Distressed Debt and the K-Shaped Recovery

Richard K. Green: Good evening everyone, and welcome. The topic of tonight's discussion is distressed debt. And we're very pleased to have with us, Sean Armstrong of Westport Capital. Sean, is among other things, a long-standing member of the Lusk Center Board, and is I think one of our most insightful board members, and has made a pretty decent living thinking about, how to invest in distress debt. So Sean, thank you for being with us tonight.

Sean Armstrong: Thanks Richard. I appreciate the time.

- So I always start these conversations by asking people to just tell us a little bit about how they got to where they are today? So if you could just walk us through your career progression, starting as early as you like, but ending sort of close to where we are right now.

- Okay. All right. Well, I'll skip preschool. So actually I had a bit of a career detour. I actually went to medical school, realized I didn't wanna do that. So part of the way through there I left. And then I spent the next five or six years figuring out what I was going to do. Was fortunate enough to be admitted to the USC MBA Program, with a view to entering finance, not really knowing exactly how I would do that. And upon graduation, I got a job at Trust Company of the West in the high-yield credit department as an analyst, I spent about two years there. At the time that group was closely aligned with a corporate distressed group, and in the early nineties, which was when I graduated and started work, the S&L crisis was still evolving and being worked through, and they began to see a lot of real estate related distress debt coming through the desk. I had spent some time prior to business school in real estate related arena. So I kind of put my hand up and said, "I'd like to be involved in this effort." And they quickly assembled a group of us and raised about $500 million for what was then called the distressed mortgage fund. So we all got kind of a baptism by fire in the nineties, buying distress assets, figuring out how to go through foreclosure, figuring out how to deal with bankruptcies. Some of that was occurring on a single asset basis, and some of it was occurring at a corporate level. So our unifying theme was always that there was some meaningful portion of the asset base that was real estate. And sometimes that was buying distressed properties or distressed loans. Sometimes that was buying distress securities, principally debt securities. So we had the opportunity through the course of the ensuing 10 years. And I should note actually that, less than a year actually after we formed the fund, an entire floor of TCW moved out to form Oaktree. So actually the majority of what I was just describing was my time at Oaktree starting in 1995. And so we worked on large corporate restructurings. Many of which would be familiar to folks today. Some of them were single asset deals, where we were buying the loan, or buying a distressed asset from a lender that had already foreclosed, and then figuring out what to do with it. And as recovery began to evolve, we began to evolve as well, and became more traditional real estate investors, buying assets that needed to be turned around, that needed to be repositioned. We went through obviously a few cycles, we went through the Russian debt crisis in the 98, long-term capital management. We went through the tech crash at the beginning really late. Well, I guess the beginning of 2001, and then that was doubled up by 911 in 2001. And then began to participate in the recovery that ensued from say 2002 to 2006 or 2005. And that's when a group of us that were in the Oaktree Real Estate Group, was the senior group. We left kind of around the same time to form Westport. And that's where I am today. I'm the Managing Principal of Westport Capital Partners. So this is actually my longest stint at... We're completing our 15th year in December. And so in the , we started Westport. We then had a great financial crisis. We had to manage, you know, our existing investments as well as try to find ways to take advantage of the opportunities that were being presented to us. And then, you know, the recovery started probably in earnest in 2010 in a very slow fashion. Again, working on individual distressed assets, we actually were part of a group that capitalized De Novo Bank. So that was an interesting process to go through and start to acquire distressed banks through the FDIC loss share process. And then, you know, as the recovery continued to evolve, we evolved also, again came back to more of this single asset renovation, repositioning that really wasn't a lot of distress there were some distress deals to do, either distressed assets again that were owned by banks or other lenders that we acquired, and some cases we acquired the loans. In some cases, we even acquired CMBS debt. We got a few situations where we bought the controlling classes of seriously distressed CMBS deals and oversaw the workout and disposition of those assets. So we've done a lot of stuff. We find ourselves, you know, we found ourselves late cycle in 2019, we went through a leadership change at the firm, where the partner who had been our managing principal, retired at the end and I stepped into that role. And then COVID hit, and turn the world upside down. So today, we'll talk more about that. But today we find ourselves in some very interesting times. So that's the history.

