The business model of the traditional (i.e., non-distressed) private equity fund is challenged.
Typically, a private equity acquisition is a purchase of a target company’s “equity,” negotiated privately, often on a friendly basis and financed partly by borrowings (i.e., new debt secured by the target company) and partly by equity from the fund (i.e., cash from fund’s investors). To the extent the equity in the target company increases in value following the acquisition, the effects of leverage provided by the debt compound the returns on the cash invested by the private equity fund. However, today’s economic and credit environments are not inviting to this type of transaction. As good companies with bad balance sheets are defaulting at a rapid pace, the economic and credit environments invite acquisitions of companies through their debt and a restructuring process. Indeed, what some funds have discovered is that debt can serve as the new equity and bankruptcy courts the new platform for control transactions.
The traditional private equity fund is keenly aware of the opportunities for purchasing good companies, with bad balance sheets, at good prices, by buying debt and converting it into equity (thereby fixing the balance sheet issues). However, one of the characteristics of private equity funds -- which makes the good funds so successful -- is their deliberateness. Consequently, private equity funds are not jumping into the treacherous waters of distressed investing without a life vest, but are considering carefully whether it makes sense for them to get into the distressed investing game and, if so, how best to succeed. In connection with their deliberate consideration, private equity funds are focusing on three concerns, each of which can be addressed, thereby throwing the game wide-open for these funds to invest and prosper.
The three issues are as follows:
Private Equity Funds Like to be Friendly, Not Hostile: The perception of private equity firms as corporate raiders is misconceived; today’s genteel private equity funds prefer to strike a deal collaboratively with the target company and its management. As such, the funds are concerned that buying debt of a competitor fund’s portfolio company to convert it into equity, thereby gaining control, will be considered a hostile act. In some cases, this will be true, but each case is different. In fact, many current equity investments by these “financial sponsors” are totally wiped out, so there is the opportunity for the private equity fund to participate in the restructuring process and remain friendly with the financial sponsor. The reason for this is a result of the dynamics of the distressed investing world -- a world that is not genteel and not for the feint of heart; rather, the tactics employed resemble street fights, with certain rules, which were made to be broken. Oftentimes, financial sponsors take the brunt of the attacks and threats from distressed investors, especially threats of lawsuits and the withholding of releases (thus, keeping the option of a lawsuit open) if the sponsor does not “fall into line.” The private equity fund purchasing debt to convert it into equity, however, can act differently, offering olive branches rather than switches to sponsors and management teams. In many situations, the olive branch may be in the form of a release, which some have observed is the new recovery for out-of-the-money sponsors (a principal at a private equity fund came up with that phrase). Consequently, in the right situations and with the appropriate understanding of the process and communication with the target company, a private equity firm can purchase debt for purposes of taking control and remain friendly.
Private Equity Funds Like Due Diligence. In the typical private equity deal, the fund approaches management to discuss a buyout and then is allowed to conduct extensive due diligence. In the distressed transaction, the distressed investor traditionally purchases the debt without any inside diligence. This, of course, is anathema to the private equity fund. Yet, during the pre-Summer of 2007 credit bubble, companies issued large amounts of leverage loans and, as a result, the capital structure of these companies are tilted heavily toward senior secured bank debt. The importance of this is that the holders of leveraged loans are entitled to a certain level of confidential information pursuant to their loan agreements. In general, the information is provided to the holders of leverage loans via postings to a closed intranet site. As a result, a private equity fund considering a purchase of a company’s leveraged loans, can approach management and ask for a certain level of information. The information received can be tailored to provide the private equity fund with sufficient information to determine if it wants to purchase the loans (i.e., whether the fund believes that they are the fulcrum security) and the company with comfort that the information could be shared with the other lenders on the site without fear of damaging the company if the information leaked out. Once the information is posted to the site, the private equity fund would be free to trade to purchase leverage loans from the other lenders. Thus, a private equity fund can get its proverbial cake and eat it too - i.e., obtain information to determine whether to put money to work and, if it makes that determination, to purchase the loans it needs to take control of the target company. (Of course, before doing this, a lawyers should be consulted!)
Private Equity Funds Like Negotiating Private Equity Transactions, Not Chapter 11 Plans. The negotiations surrounding private equity transactions and distressed debt transactions are as different as arm wrestling is from WWF wrestling. In the private equity transaction, the private equity fund negotiates with lenders regarding the terms of a new loan, management regarding the terms of employment agreements and option plans and the board regarding the price to be paid for the shares of the company. In the distressed debt transaction, the private equity fund not only needs to negotiate with the company, but also other lenders in the bank group, potentially bondholders and, then, in many cases, if a chapter 11 case is commenced, a creditors committee and other parties, with a bankruptcy judge ultimately presiding over the restructuring plan. The negotiating tactics in these two transactions are very different and the distressed debt transaction is not in the private equity fund’s sweet spot. However, private equity funds can “buy” that expertise, either by hiring advisors or hiring the right person or people with restructuring experience. Thus, the expertise, experience and personality needed for negotiating restructuring transactions is available - private equity funds just need to determine the best way to obtain it and integrate it with their investing teams.
The concerns of distressed investing by private equity firms can be -- and will be -- overcome. As a result, it is only a matter of time before private equity funds jump into the distressed investing world with both feet. And, when they do, as Coldplay sings, they will find that “there’s gold in them hills.”
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.