VIEWPOINT – Private Equity - Rethinking Trouble
Daily Bankruptcy Review. April 11, 2007
Cynics that we are, we assume that the current private equity boom will end in tears for at least a few dealmakers. It's just the nature of any boom that some people will make money and others will make mistakes. But having done workouts through numerous cycles, even we are a little daunted by what we believe will be the challenges characterizing any future PE downturn.
Many experts have already registered their concern about some of the structural difficulties prospective workouts may be facing; layering on top of those the fundamental ways that the identity and role of the participants has been altered by the developments of the last few years will add perceptibly to the complication and stress involved in working out private equity deals gone bad.
Let's start by reiterating some of those structural concerns, starting with the financing itself. Private equity capital structures used to be pretty simple - senior, equity, maybe a little mezz thrown in. Now they have more tiers than one of Donald Trump's wedding cakes, and each tier embodies its own special rights and concessions, many of which are untested and sure to be litigated when trouble hits.
Secondly, figuring out who resides at each stage of the capital structure, and what their ultimate economic interest is, may be virtually impossible today given both the rampant trading of all creditor positions and the widespread use of derivatives and other financial measures which serve to divorce ownership from exposure.
Finally, thanks to the generosity of "covenant lite" loans with all their lender giveups, monitoring moratoriums, and debt payment postponements, there will be many companies arriving at the workout table looking less like the walking wounded and more like the living dead. Human nature being what it is, free of banks holding their feet to some covenant fire, more than a few sponsors will deny the reality of their portfolio company's condition till virtually the bitter end.
But if the situation is challenging, figuring out who is in charge will be no less so. In the past, finding a way out of a distressed private equity mess would have fallen to the agent bank who would have ruled the creditor roost, with the sponsor speaking for equity. Not to minimize the contentiousness that always accompanies workouts, but there was a process in the past that was often driven by the players fulfilling a certain predictable role.
Unfortunately, there is nothing predictable about how players will act going forward.
The banks, for example, are almost certainly not going to be as pivotal to workouts as they were in the past, having offed their exposure by syndicating, mitigating their risk with collateralized loan obligations or credit default swaps. Their exit, though, also means the deals may be woefully short of workout expertise given the raft of new players who've entered the private equity arena in the latest PE deal surge.
Take the CLOs, which now hold a substantial portion of all leveraged loans, including those funding private equity deals. In 2006, $93 billion of CLOs were issued by more than 250 managers, most of whom weren't around five years ago. Many of them are ill-equipped to deal with workouts and, frankly, their preferred strategy is to trade out of a
credit that's going south anyway. The issue for them will be what happens when there are more than a few bad credits and not a lot of buyers on the other side, forcing them to hold the paper. Unless they have somehow staffed up on restructuring capabilities in ways that aren't apparent right now, it is unlikely that they will have significant input in the determination of the fate of a troubled credit.
What we may see filling the vacuum are the hedge funds. To the chagrin of private equity sponsors, who have become quite activist in adopting measures to keep them out of their deals, hedge funds have successfully become major holders of private equity debt. They've even begun sponsoring their own CLOs, some of which have been described (unnervingly to PE sponsors we're sure) as incubators for distressed situations. The theory here is that the hedge-fund collateralized loan obligation buys broad swaths of leveraged paper, allowing it to get a bead on situations which might become more interesting investment plays, even targets for a dreaded loan-to-own strategy. Unhappy credits can be sold by the CLO to the sister hedge fund which can then consolidate further investment in the faltering PE company to effectuate its ultimate strategy.
Of course, this isn't meant to imply that many of the newer hedge fund players have any particular claim to distressed expertise either. In fact, some are already drawing ire from PE guys who comment on how "unconstructive" they can be when a deal gets in trouble. But only time will tell whether hedge funds will be judged to be short-term players, not interested or incentivized to take action with regard to the long-term health of a company - or steely-eyed investors who don't roll over as quickly as lenders whose allegiance may be driven more by their fees from PE sponsors than they are to the outcome of any one deal.
Complicating the prospective battles between private equity and hedge funds will be management's role. Historically, private equity sponsors called the shots as far as the financial moves of their portfolio companies, but with all these club deals out there, cosponsors may not see eye to eye over which of them speaks for the group. Compounding all this is the fact that the world is very different from the last times PE companies went into the tank in a big way (remember the LBO fizzle of the late eighties and early nineties, or the leveraged loan debacles of 2001-2002?). Those periods were way before the words "zone of insolvency" had ever been uttered by an unfriendly bankruptcy attorney. Consideration of that phrase will force managers to think about how and when they switch their allegiance from equity, and the sponsors who probably gave them their jobs, to include creditors as well. How well, and how easily, will they be able to do that? What all this suggests is that rather than assuming that the good times will continue to roll, the constituencies likely to be most affected by private equity distress - CLOs and CDOs, hedge funds and even company managers - expend a little effort thinking through how and where they’re going to get help if distress becomes chronic.