- So and that's... So I wanna take you through that history a little bit though as we move back up toward today. So take us back to the aftermath of the savings and loan crisis, and the Resolution Trust Corporation. I mean, this was sort of the beginning of this being a business model is sort of looking at the assets that had failed and determining which ones were worth buying and which ones you wanted to take a pass on. Since there was really not a lot of history in doing this kind of thing, how did you go about making those sorts of decisions back in the nineties?

- Well, you have to appreciate that, that was twenty-five years ago. So we were all pretty young and given a lot of responsibility, and the leadership was only probably 10 years older than we were. So they'd had a lot of experience and had gained just in a year before us, not a whole lot earlier, but, you know, realize that corporate distressed investing probably started as a business in 1991, that's when Howard and Bruce, Howard Marks and Bruce cars, raised the very first TCW Special Credits Fund to buy distressed assets. So we had some roadmaps in terms of what, you know, bankruptcy looked like, bankruptcy law was on the books, it was evolving, foreclosure, you know, varies state by state. So we had to understand, are you in a judicial state or a non judicial state, what does that mean? What's the pathway? And then, you know, one of the main differences that we had was, when a distressed loan asset is in the hands of a lender of any description, specifically regulated lenders, they're under very, very tight constraints, in terms of the flexibility that they can have is very limited, the workouts that they can do with the borrowers are very limited. And so it's a very value destructive sort of a process for a lender to actually, you know, certainly to take an asset back onto their books and then try to figure out what to do with it, and then sell it. You know, we built all our models from scratch, this was pre-Argos. Argos was sort of out there kind of maybe for the very, very poor type of assets. We were doing all our work by hand and--

- By hand, I mean, were there like shopping centers that had 300 tenants in them and you had to sort of write out tenant by tenant, what was going on?

- Yep, we had to do that. We had to do that with office buildings, we had to do that with hotels, we had to do that with casinos, we did that with, you know, a wide variety of different types of assets and trying to figure out, you know, what do you do here? And realize we were in an economic crisis that doesn't just affect the real estate, part of the reason, real estates is in crisis, is because their revenue streams are interrupted because a tenant stopped paying. So you had to figure out, you know, what do I do to get control of this asset? Sometimes both from the landlord , existing owner as well as the tenant. Sometimes, you know, and this has been a persistent theme. Sometimes you could have a tenant that's doing fine, or a tenant that wants to come into a building, but you have a situation where a landlord is under-capitalized, or they're underwater. We saw a lot of this in the post great financial crisis. We saw a lot of this at that time also where, you know, the analogy I make is, if you had a loan that was at 70 cents when the property was worth par, and now the value of the property is dropped to 80, what's the motivation of that owner to put more capital in, because his basis is already so high. So you know, what can be done to reset that basis to make it economically viable for an investor, whether it's that owner or a future owner to invest capital? We had situations where we had tenants ready to go, ready to sign a lease, but needed to know, who's gonna pay the broker? And who's gonna pay for the tenant improvements? So a lot of that basis reset had to happen through that process. But I don't wanna say we were making it up as we go. You know, we relied heavily on our lawyers to help us try to understand the legal processes, but in terms of figuring out what to do with the property, I mean, a lot of times you're sitting around being as creative as you can, trying to figure out how to navigate that.

- So were there examples of... So clearly you had some home runs. Right, were you able--

- We had some home runs. We had some singles, and then we had, you know, some of the three strikes you're out.

- so tell us a little bit about... People like to hear about stuff that doesn't work out so well, and then we'll come back and talk about your triumphs. So give an example of something that just didn't work out. No pun intended, in this case.

- Sometimes cheap can stay cheap. And sometimes things can appear very attractive because the price at which it's being offered to you represents some dramatic discount to either the face on amount of the debt, or the price at which the property had traded previously. You know, we've relied a whole lot less on appraisals, because appraisals are a moment in time, they're very, very backward-looking, and I don't wanna denigrate the appraisal industry, but they serve a function in a certain way.

- Well, they're kind of required to be backward-looking, that's their rules set like that.

