This article isn't about the cyclical downturn in the shipping industry, or even about Genco's (GNKOQ) long-term prospects, it's about bankruptcy and who gets to pick at the carcass. Here's the situation: Genco (previously GNK) was insolvent. Luckily, management and creditors worked out a deal before the company had to seek bankruptcy protection. The plan received widespread support. The expectation was that the company would undergo a quick "in and out" restructuring, an outcome that would minimize costs for all. Analysts pointed out that shareholders were lucky to walk away with warrants valued at somewhere between $0.25 and $0.89 a share. Everyone seemed satisfied with the outcome. That's until a group of bottom-feeding hedge funds swooped in, quickly accumulated significant positions, in an attempt to subvert the bankruptcy process.
Baffling Stock Price
Now, you may have noticed Genco shares are trading higher over-the-counter (as GNKOQ) than they were on the NYSE (as GNK). Seemingly, declaring bankruptcy was positive for stockholders. At first, many of us thought the price was artificially high because shareholders misunderstood what they were getting in the bankruptcy (investors will still have to pay for their new shares). Or perhaps it was due to short covering (the % of the float held short went from 35% to about 13% in April alone)? But on May 5th, through a regulatory filing, it was revealed that Aurelius and its affiliates had purchased over 4M shares on the open market on April 22nd and 23rd, that is, right after the company declared bankruptcy. This hedge fund specializing in distressed securities paid a whopping $1.88 on average for Genco stock. Obviously, they had a hand in bidding up the stock price.
How These Warrants Work
The initial takeaway for many was that shareholders would walk away with about 6% of the new company (before dilution from management of course). But that's not entirely true. Existing shares are being cancelled and as a result, current shareholders will have to pony up to purchase that small slice of the pie later on. So if you own GNKOQ, you will soon receive options that will give you the "opportunity" to buy shares in the new company, at a price higher than the expected market value. As explained by Seeking Alpha contributor Michael Cutler, Genco pegs the value of its new stock at less than $20, while the strike price on the warrants will be roughly $21. So the warrants have no intrinsic value. Their only selling point is the expected volatility of the underlying security.
No matter what assumption you use, these warrants are worth considerably less than $1 apiece. But don't just take my word for it; let's look at the various estimates out there. An analyst at Maxim Group estimated the bankrupt stock is worth only $0.25 (source). A writer at TradeWinds pegged the value at only $0.60 (source). SA contributor The Specialist estimates $0.30 (source). Another blog writer arrived at about $0.40 per share (source). But the most convincing is that Genco itself cautions investors that its own warrants are only worth about $30M to $36M, which translates into about $0.81 per share (source). And that's if all goes according to plan.
Not a Great Deal, Except Possibly for Aurelius
The math simply doesn't add up. Seven years from now, equity holders will need to pay $77.8M just for the right to participate in any upside. That's on top of the $2+ you have to pay now per share (so about $95M for the whole lot) of the soon-to-be canceled stock. To any interested buyer, that's $172M for the privilege of owning 6% in a new stock of a failing company. And if you compensate for risk or use a non-zero discount rate, these warrants get even pricier. A better strategy would be to just wait for their IPO and see how things play out. But in this case, if the "smart money" is willing to pay such a large premium, it's because they think they have an ace up their sleeve.
Obviously, for hedge funds like Aurelius, it's not really about the present value of the warrants. It's about getting a seat at the table. Essentially, these vulture investors are trying to muscle their way into the bankruptcy process and gain leverage over creditors. Aurelius admitted as much in the Schedule 13D they filed with the SEC:
[We] may seek to influence the outcome of the Bankruptcy Proceedings, including, among other things, through (i) direct and/or indirect communications with participants in the Bankruptcy Proceedings and (ii) direct and/or indirect communications with other persons, including other stockholders or creditors of the Issuer. Aurelius Capital Management, or one or more other Aurelius Entities, may become actively involved in the Bankruptcy Proceedings, with the goal of protecting and maximizing the value of the Aurelius Entities' respective investments, which may include seeking membership and serving on an official committee of equityholders in the Bankruptcy Proceedings.
