Skip this article if every company in your portfolio is a winner. If you want to be honest, read on…
Times are tough. It is likely that at least one of your investments is performing poorly or, even if performing well, is over-levered. Maybe your fund is being asked to put in more money. Maybe it’s being told it’s totally out of the money and that it should get out of the way. Either way, the situation is already taking up precious time your team could be spending on more productive activities and you may already be incurring significant professional fees. So what do you do?
If you are like most private-equity players, your experience in this world is limited. You are accustomed to being the alpha male or female in the room with the checkbook and you are—if you have survived in the industry for a while—usually successful. And, you are not accustomed to being threatened with being sued for “breaching your fiduciary duties to a company in the zone of insolvency.”
Welcome to our world. Here’s a little tour. First the set up: Your fund—let’s call it Fund—invested in Loserco. Loserco has a $30 million secured loan from, let us call it, Bank, including a revolver which is fully tapped out. Another fund, we will call MezzFund, is owed $15 million of subordinated, secured debt. Loserco is in payment default to MezzFund and while only in covenant default to Bank, there is a question about whether Loserco will be able to make its next interest payment on August 1st. Loserco is EBITDA-positive. You control the board. You think Loserco would sell for about $40 million if sold today but that’s a rough guess.
At the risk of stating the obvious, the $40 million of gross proceeds is insufficient to satisfy MezzFund’s debt and as a result, that debt represents the “fulcrum” security. In other words, it is the de facto economic owner of Loserco at this point in time. Let’s assume that the reason for the payment default to MezzFund was not the result of a block triggered by the covenant default on the Bank loan.
What Do You Do?
Infuse capital? Try to lead a “shared pain restructuring”? Give up, get out of the way, and write off the investment? What are your cards?
The threshold question to answer is this: What caused Loserco to falter as an investment? Answering this question will inform the judgment of whether the cause can be fixed and a further investment underwritten.
Is Loserco’s struggle a result of product substitution? Does Loserco manufacture a product that has been replaced in the market by another product—as typewriters, ribbon and correctable tape were supplanted by word processors and personal computers? Has Loserco’s management team failed to execute on an operational strategy or has execution suffered from an incorrect assumption—consider a health care provider who depends on reimbursement at a certain level and expands into new territories where the reimbursement scheme is different than its original service area such that its revenue and cost structure are no longer aligned. Is Loserco a defendant in significant litigation such as products liability or intellectual property infringement?
Asked more simply, is the cause that created the distress operational, financial, regulatory, circumstantial, cyclical, structural, or some combination?
After diagnosing the cause, the next questions to address are whether the problem can be adequately addressed, and at what cost. Does the solution involve readily identifiable cost cutting? A change in management? A full-blown operational restructuring including facility closings or consolidations?
In almost any situation, the solution requires further investment. The complexity and severity of the solution influence the underwriting of that incremental investment since the Fund must generate a return, if not a higher return, on this new investment considering the heightened risk and potential loss of the initial investment.
You must also determine whether there is capacity in the Fund to make an additional investment. Capacity can be gated by a limit on an investment in a single portfolio company—frequently 20 percent of the total commitments. It can also be gated by the total investing capacity of the Fund and whether it has any committed capital available to be called. The answers to these tests may force your hand. If the Fund that made the investment is fully invested, but you’ve raised a second fund, you may seek to make a cross-fund investment. Restrictions on making such cross-fund investments are generally detailed in the Fund’s governing documents, but typically require consent or approval of an advisory board or some percentage of limited partners.
Playing Your Hand
Assuming an additional investment makes good business sense, the Fund needs to consider how best to structure such an investment to protect it to the greatest extent possible. The structure of any further investment must take into account the intrinsic fairness of the investment and its impact on other stakeholders and avoid the appearance of self-dealing that could give rise to recharacterization or equitable subordination of the investment.
The infusion should, at a minimum, go in as a loan rather than an equity investment. Though quick and easy, equity is at the greatest risk in the event of future bankruptcy. If properly structured, a loan provides some downside protection in the event of a further restructuring by granting the Fund priority over unsecured creditors and, at a minimum, equity. Particular care is required to structuring a loan for Loserco, considering Loserco’s capital structure with two existing tranches of debt. Particular attention must be given to any negative covenants prohibiting Loserco from incurring additional debt and intercreditor issues among Bank, MezzFund and now Fund. The parties must also be mindful of whether trade creditors may alter their credit practices upon learning of this incremental debt and tighten Loserco’s trade terms. In that instance, the financial support would have the unintended consequence of pushing Loserco further down the slippery slope, as Loserco’s capital needs would likely increase to meet the new trade terms.
The Fund may determine that an additional capital infusion makes sense only if it is made in concert with an overall debt restructuring by Loserco’s other creditors. A broader debt restructuring may or may not require a Chapter 11 proceeding to bind dissenting creditors.
The Fund may also consider purchasing the debt from MezzFund or the Bank at a discount. Benefits of purchasing debt may include giving the Fund a bigger seat at the table; enabling Fund to control the fulcrum security and, in the interim, relieve a stress point on Loserco; providing a means for the Fund to retain control of the portfolio company after confirmation of a Chapter 11 plan where existing equity otherwise is out of the money; or putting the Fund in a blocking position with respect to any competing plan.
The availability of this option may, however, be limited by the terms of the credit documents that commonly restrict the rights of a sponsor to buy, or participate in the management of debt in a portfolio company’s credit facility. Moreover, buying debt rearranges the chairs on the Titanic—so to speak—but does not put any capital towards a solution. Your Fund must be particularly mindful of its limits on investing in Loserco, as amounts allocated to purchasing debt will reduce the amount of dry powder available for injecting capital directly into Loserco.
If purchasing debt is an option that makes sense under the circumstances, there are several ways to effect the buy. Direct purchases from selling lenders, participations and rights of subrogation are commonly used mechanisms.
In the context of a debt purchase, your Fund must be mindful of the longer-term solution. If that solution includes a more fulsome restructuring that allows other stakeholders into the equity ownership of Loserco, the transaction may take on aspects of a club deal in which your Fund loses control. Distressed companies often suffer under club ownership because of the absence of a strong, decisive, controlling owner directing strategy, operations and the turnaround. The company may languish from paralysis by analysis and lack of consensus among the club.
In the heat of the moment, your Fund must also consider the interests of management when crafting the strategy. If your Fund is out-of-the-money, it is likely, too, that management’s incentive is out-of-the-money. Whether your Fund is trying to incent existing management or new management, a comprehensive restructuring should provide for an appropriate restructuring of the management incentive. Possible solutions include granting new equity, repricing existing equity, establishing new hurdles for participation or some combination.
Don’t Overplay Your Hand
The expression, “hogs get fat and pigs get slaughtered,” applies full force to these situations. If you are out of the money you cannot negotiate the same way you would if you were not. Even if you are in the money, tight credit documents likely give the portfolio company’s lenders a lot of levers.
As the song goes, you gotta know when to hold ‘em, when to fold ‘em, and when to walk away.
Jonathan Friedland is a partner with Levenfeld Pearlstein in Chicago, where he represents sponsors in buying distressed businesses and in dealing with the financial distress of their own portfolio companies. David Lorry is a principal of Versa Capital in Philadelphia, a sponsor that focuses on buying financially distressed companies.