17 An Overview of the Private Equity Distressed Debt and Restructuring Markets Kelly DePonte, Partner, Probitas Partners Distressed debt and restructuring investing is a small but These factors make the sector complex, and this chapter is growing sector of the private equity market, one with several meant to provide a general overview of issues that are covered unique characteristics: in depth in a number of the other chapters. • In a private equity market that is becoming increasingly INVESTMENT STRATEGIES AND DEFINITIONS global, it is one where local laws and regulations still have a significant impact. For many investment strategies, Before covering how the market has developed, it would be local bankruptcy laws and their practical application are useful to define the investment strategies that are prevalent in tremendously important – though for global companies the the market. It needs to be said that the “pure” strategies question of which bankruptcy law applies is not always described below are useful for discussion purposes, but that straightforward. many funds utilize hybrid strategies in some form of combi- • Hedge funds are a significant competitor in the sector. nation. Recently, hedge funds have begun to compete with private equity funds for transactions on a limited basis. In the Distressed Debt Trading Distressed Debt sector, however, hedge funds have been At its simplest, Distressed Debt Trading involves purchasing significant competitors for years, especially for funds pursu- debt obligations trading at a distressed level – for example at ing Distressed Debt Trading strategies. 40% of par value – in anticipation of reselling those securities • Within the sector, fund managers pursue greatly divergent over a relatively short period of time at a higher level, gener- investment strategies. The investment strategies used by ating a trading profit. Distressed Debt traders are looking for fund managers in the sector (described in further detail in investment opportunities in which they believe the debt obli- the Investment Strategy sector below) are very different gations are fundamentally mispriced and will rebound in and require diverse skill sets to execute successfully. value. The holding period on an individual security is usual- • Investment opportunities in the sector are counter-cyclical ly weeks, sometimes days, and the size of a particular position to the general economy. Established private equity sectors is not directly relevant.This is the most liquid of these invest- such as buyouts, venture capital, and mezzanine investment ment strategies, and in part for that reason hedge funds are are not totally dependent upon general economic cycles, but major players in this sector. their returns are generally positively correlated to econom- ic trends; a strong economy in general helps generate strong Distressed Debt: Active/Non-Control returns and a weak economy hurts returns. The reverse is Active/Non-Control strategies are substantially different true of Distressed Debt and Restructuring Funds, as a weak from Trading strategies in that their goal is to accumulate economy generates in general increased investment oppor- significant positions in companies that are likely to go tunities. through, or are in, a bankruptcy restructuring process. The 18 The Guide to Distressed Debt & Turnaround Investing goal is to gain a position of influence in that restructuring a Restructuring focused fund or at other times taking the process in which the value of securities – and indeed the lead themselves. This most often occurs when they have par- nature of the end securities exchanged – is negotiated in ticular industry or country expertise (as was the case with bankruptcy in order to maximize returns. This complex Ripplewood and J.C. Flowers in the Shinsei Bank transac- process necessitates a longer holding period than in Trading, tion in Japan) though in general buyout funds avoid restruc- as well as larger, more concentrated portfolio positions. turing transactions especially if the company is already in bankruptcy. Distressed Debt: Control In this strategy,the fund manager builds a controlling position Lastly, though not private equity funds per se, there are also in the fulcrum distressed security in a bankruptcy proceeding opportunistic real estate funds that are focused on distressed in order to effectively buy control of the target company transactions, and several firms such as Cerberus and Lone through the bankruptcy process, either alone or as part of a Star got their start in this area before broadening their man- syndicate. With this strategy, the distressed debt position is in dates into corporate investments as well.The dynamics of the many respects the start of a much longer process, as after the distressed real estate market are somewhat similar to the pri- fund manager wins control of the target he acts very much as vate equity market, though the economic cycles and the types a buyout fund manager would, controlling the company and of assets are quite different. turning it around in order