Hawker Beechcraft Distressed Debt Investment Analysis

Case Study prepared by Stephen G. Moyer

Never had the investment committee of Arch Capitali (Arch) been as divided as it was on an otherwise
sunny afternoon in mid-town Manhattan. It was mid-March 2012 and the anticipated economic
turnaround that would lift the fortunes of its large investment in Hawker-Beechcraft Corporation
(Hawker), a premier business plane manufacturer located in Wichita KS, seemed a distant hope and the
investment was in a nose-dive.
Arch, which had deployed over $5 billion in distressed debt investments over the ten years of its
existence, viewed itself as one of the premier distressed investment funds in the world returning an
average net IRR to its investors of 16.8%. Rob Shapiro, CIO and a co-founder of Arch, was worried what
a serious debacle with Hawker, which had now been prominently associated with Arch because it was
well known that Arch was the largest secured debt holder, could portend for Arch. Arch had begun
marketing a new fund, to take advantage of the prospective European melt-down, and had found
significant investor resistance due to its lack of a European track-record. A high profile loss in Hawker
could jeopardize the success of European fund raising efforts. And, of course, Shapiro had over $50
million of his own net-worth in the fund which held the Hawker investment.
When Arch began accumulating the secured term loan of Hawker in the first-half of 2010, an economic
recovery, though modest, seemed in placeparticularly in China and India which Arch was convinced
were poised for an explosion in private jet demand as a result of their poor domestic commercial airlines
and ballooning population of mega-millionaires. At that time Hank Hammer, the Arch partner that had
internally promoted the investment in Hawker, viewed Hawkers secured term loan trading at 65 as an
attractive investment given the implied valuation where Arch was creating the company. Hammer, who
had attended the Air Force Academy, flown innumerable combat runs in Desert Storm, graduated as a
Baker Scholar from Harvard Business School and then enjoyed a meteoric rise to partner at Arch, was
aware of his potential bias toward aviation and had constantly fostered dissenting opinions as he made
the case for an investment in Hawker.
Hammer had been monitoring Hawker for more than a year before he decided to recommend
investment. Over the course of that time, market concerns over declining revenues had put Hawker into
an over-leveraged tail spin. During the first-half of 2009, Hawker, which was controlled by Goldman
Sachs, repurchased almost $500 million of its unsecured debt at a deep discount, which significantly
reduced leverage and shaved $45 million in annual interest expense. Hammer felt that while there were
certainly still some clear risks, that the strengthening economic outlook together with Hawkers
improved balance sheet made the secured loan compelling. He also considered Hawkers remaining
unsecured bonds, which were trading 30 40 points cheaper, but felt the better risk-adjusted return
was in the secured loan which he viewed as having minimal downside risk given the value of Hawkers
core operations:
Copyright 2012 by Stephen G. Moyer

Page 1

Hawkers Beechcraft unit was the premier manufacturer of twin turboprop planes.
These aircraft had a defensible market niche because they were more economical than
jets to operate, were relatively fast, and had the ability to land and take-off on relatively
short, unpaved runways of the sort found in less-developed countries and remote parts
of developed countries where commodity and energy extraction activity was bolstering
demand.
Hawker had the largest network of dealers and related maintenance depots in the world
which generated consistent, high-margin revenue due to the need to regularly service
its 37,000+ in-service fleet.
Hawkers small military related business which made single engine turboprops used as
jet-fighter training aircraft had a long-standing monopoly-like contract with an
additional 8 years of guaranteed plane sales and 20-years of guaranteed maintenance.
Hawkers 750 900 family of business-jets (6-8 passenger) was well regarded, enjoyed
significant market share and had just been upgraded.

Of course, Hawkers debt would not have been selling at significant discounts if there had been no
turbulence in the forecast. The biggest concern, in Hammers mind, was the introduction of the
Hawkers newest jetthe mid-size (8 12 passenger) Hawker 4000. The Hawker 4000 was a great plane
with horrible timing. It had been introduced at the end of 2006 as the clear technical leader in the
category with a ground-breaking composite fuselage that permitted a more comfortable oblong (as
opposed to circular) cabin configuration (more shoulder and head room) and weight-related operating
efficiencies. The planes pre-delivery sales, which included an initial 50 plane order from NetJets, had
exceeded expectations. However, when the recession hit additional sales halted and NetJets had been
able to cancel its order with virtually no penalties. Hammer had retained an industry consultant to
independently analyze the Hawker 4000s market viability and the conclusion had been that although
there were definitely competitors in the class, everyone had suffered a similar decline in sales and that
when the cyclical rebound in demand returned, the 4000 had sufficient brand-recognition and
demonstrable operating advantages that it should capture meaningful market share assuming
appropriate marketing and pricing. Hammer also took the time to personally pilot the 4000 as well as
several competitors to convince himself it was best in class.
Hammers other significant concern was Hawkers unionized labor force. Almost all of Hawkers
manufacturing operations were in the U.S. (85% by headcount in Wichita) and they were represented by
the International Association of Machinists and Aerospace Workers (IAMAW). Based on publically
available financial statements, which was all Hammer could review without becoming restricted and
thus unable to easily make an investment, it was difficult to analyze how Hawkers labor and production
costs compared to its competitors. He assumed Hawker had higher costs than its Brazilian competitor
Embraer, but Embrear was a relative new-comer and only in the jet market. He also assumed that
Hawker probably had a less favorable collective bargaining agreement than Cessna, which was also
Wichita based. Based on his research, Cessna had a very constructive relationship with labor whereas
Hawker had been the subject of several strikes in the last ten years. In addition, Hawkers underfunded
pension liability was $297 million at year-end 2009.
Copyright 2012 by Stephen G. Moyer

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Hammers investment summary to the committee had been compelling:

