Distressed Diva Loved Her Companies Too Much to Mark Them Down
Yesterday, the Securities and Exchange Commission brought civil securities fraud charges against Lynn Tilton and her firm, Patriarch Partners. Lynn Tilton once had a television show called "Diva of Distressed." "It's only men I strip and flip," she said in the pilot. "My companies I keep long-term and close to my heart." Here is a Jessica Pressler profile of Tilton in which a former employee complains that "the experience of working for Tilton was so emasculating that it took him months after leaving the firm to have sex again." Lynn Tilton is what people call a colorful character, is the point I am trying to convey.
And yet the SEC case against her is a strangely colorless thing. There are no scandalous e-mails or misspelled instant messages. 1 What there are instead are charges that seem so simple and obvious that they almost can't be right. Patriarch Partners managed some funds (named Zohar I, II and III, and referred to as CDOs or CLOs 2 ) that raised money by selling notes to investors and invested that money in making loans to distressed companies. It charged management fees of 2 percent of the assets in those Zohar funds. 3 Sometimes the companies, being in distress, would do things like not pay the interest due on the loans. You might think -- and the SEC would think -- that that would reduce the value of the loans: If you lend someone $100, and he stops paying you interest, you can't really be confident that he'll pay you back the full $100.
Patriarch, however, mostly did not mark down the loans: It would lend a company $100, and then count that as a $100 asset on the Zohar books even if the company was months past due on interest payments. So it would keep collecting $2 a year in management fees for that loan. According to Tilton's calculations, the funds had loans worth at least 105 percent of the investors' principal amount at all times, 4 but many of the companies with loans valued at 100 cents on the dollar had "failed to pay as much as 90% of the interest that they owe." The SEC thinks that this sketchy math got Tilton some $200 million in undeserved management fees.
So: That sounds bad! But it sounds bad in a really straightforward and obvious and boring way. The SEC claims that Patriarch has been doing this for 12 years. 5 The SEC has itself been investigating Patriarch for five years. 6 If Patriarch's misconduct was as simple as the SEC claims, then what took so long?
One possibility is that it's not that simple. According to the SEC complaint, the Zohar funds classify loans into two categories, delightfully named Category 1 (bad) and Category 4 (good). 7 Category 4 loans are supposed to be "current," and are valued at their principal amount. Category 1 loans are supposed to be "defaulted," and "are valued at a lower amount." But, says the SEC, that's not how it worked:
However, instead of following the definitions set forth in the indentures, Tilton has consistently and intentionally used her own discretion to determine how an asset should be categorized. Respondents do not lower an asset’s valuation category unless and until Tilton decides that she will no longer “support” the Portfolio Company. By “support,” Tilton means that she will continue to provide financial and managerial support to the Portfolio Company.
Loans originated or acquired by the Zohar Funds were generally initially assigned the highest valuation category -- a Category 4 or Collateral Investment. Over the life of the Funds, Respondents have recategorized a Portfolio Company’s loans as a Category 1 or Defaulted Asset only if and when Tilton decided she would no longer “support” the Portfolio Company.
So: "Loans originated or acquired by the Zohar Funds were generally initially assigned the highest valuation category." That's how lending usually works: When a bank lends you money, it expects you to be able to pay it back. But the Patriarch/Zohar business was a little different, in that its loans were to companies that were distressed from the beginning. (From Patriarch's Form ADV: "Often, the Investment Adviser seeks to make opportunistic investments on behalf of its CDO Clients with the primary purpose of obtaining influence over or control of financially troubled companies, focusing on 'turning around' these Assets by restoring their value, thereby preserving jobs in the applicable industries in which such Assets operate.") So the initial category of these loans can't have meant, like, "rock solid." The model could be something like:
- Patriarch/Zohar lends distressed Company X $100 at 15 percent interest plus equity warrants. 8
- Everyone knows going in that Company X will take some time to get back on its feet and probably won't pay any interest for a while.
- Everyone's cool with that.
- If Company X gets back on its feet, then it starts paying really high interest and the warrants become worth something and the whole investment is worth way more than $100.
- If it doesn't, then it never pays any interest, most of the principal is probably lost, and the whole investment is worth way less than $100.
- As long as Tilton is trying to get Company X back on its feet, it's hard to know which outcome will obtain, so for simplicity you just value the investment at $100.
- Once Tilton gives up, sure, write the thing down.
I am not sure that that little model exactly complies with U.S. generally accepted accounting principles for loan impairment. But arguably it's sort of rough justice. In particular, if the loans are distressed from the beginning, then it seems silly to write them down immediately. Presumably Patriarch/Zohar made a $100 loan for $100 of expected value, even after accounting for some missed interest payments at the beginning, so writing the loan down for early distress would not reflect its actual economic expectations. I think that's what Tilton is getting at here: 9
Tilton said that the investors in her funds are sophisticated investors and that the finances of the CLOs were properly disclosed in monthly statements. She added that the nature of her business, turning around distressed companies, takes years and often has high failure rates, which investors also understand. But Tilton said she has also had a number of corporate successes that haven't seen their value marked up "because we don't change the value until it's sold or there's an event."
Again, GAAP accounting tends to be rather humorless on this point: You mark down loans that don't perform as expected, but you don't mark up loans that perform better than expected. But these are private funds providing investors with unaudited financial statements; the SEC's case is not about the nuances of GAAP but rather about whether investors were deceived and defrauded. (Though, I mean, it's also about GAAP! 10 ) And those monthly statements do seem like a helpful fact. In an e-mailed statement, a spokesman for Patriarch Partners said:
The investors had sufficient information to evaluate the cash flow performance of the Funds and the underlying companies over the last decade. Cash flow performance of the companies is detailed in monthly and quarterly trustee reports and related materials on a loan-by-loan basis as is the categorization of the loans.
That seems to mean that investors knew things like:
- Company X was Category 4 (the good one).
- Company X's loan was held on Zohar's books at par.
- Company X hadn't paid interest in a year.
Again, Patriarch allegedly did this for 12 years. The SEC complaint contains various claims that Tilton's discretionary re-categorization of loans was not disclosed to investors, but if they had the cash flows presumably they could have figured it out pretty easily. You'd think that if investors weren't okay with the apparently not-so-GAAP valuation methodology they'd have complained before now. 11
One other weird thing about that accounting: When Tilton says that she doesn't mark up the Zohar funds' investments for success, she's not just talking about marking up loans. Perhaps the weirdest thing about Patriarch Partners is that it was an owner, a manager and a lender to the companies that it rescued, all at once but in slightly different ways. This is often described in terms like: "The Zohar CDO's are unique in that they own debt issued by private companies that are solely owned by the investment manager," 12 i.e., Patriarch, or "Patriarch-managed CLOs own dozens of Patriarch loans issued to Patriarch-owned companies," or "What’s unique about Tilton’s deals is that she’s the owner of all the underlying companies borrowing money from her investors." The idea is that Tilton owns Patriarch, Patriarch affiliates are the equity owners of the portfolio companies, and those companies get their debt financing from the outside investors in the Zohar CDOs, which are also managed by Patriarch/Tilton, which is a weird conflict of interest.
This seems to be sort of true, but not entirely true. From the SEC complaint:
In connection with the loans made to distressed companies, the Zohar Funds obtained equity in the Portfolio Companies. Tilton also obtained equity in many of the Portfolio Companies through other entities she owned.
So the Zohar funds, not just Tilton/Patriarch, were equity owners of the distressed companies. (In fact the SEC lists Zohar first: The funds got equity, and sometimes Tilton did.) Here is how Patriarch puts it in its Form ADV:
In addition to controlling credit positions in companies acquired on behalf of the CDO Clients, as these same companies may often be seeking sponsorship from a sophisticated equity owner, affiliates of the Investment Adviser often may take an equity position in these same companies. Despite being under no legal obligation to do so, these affiliates often transfer to CDO Clients the equity ownership of Assets in which the CDO Clients invest, thereby increasing the potential for returns on such Assets beyond the investments made by the CDO Clients. No credit is given to this equity ownership by the rating agencies and the value of this equity ownership is not used in fee calculations. These equity interests help ensure that the incentive of the Investment Adviser is to enable the CDO Clients to repay, first, outside investors, with returns inuring to the benefit of the Investment Adviser only after payment in full of all outside investors in the CDO Clients. This equity ownership also provides an additional potential source of funds to the CDO Clients.
