Never Let a Capital Structure Crisis Go to Waste Part 1, Co-Authored by Gordian Partners | The Deal

Peter S. Kaufman, President, David L. Herman, Partner & Liam D. Ahearn, Managing Director Co-Author Op-Ed: Never Let a Capital Structure Crisis Go to Waste

Part One of a two-part series, The Deal

August 4, 2021

This article was originally published on TheDeal.com (subscription required)

Private equity firms with portfolio companies experiencing capital structure challenges also have opportunities.

Never Let a Capital Structure Crisis Go to Waste – Part One: Private equity firms with portfolio companies experiencing capital structure challenges may not believe it, but opportunity is knocking. It’s the opportunity to either purchase their debt at a discount or to revest the portfolio company with a new capital structure that benefits shareholders at the expense of its lenders. Uncertainty in the financial markets or in the company’s own markets can be utilized far more nimbly in negotiations by the sponsor than by its creditors.

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1. The classic scenario is that a portfolio company runs afoul of certain covenants (usually leverage) or experiences liquidity pressure. The reasons can range from macroeconomic issues such as Covid-19 to faltering operational underperformance leading to an overleveraged balance sheet to all sorts of other internal and exogenous factors.

2. Lenders are fearful of uncertainty. The Lender 101 playbook is to demand that sponsors/owners inject new equity beneath the existing capital structure — or as we call it, “Mount Debt” — all in return for only short-term waivers (three to six months) and fees. Lenders do not expect sponsors and their portfolio companies to push back on these asks.

3. Sponsors with vision and will can and should reject this fund-more, go-along, get-along approach. If well advised, sponsors can impose a shareholder- and management-friendly capital structure overhaul, obtain multiyear covenant relief and debt service holidays, or both.

4. Gordian views equity value in these situations as not determined by a strict priority waterfall but rather from the equity-centric standpoint of (i) option value, (ii) control value and (iii) net operating loss value.

5. In connection with this revesting, sponsors may now be willing to inject new capital if they have it available.

In short: We advocate elegant and comprehensive capital structure solutions; not temporary Band-Aids. And we only want to see new sponsor funding come in as part of an overall fix — and not before. We also want to dispel the myth that a financial restructuring equates to creditors receiving all or most of the equity. That does happen, but by and large only when financial advisers involved are unable to give unconflicted advice to boards (for example, when they also advise financial creditors in other deals).

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