Look, if we wait for a clear turn-around in plane sales Hawkers debt will trade up and we will lose the
opportunity. Thats the same reason weve been investing in home-builders before a demonstrable
uptick in new home sales. We know corporations are sitting on record amounts of cash and that they
are way over due in upgrading their plane fleets. We know that the ranks of multi-millionaires in China
and India is mushrooming and that these people hate domestic commercial offerings as a practical
matter and yearn for the prestige of private plane ownershipthese were the same guys buying Ferraris
when there were no roads to drive on. Further, based on discussions with the biggest trader, I believe
that Goldman has been in the market this month buying the unsecured noteswhich are junior to the
secured loan I recommend we buy. If they see value in the unsecured notes, the secured loan has to be
money good.
We are basically buying the Toyota of the industryBeechcraft is the always reliable Toyota workhorse
for mass-market everyday needs while Hawker is the Lexus of the private jet market. At a price of 65,
the yield to the 2014 maturity of the bank debt is 12%, which doesnt suck and remember that Goldman
just bought a lot of unsecured bonds below us. If this thing turns around as we expect then the bank
debt should be at par by 2012 and our holding return will be 25%. If the worst case happens and we
own this thing, then we will have effectively purchased it for about $1 billon when Goldman paid $3.1
billion 3-years ago and I cant believe there wont be Chinese buyers of the IP implicit in a manufacturer
with internationally certified airframes.
As Hammer now gazed out the 47th floor window overlooking a frozen Central Park, he remembered
those words and wondered how it had gone so wrong. The Hawker 4000, which he had so much
enjoyed test flying, seemed an Albatross that could sink Hawker and potentially his career at Arch. In
2010 and 2011 Hawker reported a cumulative loss of $935 million. Instead of being a shinny Toyota,
Hawker now seemed more like the mud-brown Yugo that no-one would buy because they werent sure
the company would be there in future years to make spare parts. Backlog had plummeted and suboptimal production volumes were killing costs. Vendors had started to put the company on COD terms
and even after drawing the remaining availablity on its $240 million revolving credit facility in the fourth
quarter of 2011, Hawker was out of cash.

Goldman had hired Steve Miller, the vaunted turn-around artist, in February 2012 to assume control.
Miller had called Hammer yesterday to give Hammer an operational update and to ask for a $125 million
rescue loan. While Miller tried to project an aura of control, Hammer surmised that operations were
in free-fall. Miller was emphatic that the new funds were needed immediately. But he also did not
sugar coat the situation and made it clear that there were many challenges to confront and that an
additional financial restructuring and probably even a Chapter 11 bankruptcy were in Hawkers future.
Hammer indicated it was unclear Arch was willing make the Rescue Loan, but it would be much easier if
Hawker immediately filed Chapter 11 and Arch lent the money on a preferred basis as a debtor-inpossession (DIP) loan. Miller said they needed more time to arrange an organized pre-pack Chapter
Copyright 2012 by Stephen G. Moyer

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11 that would project to the market that Hawker would quickly emerge as a healthy Phoenix; if it filed
now on a disorderly basis it would badly jeopardize its employee, dealer and customer loyalty. Miller
reminded Hammer that when GM was on the bankruptcy precipice many thought it would be forced to
liquidate had the government not assured the companys quick exit from the bankruptcy process
unfortunately, Kansas was not a swing state so there would be no help from Uncle Sam. Hawkers
lawyers had figured out how to make the Rescue Loan safe for Arch, but it would mean undermining the
collateral support for the secured loan Arch currently owned. Miller said he thought it was in Archs
best interest to prime itself, but it they didnt want to do it, he had a lot of phone numbers on his
speed dial.
Rob Shapiro listened to Hammers update and had many concerns:

Not only were they being coerced to make the new loan to save the existing investment, but
the new loan would itself undermine the quality of the existing loan.
At the time of investment Shapiro had been persuaded that owning Hawker for a $1 billion
valuation wasnt such a bad worst-case scenarionow he wasnt sure. Hawker was
hemorrhaging cash. The $125 million current ask was just the start$300-500 million more
could easily be required to keep the company afloat.
Was the Hawker 4000 salvageable given its tarnished start. Sure it was leading edge in 2006
when launched, but now Embrear and Bombardier/Lear had launched updated offerings and
had deep pockets to weather a protracted pricing battle.
China, the hoped for source of demand, was experiencing a slowdown in growth and it was
quite clear the military was unlikely in the near-term to reform antiquated flight plan
authorization procedures that would make the convenience of a private jet realizable. Even
worse, a key potential fall-back buyer for HawkerChina Aircraft Corporation (CAC)had just
entered into a business jet manufacturing joint-venture with Cessna.
Even if Shapiro could imagine Miller having the ability to brow-beat the other creditors into
agreeing to some type of pre-pack Chapter 11, what about the union. Chapter 11 was often a
great tool to force concessions out of unions but not if the process had to be completed
quicklythe law gave unions too many ways to stall. Hawker might be forced to just live with
the existing agreementincluding the massive pension obligation (which at 12/31/11 stood at
$493 million).

Hammer acknowledged that these were legitimate concerns and that neither he, nor anyone else, had
good answers. But what did they want to dorefuse to make the Rescue Loan and worry that someone
like Carl Icahn would and potentially be in a superior position to them? Hammers gaze returned to
Central Park and the now setting sun wishing for some source of light. Shapiro also looked at Central
Park thinking, among many things, the London office lease he had just signed had been a bad idea. He
came back to the moment and told the group he needed the following to make a decision:
A.

Rescue Loan: Should Arch make the loan? Was it safe as Miller purported? What pricing
could they demand?

Copyright 2012 by Stephen G. Moyer

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B. The Existing Secured Loan Investment: They owned $400 million face of the secured loan and it
was trading at 70. How would the Rescue Loan impact the value? What were the likely
restructuring scenarios for Hawker and how would these impact value? What was the damn
loan worth and should Arch buy, sell or hold?
C. Hawker Restructuring: If Hawker needs to go through a Chapter 11 bankruptcy, how much will
the business be harmed? Is it worth it to stay in Chapter 11 longer in order to terminate the
pension and redo the collective bargaining agreement? Should Hawker keep it current business
mix or discontinue or sell parts of it?

