Littlejohn Sees Prime Time To Invest In Distress

These are busy days for the Greenwich, Conn., turnaround firm Littlejohn & Co.

With three good sized deals this year, a couple of exits and a new $1.34 billion fund just closed, Littlejohn & Co., a specialist in buying distressed assets, has plenty of activity to keep up with.

Angus C. Littlejohn Jr., chairman and CEO of the firm, said that in the industrial markets where the firm concentrates, many companies became overleveraged in the boom years of 2005 to 2007, taking on debt of 4-1/2x to 7x EBITDA, and taking on covenants that would require them to drive EBITDA growth of 10 percent to 15 percent, even 17 percent compounded. Even strong companies in these mature markets can manage compound annual growth rates of only 8 percent, he argued. “You have a large inventory of companies that really are overleveraged.”

Such companies find themselves in constant talks with lenders to amend and extend their loan agreements, to remain in compliance with their convenants, Littlejohn said. “They are not going to be able to outgrow that debt. At some point, they are going to have to restructure that balance sheet.”

Littlejohn & Co. focuses on companies with $150 million to $850 million of revenue, primarily with a North America focus. The firm typically invests $50 million to $100 million per transaction, or $100 million to $300 when it invests in distressed debt. Although the firm can invest in a wide range of industries, much of its effort goes into industrial companies, manufacturing assets, distribution, chemicals, automotive, food, and electronic components, Littlejohn said. The firm tends to stay away from retail, fashion, restaurants, and industries where fads and trends play large roles in the business outlook.

While the firm concentrates on underperforming businesses, not all of them are deeply troubled. Indeed, the firm estimates that only a third of its portfolio consists of companies with both operational and balance sheet problems.

Another third consists of corporate carveouts, with marketing and financial infrastructure needed to be developed around them, Littlejohn said. “A lot of the direction comes from the mother ship. Separating that, establishing the entity as a standalone entity requires a lot of operational actions that are not dissimilar to what we would undertake in an operational restructuring.”

The remainder of the portfolio consists of companies that are not broken, but which have problems that Littlejohn & Co. can fix without a complete restructuring.

“These are companies that don’t have great critical mass. They don’t have great resources, people or financial or otherwise. Regardless of which way we attack the investment, it’s a very hands-on, time intensive approach,” Littlejohn said. “It’s a very focused strategy, a very hands-on strategy.”

Fresh Capital

The firm announced this month that it has closed its Littlejohn Fund IV LP, at $1.34 billion, above its $1.25 billion target and just shy of its $1.35 billion hard cap. The firm raised its previous fund in 2005 with capital commitments of $850 million.

The new fund is targeted to invest about 80 percent of its capital in conventional control investments and the remaining 20 percent in distressed opportunities with the intent to gain control, often by buying up debt from the target’s creditors. The new fund takes advantage of a 2007 agreement with the firm’s limited partners, which first approved broadening the mandate to include investing in non-control positions in addition to its conventional leveraged buyouts.

Littlejohn & Co. has been taking advantage of the non-control authority. In October, for instance, the firm announced that it has led a restructuring of Cosmetic Essence Inc., a $300 million-revenue contract manufacturer for the cosmetics, fragrance and skin care industries.

The firm had actually held a position in the company’s debt for quite a while before it was able to complete the restructuring, Michael Klein, president.

Likewise, in January, Littlejohn & Co. brought a troubled swimming-pool equipment company, Latham International, out of bankruptcy. Through the pre-packaged Chapter 11, Latham was able to eliminate more than $180 million of debt from its balance sheet, a 90 percent reduction from what it owned before the filing.

The distressed-debt business has developed with the help of two debt experts who joined the firm in 2005. They are Robert E. Davis and Richard E. Maybaum, both of whom are managing directors and partners. Davis previously had been a managing director and founding member of Oaktree Capital Management‘s Mezzanine Fund, while Maybaum had been a portfolio manager at the hedge fund Ramius Capital Group LLC.

A central issue in distressed-debt deals, Littlejohn said, is simply finding the assets in the first place. Unlike larger deals, where creditors can be readily identified through public records, in these mid-market transactions, an important element of the diligence is in finding creditors that might be interested in selling.

Investing in distress is cyclical, Klein said. “Right now a lot of our efforts are focused in that area.”

The segment also can be challenging because of the emotional issues it raises among targets, Klein said. In a not-atypical situation, Littlejohn & Co. will approach a management team with a $75 million offer, while the executives believe their company is worth $150 million, Klein said. “It’s like I’ve called your baby ugly. It’s personal to you.”

As a result, while many buyout firms favor proprietary deals that avoid auctions, in the distressed segment, auctions can bring a welcome whiff of reality to the process, Klein said. “The auction process allows for the market to speak and it is better for us to have the market tell the seller that their company is ugly and not worth what they thought, as opposed to us being the first to tell them.”

In about half of the firm’s deals, Littlejohn & Co. ends up as the only group pursuing the investment because the others have dropped away, he said.

Littlejohn said he expects to see strong deal flow, as survivors of the Great Recession continue to struggle with heavy debt loads and slow economic growth. This also can give the firm a favorable position in sponsor-to-sponsor handoffs as funds near the end of their investment cycles.

“Time is the enemy in our business,” Littlejohn said. Sponsors end up selling mediocre performers because they don’t have the time to stay with the turnaround, he said. “Even if the seller had the ability to do that, they don’t have the time any more.”

The firm’s economic forecast doesn’t call for a double-dip recession, which increases the opportunities for turnarounds to thrive, Littlejohn said. “Once you have a stable environment, a lot of good things can happen.”