- And that there's a challenge involved especially in a declining market, right? But, so you know, one example that was a complicated situation, that ultimately worked out okay, but it was rough. We started acquiring bonds in a distressed bond. So when the capital structure was a publicly traded hotel company. They had a lot of individual or group property level mortgages. They had bonds that traded, and then they had some trust preferred or the complicated security called a trust preferred, traps they call them. And then there was the common equity. And this was a post 911 scenario where they were struggling, but we were looking through the assets and looking and trying to understand, you know, where does the value level fall? We talk about, where's the fulcrum security in the capital structure? The point at which you can experience the most upside and downside sort of protected. So the mortgages really weren't traded because they were trading 'cause they were senior secured loans and they were well covered by value, we thought. And then we had the bonds that the trust securities were in a small number of hands, and not that interesting, and frankly looked like they were out of the money. The common looked like it was out of the money. So the bonds looked like they were the the fulcrum security and the right place to be. So we acquired a meaningful position of the bonds in one of our Oaktree funds, enough to give us a material say in what was going on with the company. There were Blackstone frankly was another big holder of bonds at the time. And so we were acquiring the bonds and then ultimately the company got to a point where they had to file bankruptcy. And so we thought, you know, okay, that's good. We'll get control of the assets. The challenge was that, the bankruptcy filing also triggered a lot of defaults on the underlying loans. And we thought that would be adequate cashflow in order to keep them covered. But those lenders got very aggressive. So ultimately what happened was we ended up on the board, we converted the company, we brought them out of bankruptcy, we installed new management, but the properties then just never really performed as well as we would've liked. They required a lot of capital, they were, you know, older property, and frankly we probably could have done... I could have done more work on understanding the underlying assets better. It probably took too much of a macro view just looking at value. Ultimately, we made fine money. I think we ended up making, you know, a high single digit IRR on the investment, and eventually the company was sold and wound up and then we left, but that was one where, you know, learned a lot about what it's like to buy, you know, what appears to be a senior enough security, but I think it was Liam Neeson, in one of the Star Wars movies said, "There's always a bigger fish." And so those senior mortgages were something to deal with. So a lesson frankly that we carried forward into the great financial crisis when we were looking at, you know, we were offered... When securities were all under pressure at all levels. The application of that lesson at that point was, you know what? Give up a little perceived upside in maybe buying a secondary security and go for the senior layer in the capital structure because ultimately at that point, you're controlling your own destiny in a way that you wouldn't be if you're getting squeezed in the middle.

- But does that mean you find mezzanine debt particularly appealing nowadays? Or did you move more I mean, it seems like that would be the fulcrum.

- So mezzanine debt basically is the same thing. It doesn't have accused of, mezzanine debt, basically high-yield debt that sits between the senior secured and the common. So in a traditional real estate structure, that's the mortgage, and then there's the property owner. It's an analogous capital structure. So Mezzanine, I think is a tricky place to be. I think originating Mezzanine when times are really good, is a dangerous prospect, because if the cycle turns, one of the things you need to look at, like I always get nervous when I see someone saying, "Well, here's a $20 million mez piece you can buy and it's got a 12 or 13 or maybe a 15% coupon on it." But you're sitting on top of a $100,000 of senior debt. You need to make sure that you can service that $100,000 dollar debt, if you find yourself in possession of the asset, especially if cash flows get compressed. I think what's interesting right now is, we are starting to look at, whether you call it mezzanine debt or preferred equity. We're seeing some interesting situations where people are looking for capital, particularly in hospitality right now. And you can reset the basis, if you can get comfortable with where the last dollar that senior is. And if you feel like you can adequately service that debt if it came to that. I think that's kind of an interesting way to provide equity to provide capital rather to some of the distressed situations that we're starting to see now.

- The reason I asked is when you look at, the story of what I'll call this generation CMBS the post GFC generation, their LTVs are usually pretty low on the CSPs, but they almost inevitably have something in between them and the equity. And sometimes it's quite substantial.

