Searching for distress

With restructuring deals hitting the headlines daily, distressed debt has become the new dotcom as an increasing number of private equity managers look to buy into it as a means to gain control of a company's equity. What was once an investment approach reserved for "vulture" hedge funds is now a tactic executed by the likes of KKR. While the risks involved are enormous, US firms have been engaging in this tactic for some time now, and there is evidence to suggest that the UK is next on the trail.

"A lot of my private equity clients have recently launched vehicles to invest in the senior secured loan space in the US, which is very distressed. But they have also made provisions to invest in Europe when the time comes, suggesting that the market for distressed debt will get larger here," says Steve Langton, vice president of Bank of New York Mellon's alternative investment services' private equity division.

The "loan-to-own" method of investing is seemingly brilliant: you wind up capturing the majority of equity in a company that was previously unavailable to you, but at a much cheaper cost. The result could mean whopping returns.

The idea, however, is not as easy as it seems. "Traditional private equity firms that have only played in the equity arena are going to need to tool up to start playing in the distressed debt market," says Adam Levin, partner at international law firm Dechert. He continues: "The firms engaging in this are opportunistic and aggressive - they have to be plugged into the existing debt holders as well as with the accountancy firms that are appointed administrators. They also need to have extra skill sets to deal with not only the debt issues, but also the administration process and how to manage the business back to profitability."

Levin explains that this long-term strategy is one that requires patient and diligent advisers, as the process can prove quite risky. "Even if you pay 50 for debt that has a face value of 100, it could end up being worth zero very soon. The key to this is understanding the value in the underlying business and the implications for the debt holders. This type of deal is not failsafe. You have to see around all the corners and be able to handle what both the secured and unsecured creditors are going to do."

Nevertheless, the benefits are impossible to ignore. Even if a manager can't gain control all of the equity, it can still double its money. But is it a risk worth taking? Teams can lose a lot of time and energy on a deal like this, as well as a substantial amount of capital.

While the loan-to-own strategy is certainly not new, opportunities are rising. Journalists are eager to report on a recovery in the markets, but the fact is Europe is a long way off, as the recession has yet to impact company earnings. According to Bloomberg, 211 companies with bonds and loans missed interest payments in 2009 worldwide, up from 55 in the same period for 2008. As an increasing number of businesses struggle with their loans in 2010, private equity will have more of a reason to look at acquiring companies through their debt, especially if the company in question is operationally sound and has simply been over-leveraged.

"Until now, government stimulation has been propping up banks' liquidity and, as a result, not a large number of restructuring deals have been happening," says Levin. "But I think we're heading to a crunch point in 2010 when governments will announce that the stimuli will stop, and as a result we'll see sales of bad debts by the bank without adding too much to their balance sheet woes due to the support they've had."

Private equity funds that are at the end of their life will also have to start disposing of their assets. Unless managers can shuffle their investments into new funds, they will either have to pass them back to LPs or sell them as a block. A block sale, however, is probably going to realise more value for LPs than slicing assets up and giving each investor a tiny portion. For these reasons "there is every likelihood that a loan-to-own wave of restructuring will hit us in the next 12-18 months," Levin predicts.

Success through distress

In anticipation of this crunch, distressed debt funds are on the rise. Just last week, Oak Hill Advisors surpassed the firm's $750m target for its OHA Strategic Credit Fund, holding a final close on a staggering $1.125bn. The vehicle, which was initially launched in March 2008, targets opportunities in stressed and distressed loans, bonds and other investments.

Distressed debt investors Oaktree Capital and Alchemy Partners, via the secondary debt market, built up a substantial stake in beleaguered UK estate agency Countrywide with a view to taking full control of the company. The pair supplanted US buyout firm Apollo, who paid £1bn for Countrywide in May 2007, just before the downturn. These types of vehicles have always either looked to trade the debt they purchase through the secondary market, or to acquire a controlling stake in a company. But while these funds are familiar with debt structures and transactions, they may be lacking in other areas when it comes to taking the reigns: "There are important differentiations between the operational turnaround expertise certain equity funds can deliver, and the distressed debt funds who agitate for change through buying discounted debt which they may then trade out of," says Steven Clarke, head of UK direct investment at alternative debt provider ICG.

In other words, it is difficult to gauge the motives of distressed debt funds, as often they look to trade out of the debt they purchase, never requiring them to actually work with the company. Does this give buyout houses an advantage?

"Traditional private equity firms are certainly alive to the fact that this might be a sensible route. The question is whether these firms can adapt their skill sets. Maybe some can and maybe some can't," asserts Mark Aldridge, partner at BDO Stoy Hayward.

There is also a problem of conventional buyout houses not having the mandate to invest in distressed debt. These funds all have an intended investment criteria, whether it be growth capital, buyouts or venture. But this is nothing fresh funds cannot solve, especially with LPs becoming increasingly interested in the distressed debt markets.

"Turnaround firms like Endless and RCapital may well be looking to raise new funds to buy distressed debt, as they have the operational expertise to improve companies," Aldridge continues.

While the opportunities for private equity are there, it is still too early to tell if the work is worth the effort, as no monies have yet been realised. The whole distressed debt discussion revolves around future potential, and private equity has plenty of it. Only time will tell whether traditional players can adapt to this new surge of restructurings. After all, hedge funds aren't the only ones that can play with risk.

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