COMPANY HISTORY
Hawker traced its roots to Beech Aircraft Corporation founded in 1932 in Wichita KS. Raytheon
purchased Beech in 1980 to diversify its largely defense oriented operations into civilian aviation. In
1993, Raytheon acquired British Aerospace Corporate Jets (BACJ) from British Air and decided to
resurrect the Hawker brand used by certain of BACJs predecessors for its small to medium sized jets.
In March 2007, Raytheon sold its Raytheon Aircraft operations to Hawker Beechcraft Corporation (HBC),
a newly formed acquisition corporation controlled by GS Capital Partners VI, an affiliate of Goldman
Sachs, and Onex Partners II, an affiliate of Onex Corporation, for $3.3 billion, which was later adjusted to
$3.1 billion. The purchase price represented 8.1x trailing EBITDA. Raytheon recorded a pre-tax gain of
$1.6 billion on the sale. HBC financed the acquisition approximately as follows:
Secured Term Loan

8.50% Sr Notes
8.875/9.625 PIK Sr Notes
9.75 Sr Sub Notes

1,300.0
400.0
400.0
300.0

Total Debt
Equity Contribution

2,400.0
700.0

Total Purchase Financing

3,100.0

Hawkers year-end balance sheet following the acquisition was as follows:

Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets

Summary Balance Sheet

569.5
80.1
1,289.3
121.0
2,059.9

PP&E
Intangible Assets
Good Will
Other Assets

655.7
1,118.2
716.0
125.4

Total Assets

4,675.2

Copyright 2012 by Stephen G. Moyer

at 12/31/07
Advances
Accounts Payable
Current portion of LT Debt
Other Current Liab
Total Current Liab

541.2
323.6
69.6
257.7
1,192.1

LT Debt
Pension & Benefit Oblig
Other LT Liab
Total Liabilities
Equity
Total Liab & Equity

2,377.3
16.4
85.0
3,670.8
1,004.4
4,675.2

Page 5

At the time of the acquisition, the future of private aviation seemed very promising. Deliveries for both
business jets and turboprops had been recovering strongly since a cyclical trough in 2003. Business Jet
demand in particular had been buoyed by the growth in factional ownership schemes that had
significant tax and regulatory advantages compared to the leasing market.

Aircraft Delivery Trends

1200
1000
800
600

400
200
0
2000

2001

2002

2003

Turbo Prop

2004

2005

2006

2007

Biz Jets

Hawker had just obtained FAA-type certification for the Hawker 4000 composite-body super-mid jet in
November 2006 and had an initial 50-plane order (worth over $1 billion) from NetJets.
OPERATIONS
Hawker has three reportable operating segments:
Business Aircraft: Hawkers business aircraft segment combines both its jet and propeller
manufacturing activities. The business jet group targets three distinct segments of the business jet
market:

Super-Mid Jet: Hawkers 4000 was arguably the technological leader in this category when
introduced in 2006. Jets in this class can carry 8-12 passengers with transcontinental range and
cost $20 25 million depending options.
Mid-size Jet: Hawkers 750 900 family of jets based on a common airframe offered a suite of
options in this segment. Jets in this class can hold 4 6 passengers, have an effective range of
approximately 2,200 nautical miles (e.g. San Francisco Chicago/New York Dallas) and cost
$13 17 million. According to the General Aviation Manufacturing Association (GAMA), the
Hawker 750 900 family had approximately 33% market share in 2008.
Light Jet: Hawkers Premier/400 family of light jets targeted this segment and according to
GAMA accounted for 20% of 2008 deliveries. Planes in this class hold up to 4 passengers, have
an effective range of approximately 1,500 nautical miles and cost $5 8 million.

Copyright 2012 by Stephen G. Moyer

Page 6

Business Jet operations were hard-hit during the recession, particularly the Hawker 4000 which suffered
the cancellation of the NetJets order. Besides the cyclical decline normally associated with a recession,
the Obama administrations high profile criticism of corporate excess tended to make corporations
more reticent to use business jets, particularly after the public tongue-lashing the Big 3 auto executives
received when each admitted to flying a private jet to appear at a Congressional hearing. Also
contributing to the sales decline was a particularly acute fall-off in used aircraft prices which made the
implied economics of new aircraft investment exceptionally unattractive. Compounding the macro
challenges, it now appeared that Hawkers financial condition was hurting its competitiveness as in 2011
the primary rivals of its 750-900 mid-jetsthe Lear Jet 45/60 family and the Cessna Citation XLS
experienced upticks in deliveries whereas Hawker lost its category dominance.

Hawker Business Jet Deliveries

Mid-Size Jet Delivery Trends

100

100

80

80

60

60

40

40

20

20

0
2006

2007

Hawker 4000

2008

2009

Hawker 750 - 900

2010

2011

0
2008

Hawker 400/Premier

2009

Lear 45/60

2010

Hawker 750 - 900

2011
Citation XLS

Hawkers competitiveness in the light-jet market was also under considerable pressure. However there
the biggest issue appeared to be new entrants. Embraer had entered the segment with the very
competitively priced Phenom 300. And although it had experienced several delays, Honda was
scheduling 2013 deliveries for its heavily promoted HA-420 and reputedly had a 65 plane backlog. In
December 2010, Hawker decided to curtail production of the Hawker 400 until inventory became
aligned with demand. In December 2011 Hawker took the further step of suspending development of
the new Hawker 200 (that would replace the prior Premier series) citing a weak outlook for the light jet
market.
Business Jet Revenue & Backlog Trends

