Distressed debt trading is, simplistically, short-term trading in troubled company debt. The strategy was born from the workout departments of commercial banks, where non-performing corporate loans were sold at a discount to par to investors taking a view on recovery values. Positions are normally held in a trading book, and revalued regularly on a mark-to-market basis. Credit, capital structure, bankrupcy process and cash flow analysis skills are critical to the investor who must consider the liquidation, breakup or restructuring value of the troubled company’s debt.
Leveraged buyouts generally involve the purchase of a controlling equity stake in a stable, growing company. Predictable future cash flows are ‘leveraged’ such that the acquisition can be largely debt-financed, helping to boost equity returns on successful exit. The investment is normally held by the fund at cost until sold – up to five years or more after the buyout. Valuation, forecasting and business plan analysis skills are required to consider and make the investment. Additionally, LBO managers must function effectively at the board level, working closely with company management to set and execute what is often an aggressive and accelerated plan. Management is crucial and most buyouts are backing a specific team with a well-developed plan based on their intimate knowledge of the company and its market.
Investors in distressed private equity are neither short-term debt traders nor buyers of stable, cash generative companies. The strategy, also known as ‘distressed-to-control’ or, less eloquently ‘loan-to-own’, involves the purchase of troubled company debt with the aim of converting that debt into a controlling equity stake in the restructured business. The position might be sold soon after the debt-for-equity exchange (which itself could take one year or more), or held for longer – perhaps through an operational restructuring, to allow the equity to appreciate. Either way, the distressed private equity investor needs the analytical and bankrupcty-specific skills of the distressed trader, the medium-term business planning and board-oversight skills of an LBO investor, and the ability to drive a restructuring process (either in or out of court) while a company is going through crisis. Thus the strategy requires not only deep specialist skills, but also the ability for the fund manager to invest significant time, energy and resource into the restructuring process – inevitably at the expense of working on other opportunities.
Beyond the issues of investor skills and bandwidth, whether approaching distressed private equity from either the hedge or buyout ends of the spectrum, changes are also likely to be required to the fund structure and the investors’ approach to portfolio company management.
The flexibility afforded to a fund manager is governed by the contractual terms with its limited partner investors. Rules governing redemption notice periods, permissable asset classes for investments, whether the fund can take minority or majority stakes in targets and make hostile acquisitions are key. Together, they will influence whether and to what degree the manager can participate in a given opportunity.
Investor liquidity: The typical hedge fund provides investors withthe right to withdraw capital on relatively short notice (for example monthly or quarterly), while in a buyout fund, the investor is usually locked in for the life of the fund. A distressed private equity position is a highly illiquid investment where timing and management of the exit process are critical to returns. A premature forced sale to meet investor liquidity demands could be catastrophic to investment performance. More and more high profile hedge fund managers are implementing less liquid terms so they have more freedom in their investment style and to provide stability to their business. Others are adopting structural mechanisms that help balance investors’ liquidity with what is in their portfolio, including fund level gates, side pockets, long initial lock-ins and/or longer on-going liquidity (annual, bi-annual or longer).
Investment restrictions: The optimal entry strategy for a distressed private equity investment usually involves buying into one or more classes of debt, which comes with certain rights and influence in a restrucuturing negoatiation. Hedge funds generally have few restrictions on the class of security they can acquire in a given situation. In contrast, most private equity players are precluded from investing in debt or mezzanine securities, or from taking minority positions. To offset these and other limitations, some private equity managers have launched parallel hedge fund strategies or otherwise adapted the terms of their (subsequent) funds in order to increase investment flexibility.
Generally speaking, the longer the investment period the more the return is dependent upon company management to execute its business plan. Thus most buyout managers consider themselves perhaps above all else, investors in management.
Like buyout, distressed private equity is dependent on management’s ability to deliver, but usually does not have the luxury of backing a team at the outset. In a distressed situation, incumbent management is often part of the problem, in denial, or simply not sufficiently experienced in the challenges of navigating a financial crisis. Sponsors will therefore often seek to fill the void with board-level interim or crisis managers at the CEO, CFO, CRO (Chief Restructuring Officer) level who have the expertise to quickly asess the situation, stop the bleeding and stabilise the company while the restructuring plan can be worked out and a permanent management team put in place.
Given the levels of debt being used to finance the burgeoning buyout and corporate M&A market, loose covenants papering over a multitude of corporate sins, and cyclically low levels of defaults, it seems certain that the supply of distressed investment opportunities is sooner or later going to rise – perhaps exponentially. At the same time, the challenges and complexity of this next wave of restructurings are likely to exceed those seen in the past. Leveraged structures have become increasingly complicated, trading and credit derivative use have accelerated, and the number of market participants has multiplied with the advent of hedge funds and other structured investment vehicles. Determining the identity and objectives of the different stakeholders in a workout negotiation will be a very difficult and dynamic process. Implementing restructurings is likely to require more, not less, specialist knowledge and advisory support.
All this suggests that the supply of distressed private equity opportunities could well increase faster than the market is able to absorb them – creating a very interesting opportunity for those who are equipped to handle the deals. And, inevitably, creating some rather large headaches for those who thought they were better equipped than they were. And this, perhaps, will be the true test of convergence.