With the prospect of more companies entering distressed situations, now is a good time to dust off the loan-to-own playbook.
For investors of a certain stripe, vulture plays can lead to lucrative returns, but legal pitfalls line the path to success. Jonathan Landers, an attorney with Gibson Dunn & Crutcher, recently wrote about how the courts view the loan-the-own strategy.
The essential mechanics of a loan-to-own investment are little changed. Through a combination of equity and secured loans, an investor buys into an overleveraged company that’s capable of performing well. If the business succeeds, the investor’s equity stake—usually 25 percent or so—would generate a tidy return with little or no fuss.
If the company enters distress, however, then the investor typically proposes to covert his debt to equity, pay off creditors and generally reorganize the business, all the while operating on a fast track. The loan-to-own investor has an advantage, since at any time he can threaten to foreclose and leave everybody else with virtually nothing, Landers wrote. At all times, the investor technically lacks voting control, which means he can skip board meetings and other potentially messy obligations.
“Of course,” Landers wrote, the investor “is never far away and casts a big shadow.”
From a legal standpoint, a loan-to-own strategy is most vulnerable to a claim of breaching fiduciary duty—that a company’s board of directors or management shortchanged other creditors and equity holders by playing ball with the loan-to-own investor. As one strategy, Landsman wrote, if a loan-to-own investor is “sufficiently circumspect” (by not participating in board meetings, for instance), the investor can eliminate liability and escape the claim.
Recent court cases have also cleared loan-to-own investors of the breach claim based on so-called “deepening insolvency,” another way of saying the loan-to-own investor made things worse, according to Landers. Some courts have found the opposite to be true—that the reorganization led by the loan-to-own investor has increased the company’s value.
One more point. For a loan-to-own strategy to work, distressed companies must show that they pursued every possible transaction and sought out the best possible deal.
“But one can’t insist on miracles,” Landers writes.