When Restructurings Are A Good Thing –

While bankruptcies are usually thought of as a worst case scenario, they also present an opportunity, and buyout groups won’t hesitate to acquire a business through a Chapter 11 process. Firms do approach these deals differently, though. There are those that will accumulate the debt to gain control and others that will stay on the equity side and compete in the court-sponsored auction. Here’s a look at two recent examples:

Black Diamond Secures Smarte Carte

The convergence between private equity and the hedge funds has taken on multiple forms. In many cases hedge funds are merely another debt provider used to facilitate a buyout, but increasingly these blurred lines take root in restructuring situations where investors accumulate the distressed debt of company with the sole intention taking control. Hedge funds do this, buyout groups now look at this kind of transaction and the more abstract hybrids, with hedge fund and private equity components, seem as if they were formed with this very transaction in mind.

The most recent example comes in the form of Black Diamond Capital Management’s acquisition of Smarte Carte Corp., a provider of airport baggage carts and lockers.

Since the early 1990s, Smarte Carte has been a serially owned private equity portfolio company. Castle Harlan acquired the business in 1993, sold it to Haas, Wheat & Partners, which then exited through a sale to Blum Capital Partners. Smarte Carte relies heavily on airport traffic, and after the September 11 terrorist attacks in 2001, it saw a precipitous decline in customers using its lockers and luggage carts. On top of its $192 million debt load, accumulated through the string of buyouts, the dip in the business proved to be particularly burdensome.

Black Diamond, though, saw an opportunity. The firm began acquiring the senior secured debt of Smarte Carte in the fourth quarter of 2003. The goal was always to convert its debt into equity and eventually gain control, and Black Diamond continued to pour money into the company’s senior debt. It eventually became the largest lender in the business, with GE Commercial Finance representing the the largest behind Black Diamond.

Ultimately, in February of this year, Smarte Carte entered bankruptcy protection. After some wrangling with its smallest secured debt holder, Smarte Carte exited Chapter 11 earlier this month, and through the process Black Diamond was able to convert its debt into a 76% stake of common stock, while GE Commercial Finance held the balance.

According to reports, Castle Harlan had tried to buy the business prior to its bankruptcy and had offered between $135 million and $155 million.

In a prepared statement, Black Diamond told Buyouts, “… Its operating performance has been steadily improving over the past few years. The problem at Smarte Carte was a dysfunctional balance sheet that was overlevered.”

Through the restructuring, $192 million of debt has been shaved down to $14 million. Black Diamond wouldn’t provide any performce data, but reportedly it was operationally profitable prior to the bankruptcy filing.

With a new balance sheet, improving industry fundamentals and a fresh start, Black Diamond may find itself in the same position as Castle Harlan, which was able to realize a more than 10x return on its investment. A new cycle begins.

Trinity Hunt, Capstar Take Over DMX

When Trinity Hunt Partners first looked into buying Liberty Media’s DMX Music Inc. subsidiary, the firm was interested, but not yet sold. The company’s defensible market niche and recurring revenue appealed to the Houston-based firm, and industry veteran Steve Hicks was lined up as partner, but numerous liabilities in the form of real estate leases and employment agreements were enough to turn the buying group off. That is unless DMX went through a bankruptcy process and was able to shed those liabilities.

“This deal was brought to us by the Capstar Partners management team and Steve Hicks,” Trinity Hunt Partner Daniel Dross said. “It has been profitable on an EBITDA basis for some time, but because of its high level of indebtedness, it was overwhelmed by the interest burden and at the net income line it was unprofitable… It wouldn’t be a transaction that we’d pursue without a bankruptcy.”

Trinity Hunt and Capstar worked with company management and the creditors on devising a plan, and as part of that blueprint, DMX filed for bankruptcy in February. THP Capstar (the buying group’s acquisition vehicle) was named the stalking horse bidder, and negotiated a $2.25 million break-up fee. The primary threat was that a new bidder would emerge and Trinity and Capstar would be left empty handed. “You always have that risk when you enter a voluntary proceeding like this,” Dross said. “A few other bidders did emerge for various components, but it was decided that our offer was more compelling than selling the company off in pieces.” Ultimately, THP Capstar was able to acquire the company for around $75 million.

Now, with the liabilities trimmed, the investment looks like a no-brainer. DMX is one of two industry leaders in its market, with Muzak being its primary rival. The company generates roughly $186 million in sales and in 2004 had EBITDA of roughly $17 million on a pro forma basis (an $18.9 million net loss), and the investors expect those numbers to expand, especially without the same debt obligation. What’s more, the company has the security of long-term contracts with its consumers, and further growth is expected to come from bolstering the sales staff and pursuing co-promotional opportunities with artists, retailers and movie studios.

Dross insists this is not a turnaround situation. “This has been a non-core asset. One that has not gotten that much attention for some time, so this is more a story about revitalizing a good business and making it great. We will be able to operate it more efficiently than it has been run in the past. [The bankruptcy] allows us to basically get a fresh start so we don’t have to inherit the liabilities and be saddled with all those recurring charges.”