In Distressed Debt Risks and Costs for PE Firms we discussed the problems a company with distressed debt may face. Now we will cover some examples of how Private Equity firms may choose to deal with the challenges.
Scenarios to Help Private Equity Firms Navigate Distressed Debt Challenges
Scenario One: Manufacturing
XYZ is a widget manufacturer with $100 million of secured bank debt. The company has seen its EBITDA fall from $30 million to $10 million due to a combination of rising cost of goods sold and stagnating demand for its product. Although profitability enhancements are possible, it is unlikely that XYZ will ever get back to the $30 million level. The banks, whose debt is trading privately around 80 cents, are demanding that the Private Equity firm sell XYZ so the banks can exit the credit.
The Proposed Solution
The company’s investment banker anticipates that the M&A market sale value will be $80 million. If the Private Equity firm goes ahead with the sale, the banks will take a loss, realize the $80 million in proceeds, and the Private Equity firm would receive nothing.
This scenario is a common occurrence in our business. The banks have a strong hand, with their $100 million loan and all of the assets encumbered as their collateral. But the Private Equity firm still holds the “control value” card.
The Role the Private Equity Firm Can Play
This “control value” stems from the Private Equity firm’s ability to direct the Board. While the banks can certainly (sooner or later) take action to force XYZ into chapter 11, it may take time and money to achieve such an end. Further, if the banks unilaterally seize the company, they may put themselves in the litigation gunsights of the Private Equity firm.
Moreover, the Private Equity firm (hopefully together with its management team) is in a position to influence how the M&A process is conducted. In turn, this will affect the banks’ ultimate recoveries.
Under these circumstances, we have had significant success in negotiating M&A proceeds sharing arrangements between the banks and the equity owners.
Such an agreement might contemplate a sliding scale in which the Private Equity firm would receive:
- 5% of the first $50 million
- 25% of the next $30 million and,
- 50% of any overage until the banks get out whole
Under this construct, the Private Equity firm would receive $10 million at the anticipated sale value of $80 million. The banks would not be made whole until the sale price reached $140 million.
A well-advised Board can still recoup meaningful value in such a situation – while avoiding unnecessary litigation with the banks.
Scenario Two: Healthcare and Private Equity Firms
Distressed debt at a portfolio company poses both a challenge and an opportunity to Private Equity firms. To further illustrate this, we establish another hypothetical situation as follows.
ABC has consolidated a nationwide group of medical practices through acquisitions, leaving it with secured bank debt of $100 million and $100 million of unsecured bonds. Due to changes in reimbursement rates and other adverse factors, EBITDA has declined from $50 million to $10 million, causing the bonds to fall to 50 cents on the dollar.
The Private Equity owner believes that much of the profitability drop can be recouped through a few years of hard turnaround efforts. However, until the turnaround produces tangible results, ABC has been advised that it will be impossible to refinance out the banks at par.
The Proposed Solution
The banks have been advised that a quick sale would result in $150 million in proceeds, and they are pushing for that to happen. In a “strict waterfall”] context, the banks would be repaid in full, the bondholders would get 50 cents and the Private Equity firm would receive nothing.
The company may be in covenant (or even payment) default with the banks, but there is no automatic mandate to defer to the banks’ bidding.
The Role the PE Firm Can Play, Option One
As we discussed in scenario one above , the Private Equity firm has “control value”, which can be used to impede a rush towards a quick M&A transaction.
Assuming that ABC can reach profitability of $30 million (reversing half of the decline), the future value would allow the bondholders to achieve at least a par recovery and provide the Private Equity firm with a healthy recovery.
But if the banks are being obstreperous, how does the Private Equity firm turn the tables?
Turning the Tables with Option Two for the Private Equity Firm
The two “losers” in the banks’ scheme would be the bondholders and the Private Equity firm. It makes sense for them to band together to impose a completely different regime on the banks.
In this hypothetical, we would envision advancing the concept of a “cram-up” to be implemented in chapter 11.In bankruptcy, as long as a third party, consenting class of creditors approves a Plan of Reorganization], the Plan can be “crammed down” on all other constituencies.
Typically, a senior class of creditors consents and then a more junior objecting class gets a distribution of the crumbs after such senior class gets paid in full. This is a very bad outcome for the Sponsor, of course, which would get nothing in this fact pattern.
