Pinstriped chameleons

When the crisis hit, distressed debt investors quickly began filling up their war chests and raised huge funds to buy into struggling firms through their debt. Such groups, many of which were hedge funds, are indicating that "debt is the thing to do and the place to be" for the short and mid-term. To them, it offers an attractive risk versus reward while being less volatile than the stock market.

Rather than indiscriminately buying leveraged loans, distressed investors are acquiring single loans of specific companies from distressed lenders, many of which have to vacate whole geographies. An example of this is HSH Nordbank, which is selling off portfolios in Russia and Eastern Europe. Other banks sell as they are unable and unwilling to become owners of businesses.

"The selling banks really don't have a choice - they have to increase or change the quality of collateral," explains Morten E Astrup, CIO of Storm Capital, a pan-European investor in transportation, energy, and real estate, with an emphasis on the Nordic region and Russia. "We like buying from banks because that also means you get the financing into place."

In Germany, it was mainly international banks that sold debt on the secondary market in a desperate bid to clean up their balance sheets, often pressured by government shareholders. But this is about to change. "We expect the real wave of sell-offs by German banks to hit in the second part of the year, and then see a corresponding rise of loan-to-own bids," explains Dr Gernot Wunderle, managing partner of corporate finance firm goetzpartners.

Strategy shift

The current window of opportunity brings a lot of new players to the market, some of whom move into equity to protect the value of the asset they invested in. "We were traditionally mostly active in bond and equity trading, but we are now taking advantage of opportunities in distressed debt and special situations in equities, where we see a need for change in order for the companies to survive," explains Astrup. "In one situation, we were invested through a company's equity and had to move into the driver's seat to prevent the worst during the downturn, which led to a complete change of management and a cancellation of the company's investments."

Not every hedge fund has the skills to capitalise on the opportunities, and others are hampered by a fund strategy that doesn't allow them to invest in distressed debt. But those who are in a position to take advantage are facing rich feeding grounds and many are gorging themselves on these cheap loans, which can make them the dominant players among the lenders.

There is no shortage of opportunity out there. While many company vendors hold on to their assets, leading to a relative scarcity of healthy assets up for sale, there is no such scarcity in the debt space, with some sectors especially promising. "Automotive, fashion, and industrials are obvious targets, as these don't seem to have reached the bottom quite yet, and there will be a lot more distressed debt on the market," explains Dr Thilo Hild, co-head global insolvency and restructuring group at law firm Kuebler. "The feeling is that once the economy gains momentum, these sectors will benefit strongly from the increased demand. Not only are high-class assets suddenly available, they are also relatively affordable."

Other factors also play a role. "The community knows which companies are struggling: who have breached covenants, how willing the investor is to put in more money and what the contracts are like," Wunderle explains. "Some private equity investors buy into their portfolio company's debt, rather than reinvest in the equity, and also as a protective measure against opportunists."

While traditional lenders are mainly concerned with seeing the debt paid off and traditional bond holders tend to be more sedate, distressed investors can take an activist approach and employ an aggressive 'loan-to-own' strategy. Depending on the amount of debt owned, this can lead to them ending up with the majority of the equity and pushing the private equity sponsors out. However, this doesn't succeed all the time; the legal structure has to allow this kind of influence.

Out of the shadows

Most attempted or successful loan-to-own bids happen under the radar, but in Germany, opportunistic investors targeted several large companies with enterprise values of more than EUR1bn in the span of a few weeks, which brought the industry back into the headlines.

Apollo Management, TowerBrook Capital Partners and York Capital led the senior lender consortium, which took control of Monier Group, pushing PAI partners out (see page 50). Oaktree Capital set its sights on alumina-maker Almatis, owned by Dubai International Capital, but restructuring talks ended when Almatis's trading improved enough for DIC to tackle the restructuring on its own. It is unlikely that Bavaria Yacht's trading can bounce back enough for Bain Capital to defend its position against Oaktree, which is seeking ownership of the over-leveraged yacht builder, which was financed with 14x its 2007 EBITDA of EUR82m.

In all of these cases, the debt was heavily syndicated and sold on the secondary market by international banks, where it was snapped up by hedge funds. The hedge funds then acted as intermediaries and traded the debt to stake-building restructurers or opportunistic investors such as Cerberus or Oaktree, which then conduct the loan-to-own bids.

The challenge for them is to build a large enough stake to make a credible loan-to-own bid, either by offering a rollover to the other lenders, or getting a large enough number of senior lenders behind them. It also depends on the debt contract - how big the stake has to be to force a debt-to-equity process, or force the company into insolvency, from which it can be bought out.

The complexity and variables are one of the reasons why we haven't seen more loan-to-own bids, which - while increasing in number - remain relatively rare, according to industry insiders. But even if a straight-out loan-to-own bid is unsuccessful, hedge funds hold large positions that bring them to the table in restructuring talks for ailing portfolio companies.

Uneasy bedfellows?

The mainstream press has made much of the conflict between private equity owners and activist hedge funds or other distressed investors, but the reality is less black and white. The relationship between sponsor and opportunist largely depends on the financial position of the private equity owner. "Professional owners, such as private equity firms, see the problems in a company clearly," states Erik Mathiesen, CEO of Storm Capital. "If they still have money to invest, they can benefit from an aggressive hedge fund that pushes for the necessary changes during a refinancing, when both sides can reinvest in the company and clear up the shareholder structure."

Such "marriages of convenience" are just one scenario. Another is that a hedge fund opens up an exit strategy, as one industry insider points out: "Once the asset has been recapitalised and produced a good IRR, the private equity investor is happy to cede control and walk away, especially with assets that have already broken covenants. This can be a comfortable solution, as it leaves the reputation of the private equity firm intact."

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