Eyeing Europe

When Canadian communications giant BCE Inc. cut off long-term funding of Montreal-based voice and data communications firm Teleglobe in April 2002, it did so with a heavy heart and a considerably lighter pocket. The firm, which had paid $7.4 billion in late 2000 to acquire the 77 percent stake in Teleglobe it didn't already own, took a reported charge of $8.5 billion when it finally gave up on the tanking telecom carrier. Perhaps more in hope than expectation, Teleglobe announced it was examining a “range of restructuring options” as it entered bankruptcy via Chapter 11 to protect it from creditors during negotiations.

Just over a year later, in May 2003, New York hedge fund and private equity firm Cerberus Capital Management invested $93 million in the $125 million acquisition of Teleglobe alongside TenX Capital Management. This followed the assumption of debtor-inpossession lender status by Cerberus, replacing an affiliate of BCE Inc in the role.

Fast forward to last month when Teleglobe acquired publicly traded ITXC Corp, and the merged company listed on Nasdaq under the Teleglobe name – two events after which Cerberus and TenX's shares were worth some $270 million, representing 2.7 times cash invested, or a 270 percent unrealised IRR.

This is a classic example of how so-called “distressed debt for control” investors can exploit Chapter 11 to their material advantage. Such investors seek to acquire debt positions at a discount from existing shareholders looking to bail out, which can give them a controlling position in a bankruptcy. They will often then look to convert that position into an equity stake – either soon after the company emerges from bankruptcy or once it has been turned round and is able demonstrate ongoing profitability – and then grow the company and seek an exit in due course in the same way as any mainstream private equity firm (see also Distress relief, page 51).

Firms such as MatlinPatterson, Oaktree Management and Wilbur Ross are all well versed in the techniques of distressed investing and have pushed the process to new levels of sophistication in recent times. For example, rather than waiting to take their place at the negotiating table, many are now buying positions in “pre-packaged” Chapter 11 filings, where a thorough plan of reorganisation is submitted at the time of the filing. Approval of the plan will normally take just a few weeks, allowing investors to sidestep months of (often torrid) negotiations.

ALL IS QUIET
The problem in the US is that recent opportunities to demonstrate such sophistication have been few and far between, as very large bankruptcies have been abated. “The distressed market has been really quiet,” says Kelly DePonte of private equity placement advisors Probitas Partners in San Francisco. “It reached a peak in 2002 and then retreated pretty quickly.” DePonte points out that there will always be a proportion of companies getting into trouble and that there have been a number of smaller restructurings coming through the pipeline, but with the economy ploughing a reasonably steady furrow, the big ticket deals have been slow to emerge.

Randall Eisenberg, senior managing director of FTI Consulting, a professional services consultancy in New York, believes that the significant amount of liquidity currently available in the capital markets is providing a temporary solution for companies that would otherwise be restructuring formally or going through formal court proceedings. “Some will take this additional liquidity and time to fix their businesses, but others won't be able to and will ultimately be in a much more precarious position once this additional liquidity runs dry,” he says. Eisenberg's view is that at some point within the next 18 months to two years, the chickens will come home to roost in the form of a significant increase in the number of restructurings due to loan covenant violations or inability to service debt.

Specialised funds can buy debt and reap spectacular returns

There are currently some signs that the situation may already be changing as uncertainty – partly as a result of further interest rate rises – begins to obfuscate the economic outlook. Oaktree Capital Management had planned to launch the marketing of its latest $1 billion fund – OCM Opportunities Fund V – in May 2003, but according to sources close to the firm, decided to postpone it due to lack of deal flow. Clearly sensing a fresh opportunity, the firm in June this year re-launched the fundraiser and is reported to have pulled in the likes of Teachers Retirement System of the State of Illinois and San Francisco Employees Retirement System. In another positive sign, New York-based KPS Special Situations closed its second fund on $404 million in March, surpassing its $350 million target.

But whether the domestic market comes back or not, US distressed investors are apparently seeking to shed their dependence on it by turning their attention to prospects in Europe. There is already potential deal flow there for restructuring specialists, much of it stemming from the technology crash of 2000 and 2001. Referring to the UK market, Philip Davidson, head of restructuring at financial services firm KPMG, says: “A sustained period of benign economic conditions encouraged companies to gear up for growth ahead. Lenders were willing to back cash flow deals that depended on high growth in revenues. The financial packages that were put in place often could not be supported when growth eased off.” Some of these businesses have since fallen over. Others struggle on with heavy debt burdens not knowing if or when the pressure will finally take its toll.

EUROPE TURNS NEW CHAPTER
Until fairly recently, distressed debt-to-equity investments have been precluded in Europe by the absence of Chapter 11-style legislative frameworks. But this is beginning to change. In the UK, the 2002 Enterprise Act stipulated that when a company enters administration, it is the job of an independent administrator to balance the interests of all creditors. This has helped to overcome a situation where secured lenders – normally banks – had nearly all the say in determining the fate of an ailing business. Although lenders still get preferential treatment, they are not in control of the process to the extent that they enjoyed prior to the Act's introduction.

This change, which ensures that greater emphasis is given to rescuing companies rather than liquidating them, is not unique to the UK. In Italy, for example, amendments to the Amministrazione Straordinaria insolvency procedure in December 2003 – at least partly designed to facilitate the more straightforward purchase of companies from within the disgraced Parmalat group – brought that country more into line with Chapter 11 as well. Indeed, in most European nations there is now legislation akin to Chapter 11. As a result, the problem is not so much that there is no framework for distressed debt investing, more that so far it has been rarely used.

There are signs that – at least in part due to the more promising legislative environment – US investors are beginning to get busy on the Continent. For example, Cerberus was reported to have been an interested party in the sale of Transbus, the bus-making unit of UK engineering group Mayflower, which went into administration in March 2004 following the discovery of a £20 million hole in its accounts. At the time of this article going to press, however, rumours had surfaced that the firm had withdrawn its interest.

GERMANY CALLING
But while there are some encouraging signals for restructuring specialists, progress has been slow in the one market the US big-hitters would really like to penetrate: Germany. Companies in that country have the highest debt to equity ratio of any major European nation, according to Bundesbank data. A recent restructuring symposium in New York sponsored by law firm Allen & Overy concluded that German banks are now under unprecedented pressure to clean up their loan portfolios.

One estimate at the symposium put the total amount of distressed debt in Germany at €300 billion, only ten percent of which is currently being traded. The reason for this is that German banks have tended to stand by their customers through thick and thin, meaning that loans were often held on their books until companies go bust. This attitude appears to be changing though, partly as a result of pressure from the German Government for banks to increase their profitability, and partly as a result of the European Union's Basle II regulations that from 2006 onwards will demand that higher risk assets be backed by a higher percentage of capital.

As a result, there are signs of progress. In June, Dresdner Bank's institutional restructuring unit (IRU) completed the sale of “non-strategic assets” from its UK portfolio in a transaction worth €350 million. The IRU was set up at the beginning of 2003 and by March 2004 had reduced the firm's non-strategic assets from €36 billion to just over €16 billion. It is a trend that has not gone unnoticed. “The time for US restructuring specialists to move into Germany en masse has not arrived yet, but they know it's time to get up to speed on German bankruptcy law because they can see the opportunity coming,” says DePonte.

This is a message reinforced on the website of Frankfurt-based law firm Broich, Bayer, von Rom, which states: “Given the immaturity of the German market for distressed debt investments, specialised funds with superior valuation capabilities may acquire debt positions with a steep discount to their market value and reap spectacular returns in the debtor's restructuring or reorganisation.” Difficulties penetrating the market there may be, but what investor of any type would pass up the chance of “spectacular returns?” Definitely time to start swotting up on those regulations