Slim pickings

Take a trip through the PEI archives back to autumn 2006 and you’ll be reminded that people weren’t quite yet comfortable calling the top of the market. But private equity distressed investors were beginning to rub their hands in anticipatory glee, noting that the boom cycle’s high valuations, excess liquidity and low interest rates couldn’t continue in perpetuity.

Indeed, one year on, the term “credit crunch” was beginning to appear regularly in our pages – but no one was prepared for the severity of the global economic crisis that was to unfold over the next two years, causing large financial institutions to collapse, stock markets to plummet and the entire global financial system to be called into question.

The severity of the crisis – and the subsequent responses by banks and central governments –dampened a lot of the anticipatory glee.

Josh Wolf Powers, founding partner of New York-based turnaround and restructuring firm Blue Wolf Capital Management, has been predicting an avalanche of opportunities related to distress for nearly five years. He’s still waiting for the wave of conventional distressed opportunities, he says.

“There just has not been the avalanche of companies in the US filing for Chapter 11 bankruptcy protection,” Wolf Powers says. “And when they have filed for Chapter 11, they’ve typically been far further gone, so the Chapter 11 has resulted in a liquidating [Chapter] 7 or has been a reorganisation opportunity available primarily to the lenders, to the senior creditors or secured lenders.”

That’s resulted in a number of distressed debt specialists like Oaktree Capital Management, Anchorage Capital Partners, Towerbrook Capital Partners and Wayzata Investment Partners taking over companies (often from private equity firm sponsors), but Wolf Powers says “even those opportunities haven’t been as numerous as anyone imagined”.

Banks and bailouts

Howard Marks, chairman of Oaktree, reminds our readers this month (see p. 44) that the “things that are good for most investors, and most citizens” aren’t so wonderful for those hoping to find distressed investment bargains.

Thus various government bailouts and stimulus packages over the past two years – which one veteran distressed investor dubbed “the socialist bailout game where the consequence of taking absurd risk was forgiven” – have helped restore confidence and revive credit markets, but suppressed the supply of distressed investment opportunities.

However, it’s the actions – or rather lack thereof – of lenders that industry insiders most frequently point to as a principal reason why the expected plethora of distressed investment deals still hasn’t  come to fruition.
“Lenders – in particular banks, but also hedge funds and other non traditional lenders – chose rather than to exit their uneconomic holdings, to essentially ‘live to fight another day’ by neither admitting defeat nor funding continued investment,” says Wolf Powers. 

Reeling from mortgage-related losses and caught out by the suddenness of the downturn, many banks hadn’t taken reserves against corporate loans that should have been marked down and become distressed investment candidates, says David Blechman, who  in August 2009 left Sun Capital to join distress- and turnaround-focused Tower Three Partners. “If it’s on your books at par, you’re not going to transact on it. You have to mark it down first,” he says.

“So in late ‘08 and the first part of ‘09, a lot of those lenders just weren’t willing to do anything yet. And meanwhile, to the extent that it was [private equity and hedge] funds holding the bank debt, more and more of those funds were willing to own the company,” Blechman says. “So there were far, far fewer actual distressed private equity control buyouts of these companies as a result of those two things.”

The situation has been the same on both sides of the Atlantic. “The banks are sitting on their hands wherever possible,” says Stephen Keating, who left 3i in 2007 to launch London-based distressed investment and turnaround fund Privet Capital.  “They’re really only dealing with the cases where there is a crisis, there is a cash need, or they are very concerned about value going down and being at risk. So they are only dealing with the ones they have to.”

While many lenders may be increasingly ready to divest some of these assets, industry participants say they aren’t likely to attract many true distressed investors now, either because the assets are no longer “distressed” given the market rally seen in the first part of 2010, or because they’ve essentially become “zombie companies” while sitting on the banks’ balance sheets.

“You have a lot of these zombie companies which for a couple of years have not made the sort of investments that would be necessary in order to position them to really capitalise on any return of macroeconomic growth and health,” says Wolf Powers. “But neither have they suffered the complete unavailability of liquidity that would drive them into liquidation.”

When they do reach liquidation stage, he continues, typically the company has been stripped of the attributes that make it attractive to distressed for control investors as opposed to liquidators and traders. “If you take a company and starve it of capital and wind it down gradually and slowly, preserving liquidation value, what you do is you strip away the ongoing business concern value,” Wolf Powers says.

