Distressed Debt Risks and Costs for PE Firms

In this distressed debt for private equity firms blog series post we cover cover the potential distressed debt risks and costs that private equity firms need to think about if they have a portfolio company in trouble.

The Risks Distressed Debt Represents for PE Firms

Financial distress at a portfolio company is a huge value-minimizing risk for a Private Equity firm.  In today’s competitive fund environment, the difference between having an investment with just a middling return and one that is a complete wipeout may be the difference between being able to raise a follow-on fund or not.  

At Gordian, we seek to work with Private Equity firms to maximize their recoveries from troubled investments.

Unless a Private Equity firm intends to take direct or indirect advantage of the capital structure opportunity afforded by low bond prices, there is little to like about having distressed debt.  Clearly, Private Equity firms need to address the challenges distress has for protecting or maximizing the value of their investments.

RELATED: Distressed Debt and Private Equity Firms

Key Signals, Perceptions and Outsider Concerns

Depressed bond prices clearly signal financial weakness to suppliers, employees and other key constituencies.  At the very least, being perceived as “distressed” makes doing business harder. As outsider concerns grow, the company may have to make cash payments in advance for goods, and hiring good people may be next to impossible.  The ensuing adverse effects on financial performance just make matters worse.

RELATED: My Company Is In Real Trouble. Read: Strengthen Your Team with Outside Relationships

The Costs of Raising Additional Capital with Distressed Debt

If the company needs additional capital in the foreseeable future, then the outlook can get even bleaker.  High bond yields (the flip side of the low price coin) will undoubtedly translate into high costs of capital for pari passu and senior grades of debt.  

Debt that is junior to the extent bonds may be totally unavailable regardless of the stated interest rate.  Higher credit costs also translate into lower normalized equity multiples.  In short, financing will get a lot more expensive for the Private Equity firm’s portfolio investment.

Even when a portfolio company’s debt does not actively trade or have publicly-available “marks” (i.e., quite a lot of bank debt), many of these issues will still plague management and the Board.  After all, new financing sources and major customers are still going to look under the hood at covenant breaches and other financial challenges.

With High Risk and High Costs Is Selling the Only Option?

Increased financing costs, limits on available financing, greater operating difficulties and other challenges may just mount over time, creating a bigger mountain for Private Equity owners to surmount.  But other than selling the company at an inopportune time or pouring good money after bad into the situation, what can the existing equity constituencies realistically do?

The answer is “plenty”, as long as you are timely in recognizing that existing equity may hold important bargaining chips vs. creditors – Board control, massive influence over any M&A process, dominion over financial and other information, and (maybe even) loyalty of the management team.  

In upcoming posts, we will discuss how an adroit Private Equity firm can use advantages such as these to garner significant value from a situation others may deem to be hopeless. Subscribe for updates and contact us if you’d like to have a conversation.