Light Jet Delivery Trends

8,000.0

160
140

7,000.0

120

6,000.0

100

5,000.0

80

4,000.0

60

3,000.0

40

2,000.0

20

430

500

441

309
238

213

1,000.0

0
2008
Embraer Phenom 300

2009

2010
Citation CJ2/3

2011
Hawker 400/Premier

Copyright 2012 by Stephen G. Moyer

450 D
400 e
350 l
i
300
v
250
e
200 r
150 i
100 e
50 s
0

2007

2008
Total Deliveries

2009

2010
Revenue

2011
Backlog

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Propeller driven aircraft had always been the focus of the Beechcraft division. The core product group is
the King Air family of turboprops, which in 2008 controlled 42% of the passenger turboprop market.
Over its 25-year life, over 6,000 King Airs had been sold, making it the largest selling business turboprop
in history. Beechcraft also manufactures and sells a variety of single and twin piston engine planes
primarily under the Bonanza brand. While Beechcrafts deliveries had yet to rebound, in 2011 they were
relatively strong compared to the industry as a whole which experienced a 7.7% decline in turboprop
deliveries.
Bottomline, however, the business plane division was incurring massive losses even adjusting for noncash items such as asset impairment charges, that were flying Hawker into banrkuptcy
Business Plane Rev & Adj* Oper Income

Beechcraft Prop Delivery Trends

200
180
160
140

3000

200.0

2500

100.0

0.0

2000

(100.0)

120

1500

100
80

(200.0)

I
(300.0) n
c
(400.0)
.
(500.0)

1000

60
40

500

20

2006

2007

2008

2009

King Air Family

2010

2005

2011

Baron/Bonanza

O
p
e
r

2006

2007

* Adj to exclude impairment charges

*

2008
Oper Inc

2009

2010

2011

Revenue

Trainer AircraftIn 1995, Raytheon won a contract to provide pilot training aircraft to the U.S. Airforce
and Navy under the Joint Primary Aircraft Training System (JPATS). The contract was for the delivery of
approximately 800 aircraft, called the T-6, through 2018 and then service and support potentially
through 2050. The T-6 is a single-engine turboprop capable of flying 365 mph.
Almost immediately after the close of the LBO, serious production problems arose with the trainer due
to quality control issues associated with an essential vendor. These problems continued into 2008 but
Hawker was able to make some deliveries to the U.S. Air Force and to all of its foreign customers.
Deliveries spiked in 2009 as the supply issues were resolved.
Trainer Revenue & Backlog Trends
1200
1000
80

82

800
62
600
36

400

Trainer Operating Income Trends

120

109

25
200
0
0

D
100 e
l
80
i
v
60
e
r
40
i
20 e
s
0

2005

2006

2007

Trainer Aircraft deliveries

2008

2009

2010

Trainer/Attack Rev

2011
Trainer Backlog

Copyright 2012 by Stephen G. Moyer

100.0

18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%

80.0
60.0
40.0

20.0
2005

2006

2007

Adj Operating Income

2008

2009

2010

2011

Adj Operating Income %

Page 8

In 2010, the U.S. Air Force began conducting final tests for a weaponized Light Air Support (LAS) air
plane that would be used primarily in Afghanistan by the Afghan military. Hawker developed a modified
version of the trainer, the AT-6, for consideration. The only other finalist was the Super Tucano
developed by Embraer. Embraer was a Brazilian aircraft manufacturer but said it would use U.S. based
Sierra Nevada Corp. as its prime contractor and build the planes in Jacksonville, FL almost entirely out of
U.S. supplied parts. In December 2011, a $355 million LAS contract was awarded to the Super Tucano.
Hawker immediately challenged the award in court and in February 2012 the Air Force withdrew the
contract with Sierra Nevada and agreed to re-evaluate the award decision.
Through 2011, approximately 600 T-6s had been delivered under the JPATS contract and an additional
100 to other governments including Canada, Greece and Israel. Trainer backlog at the end of 2011 was
down materially due to primarily to U.S. Defense department cutbacks.

Customer Support/MaintenanceWith over 37,000 planes in service, Hawker has among the largest
installed fleets in the world, which it supports with the largest network of owned and/or authorized
service centers in the industry. Hawker has 11 owned service centers in the U.S., U.K. and Mexico and a
network of 95 authorized service centers in 27 countries which sell parts and provide regular
maintenance and upgrades.
The Support segment had been a strong and stable performer since the acquisition. Operating margins
had been significantly improved by a combination of tight expense control as well as expanded gross
margins on part sales. The modest revenue decline in 2009 was attributed to a customer deferrals of
certain maintenance processes that were subsequently completed in 2010.

Customer Support Segement

Adj Revenue and Oper Inc Trends
600.0
550.0
500.0
450.0
400.0
350.0
300.0
250.0
200.0

120.0

100.0
80.0
60.0
40.0

20.0
-

2005

2006

2007

Adj Oper Inc

Copyright 2012 by Stephen G. Moyer

2008

2009

2010

2011

Adj Customer Support Rev

Page 9

2009 Financial Restructuring

In 2009, following a decline in profitability in 2008 coupled with the weak post-Lehman state of the
economy, investors were concerned about the Hawkers viability. In the first quarter of 2009, Moodys
Investors Service downgraded the rating of Hawkers Senior Bonds from B2 to B3 with a negative
outlook. Prices of Hawkers outstanding debt securities declined markedly.
Goldman Sachs, Hawkers equity sponsor, recognized that these price declines represented a unique
opportunity to deleverage Hawker and save interest expense. Hawker had $531 million in cash at
December 31, 2008. During the first quarter of 2009, Hawker quietly entered the market and
repurchased $222 million face amount of its outstanding bonds for $41 million resulting in a recorded
gain, after various accounting adjustments, of $177 million. When these activities were reported at the
end of quarter, bond prices rose but Hawker continued its repurchases via a tender offer and retired an
additional $274.6 million for an aggregate cost of $96.1 million. Best of all, because in 2009 Hawker
recorded a pretax loss of over $500 million, it paid no tax on the approximately $300 million of
cancellation of indebtedness gain realized on these repurchases. Annual going-forward interest savings
were $44.5 million.

