Unlikely bedfellows

Distressed businesses have always represented an opportunity. The instability created by a particular business’s failings creates the opportunity for institutions that are used to dealing with special situations. It is not possible to price the assets in the same way as one would assess a solvent business and for that reason there is always the opportunity to pick up a bargain.

Having said that, the business of investing in distressed situations has become something of an art form and the market has now reached a significant level of maturity. Private equity firms and hedge funds have recognised the opportunities that are created by distressed businesses and have poured into the European markets with great enthusiasm and energy.

While there have been noticeable success stories among the indigenous firms within each of the key European jurisdictions, it must be recognised that the US firms that have entered the market have leveraged off their experiences over the last decade or so in the US and this has given them some competitive advantage when breaking into the crowded European market place.

The problem that many of the US entrants have faced is that Europe does not present a homogenous legal market, in stark contrast to the United States. There has been much debate over the last few years across Europe as to how far the European legal systems should attempt to emulate the Chapter 11 process (the default setting for rescuing companies in the US).

In the end, however, the only thing that is uniform about the insolvency processes of the various European jurisdictions is their complete lack of uniformity. Efficient pricing can only be derived from extinguishing as many variables as possible and the difficulties created by the inconsistent legal systems operating within Europe should not be underestimated.

As an aside, this lack of clarity/uniformity in itself can be regarded as an opportunity because, as seasoned private equity players would say, a “transparent market” results in higher prices. It is interesting to note that while most European debt instruments closely follow US practice there are some significant differences.

The fact that many US terms are simply adopted without thought into the European model can add to the confusion. An example is the way that second liens have formed part of the capital structure in the European markets. They have taken the position between the senior debt and the mezzanine but have found this space a little crowded given that once again, in stark contrast to the US, mezzanine debt in Europe has always been secured debt and has been priced accordingly.

In the UK at least, these vagaries are “glossed over” as a consequence of the liquidity within the market. The principal concern of debt providers is to position themselves well for a refinancing rather than to give any real consideration to their recovery position in an insolvency.

Things change, however, and it is worth spending some time considering the likely winners and losers when and if the UK market takes a downturn.

The current trend towards “pre-packs” clearly favours two distinct stakeholders, namely the secured creditors and the managers of insolvent businesses. The latter are particularly well placed where the business concerned relates to the provision of services.

Much has been written about pre-packs but in essence they can be summarised as a restructuring solution whereby a business can effectively re-base its balance sheet and continue to trade having had the benefit of removing all non-essential debt and, quite often, leaving behind the equity holders. The corporate entity is left behind but the new entity often includes elements of the old management team.

The only obstacle to a pre-pack is that an appropriate price must be paid by the new entity for the old business’s assets. If the business is a service business dependent on goodwill, the “fire sale” value of its assets will of course be extremely low.

In certain situations, the secured lenders will be prepared to roll over their debt into the new entity. In this scenario, the new entity can afford to pay up to the value of the secured debt knowing that the payment will effectively circulate back to the secured lender.

There are obvious opportunities for management to engineer a situation whereby the previous equity structure is left behind in the old entity and a more favourable equity structure is created in the new company.

If the business was fundamentally profitable but was struggling under too high a debt burden, the temptation to use a “pre-pack” rather than a more consensual restructuring or scheme of arrangement is high.

As ever, where there are winners and losers there are opportunities. The previous equity providers will lose out unless they are prepared to take out the secured lenders or provide ongoing funding to the distressed business. There is currently no opportunity for institutions to advance monies on a “super priority” basis such as the debtor in possession or “dip” financing that is available in the US.

There are opportunities however, for those who are participating in the new entity. They will have acquired a business shorn of its previous high levels of gearing and with significant upside prospects.

The current state of the market is providing plenty of financing and equity opportunities for a distressed business that is looking to engineer some form of restructuring.

It is not the purpose of this article to comment on the rights and wrongs of pre-packs becoming the “default” restructuring tool. The authors would, say, however, that it is in complete opposition to the intention of the Enterprise Act and in particular the primary purpose of an administration, which is to preserve the company as a corporate entity.