How Chapter 11 Can Be "Hijacked"
Any bankruptcy plan must be approved by all classes of claimholders, including shareholders. In cases like Genco where there isn't enough money to go around (more on that later), equity holders temporarily hold considerable power. Between now and June 15th -- when existing Genco shares become worthless and creditors take control of the company -- Aurelius and its fellow hedge funds can legally try to hold the company hostage (in economics, it's called rent-seeking). Their ransom demand is for bondholders to sweeten the current offer. To exert influence, the vulture investors are threatening to derail the plan for everyone involved. In effect, a small slice of the equity is creating a big stink just so they can pressure over $1B in creditors. It's the classic "holdout" problem. And they don't care, the lawyers for the equity committee that Aurelius created are being paid for by Genco, not the hedge funds mounting the challenge. Just one of the intricacies of bankruptcy law.
On April 22nd and April 23rd, Aurelius purchased close to 4.3M shares on the open market at prices between $1.69 and $2.05. That's on top of the 800,000 shares purchased at the same time by another hedge fund, OZ Management (source). Between the two of them, they own close to 20% of GNKOQ. On those 2 days, when Genco started trading on the pink sheets, those 2 buyers accounted for about a quarter of total volume. Though interestingly enough, trading has been low ever since, which may indicate no other hedge fund is making a serious play for Genco shares.
Vulture Investors Are Opportunistic by Nature
According to Morningstar, Genco bonds have rebounded from about $0.20 on the dollar last year to just below par today. And OZ Management coincidentally was one of the hedge funds that profited from this dramatic increase. By my calculation, OZ made at least $650K buying and then selling convertible bonds from Feb. 19th to April 9th (source). In fact, it played both sides. OZ started selling its bonds on April 4th, which you will remember is the day after the restructuring plan was approved by lenders on April 3rd. So basically, OZ bought bonds when Genco was in negotiations (of which it was part of) and then when the outcome was announced publicly, it unloaded its debt. I wonder which way OZ voted when it was on the other side of the fence? Did it support the plan initially, watch the value increase when an agreement was reached, cash out, and now oppose that same plan as a shareholder?
That's not to say that vulture investors are inherently evil. Or that Genco creditors are magnanimous small-time investors being unfairly bullied. This battle pits rich hedge funds specializing in distressed securities against each other; investors with deep pockets like Strategic Value Partners and Mohawk Capital. And then there's Centerbridge Partners, which owns more of 20% of the stock and has two seats on the seven member Genco board. According to TradeWinds: "Centerbridge purchased the lion's share of debt from Genco's $1.3bn credit facility when it was sold on by DNB and other lenders." Therefore, considering that such a large debtholder has more to gain from its bonds than from its equity, we can safely assume that Centerbridge will use their clout to oppose the Aurelius-backed equity committee.
Why Management Is On Board
Similarly, there's no reason to feel sorry for those stuck in the middle, including the company's insiders, who own another 20% of the float. Current management has a vested interest in the status quo, namely keeping their jobs. In fact, The Wall Street Journal reported that Genco Chairman Peter Georgiopoulos took home close to $2M in compensation and perks last year, on top of another $2M paid to Genco directors and key executives. This excessive compensation is somewhat ironic considering Genco effectively defaulted because it couldn't pay a $3.1 million interest payment.
Genco Shipping and Trading Is Insolvent
In order to dismiss the objection from vulture investors, all creditors need to prove is that they aren't going to get paid in full. In Genco's case, claimholders are still likely to be impaired (as SA contributor Stanislav Oleynikov explained), so shareholders don't really have a right to complain. Though, the situation doesn't look so bleak on paper: Genco lists assets of $2.4B and liabilities of $1.5B in its bankruptcy filing. However, the important detail here is that $2.4B is the book value of assets. As reported by Bloomberg, the market value of Genco's assets is a mere 50 cents on the dollar (or about $1.2B). Unfortunately, for Genco, it bought its ships pre-recession at highly inflated prices. Now that the industry is in shambles, it's very difficult to sell ships to a bunch of competitors with severe overcapacity and no money. The fleet of dry-bulk ships grew 84% since 2008, while demand only increased by 31%, creating vast overcapacity that has already sunk other carriers.