1H09 Debt Repurchase Activities

8.50% Sr Notes
8.875/9.625 PIK Sr Notes
9.75 Sr Sub Notes

12/31/08 1Q Repuch 3/31/09

400.0
(128.0)
272.0
400.0
(14.6)
385.4
300.0
(79.4)
220.6
1,100.0

Cash Spent
Avg Price
Gain Reported, Net

(222.0)
(41.0)
18.5%
177.0

878.0

Tender
6/28/09
(89.1)
182.9
(110.0)
275.4
(75.5)
145.1
(274.6)
(96.1)
35.0%
175.0

603.4

In the fourth quarter of 2009, Hawker was in default of various secured loan covenants. As part of the
resolution of these defaults, various covenants were adjusted and availability under the $400 million
revolver was reduced to $240 million. In addition, on November 25, 2009 the Term Loan lenders
extended a new $200 million Incremental Term Loan due at the March 26, 2014 maturity of the original
Term Loan. Compared to the LIBOR +200 b.p. pricing on the Term Loan, the Incremental Term Loan paid
LIBOR +850 b.p. and was issued with 6% original issue discount. Proceeds of the Incremental Term Loan
were used to pay-down the revolver. Arch, which by this time had accumulated over 25% of the Term
Loan, actively participated in the negotiations and took a pro-rata participation in the Incremental Term
Loan.

Copyright 2012 by Stephen G. Moyer

Page 10

Emergency Cash Needs

During Millers initial update call with Hammer, he explained that for the last several quarters operating
losses combined with vendor concerns over Hawkers viability had caused an increase in working capital
that had drained liquidity and now threatened to halt operations. At the beginning of 2011, Hawker had
$310 million in cash and all $240 million available on its working capital revolver. During the fourth
quarter Hawker fully drew down the revolver (then $190 million available) as a defensive maneuver
anticipating it would be in covenant default at year-end and wanted to maximize liquidity before the
facility was frozen.
As of March, Hawker was getting low on cash and needed additional capital immediately or it would be
unable to pay for essential components to keep production lines running. Miller realized that given the
high probability of a bankruptcy, prospective lenders at this point would prefer to lend the company
money after the formal filing of a bankruptcy petition so that the loan could be structured as a debtorin-possession facility (DIP) and receive preferred recovery status under Bankruptcy Code (BRC) 503.
Essentially, under BRC 503 any liability incurred by the debtor after the filing of the bankruptcy petition
is deemed an administrative expense and given a recovery priority over any pre-petition liabilityunless
such liability was effectively elevated to the status of an administrative expense by the terms of 503
itself.
Miller and his legal team at Kirkland & Ellis recognized that there were two problems with trying
to raise capital for Hawker pursuant to a DIP. The first was timing. Strategically, Miller, who
had only been on the job for only five weeks, wanted to at least attempt to see if a voluntary
restructuring was feasible and avoid a Chapter 11 altogether. Hawkers marketing group had
been adamant that its financial condition was making it difficult to sell planes now and it would
be impossible to make any sales if Hawker was in bankruptcy. Miller realized a voluntary deal
was a long shot given the complexity of the capital structure and the challenges facing Hawker,
but felt the upside in-terms of preserving Hawkers brand image justified the effort. If the
consensual restructuring proved infeasible, then he felt it was imperative that when Hawker filed
for Chapter 11 to effect the restructuring that it do so on a pre-agreed basis with the support of
the major creditor constituencies so that Hawker could enter the process with a clear road-map
to the future so that employees, vendors and, most importantly, prospective customers would
believe in Hawkers long-term viability. Miller said he needed at least 60 days to organize the
creditors, attempt to negotiate a voluntary deal and, failing that, prepare all the paperwork
needed for a pre-arranged Chapter 11.
The second issue was collateral. Even though BRC 503 provides for a priority recovery for
post-petition creditors over pre-petition unsecured creditors, it did not affect the preferential
position of existing secured creditors to their collateral. As part of the $1.7 billion secured
financing facility (i.e. Revolver, Term Loan & Incremental Term Loan), Hawker had ostensibly
granted the lenders broad liens on all of its tangible and intangible assetsbasically the whole
company. The fact that the secured debt and senior unsecured notes were trading at 70 and 25,
respectively, implied that the market was concerned that the company might not be worth the
face amount of the secured debt and that there was likely little value for the unsecured creditors.
Copyright 2012 by Stephen G. Moyer

Page 11

Accordingly, even with the priority of 503, no one would want to lend to Hawker on an
unsecured basis. And with the secured debt trading at a significant discount, it was very
unlikely Hawker could argue that the collateral could be shared with a new secured lender
without impairing the existing secured lenders.
Miller told Kirklands lawyers to start earning their exorbitant fees and come up with an angle.
Kirklands lead bankruptcy lawyer on the case called his partner in charge of aircraft
securitization to see if he had any ideas. As a matter of fact.he did. The perfection of security
interests in newly manufactured aircraft actually had some nuances that very seldom came up
in the financing context relative to the process of perfecting a security interest in existing aircraft.
In simple terms, Federal Law requires a lien filing (usually documented as a mortgage lien) with
the Federal Aviation Administration (FAA) to perfect a security interest in an aircraftthis is in
contrast to county (e.g. Sedgwick County, Kansas) level Uniform Commercial Code filings that
would typically be used to perfect work-in-process inventory during the manufacturing phase.
The general rationale for the FAA filing requirement is that a mobile plane is not associated with
a specific location and thus a prospective creditor would not know where to look for notice of a
prior lien if geographical filings were deemed sufficient. Under the terms of the secured loan,
the debtor was not required to file lien documents on completed aircraft for upto 180-days
following the receipt of an airworthiness certificate. The reason for this grace period,
presumably, was that once the aircraft was certified as airworthy, Hawker would immediately
want to deliver it to the customer so that a completion payment could be collected. The graceperiod avoided the expense of making mortgage filings that would immediately need to be
redone once the customer took possession.
However, during the downturn, Hawker had continued to manufacture aircraft, in particular the
Hawker 4000, even though it had no binding contract with an end customer. As of March 2012,
Hawker had 18 fully completed aircraft for which airworthiness certificates had been granted
and 31 additional aircraft that were fully assembled and capable of flight. To supplement its
UCC filings, in the ordinary course Hawker had made N Registration filings with the FAA when
each new plane was started, but such registration filings were not lien filings. None of these
completed aircraft were subject to Mortgage Lien filings with the FAA thus the Kirkland legal
team concluded that these assets could be pledged to a new lender who could properly perfect
its security interest.
The Kirkland team had found Miller the collateral he needed to raise new money. Hawker
needed at least $125 million to fund itself until it could complete a consensual restructuring or
prepare a pre-pack. Miller believed that the finished plane inventory might conservatively be
worth $600 million, providing significant over-collateralization for a prospective new loan with the
excess value being an unsecured asset of the company that would benefit the unsecured
bonds. Consistent with the market rumor Hammer had heard when he recommended
investment, it was subsequently disclosed that in 2010 an affiliate of GS and Onex had
purchased approximately $160 million face, or 35%, of the remaining senior notes. So not only
had Kirkland found Miller the collateral he needed to raise capital, they had also potentially
found a way for GS and Onex, whose original equity investment was clearly worthless, to
continue to participate in the restructuring process and potentially retain a stake in Hawker.
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The Outlook for the Restructuring.

