Structural revolution

The common view amongst most buyout fund managers seems to be that 2008 couldn't end fast enough, and will likely go down on record as one of the toughest years the industry has experienced in recent history. Few, however, expect 2009 to be any easier. Aside from ongoing debt illiquidity, which is stagnating dealflow in all areas of the market, the (now confirmed) recession is deepening and has already claimed a series of high profile casualties on the high street.

This is causing many firms to begin looking nervously at their own portfolios and, though there has yet to be any major surge in private equity-backed companies hitting trouble due to the relaxed nature of banking covenants in recent years, expectations are that there is a storm brewing. "Any problems in the market at the moment are in relation to deals done around three years ago - we haven't seen any of the cov-lite deals running into problems yet. This will come though; in the latter part of this year there will be a second phase," confirms Malcolm McKenzie, managing director at restructuring specialists Alvarez and Marsal.

The bank question
Moreover, the fact that many of the transactions completed during the boom years have such relaxed covenants on their debt - and are therefore avoiding the classification of 'distressed' for the time being - is not necessarily the saving grace it could first appear. "The difficulty with deals being very cov-light is that when problems do come and covenants are breached, the businesses have deteriorated so much that there is no time to sort the issues out," suggests Guy Green, partner at UK-based law firm Eversheds.

Accepting this, many private equity firms have begun to examine their portfolios well in advance of any potential breaches, in an attempt to weed out those businesses that are likely to struggle in the months ahead and put measures in place to shore them up. While in some cases this could simply be a case of improving the bottom line profitability of the business in question through operational changes - particularly internal restructuring and re-focusing the business model - the truth of the matter is that many of the businesses acquired over the last three years were over-priced and significantly over-leveraged, which will require major restructuring of the capital structure to fix.

This puts a strong focus on how senior lenders are going to behave, which is anything but assured given the ongoing difficulties within the banking sector. Many on the private equity side have expressed confidence in recent months that banks will be fairly lenient, purely because they are so exposed to the problems that they simply could not deal with the volume of defaults and administrations they would face if they did not offer support. However, for precisely the same reason others take a different view: "The reality is that the banks are in a tough position at the moment and they need to reduce their exposure to the difficult positions," explains McKenzie.

Indeed, some banks with dire liquidity problems have begun to implement punitive measures to recoup capital. At the extreme end there have been anecdotal reports of major banking institutions calling out solid businesses on technical covenants - despite strong cash flow positions and the fact that they are servicing their debt - and demanding large waiver fees and monitoring fees until the covenants are met again. "This is merely a logical consequence of banks' current position - they are going to be taking a serious view of things such as technical covenants, though to be frank the attitudes will vary from institution to institution," McKenzie notes.

Despite this, banks remain in a poor negotiating position until a covenant breach occurs, meaning that in many cases they will be forced to play ball if they want to get a business on a better footing before it's too late. A case is point here is the recent news that BC Partners had allegedly approached senior lenders on its £390m investment in UK estate agency Foxtons, with the offer to put in up to £50m of extra equity - but only on the proviso that a substantial chunk of the £260m debt is written off. According to David Ascott, head of private equity at Grant Thornton, such moves will become common: "This is a typical restructuring conversation, as if the equity and debt is underwater then any additional cash would just turn immediately into debt and there is no incentive for the sponsor. Banks need to decide if there is more value in a long term recovery than in a receivership."

The pre-pack debate
But, like many of the debt structures in place in these transactions, the issue is much more complicated than a simple trade-off between equity and senior debt. Aside from the fact that many larger buyouts were in fact financed using clubs of lenders due to their sheer scale, the fact is that the vast majority of deals throughout even the mid-market were underwritten by a single bank, which then syndicated the loans off into buoyant CDO markets - meaning that there are a whole range of smaller banks, hedge funds and other financial institutions in the capital structure. And then there are the subordinated debt providers holding mezzanine, PIK and, more recently, second lien, positions.

That organising any potential restructuring deal could mean trying to get all of these disparate parties to come to some form of agreement could make the process extremely challenging. "With a syndicate of banks often in the senior portion of the debt and separate providers holding mezzanine and second lien positions, it will obviously be a nightmare to communicate and a real project management task. In addition you can't ignore the politics within the banks themselves now that could prevent a decision being reached," says Ascott.

In order to overcome these logistical obstacles many are suggesting that there may be a rise in "back-to-back" deals, where a private equity owner collaborates with the senior lender to put a business into pre-pack administration in order to re-acquire it. This would cut out the need for potentially problematic discussions with subordinated lenders; allow the senior lender to downsize its holding without selling at a substantial discount; and leave the existing owners in charge. "If the mezz or second lien lenders are not prepared to play ball, a back-to-back deal enables a form of new money restructuring that gets the banks par value on the debt and allows the sponsors to retain control - there will be a lot of deals of this nature going forward," confirms Charles Noel-Johnson, director at Close Brothers Corporate Finance.