Although these equity securities have little or no value at the time of the initial investment in such Assets, including these securities in our CDO Clients is a unique feature of our CDO Clients in that it allows the CDO Clients to capture any increase in value in the Assets arising after the initial purchase. These increases in value provide additional protection to the CDO Clients beyond their holdings of debt securities not reflected in the ratings of the securities held by the CDO Clients and managed by the Investment Adviser for no additional fee, while the senior secured nature of many of the debt securities in which the CDO Clients invest offer protection to the CDO Clients in case of bankruptcy or reorganization.
This is kind of a weird model, no? Basically Tilton finds distressed companies with equity securities worth roughly nothing, lends them money from her CDOs, and also acquires their equity. Then out of the goodness of her heart -- or out of a desire to avoid the conflicts of interest otherwise inherent in the structure -- she donates some (all?) of that equity position to the CDO funds. Which are thus not so much CDOs as they are weird distressed-private-equity funds, albeit private equity funds with a mandate not to invest in equity. 13 The equity is worth nothing at the beginning, but sometimes it goes up in value, and then the CDO investors capture the value. But Tilton doesn't charge management fees on that value -- which she contributed to the CDO for free -- until the equity is sold.
Somehow this doesn't quite feel like something a real investment adviser would do, but there it is in the Form ADV, and confirmed in the SEC's own complaint, so it must be true.
I don't know what to make of this. Tilton is a controversial figure, 14 and Patriarch's business model -- in which Tilton controls both the borrowers and the lenders, keeping some equity for herself and giving some of it to her CDO investors -- is pretty strange. And no one is all that thrilled with the performance of the Zohar funds, which seem to have lost a lot of money for their investors, though that is hard to measure in part because Patriarch is slow to take write-downs on the loans and, sure, also slow to take write-ups on the equity positions. 15 But the SEC's case feels sort of lame to me. The core complaint is that Tilton valued the Zohar loans like performing loans even though they weren't performing, which seems to be true enough as far as it goes. But it is hard to believe that anyone was all that deceived by it: The investors wanted distressed loans, and distressed loans were what they got.
It's easy to imagine that the SEC came in five years ago expecting to find a really juicy fraud, the kind where Tilton and her employees sent each other e-mails full of sexual innuendos about the terrible things they were doing to investors. And the investigators spent five years rooting around and didn't come up with anything like that. So they brought this case instead. This case is fine, I guess, and the SEC brought it in its own administrative courts, increasing its chances of winning. But really it seems only fair to expect some drama from an SEC fraud case against Lynn Tilton, and this one is pretty short on drama.
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The SEC clearly had access to Patriarch e-mails, but all it came up with was stuff like this:
Numerous emails show Tilton directing the amount of interest that a Portfolio Company should pay, which may or may not equal the amount that the company wishes to pay. For example, in a 2011 email chain, a Patriarch employee asked Tilton for guidance on interest payments from several different companies. In response, Tilton directed that one company should pay $50,000, one company should pay $142,000, and one should pay $12,800. None of these amounts matched the amount of interest due on the loans to these Portfolio Companies.
The SEC refers to these funds as collateralized loan obligations, or CLOs. Patriarch's Form ADV brochure refers to them as CDOs, which normally stands for "collateralized debt obligation," though the ADV also refers to them as "collateralized loan obligations." I will mostly call them "funds" in the text.
Divided into a "Senior Collateral Management Fee of 1% of the amount of assets in the deal," and a "Subordinated Collateral Management Fee," also of 1 percent.