As Hammer left the Investment Committee meeting he tried to methodically start analyzing the
restructuring options, but soon recognized there were significantly more variables and
uncertainties than typically confronted a distressed investor. Archs decision to remain public on
the investment so that it could freely trade its position, meant that Hammer had only Hawkers
public financials for his analysis. If Arch decided to move forward with the Rescue Loan, then
they would certainly demand to see non-public operating data and projections, but doing so
would cause Arch to become restricted and it would t not be able to either add-to or sell its
existing position. Before they made the decision to get restricted, Hammer would have to do his
best with the available information.
Usually the methodology for estimating the recoveries from a distressed investment was fairly
straight forward:
1. Estimate the value of the debtor at the end of the restructuring process.
2. Determine the size and waterfall priority of creditor claims, and compare this to the
estimated valuation to derive expected recoveries.
3. Consider the most appropriate capital structure for the reorganized debtor and how this
could impact the form of recovery.
Estimating the potential value of Hawker:
How was Hammer to value a business that was hemorrhaging cash, was potentially in the process of
badly damaging its brand, and had ongoing weakness in its primary markets? Hammer was also worried
about management. Miller was the king of turnarounds, but what about the team that got Hawker in
this messassuming Hawker survived, wouldnt they still be there making the day-to-day decisions.
Hammer was also worried that Miller had been essentially hired by Goldman, whose economic stake
was its out of the money equity investment and the senior notes it had purchased at a discount in 2010.
To deliver any value to these investments might require Miller to take more risksometimes associated
with the baseball phrase swing for the fencesthan a strategy that would attempt to maximize the
expected recovery to the secured debt.
Hammer decided that a sum-of-the-parts approach would be the best methodology to try and estimate
the value of Hawkers various pieces.
Customer Support/Maintenance: Hammer decided to start with what seemed like the easiest piece
first. Hawker clearly had a large installed fleet of planes and no matter what else happened these would
continue to need periodic maintenance and spare parts. While the division was not completely immune
to cyclical swings, revenue contraction at the 2009 trough had been much less than in the
manufacturing divisions and the margins had also shown resilience. The strong revenue rebound in
2010 suggested that the 2009 slowdown was largely a short-term deferral of maintenance that
eventually had to be completed in 2010 and 2011. Since the 2007 LBO, margins had improved but were
probably as good as they were going to get. Hammer assumed that the business required minimal
capital expenditures itself, although it was unclear what was required on the manufacturing side to
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continue to produce parts. In fact, this was among Hammers biggest concernswhat would happen to
the service business if there was a curtailment in the supply of parts?
Analysis of Support Segment
Customer Support--Rev
Rev of Sold Fuel Line Biz--Est*
Adj Customer Support Rev

2005
579.5
(83.0)
496.5

2006
551.0
(83.0)
468.0

2007
535.0
(83.0)
452.0

2008
522.8
(48.5)
474.3

2009
438.3

2010
544.6

2011
562.2

438.3

544.6

562.2

Rept'd Customer Support Op Inc

Adj for Inventory writedown
Adj Oper Inc

12.0
0
12.0

30.6
0
30.6

55.6
0
55.6

82.5
0
82.5

44.1
31.5
75.6

97.5
0
97.5

95.3
0
95.3

2.1%
5.6%
10.4%
15.8%
10.1%
2.4%
6.5%
12.3%
17.4%
10.1%
2.4%
6.5%
12.3%
17.4%
17.2%
2005 & 2006 Revenue contribution estimated.

17.9%
17.9%
17.9%

17.0%
17.0%
17.0%

Rept'd Operating %/Total

Rept'd Oper %/Adj Rev
Adj Oper %/Adj Rev
*Fuel supply business sold in 3Q08.

