Supporting the structure

Italian yacht maker Ferretti is no stranger to private equity. Founded in 1968, it clocked up a hat trick of buyouts by 2006. In 1998, Ferretti had been acquired by Permira for EUR21m, eventually going to list in 2000. Permira was eager to get back on that boat and re-acquired it in 2002 with a EUR633m purchase of 93.7% of the company's share capital. Most recently, Candover bought it in 2006 for EUR1.7bn.

Just a year ago, history looked set to repeat itself: In May 2008, rumours circulated indicating Candover was eyeing up a second IPO for the business. It was before the full extent of the economic downturn was apparent, and Ferretti was posting profits of EUR158m on a EUR933m turnover (2007). In September, the Italian market regulator (Consob) granted the authorisation for the IPO on both the London and Milan bourses. How things change ...

By January of this year, the wind had come out of Ferretti's sail. The target defaulted on an interest payment that same month, with Candover under pressure from RBS to inject more money into the business to prop it up. At the time sources called the issue a "short-term liquidity squeeze". Rothschild was appointed to assess restructuring options for the company's EUR1bn-plus debt pile. Initially Candover was expected to participate in a EUR100m capital injection but by February, it had walked away written off its investment; Permira had already done so.

The long-awaited wave of defaults is starting to take shape, with levels doubling in Q1 to 3.8% for European leveraged loans by number of borrowers. The figure stood at 1.8% for Q4, according to Fitch Ratings.

"Over the last 12 months, the majority of high-profile cases have been private equity portfolio companies, often acquired in the 2006-07 period; often over-levered and with an overly optimistic outlook," observes Bruno Cova, a partner at Paul Hastings who heads up its restructuring practice.

Much of the trouble is likely to come from "recycled deals" - those passed between sponsors (secondary, tertiary buyouts (SBOs/TBOs)) - and recapitalisations. Both types of deal were rampant during the boom years of 2005-H1 2008 and involved aggressive growth forecasts, which are increasingly difficult to attain. Managing director Igino Beverini at Lazard's Italian practice concurs. "This first wave of restructuring consists mostly of distressed private equity portfolio companies acquired over the last three years, during the LBO bubble of over-levered transactions. We are seeing an increasing number of companies facing deteriorating results. That, plus the over leveraging that they took means they are most likely breaching their covenants."

Ready or not, here it comes

Given the conditions that preceded it, the current wave of restructurings should come as no surprise. Yet reactions from financial sponsors have been mixed, covering a wide spectrum, from those who have managed to pre-empt the problem to those who have tried to capitalise on it. As Cova goes on to outline, there are at least four categories of GPs:

Far-sighted investors: They have pre-empted future problems, have companies with strong EBITDA but require a re-adjustment of the financial structure to withstand the storm. These sponsors have typically entered into early negotiations with their lenders, thus avoiding the need to operate under the Damocles' sword of an insolvency filing and pre-empting breaches of covenants.

Understandably surprised investors: Their companies were performing well but became victims of the sudden economic downturn and lower trading figures. These sponsors were literally taken aback and have had a very limited time to organise a restructuring, often with limited options available.

Short-sighted investors: They saw things coming, but took too long before deciding to take action, and as a result had to face a restructuring with a weakened business case and limited options.

Cynical investors: Those who try to capitalise on the on-going environment by seeking a re-adjustment of terms from creditors - which would see their returns increase at the expense of the creditors.

Little is heard of those who succeed in carrying out the restructuring for their portfolio company, nor of those who try to capitalise on the situation. Unfortunately for the "surprised" and the "short-sighted" investors the spotlight can only be avoided for so long.

Changing times - changing structures

Restructurings typically include a combination of the following: interest holidays, postponement of payments, debt write-off, debt-for-equity swap, new financing, disposal of assets, capital injection by the existing or new shareholders and financial instruments. "Up until last year, restructuring proceedings seldom included a write-off from banks. The nominal value was kept as banks were reluctant to touch the nominal value of their credit. After the collapse of Lehman the changed economic scenario has made it impossible to address restructurings by simply 'taking a holiday' from interest payments and the terms of the restructurings have become more dramatic for lenders and equity-holders - as in the case of Ferretti," states Cova.

In the case of Ferretti, neither the company nor the financial backers could foresee that the recession would be this deep. Indeed, by January 2009, the picture was not as rosy as it has once been.

Since Ferretti's January turbulence, the company has succeeded in renegotiating its debt, reducing it to EUR550m against a conversion of credits into exit participation rights, an EUR85m capital injection underwritten by the founder with some of the management team (EUR70m) and Mediobanca (EUR15m). RBS has also agreed to grant medium term facilities to fund working capital requirements (EUR65m) and three major financial institutions (already partnering with Ferretti), have extended the short term facilities (EUR24m) to medium term ones.

Law not on your side

The legal framework in Italy has not always been favourable to creditors during restructurings but since the introduction of the "Marzano Law" in 2003, the legislation is "more creditor-friendly, restructurings are easier to carry out and the process can be expedited," says Cova. Furthermore, "Banks tend to be supportive, the deciding factor of their position being as usual the liquidation value. Banks prefer any scenario to a liquidation process. They will look to 'share the pain' with other lenders and the equity holders and look favourably at investments by new equity sponsors," asserts Cova.

But while the process is more creditor-friendly, it remains complex. In fact, "restructuring faces three main challenges: the scarcity of new capital (which is often super-senior and well protected); the complexity ensuing from the capital structure; and the number of lenders. The more of them the more difficult the procedure; this is especially true considering that - in Europe, not just in Italy - debt instruments are trading at great discounts, even those of good companies," stresses Beverini.

While the situation of senior lenders is more or less clear it is not quite the same for junior debt providers. "So far mezzanine has come out rather well - even if they are out of the money - as they often have contractual rights granting them negotiating leverage in a pre-insolvency process," says Cova. However, Beverini goes on to add that despite some having "some leverage due to contractual agreements, more often than not they don't fare particularly well."

Cautious about opportunities

But like always, one man's loss is another's gain. Distressed companies may see many industrials buyers take up the opportunity to acquire good assets at a discounted rate, perhaps offering creditors to take it off their hands in exchange for a write-off. In the end, creditors will sell to the bidder with the best offer, whether it is a private equity firm or industrial player. "This wave will present those cash-rich private equity houses with many investment opportunities. Those with strong industrial and sector expertise will prevail as they will be better equipped to turnaround the company," observes Cova.

Industry experts expect this second wave to start in the second half of this year, once companies have published their yearly results. "There are funds looking at distressed firms (such as PAI-backed Saeco, or the IT Holding assets), but in general they don't believe the market has reached the bottom yet and are therefore waiting for valuations to come down even further," Cova goes on to add. But, "It remains difficult to prognosticate which sectors could see more affected. What is true is that the recession is a deep one and there is no such thing as a safe-haven, not even for counter-cyclical sectors," concludes Beverini. Caution, it would seem, remains the mot du jour.

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