See paragraphs 30-32 of the SEC order. The funds were required to test their Overcollateralization Ratio, defined as "Value of Funds' Loan Assets" over "CLO Investors' Principal." The threshold percentages for the three funds varied from 105 to 112 percent. And "based on Tilton's inputs, the OC Ratio test has never failed."
From paragraph 1 of the SEC order:
Since 2003, Respondents have defrauded three Collateralized Loan Obligation (“CLO”) funds they manage and these funds’ investors by providing false and misleading information, and engaging in a deceptive scheme, practice and course of business, relating to the values they reported for these funds’ assets.
From a February Bloomberg News story:
SEC officials began asking for information on the Zohar funds about five years ago and informed the firm of their plan to recommend the filing of an enforcement action in October, according to the letter.
Zohar III used "Defaulted Investment" for Category 1 and "Collateral Investment" for Category 4. The other two funds apparently had categories 2 and 3, though they don't seem to have gotten much use. From the SEC:
Each indenture contains a very specific definition for each asset category. Under the Zohar I and II indentures, an asset may be categorized as a Category 4 only if it meets specific criteria, most notably that the asset is “Current.” A loan is “Current” when it is not “Non-Current.” A “Non-Current” loan is a “Defaulted Obligation” which has “previously deferred and/or capitalized as principal any interest due.” A “Defaulted Obligation” is a loan “with respect to which a default as to the payment of principal and/or interest has occurred (without regard to any applicable grace period or any waiver of such default) but only so long as such default has not been cured.”
This is all made up, but see the illustrative "Minimum Weighted Average Coupon" of 10 percent in the Zohar III offering memorandum (page 4). The offering memo also refers to "Equity Kickers" that might come with loans.
I think it's also what she's getting at here:
Ms. Tilton said the CLO fund documents don’t require Patriarch to classify loans with short-term problems in default, she said. Indeed, she added, bumps in the road are normal for many of her companies because she actively seeks to invest in distressed businesses. ...
“It is not passive by any means, but a very active strategy where the value depends deeply on our participation,” Ms. Tilton said.
In fact, Tilton had the authority to waive lots of protections in the loans. See page 46 of the Zohar III offering memo:
The Issuer will exercise or enforce, or refrain from exercising or enforcing, any or all of its rights in connection with the Collateral Investments or any related documents or will refuse amendments or waivers of the terms of any Collateral Investments and related documents in accordance with its portfolio management practices and the standard of care stated in the Indenture. The Issuer's ability to change the terms of the Collateral Investments will generally not otherwise be restricted by the indenture.
You could read that to mean that Tilton has a lot of discretion over her borrowers, including the discretion to waive defaults. If she's waived a default, then the loan isn't defaulted, QED.
Paragraphs 57-68 of the SEC complaint cover the claim that "The Zohar Funds' Financial Statements Are Also False and Misleading," in part because they did not follow GAAP impairment methodology. That ... seems right. But if sophisticated investors in private funds were aware of their non-GAAP accounting, then it seems like a bit of a gotcha to bring fraud charges based on that accounting.
Don't get me wrong, they've complained. MBIA, which insures some of the CDO notes, sued Tilton and lost a couple of years ago over some very boring ratings issues. And presumably they've complained about performance, which is not so hot. And I'd bet some of them groused to the SEC about this valuation stuff over the past five years. But it still seems hard to see how they could have been surprised by it.
That's from a December Odeon Capital Group equity research report on MBIA Inc. MBIA's exposure to Zohar seems to be of considerable interest to MBIA investors.
See page 4 of the offering memo ("No Equity Securities (other than attached Equity Kickers"). But of course if the equity is contributed for free then it doesn't violate the mandate.
A February Odeon Capital equity research report on MBIA says:
With the Zohar I notes maturing in ~9 months and $500mm+ of collateral debt that has yet to be refinanced or repaid, the likelihood of a default is extremely high, in our view. In the letter, Patriarch also stated its intention to commence in restructuring talks regarding all three of the Zohar funds.
Zohar II matures in 2017, and also seems to be impaired.
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