Jonathan Henes
Kirkland & Ellis LLP

A professional investor develops an investment thesis. The investor analyzes macro and micro conditions and opportunities and then determines the companies or segments in which to invest. Today, the investment thesis for private equity funds should be to buy distressed, but market leading, companies.

Consider these factors:

1. The pre-July 2007 robust credit markets enabled companies to take on more and more leverage. While the economy was humming along, these companies were able to sustain their capital structures. In today’s economic downturn, many companies are either defaulting or will be in default soon. Standard and Poor’s predicts that the default rate on corporate debt could reach 23% by 2010, which would mean at least $1 trillion of corporate debt in default within the next two years.

2. Companies in financial distress are in desperate need of liquidity. However, the credit markets are severely constrained. During the period from 2002 to July of 2007, banks developed a new business model for making loans - origination and syndication. This was made possible because the Fed increased the money supply after September 11th and there was a proliferation of hedge funds and CLOs with a seemingly insatiable appetite for buying corporate debt. This appetite is gone and, as a result, banks need to find a new business model and new money.

3. Banks and hedge funds are going through a major business model adjustment. Banks are writing down assets, which reduces significantly the amount of funds they can lend. While the Troubled Asset Relief Program is providing banks with cash, it is not enough to normalize the lending environment. At the same time, hedge funds are being hit from both sides - they make outsized returns by leveraging their investments, which currently is not in the cards, and many are suffering massive redemptions. Accordingly, the cash needed to make loans to distressed companies generally is not available from traditional sources.

4. The incumbent lenders of distressed companies - i.e., banks and hedge funds - are caught between a rock and hard place. They are owed large sums of money. Sometimes, the only way to get paid back in full is for the distressed company to continue operating, reduce its debt, fix its operations and emerge from a restructuring process stronger. However, this takes adequate liquidity and the incumbent lenders are not in a position, generally, to provide companies with sufficient funds to restructure appropriately. Thus, good companies with over-leveraged balance sheets are finding themselves on the brink of liquidation.

These factors lead to a strong investment thesis for private equity funds - i.e., provide critical liquidity to distressed companies so they can right-size their balance sheets, fix their operations and be poised to grow as the economy recovers. At the same time, the private equity funds should employ strategies and tactics to own the companies as they emerge from a restructuring process. This thesis makes sense for at least four reasons.

First, private equity funds are flush with cash and are not subject to redemptions. As a result, private equity funds have a long-term outlook. Second, competition for providing liquidity is low, thereby enabling private equity funds to put their money to work on good terms. Third, the supply of distressed companies is large and increasing by the day. Accordingly, private equity funds will be able to find great companies and great deals. Fourth, due to the lack of competition and the large supply, private equity funds can purchase distressed companies relatively cheaply and without the need for significant leverage.

A warning, however, for private equity funds entering the distressed world is that it is vastly different from the typical deal world. It takes some getting used to, and expertise in the inner workings of restructurings and the Bankruptcy Code are a must. But, if private equity funds are willing to learn, take advice from experts and enter this world, great opportunities await.

• What are other CNBC Guest Bloggers Saying?

______________________________

Jonathan Henes
Kirkland & Ellis LLP

Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.

POPULAR GUEST BLOG POSTS

• 

• How to Date a Wall Street Man 

• 

• Getting Ready to Retire? Start by Rightsizing Your Home 

• 

• Exporting an Inflation Tsunami 

COMMENTS

More Comments

 

« First | « Previous

Next » | Last »

Thank you for joining our discussion. Your comment has been posted.

ADD COMMENTS

Please Sign In or Register to participate.

In order to add a comment you must click here and accept our terms and conditions.

Edit Screen Name

Please sign-in/optin or register to be able to submit comments.

Remaining characters

CNBC welcomes your contribution. Please respect our community and the integrity of its participants. CNBC reserves the right to moderate and approve your comment.

Sorry, we are no longer accepting comments.

PREVIEW COMMENT

Your comments have not been posted yet.
Please review your submission to make sure you are comfortable with your entry.

Your Comments: