Fast forward to liquidation

Bankruptcy will become, if it hasn't already, a constantly nagging thought in the minds of private equity general partners as distressed portfolio companies find it harder to meet their debt obligations in an increasingly harsh trading environment.

Ratings agency Standard & Poor's latest default outlook report is predicting a corporate default rate among speculative-grade companies in the US of 13.9 percent by December 2009 – an all-time high. The current highest level of such defaults was 12.5 percent in 1991.

“Funding will be rationed towards more creditworthy borrowers at the expense of those at the lowest end of the credit spectrum,” this year, S&P said in its outlook report. “The continued high stress level in the financial system …is expected to ripple throughmore broadly, materially affecting the number of defaults. Although aggressive government intervention in the US and elsewhere has somewhat countered the turmoil, we now expect it to take its toll on already vulnerable corporations and the economy in general.”

There are times when bankruptcy can be a useful tool to restructure the debt of a struggling portfolio company. However, since the economic collapse of last year, firms have found significant obstacles in the way of re-organisations that have sent portfolio companies straight to liquidation instead. Factors include a lack of bankruptcy financing in the market today. Companies in bankruptcy require what's known as a debtor-in-possession (DIP) loan to help fund operations while under the shelter of Chapter 11 protection. But DIP lenders have pulled in their horns, according to Kelly DePonte, a partner with San Franciscobased placement agency Probitas Partners.

“DIP is very hard to get and some companies that tried to do a Chapter 11 had to change to a Chapter 7 [liquidation] because they couldn't get DIP,”DePonte says.

Recent legislation hasn't helped. Rules added to the US bankruptcy code in 2005 force companies to make decisions about leases 210 days after filing for bankruptcy, which many experts say is not enough time for a company to decide what stores it wants to keep and which to close down.

Distressed investors expect to see many more bankruptcies in 2009 as lenders apply greater pressure on underperforming companies. Industries especially prone to distress in the US, such as retail and automotive, will see many companies fall into Chapter 11. The International Council of Shopping Centers is predicting that as many as a further 73,000 retailers in the US may close in the first half of this year on the back of 148,000 store closings in 2008.

Private equity firms are now looking for ways to help portfolio companies restructure heavy debt loads without going into bankruptcy, or at the very least helping them prepare for a bankruptcy filing, according to Jim Loughlin, principal and managing director of restructuring firm Loughlin Meghji.

Over the past year, more private equity firms have reached out to restructuring advisers for assistance on positioning their companies for the downturn, Loughlin says.

He adds that the company works with firms on cutting costs and streamlining operations but also helps them identify attractive add-on investment opportunities.

“To the extent that firms are comfortable with their liquidity, they can bolt on some acquisitions and add value in an otherwise depressed marketplace,” Loughlin says. “If they have capital to deploy and feel good about the long-term prospects of the industry, there's a lot of opportunity available.”