The dislocation in the credit markets poses both a great challenge and grave danger to companies in distress. The dislocation, which is caused by the significantly higher implied yields to maturity in the secured loan trading market as compared to the yields to maturity that may be obtained from new issuances, is making it virtually impossible for distressed companies to access meaningful and flexible sources of liquidity. At the same time, the dislocation creates an opportunity for distressed investors to purchase strong, but over-leveraged, distressed companies for relatively cheap prices and with significant downside protection.
Here are three factors to consider:
- 1. Today, investors are able to purchase first lien, secured loans at a significant discount and an attractive yield to maturity in the trading market. For example, if an investor purchases a first lien note with a face amount of $500 million for 70 cents on the dollar, a rate of LIBOR (assume 3.5%) plus 200 basis points and a maturity of November 15, 2012, the yield to maturity would be approximately 15.85%. For a company in distress to obtain the same loan, the pricing would need to be LIBOR (assume 3.5%) plus 1235 basis points. Financing with 16% interest (exclusive of fees) is incredibly expensive and most distressed companies cannot afford it. Hence, the market dislocation. Banks and other investors can make significantly higher returns by buying loans in the open market rather than issuing new loans.
- 2. The number of companies approaching a default or that are in default is overwhelming. Some predict that $1 trillion of corporate debt could be in default by 2010. What does this mean? To put it in unscientific perspective, Standards & Poors lists 581 speculative grade borrowers. Of these borrowers, the median amount of debt is $676 million. Accordingly, if Fitch’s prediction is accurate, then more than 1,500 companies could be in default by 2010. Many of these companies are strong and valuable. Their problem is simple - they need to de-leverage.
- 3. Traditionally, private equity firms use borrowed money to buy companies, thereby enhancing their returns on invested equity (hence the term “leveraged buyout”). Today, however, banks are not lending and, as a result, the business model of private equity firms is being challenged. Nonetheless, there is a unique opportunity in the current market – a multitude of companies are over-leveraged and their debt can be purchased cheaply. Using leverage to buy a company or buying a company that is already highly leveraged at a discount has the same effect – the leverage enhances equity returns.
Taking these three factors into account, an enormous opportunity exists for distressed investors. What is the playbook for taking advantage of this opportunity? Here is one example. First, find a valuable, but over-leveraged, distressed company with little liquidity. Second, purchase, at a discount, 51% of the company’s secured debt. Third, as the company begins to experience difficulties and needs relief from its secured lenders, provide liquidity in exchange for control of the process and the ability to buy the company by converting the purchased debt for equity. Fourth, provide the liquidity in the form of a DIP loan and require the company to meet various milestones, such as confirming a plan of reorganization by a date certain, to avoid a default under the DIP. Fifth, work with the company and the company’s other stakeholders to develop a fair plan based on the valuation of the company, the company’s debt capacity and the facts and circumstances of the reorganization. Sixth, “buy” the company without needing to borrow and for a reasonable price.
It is important to remember that every reorganization and situation is different. It is also important to keep in mind that careful and extensive analysis of the company’s debt documents, capital structure, organizational structure and legal issues is necessary prior to making a meaningful investment. Notwithstanding this, the attractiveness of the dislocation in the credit markets for distressed investors is that even if the strategy of buying the distressed company does not work, the return on investment from the purchase of the company’s loans should protect the investor’s downside and even provide the investor with upside.
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.