Trainer Business: The Trainer business should theoretically also be stable, although its growth
prospects were clearly uncertain. Hammer knew there was a lot of noise in the numbers that made an
overly precise analysis impossible. Quality control issues with key vendors curtailed deliveries in both
2007 and 2008 followed by a surge in 2009. There had also been adjustments to most of the periods
primarily related to intangible write-offs and cost-of-completion accounting catch-up adjustments.
Hammer felt this was likely a 9-10% margin business, but there was significant uncertainty on the
revenue side. Approximately 75% of deliveries under the JPATS contract had been made. There had
been some success in marketing the plane to other countries, but the year-end back log figure was very
unsettling. Hammer did not know how to handicap the issue of the lost LAS attack aircraft contract. On
the one hand he felt that Hawker probably had more political clout than Embraer/Sierra Nevada
(although it was not lost on him that they had chosen Florida for their primary manufacturing facility);
but he was worried that the T-6 airframe might be at an inherent disadvantage compared to the Super
Tucano for applications that involved heavier weapons payloads and wondered how Hawkers financial
circumstances might impact the ultimate decision.
Trainer Data
Trainer Aircraft deliveries
Trainer/Attack Rev
Reported Oper Inc
One-time adjustments
Adj Oper Inc
Oper Inc %
Trainer Backlog

2005
422.9
68.6

2006
62
420.0
52.0

2007
25
357.0
26.3
12.0

2008
36
338.2
28.2
3.8

2009
109
531.3
45.5
(2.9)

2010
80
681.1
95.7
(25.2)

2011
82
649.4
25.3
66.0

68.6
16.2%

52.0
12.4%

38.3
10.7%

32.0
9.5%
809.0

42.6
8.0%
1,112.0

70.5
10.3%
625.2

91.3
14.1%
359.4

Beechcraft Business: Within the business plane division, Hammer felt it should be feasible to separate
the Beechcraft prop operation from the Hawker Jet business. As the only separate information
disclosed about the two operations were deliveries, any estimate involved a tremendous amount of
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guess work. Hammer knew selling prices and then assumed based on the Trainer business and due
diligence inquiries that the businesses should generate at least 10% operating margins. He felt this was
conservative and would effectively factor in some capital expenditure needs since planes constantly
needed updating. His diligence investigations had convinced him that there would always be a market
for the King Air turboprop and piston engines but it was obvious that volumes had declined materially
since the recession and had yet to show any signs of rebounding.

Beechcraft Data
King Air Deliveries
Avg Price
Est Revenue
Est Operating Inc
OM%=
Baron/Bonanza Deliveries
Avg Price
Est Revenue
Est Operating Inc
OM%=

2005

10%

10%

Total Operating Income--Est

2006
142
5.75
816.5
81.7
118
0.8
94.4
9.4

2007
157
5.75
902.8
90.3
111
0.8
88.8
8.9

2008
178
5.75
1023.5
102.4
103
0.8
82.4
8.2

2009
155
5.75
891.3
89.1
56
0.8
44.8
4.5

2010
114
5.75
655.5
65.6
51
0.8
40.8
4.1

2011
107
5.75
615.3
61.5
54
0.8
43.2
4.3

91.1

99.2

110.6

93.6

69.6

65.8

Hawker Jet Business: Although he recognized it was essentially an exercise in fiction, Hammer used the
same methodology on the Jet business. Looking at the data he smiled at how easy it was to make things
work on paper but difficult in practiceafter all, from 2008 thru 2011 the actual reported cumulative
operating loss from Hawkers Business Plane segment had been $1.7 billion. Given the state of the
disastrous launch of the Hawker 4000 and the recent decision to shut down light jet production,
Hammer wondered if the range of offerings could be permanently downsized. Was it necessary to have
offerings in multiple classes. Almost all the established competitors used this strategy. But Honda was
entering the light-jet business and they were only going to offer one plane (at least initially).
If there was a decision to discontinue some lines, what would be the shut down costs? The unfolding
Hawker 4000 disaster was not unprecedented. After Raytheon purchased Beech it invested in a
futuristic successor to the King Air called the Starship. It was an engineering marvel but was launched
just as the 1988 recession hit. Only 11 Starships were sold in the first three years. Production was
halted in 1995 with only 53 produced and Beech began aggressively swapping customers into new jets
so they could take the Starships out of service and scrap thema process completed around 2003. An
uncomfortably similar 52 Hawker 4000s had been produced, what should they do? The light jet
segment had too large an installed base to attempt a decommissioning so Hawker would probably have
to continue supporting these planes. Could it do so profitably?

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Hawker Data
Hawker 4000 Deliveries
Avg Price
Est Revenue
Est Operating Inc
OM%=
Hawker 750-900 Deliveries
Avg Price
Est Revenue
Est Operating Inc
OM%=
Hawker 400 & Premier Deliveries
Avg Price
Est Revenue
Est Operating Inc
OM%=

2005

10%

10%

10%

Total Potential Operating Inc--Est

2006
0
22.5
0
0.0
64
13.0
832
83.2
76
6.0
456
45.6

2007
0
22.5
0
0.0
67
13.0
871
87.1
95
6.0
570
57.0

2008
6
22.5
135
13.5
88
13.0
1,144
114.4
66
6.0
396
39.6

2009
20
22.5
450
45.0
51
13.0
663
66.3
27
6.0
162
16.2

2010
16
22.5
360
36.0
34
13.0
442
44.2
23
6.0
138
13.8

2011
10
22.5
225
22.5
30
13.0
390
39.0
12
6.0
72
7.2

128.8

144.1

167.5

127.5

94.0

68.7

Analyze the Waterfall of Claims.

With the basic pieces of the valuation developed, Hammer next considered what claims would be made
against the estate and what the payment priority of these claims would be relative to the secured debt
claim Arch owned. Generally this analysis was usually fairly straight forward. As a secured creditor,
Arch would have a preferred claim for the lesser of the face amount of its claim or the value of its
collateral. However, since it appeared there were going to be challenges on the perfection of parts of
the collateral package, Hammer began to consider what would happen if the loan was deemed
undersecured. In general, an undersecured loan (i.e. collateral value < loan amount) was broken into
two parts: a secured claim up to the value of the collateral and an unsecured deficiency claim for the
amount of the claim in excess of the value of the collateral. The deficiency claim would be treated like a
general unsecured prepetition claim which would be pari passu in priority with the senior debt, general
unsecured creditor claims, pension obligations, etc. However, it would be junior to post-petition
administrative claims. In other words, every penny that Hawker incurred as an expense or liability after
filing the Chapter 11 petition would be senior to any pre-petition unsecured claim. Hammer shivered at
the thought of how horrifically Hawkers operations were consuming cash even before the extra costs of
all the bankruptcy lawyers and other professionals started to be piled on. All this negative cash flow
would need to be financed by the DIP and effectively be senior to Archs potential deficiency claim.
Hammer reviewed the capital structure and started thinking about the implications of the subordinated
senior notes. Under the bankruptcy code, a subordinated note was a general unsecured claim for
purposes of determining classes. What made it unique was a contractual provision, which was specific
to each indenture, that generally provided that to the extent a subordinated note received any recovery
that it would turn-over the recovery to any senior claims until the senior claim was paid in full.
Hammer was pretty sure the standard provision would benefit the two senior bond issues, but he wasnt
sure whether a deficiency claim would fall within the typical definition of a senior claim. He made a
note to have the lawyers look at the subordinated note indenture.

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Hammer assumed the $125 million Rescue Loan would be made.by someone. If Arch made the loan
Hammer would insist that it be repaid from the proceeds of the DIP that was put in place after the
probable Chapter 11 filing. That way even if Arch participated in the DIP loan, the claim status of the
Rescue Loan would effectively be elevated to a post-petition claim with the same collateral.
The pension liability would also need careful analysis. As of December 31, 2011 the underfunded
amount was $493 million and growing. The treatment of this liability would depend on what strategy
Hawker took with respect to the existing collective bargaining agreement (CBA) it had with the IAMAW.
Like all executory contracts, Hawker had the option to reject the contract with the result that the
counter-party would be entitled to a pre-petition unsecured claim in the amount of its damages. The
problem was that BRC 1113 provided unions with many protections that effectively made it very
difficult to reject such contracts. Among other things, 1113 required good-faith bargaining which
was essentially code for long and drawn out. If Hawker made the effort it would still be up to the
bankruptcy Judge to make a determination that a successful restructuring was infeasible with the
existing CBA before allowing termination. Assuming Hawker needed to meaningfully downsize, rejecting
the CBA would probably be feasible, but pursuing the strategy could take at least a year and might
permanently damage Hawkers business because it was very unlikely that there would be any new
aircraft sales during the bankruptcy. But the potential benefits of terminating the CBA were material.
First, in addition to lower wage costs and no efficiency stifling work rules, further liability under the
defined benefit plan would be assumed by the Pension Benefit Guarantee Corporation (PBGC). The
PBGC would have the right to assert the current underfunding as a claim, but it would have the status of
pre-petition unsecured claim. One downside from this scenario was that the PBGC claim would be pari
passu with whatever amount of the secured loan was characterized as a deficiency claim and thus
reduce recoveries. If Hawker viewed the potential injury to the business as to grave and did not reject
the CBA, then the CBA and the related pension underfunding would be assumed by Hawker going
forward and continue to be a loadstone for it to carry.
Hammer needed to run some numbers. He needed to finalize his valuation and then start figuring out
which of the many claims against Hawker would recover value. Repaying the DIP and any unpaid
administrative expenses would clearly get the first chunk of value. Given the way Hawker was burning
cash he would have to consider budgeting $300 - 500 million for these claims. Then what ever amount
of the pre-petition secured debt was deemed adequately collateralized would be next. But after that
there would really be a food-fight among all the unsecured claims and it was unclear how much if any
scraps there would be to fight over.

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Hawker Claim Summary*

Secured Debt
Revolver
75MM Synthetic LC
Term Loan
Incremental Term Loan
Total Sr. Secured
Unsecured Debt
8.50% Sr Notes
8.875 Sr Notes
Total Senior
9.75 Sr Sub Notes
Total Unsecured
Total Debt

240.0
40.0
1,225.0
195.0
1,700.0

182.0
303.0
485.0
145.0
630.0
2,330.0

Other Potential Claims

General Unsecured Claims
Pension Obligation
Administrative Expenses
Rescue Loan
Potential DIP Loan
*Amounts differ from actual to simplify.

Consider the Form of Recovery:

Finally Hammer started thinking about the likely form of Archs recovery. Even if his computer told him
Arch was going to receive something, it almost certainly was not going to be cash. He remembered how
two years ago he had flippantly said that it would be great if they ended up stealing the equity away
from Goldman at a discount. Now that didnt seem like quite the lay-up it had back then. In a
restructuring scenario there were usually only two ways to recover value: the debt of the debtor or
equity of the debtor. Given Hawker would need to project financial strength when it exited, it was
unlikely there would be more than a minimal amount of debt at the exit. Normally, Arch strove to
acquire the post-reorganization equity on the grounds that it usually had unusual optionality. However,
if Hawker ended up having to forgo dealing with its Unions in an effort to minimize its time in Chapter
11, or had enormous costs associated with shutting down certain operations how much business risk
would this add? If Hawker ended up filing again in a few years (euphemistically referred to as a Chapter
22), then the post-reorg equity received this time around would be worthless. And Hammer recognized
that if they did control the equity they would likely be subject to a lock-up agreement that would force
them to hold the equity for as long as three years in order to not limit the ability to utilize Hawkers
$600 million and growing net operating loss carry-forwards.
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Then Hammer had a thought. Maybe the best course for Hawker would be a partial break-up. Would it
make sense for Arch to consider negotiating to have its debt holdings essentially swapped for the service
business? Or maybe the Trainer business? Arch owned some other companies in the defense sector
there wouldnt be any potential for operating synergies but they had substantial experience with the
contract bidding process. In fact, maybe there was a path to a cash recovery if all of Hawker were sold.
Hammer had noticed that every one of Hawkers competitors was part of much larger conglomerates.
Perhaps there was just too much inherent cyclicality in the business aircraft market for stand-alone
players to be competitive.
It was now 11PM and Hammer was getting a headache. He was close to coming up with the numbers,
but he wasnt sure he had any answers for Shapiro. Tomorrows investment committee meeting was
going to be a long one and the best he could hope for was to avoid a crash landing.

Arch Capital and all discussion of its personnel, strategy, decision making process, and investment activity are
completely fictional.

Copyright 2012 by Stephen G. Moyer

Page 19