Genco Is a Fooling Bet
But perhaps some investors are comparing the Genco situation to the bankruptcy at Overseas Shipholding Group (NYSE:OSG), where certain hedge funds caused such a "nuisance" that the company was ultimately forced to amend its original bankruptcy plan. However, there are several differences between Genco and OSG. The latter languished in bankruptcy for over a year before it could muster up enough support for its reorganization plan. But unlike OSG, Genco has the opportunity to exit bankruptcy protection with minimal damage to its business. Virtually all parties at Genco are on the same page. The lack of dissent at Genco won't allow vulture investors enough time to build a successful case against the restructuring deal.
The Clock Is Ticking
Genco is quickly taking on water. Even before covering its interest payments, the company is already in the red. Unless it can get its balance sheet in order quickly, the restructuring will be stalled and the company might eventually be forced into Chapter 7, a much worse solution. While the vulture investors may think they can gain leverage by exploiting Genco's inability to wait for its situation to improve, it's likely having the opposite effect. The time sensitive nature of the case will probably force the Court's hand. Equity investors won't be allowed to stall the process. Genco desperately needs to shed most of its debt and fast! The more these hedge funds fight, the easier it becomes for the judge to force a "cram-down" upon any dissenting shareholders. The reorganization plan is scheduled to be decided on June 3rd. In all likelihood, the judge will be reluctant to grant any delays and the old stock will be cancelled as planned on June 15th.
The only way shareholders will receive a bigger part of the new company is if the creditors voluntarily agree to a more generous settlement. Hence, the equity committee has less than two weeks to strike a new deal with all classes of creditors. But these claimholders will be unwilling to renegotiate for many reasons. First, there is a $26.5M termination fee on the pre-pack agreement (source). Second, there is overwhelming support for the plan among creditors: 100% of lenders and 83% of noteholders voted in favor of the plan (source). (If this was an involuntary bankruptcy plan, creditors would be in a difficult spot, but in this case management clearly supports the creditors.) Finally, it is unlikely that another large hedge fund will be looking to snap up more votes. Equity committees are supposed to be made up of the largest shareholders, but with Genco's, none of them came forward to serve on the committee. We can assume that the committee is made up of a relatively small percentage of the company's owners.
The Law Is on the Creditors' Side
In theory, creditors would be well within their right to make a new offer: equity gets nothing. Since certain creditors have effectively accepted "haircuts" on their principal, Genco's stock price should be a big fat zero. The absolute priority rule is clear, shareholders aren't supposed to touch a single penny until all the other claimholders are made whole. Yet in reality, slight violations are common. And that's why shareholders are being thrown a bone in the form of warrants. For a measly $40M or so in out-of-the-money seven-year warrants, one class of claimants -- officially the last one in line -- is being enticed to play ball. As long as the deal is fair, the judge is unlikely to rule in the hedge funds' favor. That's why Aurelius needs to get lucky at its May 22nd hearing. These types of roadblocks are usually dismissed within a day (source).
How to Profit from this Situation?
Genco buyers are now paying over $2 to get less than $1 in return. So unless your name is Mark D. Brodsky (the head honcho at Aurelius) it makes no sense to buy this stock. Noise traders will soon realize nobody else is willing to throw money out the window and only a few momentum players will remain in the market. Unfortunately, for rational investors, there are temporary short constraints on GNKOQ stock right now. The yearly rebate rate that one has to pay to borrow the stock is about as high as credit card interest, at around 24%. And Genco puts -- even though they are still trading -- are no longer readily available, as positions can only be closed. These factors are distorting GNKOQ's price. But rest assured, this stock can't evade gravity for much longer now. It's like when Wile E. Coyote falls off the cliff: He doesn't actually drop until he looks down. After May 22th it's game over for the vulture investors.
Disclosure: I am short GNKOQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I'm long SEA (Guggenheim Shipping ETF). I also hold deep out-of-the-money GNK call options as a hedge.
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