Private equity funds are structured to purchase and own companies; hedge funds, CLOs and banks are not. Yet, as many of today’s distressed companies binged on leverage loans from 2003 through the summer of 2007 and now need to restructure their balance sheets, hedge funds, CLOs and banks — who bought these loans as they were originated and syndicated – are, in fact, finding themselves owning reorganized companies as they emerge from the restructuring process.
These non-traditional owners of companies are the victims or beneficiaries (depending on one’s view) of their own making:
- Prior to the summer of 2007, hedge funds and CLOs proliferated and focused on buying debt. The strategy of many of these funds and structured products was to purchase a little bit of debt in a lot of companies, thereby “dispersing risk” and “guaranteeing” themselves a certain return (which, when leveraged, was intended to be meaningful);
- As the hedge funds and CLOs demonstrated an insatiable appetite for buying debt, banks embarked on a slightly evolved business model for the syndication of leveraged loans. The diligence done on companies seeking loans began to diminish as the fees from originating and syndicating loans increased in amount and abundance. Banks became facilitators of loans rather than true lenders; and
- Companies seeking or needing funding for growth investments or re-financings were able to secure financing easily through the issuance of leveraged loans, at cheap prices and on good terms. Even distressed companies were able to obtain leveraged loan financing.
As the economic crisis began and then deepened, the loan syndication market closed as hedge funds, CLOs and banks left the market and distressed companies, loaded up with debt, began to find themselves in default (or on the verge of default).
Thus, these companies needed to restructure their balance sheets, which required a massive conversion of debt to equity. Today, due to the prevalence of leveraged loans, many times the balance sheets of distressed companies are heavily weighted towards leveraged loans. Consequently, as the leveraged loans are converted to equity, hedge funds, CLOs and banks become the new owners.
The issue for these non-tradition owners is that they are not equipped internally to own a company and help it grow and succeed.
So what should they do?
Act like a private equity fund.
- Develop a Protocol to Act Collectively: The perceived interests of the various holders of leverage loans may conflict with one another; however, the various holders need to understand that it is critical both during and after the restructuring to speak with one voice. The group of holders of leveraged loans needs to think like a single private equity sponsor of the company to preserve and maximize value, enable the restructuring to proceed efficiently and allow the company to have clear direction upon emergence.
- Recruit a World-Class Board of Directors: Experience, judgment and expertise make an enormous difference for a company and, when done correctly, give a company an edge over competitors. As such, the new owners should work with management to determine what types of experience and expertise are needed and then recruit appropriate people to sit on the board of directors. Note, however, that new owners should refrain from attempting to force “their people, who will look out for their interests” on to a board, unless those people have the requisite experience, expertise and judgment.
- Build and Support Strong Management Teams: The strength of management team can be the difference between success and failure. As a result, new owners should make sure that the management team of their company is strong and, if not, find new management. Once a management team is in place, however, the new owners should support it, both with top of the market compensation and equity rewards tied to shareholder returns if the company succeeds in the long-term.
- Ensure that the Company is Operating Efficiently: The best private owners of companies challenge their management teams to operate their companies efficiently. This means keeping costs manageable, focusing on team work and investing capital on activities that will achieve a meaningful return on investment.
- Focus on the Optimal Capital Structure: Capital structures are critical to a company’s success. In building a capital structure, a company needs to weigh its desire or need for capital, but also other factors, such as the economic environment, the functioning of the capital markets, the cyclicality of the business and the ability to service the debt under down-side scenarios.
- Think Long-Term: Great businesses are not built overnight and, therefore, the exit strategy for a company may depend on the implementation of long-term plans. As a result, new owners need to be patient if they want to maximize the value of their equity and need to be intimately knowledgeable about the capital markets to determine the optimal timing and means for their exit.
The new owners of many of today’s restructured companies and the restructured companies of tomorrow are not equipped internally to be owners.
Consequently, they either need to become quick studies or find a partner that knows how to own and manage companies and manage companies for long term success and maximization of value.
If these non-traditional owners are able to manage their investments correctly, when the economy recovers, the investments may result in phenomenal returns.
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.