- So what's been interesting is, we've been waiting, and you and I talked about the timing of this. When we set up the timing for this conversation. I had said earlier this year that, you know, we need to wait till later in the year because the banks are not under much pressure to sell because they've been given latitude by the FEDS. And I think similarly in the CMBS world, because the last dollar for a lot of CMBS is at 50, so there was a thick traunch of mez above that. It's just that that mez hasn't started really to trade yet. I'm actually being shown a deal... So I'll give you kind of an example of that actually, somebody showing us a deal where we can potentially buy the mez on a group of four assets, there are hospitality assets in major cities, primary markets. The original structure was, I think about a $200 million first CMBS, a $75 million mez piece, and I forget in a very large well-known asset manager was the equity in that deal. And I think their equity might've been thin. So maybe it was 50 to 75 million, I can't remember. But it's an Asian Insurance Company that owns that mez piece. They thought they were buying kind of a tuck away piece of paper, and that can probably be had at something like, 30 cents on the dollar. So that means the equity is a wipe out, they've already given up, I think that the mez whole is gonna lose two thirds or 75% of their equity, but again, you know, that sounds attractive on the face of it, but the securitized debt is due in a year. So, you know, you can only fathom stepping into that, a, if you could equitize the debt, which probably is not economically interesting, but b, if you can negotiate an extension on that, so that you've got runway to be able to see your way through a recovery in the hospitality industry. So you know, this stuff's only starting to creep out now, Richard, you're not really seeing it. And what's interesting is that, the CMBS market, even in hospitality, has been remarkably strong, in one of our funds we bought the junior most traunch in a CMBS deal on a hotel that I think we paid, it was like one of our securities funds, so that kind of a lower return oriented fund. I think we paid 80, 85 cents on the dollar for it. And, you know, that's the last traunch. So you would've thought, and it's not a very thick traunch. You would've thought in a environment where there's tremendous amount of hospitality distress, you'd see security start to trade, in much steeper discounts. And they're not.

- Again, that's in part because the LTVs on them, the first place were quite low.

- I think even in the absence of cashflow, people are comfortable to say look, "My basis here is so low "that I feel very comfortable in this spot." And frankly, the special servicer will be the one sort of keeping the senior traunches current, at least for a while. I don't have to do anything. So it's interesting. There's been some other nuances too because this is a, what's referred to as a sazby bond, which is single asset or single borrower bond, and this is on a single asset. So which frankly has some interesting nuances both from the lender and the borrower side, because in some ways it evens the tables for the borrower, because if you're a one loan in a massive, you know, 300 asset CMBS deal and your loans going sideways, you don't have much say in it. But if you're the borrower in a deal, when you're the only borrower, gives you different leverage. So the next 12 to 24 months it's gonna be interesting to see how things play out.

- So tell us more generically, how do you go shopping? So you're sitting in your office, you know, thinking about what you want to acquire next. How do you... What is your process for doing that?

- Well, our process... So prior to having a change in direction of the firm and really since taken over this position. We'd had a bit of a go anywhere do anything mentality. We realized a few years ago that was... We needed to not do that, because frankly we're getting late cycle. You needed to really understand kind of what was going on. There's been a couple of major demographic shifts that have gone on in the United States. You and I talked about this, it's outflow from California and outflow from the Northeast. And the outflow from California is going to, you know, the Western 10 X California for the most part. And the Northeast is going South. The Southeast is getting bluer politically as a result of all that migration. You have some cities in the Midwest that are our bright spots and Boston is a bright spot. So what we did last year pre-COVID was we took a very deep dive on what economic factors we thought meant the most, looked at the top hundred MSAs in the United States above a million people, rank them all, and took the top core tile and said, "This is where we're focused." There's another four or five that are kind of secondary markets that we're kind of focused on. And we said we wanna stay a hundred percent focused on these markets, because this is where the people are going, you've seen this from me before. This is where the jobs are going, this is where the companies are going, this is where affordability is the best. It's where, you know, you look at some qualitative factors, lifestyle factors, it's where people are going. And so our shopping list starts with not all the places we're not gonna go. So dealer shows up, it's not on that list, these days we're not doing that. And frankly, we're strong adherence to the cave recovery profile in COVID. We are seeing growth happen. I'm actually traveling, I'm in Scottsdale, Arizona right now. I've traveled every week for the last eight weeks, mostly for work, looking at deals on the East Coast, and the West Coast. And some of the places we're talking about. And there's real growth, there's real energy going on in some of these places. You wouldn't think it from watching the news, but I was in Charleston and Charlotte and Atlanta, last week. And there's lots of activity going on. I was in Boise. Boise said that the pace of their influx from Northern California has accelerated. So our shopping list starts with knowing what markets we wanna be in. And then we've gotten very refined in our thinking in terms of product type as well. And so we are at the same time both distressed and opportunistic investors these days. On the distress side, we have a lot of distress in retail and hospitality, and we're not that interested in retail. I think it'll be, you know a very special property that gets our attention there. On the hospitality side, I think we're very, very hopeful that we'll see some interesting opportunities emerge from this. And again, gotta be specific in terms of product type, market orientation for the properties, and then the markets that they're in. So that's on the distress side. I don't know that we're gonna see a lot of distress in housing or industrial. Frankly, we're much more focused on the growth elements there. We're actually, you know, we committed yesterday to probably our second development deal that we've committed to during COVID for residential. We just bought 55 acres here in Phoenix to build a million square feet of industrial space on, because the West Valley here is exploding. We're looking at some housing deals here as well. So it's a very bifurcated market. I say that all the trends that were in place pre-COVID are accelerated and magnified, whether it's on the way up or the way down.

- So I'm interested in your... That you find that there is some promise in hospitality because one of the things that happened in the aftermath of 911, it took about six, seven years before travel returned to pre-911 levels. And then the global financial crisis hit, and then coming out of the last crisis again it took several years. And so I mean, how many years are you thinking it's going to take before hotels are filled up again? Or again, is it just very market-specific?

- Well, so for me to argue with you when it comes to data and statistics. But my sense is that the travel returned quicker than six or seven years. Then you may have data that--

- if you look at just number of people a year, that kind of stuff.

- Well, I'd say if that's the case. I mean, again, that sort of surprises me 'cause I would've thought that it recovered quicker than that. And certainly, you know, did any of us get on an airplane in 2017, 18 or 19 that wasn't packed? So the recovery profile in hospitality is going to be, I think very specific and not broadly spread. I think that you started to see already... I mean, it's interesting I get national statistics on occupancy RevPAR and ADR, and you're starting to see in the lower price points that the the RevPAR numbers... They're still down a lot, but they're down like 25% against year over year. Where I would have thought they'd be down 75% or 50%. So and as I said, I've been on a number of planes in the last eight weeks. And while total capacity sea miles are down, the planes are filling up. People are traveling. Charlotte airport was frankly not at pre-COVID levels, but probably at 70% or 80%. So for us our focus initially is on limited service, that doesn't have a big food and beverage requirement that wasn't a big component of revenue. Leisure orientation, and drive to Marcus. Marcus, I can survive without a lot of air lift coming in. Hawaii, being the foster child for the opposite of that. Right? And so I think the recovery profile that's gonna come back, you know, like just anecdotal evidence. You know, I was on a call last night for my son's soccer team. They're starting to talk about, travel soccer tournaments again. Again, not anywhere near the same level, but so you know, those kinds of hotels they're gonna start to see that business recovery. I'm not interested in that Marriott Courtyard on a Cloverleaf somewhere in the middle of the country. But if I had a limited service hotel, they see in a Monterrey or San Diego, or maybe even San Francisco, you know, potentially, where you got tourist, or Napa, you know, as an example. You got tourist traffic coming back, that will be interesting. I think that, you know, the business-oriented travel is going to be slow to recover. That's probably... It's definitely a post vaccine, you know, once we have that vaccine widely deployed, I think companies will begin to allow their employees to travel. They're certainly not gonna encourage them. So I think, you know, it's a late 22 when maybe mid 22 when businesses really sort of take the reins off of business travel. And then I think, you know the far end, the caboose on the whole train is group. So large group type of... So the know the millennium in New York, I mean, God knows when, you know, what's gonna happen to a property like that, or any of the big, big convention hotels in San Francisco or Chicago that are oriented towards even Vegas, you know, oriented to 50,000, 100,000 person conferences, that's a 24... You know, 23, 24 kind of recovery in my opinion.

- Just to sort of say, you asked me about, you know, what do we do in the S&L crisis as we fretted over every last little thing? And then you look back in 1998 said, I should have bought everything that was offered to me at the time, right? So I was speaking to a very senior guy in the hospitality industry who just his timing was impeccable. He retired at the end of last year. He said, you know, "I think we're gonna look back in 2023 "and say we should have bought every hospitality asset "that was offered to us, "because they will recover." That's not how we're gonna do it, but I have a sense that, you know, there's gonna be that element to the recovery.

- I mean, there's no doubt that they will recover, but time does matter.

- Time matters.

- standpoint. And again, I was tryna find the data. I will find it before we meet in class about air travel after 911. I'm pretty sure I'm right. It was like 2007 before it---

- and I would love to see it.

- It took about that length of time and you know, when you cross the question so you say you're traveling every week now. Are you comfortable getting on airplanes?

- Well, so our dirty little secret also, I fly myself a lot Richard. So I flew myself to Scottsdale.

- Ahh, okay. Okay, that's not fair though.

- I'm cheating a little. But I mean, I'm in hotels. I'm staying in hotels. And like this Thursday , I've been here as they said a number of times, the restaurants are open, you can eat indoors, they're packed. Everybody wears a mask, you know, once they walk in and get to the table, they can take it off. When we were in... Like I was in Atlanta, I was in Charleston, I've been in Portland. Portland's a whole other story, but you know, tourism on the streets in Charleston, the city, you know, again a subset, a fraction of what it was, but not 20% of what it was, maybe 60% of what it was.

- So well, if you look at open table reservations, which again, I like looking at data a lot too, is that they seem to be back for about, 60, 65% of where they were a year ago. And of course, two or three months ago, they were like 10 to 15%.

- Right.

- So there's no question there's been some recovery there. The reason I asked you about the plain question is, I actually am comfortable with the idea of being on a plane it's because they're become very good about enforcing masks on everybody.

- Yes.

- And, you know, the CEO of Delta, personally bans people who don't wear masks and I appreciate that. The issue for me is going through the airport, and we're enforcement but may not be quite so good, so there's a level of risk that I'm willing to take, but it only goes so far. Hotel rooms, I think are very safe. There's no evidence that there are a problem there. They're clearly... First of all, it's just seems like picking it up on surfaces. It's not a way that it's transmitted very often and then they do quick cleaning. But it's a question I'm asking people because until people are really comfortable with the idea of getting on airplanes, it's hard to see how this recovery happens.

- Well, I don't know. So again, just give you some anecdotal evidence. First of all, most hotels are leading a day between guests when they check out. So in certain ways occupancy is being a little suppressed. I was looking actually at a wide variety of hotels to come here. I saw a number of them where you know, there was only a few rooms left, so they're limiting their capacity, but I think they're yielding better. So the upper end there it's not like you can get a $700 hotel room for $300. You're gonna pay $700. It's just not gonna be not as many of them So they're suppressing capacity. Same on the airplanes. You know, they've taken a lot of routes out of service, and planes out of service. But all the flights that I were on, were either full or nearly full. And again, I think that's... So I think as we increase capacity, I think there's probably some pent up demand that's not being not being met.

- So last question, you said that you are avoiding shopping centers and I think the reason for that is pretty obvious. It's hard to see a good picture for shopping centers going forward, for reasons that go well beyond COVID as there were comorbidities retail before COVID. But do you see there to be... Some of these places to be opportunities as land place? So they're well located, could they be turned into industrial space? Could they be turned into garden apartments? And if you look at sort of, if you look at acquiring particularly distressed debt on them as the cost of land per square foot of the land, might there be an opportunity there?

- Absolutely. And most shopping centers have the best locations in an urban or suburban environment, right? They're on main streets, they've got good access to transportation, good circulation. I think that it's going to be, you know, interesting. Like what I'd love to have is, some developers, some local developer come to us and say, "Look, here's the property, "I've already talked to the city, "they are gonna be okay with turning the Macy's "into a distribution center for Macy's "or part of it for that, "or part of it's gonna be self storage, "they're gonna give us residential zoning. "We can take down part of the thing "and build 200 units on it." And I've seen a few of those deals. We actually missed on one in a Northern suburb of Atlanta. Those are gonna be the really interesting opportunities but they're gonna be... They're gonna take time because I think it's rare to have, and I don't mean to again, you know, cast aspersions on entire class of people, but it's rare to have a city council that's so... Or planning commission that's so forward-thinking or not have a lot of resistance from anti-development groups to be able to move that process forward quickly. The deal that I just mentioned, the city actually owned it. They owned it for seven years, before a developer without seeking capital to, you know, to do that, so I think that some of those could be interesting as alternative uses, and could be a wonderful renaissance for retail if they can become mixed use kind of projects.

- So Sean Armstrong, thank you for taking some time with us this evening. Really great to hear your views, and to hear your very different sort of strategy for acquiring real estate, particularly in times like this.

- Thank you, Richard. I appreciate the time. Always good to see you.