Sitting comfortably

Marc Lasry, head of New York-based distressed investment giant Avenue Capital Group, won't soften his opinion about the aftermath of the credit bubble – he believes some private equity firms harmed otherwise healthy companies by suffocating them in an avalanche of debt.

Lasry now finds himself in an enviable position as the owner of key portions of that debt. Private equity GPs that once dismissed him or viewed him with suspicion are now approaching him about helping them solve complex problems that their deals face. The problems have mostly to do with capital structures, and their unenviable position at the bottom of these structures as equity holders.

Since the middle of last year, Lasry and team have swooped in and scooped up senior secured debt in these deals, in many cases at astonishingly deep discounts. The firm prefers to buy senior secured debt, which in the current environment is often the “fulcrum security” – an almost Tolkienesque bit of jargon indicating an instrument that gives its holder the greatest chance of controlling a restructuring process, should the plot unfold in that direction.

Private equity firms that during 2005, 2006 and 2007 piled on debt and paid massively high prices for companies are now increasingly forced to deal with the likes of Lasry, a genial, calm negotiator who has the capacity to sit through bluster and screamed threats. Ultimately, Lasry's position at the top of the capital structure gives him confidence that verbal abuse can't shake.

“You don't have to be the loudest at the table. You have to know what you're doing and you have to make sure you're in the right security,” Lasry says. “We don't really care who screams and who doesn't. Distressed guys don't mind dealing with that type of behaviour because you know you'll ultimately get everything you need or want.”

LASRY IS YOUR ALLY
It is a well reported fact that many private equity firms find them-selves in tough spots today. Private equity-backed companies like Linen 'n Things, Reader's Digest, Station Casinos, Chrysler and Masonite are just a few that have stumbled into bankruptcy since last spring.

Not every debt-burdened company is headed for bankruptcy. In fact, the covenant-lite loans made during the credit bubble make it harder for covenants to be triggered. But this cushion hasn't prevented the debt of these companies from trading at steep discounts, allowing Avenue Capital to step in and become a senior lender at an inexpensive entry point.

The worse shape an equity position is in, the more the original financial sponsors are eager to speak to senior lenders regarding a way out.

For example, Avenue has been working with Kohlberg Kravis Roberts and Permira on a restructuring of ProSiebenSat.1, the huge German broadcaster that KKR has written down to near zero. Beyond the LBO world, the firm is also actively involved in the bankruptcy process for amusement park Six Flags, which has been locked in battle with Donald Trump over bankrupt Trump Entertainment Resorts.

Lasry has spent years investing in the senior secured debt of companies once considered boring, at least compared with the riskier returns produced by junior debt and equity.

But ever since the financial markets melted down last year, Lasry and team find themselves in the midst of great excitement and the prospect of generating returns that would make equity investors green with envy.

There are two paths to profit for Avenue. If, for example, a borrower ultimately is able to pay off debt at par, and Avenue has purchased this debt at a discount, this delivers a nice profit to the firm. If the company violates any covenants or defaults on the debt, Avenue is the likeliest candidate to control a restructuring process.

It's a nice position to be in. Avenue is using its new-found power to “effectuate change” at struggling companies and has played a very active role in many of the investments in its portfolio. It never looks for operational control of a company, but likes to work with existing management, or partner with outside players like private equity firms to run the company.

Therefore, Avenue can find itself working with private equity on two levels – at times the firms approach Avenue for help; other times, Avenue approaches the firms as partners on taking control of a company after it is restructured.

You don't have to be the loudest at the table. You have to know what you're doing and you have to make sure you're in the right security

“For a firm like ours, it's actually great,” says Lasry. “You're at the top of the capital structure and you have the fulcrum security, therefore you can effectuate change and in most of these situations, you're going to get paid off a portion of your debt and you're going to get a significant amount of equity,” Lasry explains during this interview at Avenue's offices at 535 Madison Avenue.

LIKE THERE'S NO TOMORROW
A large number of companies with which Avenue Capital is currently involved are backed by a private equity sponsor that used huge amounts of leverage on their acquisitions over the past few years.

“These were great companies and the buyout would have worked if you were going to continue having EBITDA grow at 10 percent a year, and the markets remaining where they were,” Lasry says, explaining why many private equity-backed companies are struggling. “The assumptions that were made were ridiculous.”

Lasry believes the private equity firms he encounters today either “deal in reality” or do not. The firms that deal in reality are willing to sit down at the table with Avenue and figure out ways to help their struggling companies. They understand that in situations in which Avenue has the senior secured debt, it is in control of the process.

Firms that don't deal in reality still negotiate with the belief that they are in control and can dictate terms to Avenue, not understanding the leverage they once had is gone.

“It's easier to work with sponsors who understand reality since they now know that you now control the process,” Lasry says. “Private equity firms don't want to create more brain damage. These firms don't want to spend time working on a company in distress when they will ultimately get zero. They would rather have their partners and associates working on new deals that will make them money, than working on restructurings where they will ultimately get nothing. Sponsors will put up a little more money but only to give themselves more options,” he says. “It's actually a pretty good process, it works pretty well since their leverage is when we will end up getting control of the company.”

Some private equity players will make negotiations tough, Lasry admits, but in his position at the top of the capital structure, he has the patience to sit through the tense atmosphere occasionally present in the heat of bargaining.

“We're involved in a situation like that at the present time, where we're in the senior debt and the sponsor is threatening to put the company into bankruptcy if we don't agree to their demands. Our response is for them to go ahead since we have the senior debt. We're not worried about the company going into bankruptcy, so therefore their threat is pretty worthless,” Lasry says. “They think they're talking to a bank since banks don't want most companies going into bankruptcy.”