This, though, feeds into an ongoing argument surrounding pre-packs, which have recently suffered from allegations that they are open to abuse by existing owners. "The problem is that the administrator isn't even in office when the sale is organised and if those creditors that fall below the value break feel a better deal could have been done then they can make a legal challenge," explains Paul de la Pena, partner at Eversheds. Defenders of the scheme argue that pre-packs are merely a way of developing a process similar to that of chapter 11 bankruptcy in the US, which is designed to save businesses by allowing ownership to be transferred to the creditors while it is continued as a going concern. In contrast, they argue, traditional administration processes in Europe are much less lenient and less often result in the company not being saved.

Criticism of the process is likely to be renewed as a result of a spate of the aforementioned back-to-back transactions and, while new voluntary guidelines were issued in January, in the long term this may prompt full legislation. "There are questions about how transparent the process is, particularly when previous owners are involved; there is no legislation at the moment and perhaps there needs to be," de la Pena continues. "Governments have historically been slow to take action and it is likely that there will be a big court battle in relation to a large deal in the next year or so that could prompt some emergency legislation."

Distress to impress
The rise in portfolio company distress, though, may actually benefit some. Recent months have seen a rise in interest in distressed debt and turnaround fund managers, with many new funds being raised and consistent suggestions that LPs see this space as the most attractive in 2009. "A number of firms have raised distressed funds targeting both equity and debt investments, though there is currently more discussion and perceived opportunity than there is deals being done," comments Ascott.

The fact that few deals are being done is seen to be a result of continuing uncertainty regarding where the market is heading and subsequent uncertainty on pricing. According to Henrik Fastrich, founder and managing partner of German turnaround investor Orlando Management, the issue is two fold: "There are questions over both where the bottom line will be for revenues and how the business plan is set up to deal with the conditions over the next few years. At the moment nobody has any answers so potential buyers simply apply big discounts and this results in a disconnect with sellers and financing banks." However, he suggest that this will change when covenant breaches begin to occur: "There will be an increase in deals in the second half of the year following some ugly breaches in the first two quarters and due a need for fresh capital, which will force sponsors and lenders to reduce their price expectations to get a sale."

This inevitably means that there may be some attractive deal opportunities to be had later in the year, as motivated sellers offload assets for which they overpaid. But some are warning against generalist funds moving too hastily into the space in search of bargains, as turnaround investments are not simple to price and model. "You can't evaluate these businesses based on the financial reports as by definition there is underperformance. You need to get in there and see the operations and the management to decide if you can make it a success," explains Fastrich.

Indeed there is even the implication that sellers may in fact target firms that have experience in this area to lead their companies forward, perhaps even at the expense of price. "Some sellers may not see price as the main issue, they may actually be more concerned with bringing in an owner that can actively manage and restructure the business successfully," Fastrich claims. This may prompt banks that find themselves in control of companies to partner with turnaround investors, as this may better protect their investment and provide a more lucrative return than they could achieve through receivership: "Banks could look to use a re-structuring fund to put the business on a better footing and may even themselves provide debt and/or equity into the new vehicle."

But the year will also present challenges to turnaround investors, who could struggle as a result of a dearth of debt and increasing timing pressure. There have been suggestions that the combination of these two factors may result in a rise of transactions financed entirely with equity, with the idea being that some of the investment will effectively constitute bridge financing that will be refinanced somewhere further down the line. This, though, is obviously a risky play, as it is based on the dual assumptions that the debt markets will recover in a reasonable time frame and the business will not deteriorate further and therefore struggle to raise debt.

As one door closes…
It is inevitable, it seems, that portfolio problems will be widespread in the coming year. Private equity firms are already said to be concentrating on their incumbent investments to better position them for the year ahead, but, in many cases, this is unlikely to be enough, particularly considering that the economy is expected to continue to deteriorate for the foreseeable future. This will lead to the need for difficult restructurings and an increase in defaults and administrations, which could further lead to legal wrangling and debate. However, with the problems affecting both sponsors and lenders alike, those that can find workable compromises could find solutions that will secure the future of many businesses, though this will involve an acceptance from all parties involved that there is likely to be a drop in returns.

Conversely, private equity is renowned for being counter-cyclical and there are those that will profit from the downturn. Distressed investors, often unfairly termed 'vulture funds' by the mainstream press, will have an important role to play in the year ahead, both in providing attractive investment opportunities to liquidity starved LPs and saving troubled businesses. As Mark Fry, managing partner at insolvency specialist Begbies Traynor, suggests, the rise in administrations and distressed sales may in fact be a sign of better things to come. "People automatically assume that distressed sales and insolvencies are bad, but they are a natural part of the recovery process and can be an example of rising confidence that we have hit the bottom and that people are prepared to do deals again. Distressed sales and pre-packs can save businesses and, importantly, jobs."

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• UK / Ireland