In this distressed debt for private equity firms blog series post we cover how distressed debt can be an advantage for private equity firms and how they can leverage these situations within their portfolio companies.
What is Corporate Distressed Debt?
Corporate distressed debt is debt that trades at levels well below par, usually for reasons generally unrelated to the fluctuations in the Treasury bond market. These debt prices became “distressed” because of investor concerns regarding heightened likelihood of an adverse credit event – default or even bankruptcy.
The Distressed Debt Opportunity for Private Equity Firms
When portfolio companies with publicly traded debt experience potential credit issues, astute Private Equity firms can view the price dislocation as an opportunity.
Perhaps the price drop was an overreaction to an unanticipated event or to a rating agency’s pessimistic take on the announcement of an acquisition by the portfolio company. In these cases, the bonds – or bank debt – may represent a great investment if the Sponsor remains bullish on the prospects of the portfolio company.
Where to Start
How should the Private Equity firm go about taking advantage of the opportunity?
Should it buy the bonds itself or cause the portfolio company to do it? We have written extensively on this topic, and believe that it is generally far better for the Private Equity firm itself to do it. Otherwise, the bonds are retired, which allows the remaining bondholders to benefit from the discount.
How should the purchase take place? Open market transaction? Tender offer (Dutch auction or otherwise)? Exchange offer for other securities? Answers to all these questions are fact-specific, and we invite you to contact us through Leslie Glassman to discuss the matters at greater length.
Beware of Red Flags Though
On the other hand, more often than not, price dislocations in corporate bonds represent real “red flags” for the Private Equity owner. First and foremost, the price drop may not have been an overreaction, but a legitimate attempt by the market to re-price the securities in order to reflect greater risk.
And the re-pricing may not have gone far enough, given today’s increased likelihood of a recession in the offing and the very real trend in bankruptcies over time towards lower and lower unsecured creditor recoveries. We will examine these “red flag” challenges for Private Equity firms in upcoming posts.
Who Should Buy the Debt at a Discount?
If such “red flags” turn out to be “red herrings”, the perceptions of risk may be overblown and there may indeed be a lot of value to be obtained through debt repurchase. Many corporate Boards reflexively consider having the company itself buy back bonds at such an opportunistic price. After all, if the purchase price is well below “intrinsic value”, aren’t the company’s constituencies better off (even after tax effects)?
Gordian Group views the world from the prism of the existing equity investors – a vantage point that should be near and dear to Private Equity firms. And from this perspective, having the portfolio company buy back its bonds may be the wrong answer. The value pickup would first accrue to the benefit of remaining bondholders, and only afterwards would value trickle down to the equity.
On the other hand, if the Private Equity firm itself buys the distressed bonds, the value pickup would accrue to the benefit of the equity holders.
We have written about this dynamic in Distressed Investment Banking: To the Abyss and Back, 2nd Edition, pg 166, Appendix A:
It seems to us that old equity could obtain a better result for itself if it directly purchased the debt at a discount, rather than have the company affect the repurchase. Old equity could potentially benefit from an enhanced control position through ownership of the debt. Initially at least, if the debt remains outstanding, old equity would benefit from any excess of value over purchase price on the debt. Moreover, since the capital structure would be unchanged, so would option value as it relates to the common stock itself. In other words, in a strict sense old equity would not be in a worse position, and actually could be in a better one.
On the other hand, due to the purchase of the debt, old equity (viewed from the entirety of its debt and equity holdings) would have increased its “skin in the game.” This actually could create problems for old equity in pursuing various aggressive negotiating strategies. Moreover, there are risks involved if a court found that old equity acted inappropriately and imposed penalties (such as subordination of recoveries on its debt ownership position) on old equity.
Despite these very real drawbacks, old equity may find that making a debt repurchase on its own could be a wise decision. Having ownership at various levels in the capital structure can potentially outweigh any such risks.
Every Situation is Unique
Each distressed buy-back opportunity needs to be assessed on its own merits. In addition, Private Equity firms (particularly those that control the relevant Boards) need to be well-advised with respect to managing the conflicts of interest that are endemic to these opportunities.
Given our 30-plus years of experience in doing this, Gordian Group can assist Private Equity firms in taking advantage of distressed bond prices. Contact us if you’d like to have a conversation and subscribe for updates.