How a “Cram-Up” Might Work
However, in a “cram-up”, a junior class of creditors can consent to a Plan, and then the company could move to have the Plan imposed on the senior class. In this hypothetical, the banks could receive a secured note with a par value of $100 million and a maturity several years out, so that ABC could have the time needed to effect a turnaround.
The bondholders and the Private Equity firm would agree to split up the rest of the capital structure in some fashion.
The (market) interest rate on the new secured bank note would be ultimately decided by the Bankruptcy Court, assuming that ABC and the consenting constituencies could convince the judge that there was a reasonable probability that the paper was “money good”.
Such an outcome can be achieved without a Court fight if the banks believe that ABC can indeed meet its burdens of proof.
Here, the strategy takes advantage of the “option value” inherent in the Private Equity firm’s potential ability to significantly increase value through operational improvements.
The “cram-up” lengthens the time available for the turnaround, while using the banks’ capital to do so. The foregoing hypothetical contemplates that the Private Equity firm would share at least some of the largesse with the bondholders on the theory that three-quarters of a loaf may be better than the prospect of none.
We have found that when a Sponsor is prepared, in a credible fashion, to file for chapter 11 in order to wage a cram-up fight, this usually leads to an advantageous (for the Sponsor) negotiated solution without needing to resort to chapter 11 at all.
Scenario Three: Oil and Gas
When debt prices enter the “distressed zone”, they tend to reflect a market perception of significantly increased investor risk
When confronted by this adverse environment, creditors generally work to take steps to decrease their risk. But (subject to various legal considerations) there is no mandate that the company accommodate the creditors’ desire.
By heading down a path that would make the debt more risky, it can set the stage for a more fruitful negotiation with the creditors.
This path contemplates the establishment of a “Newco”, and the hypothetical is as follows.
Moose Pasture Exploration is an oil & gas exploration and production company that has been adversely impacted by a significant drop in energy prices. As a result, the secured debt prices have declined to 80 cents.
Although there is a huge upside opportunity for the Private Equity owner if energy prices rebound over time, the creditors simply want the assets sold, thereby depriving the owner of its upside potential.
Alternatively, the creditors would welcome a capital injection by the Private Equity firm underneath their debt exposure. Unfortunately for the Private Equity firm, the immediate benefits to the company would accrue to the account of the creditors.
The good news for the Private Equity firm is that the company is not yet in default. Through the passage of time, it likely would be if the reserve borrowing base were reduced below the level of the outstanding debt.
The question is – how does the company get the incremental wherewithal to drill more wells and build value, without the benefits going to the creditors first?
The Proposed Solution
In a “Newco” strategy (sometimes referred to as a “Drillco” in oil & gas parlance), the Private Equity firm can establish a parallel vehicle in which: (i) Moose Pasture would contribute assets and (ii) the Private Equity firm would contribute cash. (Not all companies’ credit agreements permit this without creditor consent, but many do). As long as the terms of the Newco-Moose Pasture relationship are “fair” or “reasonable”, then the transaction can likely proceed.
This is not to say that such a transaction is without legal risk. Creditors may be mightily upset to see the Private Equity firm obtaining the upper hand, and may litigate to try to regain their negotiating position. However, if this deal is structured appropriately, it can be a “no lose” for the Private Equity firm. Either (i) it proceeds as originally contemplated or (ii) the creditors enter into negotiations from a position of weakness.
We recognize that such an aggressive approach may not be everyone’s cup of tea. But for those willing to scrap and fight for improved value recoveries, this path can be highly rewarding.
Parting Thoughts for Private Equity Firms
Private Equity these days is a very competitive business. Unless the investment firm attains top-tier performance metrics, it may be next to impossible to be able to raise another fund and remain in business down the road.
We see opportunities in focusing on disappointing investments for Private Equity firms to enhance their overall performance records. Efforts to improve operations may help the portfolio company, but the improvements may only benefit the creditors.
But by undertaking aggressive negotiations with creditors, it is possible to take advantage of the owner’s inherent “option value” and “control value” in order to change the capital structure and sweep value from the creditors.
Gordian Group’s business is all about doing just that. We work with Private Equity firms and other “Old Equity” constituencies to create and seize value. In order to do this, we avoid creditor representations. That allows us to give unconflicted advice to our clients and thus create and implement alternatives that work to the advantage of our Private Equity clients and to the detriment of many creditors.