TIMING IT RIGHT

Before the subprime crisis fully hit, distress hadn’t really begun to manifest itself save for in certain sectors like those related to housing. “So there were some opportunities there, before fall 2008, but it was all complicated by the fact that you had no visibility as to what the future was likely to hold with respect to that sector,” Wolf Powers recalls. “You saw that you were on the edge of a cliff but you didn’t know how high the cliff was or how fast you were going to fall. So that made it very hard to invest in that situation.”
Those that did take the leap did so in some cases with unpleasant results.

“A number of groups jumped too early and started buying up bonds and the like in 2007 or early 2008, figuring that we were sort of in the crisis, and of course with hindsight now we now that was just the warm-up to the crisis,” says Josh Lerner, a Harvard Business School professor and private equity scholar. “A lot of those fund investors got pretty badly burned when things turned south in the second half of ‘08.”

Likewise, Lerner says, many GPs were also burned because they waited too long to begin making distressed investments, figuring the cycle would continue for at least two to three years, based on historical recessions. Most GPs thought they would have time to adapt and see if things got any worse, he says. “I don’t think anyone anticipated how rapidly the economy – or equity prices – would recover,” Lerner says.  “In general I think the private equity industry will regret not having invested more money in 2009.” 

The snapback in equity valuations affected firms with various distressed investment strategies, including traditional private equity firms that were simply expecting to purchase cheap assets. “I think the anticipation was that we would be in an environment like one of the ones we saw coming out of the ’91 and ’01 recessions, in which we would be able to buy companies at multiples ranging from 5 to 8 times EBITDA – that didn’t happen this time, partly because of the enormous jump in the public equities markets,” Scott Sperling, co-president of Thomas H Lee Partners, told PEI last month.

It also threw off-kilter some of the distressed debt investors that look to amass a company’s debt in a loan-to-own strategy. “The average duration is two-and-a-half to three years down into the cycle at the bottom and back up. This one happened in six months – the most precipitous fall to the steepest reestablishment of value is by far the shortest in history,” says one distressed debt firm founder. “If you’re trying to [take control of a company by purchasing its debt] in a ‘V’ of six months, down and back up, you can virtually not accomplish it.”

Their firm did take over one company that way, but otherwise found itself in possession of numerous bonds in companies it wasn’t able to take over before markets rebounded.  Selling those positions has generated profit, but “you don’t get control of the company, so it’s a booby prize almost”.

THE ‘VANILLA’ FACTOR

Further complicating the “non-avalanche” of expected distressed investment opportunities were factors relating to the “plain vanilla” buyouts struck in the run up to the crash.

Many “vanilla” LBOs agreed during the frothy boom cycle were expected to fall apart during the recession and become prey for distressed investors. “I think one of the things that was surprising to many people, including myself, has been how well many of those held up during the downturn,” says Lerner. “In part that’s due to the covenant-lite nature of the deals that were struck in ‘06 and ’07, in the sense that there were relatively little EBIDTA-related covenants that might have triggered technical defaults.”  But, he adds, it also suggests the private equity sponsors did a good job in selecting assets and or recapitalising and restructuring them.

The “plain vanillas” and “JAMMBOs” (an equally unflattering nickname used in the US for “just another mid-market buyout shop”) have also, in the last couple years, begun targeting the distressed investment niches, heightening competition for dealflow.  “A host of folks who never would have described themselves as distressed or turnaround investors five or seven years ago through some combination of necessity, ambition, arrogance and the unfortunate deterioration of their own portfolios have sort of re-minted themselves as distress experts,” says Wolf Powers. “People are far more prepared to wade into the world of distressed because there are fewer opportunities across the board that are compelling to them.”

The trend has contributed to a supply-demand imbalance that’s unfavourable to the sector, says Lerner of this “crossover” phenomenon. “Essentially a lot of groups raised a lot of money and they clearly weren’t going to be able to deploy [all of it] in the traditional corporate finance type of investment so a number of them sort of switched gears.”

TOMORROW’S OPPORTUNTIES

Many distressed investment specialists will now be pulling back from conventional distressed investments, looking instead to realise their portfolios and await the next change in market cycle. “There’ll be a day when things come back,” says one New York-based distressed debt fund investor. “Come back meaning ‘break’,” he added, referring to the economy.

In many ways, distressed investment experts see the events of the past two years, and the revival of credit markets, as further building up future distressed investment cycles.

The ready credit once again available to companies today “is a great way to get through a difficult time, [but] it’s not a perfect way because eventually if times don’t get better, those chickens do come home to roost and I think they will,” says Wolf Powers. “I think that what’s happening today where relatively cyclical companies are levering themselves 6, 7 or 8 times, they’re minting the opportunities of tomorrow for distressed investors.”