to maximize profitability. THE ROLE OF BANKRUPTCY LAW Restructuring or Turnaround Restructuring or Turnaround funds target companies in dis- In most Distressed Debt and Restructuring funds, deep tress but buy them utilizing equity, sometimes purchasing knowledge and experience in bankruptcy law and its process- them before an expected bankruptcy and other times in the es are key to success.Though it can be argued that Distressed bankruptcy process. Their goal – much as it is for Distressed Debt Trading strategies may be driven more by market psy- Debt: Control funds – is to get control of companies in dis- chology and trading dynamics, in all the other strategies tress cheaply and then restructure them. This strategy also knowledge of the law and its practical workings is crucial. requires detailed knowledge of local bankruptcy law in a sim- Also key is the fact that - as is discussed in other chapters of ilar manner to the distressed debt strategies. this book - the details of bankruptcy regulation can differ tremendously country by country. Success in one legal envi- Few funds follow any one of these strategies in a pure man- ronment under a specific set of regulations does not set a ner. For example, both Distressed Debt: Active/Non-Control template that can be automatically duplicated in another and Distressed Debt: Control managers use smaller trading jurisdiction. positions for reconnaissance purposes, sometimes building them up further into core positions and at other times liqui- The starting point for any discussion of legal ramifications in dating the position in order to move on to another target. Distressed Debt and Restructuring strategies is Chapter 11 Even restructuring funds that normally do not deal in dis- of the U.S. bankruptcy code, adopted in 1978. This provision tressed debt have occasionally taken control positions of the code for the first time put real stress on reorganizing a through debt instead of equity. company so it could continue to operate instead of focusing on liquidating a company. The intention of the law was to In addition, a number of regular buyout funds will on occa- both ease impacts on stakeholders like company employees sion do turnaround transactions, at times in a syndicate with and suppliers by having a revitalized if restructured company Chapter Title 19 still in operation, and to provide debtors with at least the opposed to liquidation was a necessary first step in the creation potential for a higher level of recuperation on defaulted secu- of the Distressed Debt and Restructuring Market, the other rities than would be possible in a liquidation. key item necessary was a supply of transactions that were attractive and presented a critical mass of opportunities neces- With real reorganization mechanisms in place, it began to be sary to get investors to devote time and attention to the sector. practical to try to take control of companies through the bankruptcy process. Liquidity preference (see the attached Until the 1980s, the supply of Distressed Debt was provided table) became not just relevant in the liquidation of a compa- by “Fallen Angels” – debt instruments that had originally ny but crucial in control of a restructuring. The “fulcrum been issued by investment grade obligors whose credit stand- security” in a restructuring would be the instrument likely to ing and repayment ability had fallen. Though there was a control the future of the company – with the size of overall constant supply of this type of paper as individual companies potential losses determining which investment securities got into financial trouble in all sorts of economic environ- would be wiped out and which might be converted into com- ments, the supply was actually rather low – and a number of mon equity controlling the reorganized firm. these Fallen Angels were so badly troubled that liquidation was still preferable to restructuring. TABLE 1 – SIMPLIFIED PREFERENCE STRUCTURE The 1980s, however, saw the creation of a new type of debt Secured Debt market – the high yield new issuance or “junk bond” market – in which highly levered companies issued non-investment Senior Debt grade paper with high coupon levels reflecting the increased Subordinated Debt financial risk inherent in their capital structures. Finance the- Preferred Stock ory touted by Michael Milken of Drexel Burnham Lambert and others enticed investors to purchase these bonds on the Common Stock basis that a diversified portfolio of high yield obligations was an attractive investment as the increased yield was attractive For a number of years the U.S. stood alone with this approach net of anticipated losses on defaults. Issuance of these bonds to bankruptcy, but as these changes took hold other countries was also driven by another group on the rise – Leveraged began to consider and then adopt this approach. However, Buyout Funds – that used these bonds to help buy targeted the U.S. market is still the most advanced in this area, espe- companies. cially as regards tried and true processes and methods of applying the regulation.