Matlin, who runs a $2 billion in-house distress fund at Credit Suisse First Boston, aims to quadruple investors' money by buying senior unsecured debt selling for as little as 15 cents to 25 cents on the dollar, according to industry sources. Most investors won't touch such cheap merchandise because the companies are in such poor shape that fixing them takes a lot of work. But, say analysts, instead of loading up a company with more debt--as many vultures did in the early 1990s--Matlin takes control by swapping the debt for equity, hoping to buy companies for three to five times their cash flow, then sell them to corporate buyers for five to six times that.

THE LAST-HOPE VULTURES

Mutual funds and investment banks that bought bonds at par are finding they need to behave like predators to recoup some of their investments. Consider the Scudder High Yield Fund that bought junk bonds issued by Chicago's Metal Management Inc. in 1998. The scrap-metal recycler's chief executive, Albert A. Cozzi, raised $180 million to snap up six rivals and build his family business. Less than a year later, the formerly Nasdaq-listed company with $1 billion in revenues went bust after it failed to pay $18 million in interest on the bonds. Now, Scudder and other creditors are Cozzi's bosses. On July 1, Cozzi had to hand 99% of his company's equity to bondholders to extinguish $484 million in debt. His creditors left Cozzi in charge. "We were instrumental in the restructuring, but in no way, shape, or form are we running this company," insists a Scudder spokeswoman. Burned bondholders have, however, appointed four of the five board members, one of whom is creditors' adviser Daniel W. Dienst, a managing director at CIBC World Markets Corp. "It's a bitter pill to swallow," says Cozzi.

Other players are trying to step into failing companies much earlier to force them to conserve dwindling cash reserves by halting unrealistic expansion plans. Usually, bondholders can't intervene until a company declares bankruptcy. Investment firm Fir Tree Partners has asked the New York State Supreme Court to declare Internet services provider MPower Holding Corp. (MPWR ) insolvent. It wants the court to rule that MPower owes a greater duty to its creditor than to its shareholders, even though the company is not bankrupt. MPower countersued on Aug. 9, seeking $100 million in damages from what it believes is a "frivolous and abusive" lawsuit. All the same, says Michael J. Petrick, co-head of Morgan Stanley Dean Witter & Co.'s high-yield group, "the onus is on companies to prove to creditors that they have viable business plans."

Bondholders have started to force companies into pre-negotiated bankruptcies. Covad Communications Group Inc. (COVD ), a provider of digital-subscriber lines, filed for protection under Chapter 11 on Aug. 15 to get bondholders off its back. Covad offered them $284 million in cash at 19.2 cents on the dollar and $100 million in preferred stock in exchange for canceling its $1.4 billion debt load. "They have to restructure now," says David Rosner of Kasowitz, Benson, Torres & Friedman LLC, who represents Covad's bondholders.

THE HIRED GUNS

Convincing companies to restructure is difficult. Usually, workout specialists are hauled in by lawyers only after things really turn ugly. "I'm the guy elected to tell a CEO, `You have more problems than you think,"' says Terry Savage, co-head of Lazard Freres & Co.'s restructuring group. He is one of the throngs of Hired Guns who usher traumatized executives through a labyrinthine emergency room that extracts a toll at every step of a company's demise--and then its sale or recovery. Corporate loan sharks deliver last gasps of financing. Traders earn fees gambling billions of dollars on the chances of companies' surviving.

Then, restructuring advisers cut deals to satisfy both investors who bought claims at a discount and bondholders and lenders who earlier paid full dollar. That's getting trickier as more traders pile into distressed debt. "I may see a whole new set of faces every time I go to a bank meeting," says Bettina M. Whyte, a crisis manager at Jay Alix & Associates Inc. "Unless the deal has been inked, I have to start over again." And the longer it takes to reach an agreement, the more a bankrupt company's value deteriorates. "It's like Chinese water torture," adds CIBC's Dienst. Nevertheless, more advisers than ever are angling for the lucrative work.

However costly the process might be, companies avoid it at their peril. In the past, executives worried about vultures hovering. Now, if they're in an industry suffering from overcapacity and bloated asset prices, they should worry if vultures aren't in sight. Like it or not, the arrival of the vultures can be a sign that a sector is nearing bottom. Besides, the economy won't resume rapid growth until deadwood has been cut out, making it possible for companies to start investing again in assets that are priced to earn healthy profits.

By Emily Thornton in New York, with Christopher Palmeri in Los Angeles and Mara Der Hovanesian and Susann Rutledge in New York

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