The tenor of negotiations comes down to who the private equity firms are and which managing directors in the firms are at the negotiating table.

“The last thing you want is the guy who did the deal and the deal has blown up and he knows if he doesn't turn it, he's going to get fired,” Lasry says. “So that guy is threatening you like there's no tomorrow.”

It wasn't very long ago when senior GPs at big private equity firms were telling investors they had no truly troubled portfolio companies. If their companies were running up against debt maturities they could simply refinance the debt. On top of that, many of the companies had obligations on debt governed by loose and easy covenants, taking the pressure off for immediate restructuring.

The ability to refinance is much less than it was in the past, and even if financing is available, it comes at a higher price.

“[In the past], I would always get refinanced out. Today you can't get refinancing. So the whole key today is when your debt matures.”

Many in the market believe some private equity firms have been slow to mark down their equity investments. The dichotomy is a nuance of mark-to-market accounting, in which a debt holder has a trading price to point to, but a holder of a private equity security may use the judgment of the GP as a valuation guide.

Our view was that things were going to get worse over time before stabilising. I could not have told you it was going to get so bad, so quickly

“I don't really get it,” Lasry says. “We're sitting next to a number of GPs [at industry conferences], we own their debt, we bought it at 60 cents on the dollar and it's down to 40 so we have to mark ours at 40, and they've got their equity at par. So one of us is wrong. If they're right, we're at par; if we're right, there's no way that thing is at par,” Lasry says.

The loose and easy debt structures of the past few years have created an environment that Avenue plans to fully exploit going forward. Firms that pushed debt maturities on their companies into the future will be reaping a sorrowful harvest in the next few years, as billions of dollars of debt comes due in an environment where financing will be tough to get.

MAY 2008 WAS ‘EARLY’
Lasry and Sonia Gardner, his sister, formed Avenue Capital in 1995. Before that, the two had in 1989 established Amroc Investments, a brokerage firm specialising in distressed debt. Amroc was launched in affiliation with the Robert M. Bass Group.

The firm currently manages about $17.8 billion of capital focused on distressed opportunities. It has dedicated teams and funds focused on the US, Europe and Asia. Most of its capital is organised into a series of private equity funds, called the Avenue Special Situations Funds.

Avenue was able to raise its fifth US-focused special situations fund in 2007, before the beginning of the downturn. Avenue Special Situations Fund V collected more than $6 billion in 2007 and is approximately 90 percent invested, primarily in senior secured debt.

More remarkable was the firm's ability to raise a $1.6 billion European fund – Avenue Europe Special Situations Fund – last year amid the wreckage of the financial markets.

Avenue invested a majority of its fifth core fund in the past year, including the bulk of the fund since January, when the best deals became available, Lasry says.

Even though Avenue passed on a number of early distressed opportunities, believing prices were too high (including the “hung bridge” opportunities of 2007 and 2008), Lasry admits that in retrospect his firm started buying “early”, beginning in May 2008, and was caught by surprise by the speed and severity of the economic downturn.

“I can tell you, absolutely we ended up being too early,” says Lasry. “But that's okay. We dialed up significantly in January to March of 2009, believing prices were at unprecedented lows and that – if we were right on credit, and, because we didn't use leverage and had stable, patient capital – when the market stabilised we would be in a great position to be able to capitalise on these opportunities.”

“Our view was that things were going to get worse over time before stabilising. I could not have told you it was going to get so bad, so quickly,” Lasry says.

Avenue does not use leverage to juice returns on its distressed investments. Even when faced with investor inquiries about why the firm was not using leverage at a time when other firms were, Avenue stuck to its core beliefs.

“Funds who used leverage are having or had severe issues. The reason being that as the market went down it became very hard to hold on,” Lasry says. “Because if you're buying something at 85 cents or 80 [cents on the dollar] and you lever it three or four to one, and it drops in price to 50, you're pretty much out of business.”

“Our view is, we don't want to make irrational decisions based on the fact that we've levered these things,” Lasry says.

Buffett is dead right: when the tide goes out, you see who's swimming naked, and you saw a lot of guys just didn't look good with that tide coming out

Avenue raised approximately $1.7 billion for its prior US fund, called Avenue Special Situations Fund IV, in 2006. Fund IV was raised at a time when the distressed debt environment was less robust, so the firm only charged fees on invested capital.

At the time, Lasry says, debt looked cheap but was about to plunge to much greater discounts. “The problem was, we were buying debt at five times and then you were able to buy things at four times or less,” Lasry says.

CONTROL AND NAKEDNESS
Lasry recalls walking into his 10th annual high school reunion and spotting the former captain of the high school cheerleading squad. He was ready to show just how much he had accomplished since high school, and struck up a conversation with her.

“So she says, ‘What do you do?’ and I said I invest in companies in bankruptcy, and she looks at me and says, ‘Oh, I'm so sorry!’”.

Like the former cheerleader, limited partners have at times questioned the attractiveness of the distressed debt strategy. In particular, many have voiced a preference for “control” strategies, where sponsors are seen as having greater control over the fortunes of the underlying corporate entity.

Lasry warns that control is not necessarily a superior play in the distressed space. “People love the idea of control. Everybody thought, ‘Well, we can go fix these companies,’” says Lasry, who adds that bringing in operational partners to turn around struggling companies does not always work. “So you've got an operational guy. What's an operational guy going to do in a company that's losing EBITDA and that's levered? He's going to say, ‘I'm outta here.’”

Indeed, leverage amplifies the upside of an investment, but quickly exposes weak assumptions, of which many were made during the LBO boom.

Lasry smiles and quotes another value hunter: “It's [Warren] Buffett's line, but Buffett is dead right: when the tide goes out, you see who's swimming naked, and you saw a lot of guys just didn't look good with that tide coming out.”