Distressed to impress

In the midst of a recession, one would expect to see a huge deluge of business failures, and in turn, a large number of turnaround deals. But until lately, this was merely an expectation that hadn't been realised. However, while broadsheets are eager to report on a recovery in the markets, anecdotal evidence suggests that the bad times are far from over, making turnarounds potentially the deal of the upcoming year.

"Real businesses on the ground are going through a very difficult period, and this will continue for a prolonged period of time," says Mark Aldridge, corporate finance partner at BDO Stoy Hayward. "We haven't seen a v-curve where all the failed businesses were dumped out in the market at once. Banks have realised that there just isn't enough appetite out there. These over-leveraged businesses will be realised over a period of time."

According to S&P's H1 report on the leveraged loan markets in Europe, in the first six months of 2009 a total of 25 issuers sought covenant relief, surpassing the 22 seen in the entirety of 2008. Clearly, distressed companies are on the rise. And surely enough, turnaround deals are slowly coming out. Steve Keating, founding partner at turnaround specialist Privet Capital, predicts a busy Q4 and an even livelier 2010, with the quality of opportunities improving.

The question now is how these deals are being structured. With no or little debt available, private equity has had to find other ways to complete these deals - and fast. "Three years ago, we would use a mixture of cash flow and asset-based facilities, which is difficult or impossible to get now. As a result, depressing prices are being offered as a means to preserve returns," says Christopher Clegg, managing director of turnaround investor Endless.

In other words, transactions are often completed entirely with equity with a view to getting debt on afterwards, giving private equity houses an advantage in completing a deal quickly. Running through a debt process could take several weeks, time that the private equity firm or the company in question may not have. But turnarounds in any market are high-risk; in a market with no leverage, it seems like a complete gamble. Is it worth it?

"Now is the best time to take these types of risks, as investors stand to make a much higher return. If you take the stance that the recession is near the bottom and growth is about to start, it is easier to get comfortable on forecasts going forward and a much better idea than investing at the height of the boom," Clegg argues.

"The harder deals," he adds, "are where the management teams are strong and it is purely the market that is causing the distress. In these cases, strategic support and rapid speed of deal execution is required rather than fundamental change."

Endless has completed three turnaround deals since March, a drastic change to the six months before, which saw the private equity firm complete no transactions. Its latest deal, office supplies business Vasanta, saw £30m of new capital injected into the company alongside a significant reduction in its debt burden. Endless provided £20m, with the remainder being provided by the company's existing creditor syndicate led by Royal Bank of Scotland and Bank of Ireland. The deal was completed in only 20 days.

Distressed divestments

Even still, distressed companies are not the only potential turnaround deals these days. unquote" has recorded several instances recently of corporates divesting non-core assets. Two examples are AnaCap's recent purchase of Cattles Invoice Finance from parent Cattles plc for £70m, as well as LDC's MBO of financial education and benefits firm J.P. Morgan Invest from J.P. Morgan Asset Management. Clegg explains that most of these deals are a result of plcs looking to raise cash quickly or of foreign parents hoping to withdraw from the UK, especially in the automotive sector. "These assets are disposed very cheaply, as they often require a significant amount of time and cash from management - it's better to bring in a third party," says Clegg.

Peter Brooks, managing director of LDC in London, suggests that these non-core asset deals tend to work out quite sensibly from a risk perspective. "Although the company may have a high enterprise value, a vendor in question typically rolls over say 30% and subordinates it, meaning the private equity firm is effectively only paying and servicing 70% of the cost of the business."

He continues: "The sale of non-core assets soar in a recessionary period. Bundling tends to occur in an up-cycle, as debt is cheap and rifle shot accuracy of what you are buying tends to spread. This all reverses in a downturn and companies look to 'un-bundle' and get back to their essential core business."

In fact, LDC has been dabbling quite heavily with companies requiring operational work. In August, the private equity firm backed the £5.6m MBO of Modelzone Holdings in a deal that saw LDC work with management 18 months prior to investing. While the company wasn't in technical "distress", the firm felt it needed to turn its operations around before becoming an investor.

According to Brooks, the asking price was slightly high when LDC was first introduced to the company, but as the business began to improve, the price of acquisition (3.8x LTM Ebitda) became fair. The private equity house also made a point of replacing the bank debt in the deal structure with its own money, to ensure there were no controlling covenants, so as to de-risk the deal as much as possible.

"If this deal had been done two years ago, when completion demands were greater and considered rounded due diligence less, the risk would have been much greater. Now we're transacting a fair price - we have low gearing, full visibility - due to the length of time of our involvement - and have gained real insight into the business," adds Brooks.

Secondary opportunities

But while corporates are suffering, they are not the only ones. Headline after headline reveals that private equity firms are deep under water and that many of their assets are under performing at best. Candover was the first to hit troubles and many others may soon follow.

However, secondary buyouts are not nearly being carried out at the level as would be expected, with only four being completed from January to August of this year, compared to 37 transactions for the same period in 2008, according to unquote's proprietary database, Private Equity Insight. Is this set to change?

"I think we're heading to a crunch point in 2010 in terms of turnaround deals," says Adam Levin, partner at international law firm Dechert. He explains that private equity funds that are at the end of their life will soon 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 is likely to realise more value for LPs than slicing assets up and giving each investor a tiny portion.

Aldridge too is of the same mind: "There is a lack of reality in terms of the value of existing private equity portfolios. Managers think their portfolio is worth a huge amount of money, but if they looked at it as a buyer, they would have an entirely different perspective." He continues: "Sooner or later, they will have to take a reality check."

Eventually, GPs will need to realise value for their LPs, or they risk losing an investor in their next fund. Says one banker: "The inherent benefit for the GP in holding a company might not be worth it for an LP, as LPs needs to receive distributions in order to meet their return targets." This means that the difference in returns that would result from waiting might mean significantly more to the manager than to its investor.

Vendors in turnaround deals may vary, but they all tend to have one common characteristic: the need for quick cash or operational expertise. As more companies bear the brunt of the recession, these transactions will begin to increase in popularity and more private equity firms may rebrand themselves as turnaround specialists to get in the game. Alchemy Partners did this in 2006 and, just last week, advisers Alvarez & Marsal launched a private equity unit for this purpose. These firms may not be the first, but they almost certainly won't be the last.

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