By Eric Peghini and Chris Khoury
Many are familiar with the story of Bear Stearns’ monumental stock collapse and the sale of the investment bank to JP Morgan in 2008 at $2 per share – almost 1% of the original value of the year before. The notion of purchasing a competitor at such a discount is borderline unfathomable. Unfortunately, the takeover created such a substantial regulatory and legal liability over time that led Jamie Dimon to declare his regret of the acquisition.
But is there a way to acquire a failing company cheaply and make a profit: can we buy extremely low and still sell high?
Welcome to our primer on distressed private equity.
While many readers may have heard of restructuring and distressed M&A within investment banking, we introduce the buy side standpoint. Within this subgroup of financial sponsors, the investors look to acquire distressed companies (operationally struggling, defaulting, or bankrupt) at a discount, improve it, and exit. Contrary to the deal-flow in most areas within financial services, when markets are tough, activity increases for these turnaround companies. The primary distinctions between the conventional (growth/buyout) private equity fund and a distressed fund are as follows:
- The mentality is different.
A traditional fund seeks to identify strong cash-flows in order to make a good company better. In distressed private equity one instead attempts to turnaround a tanking company via restructuring in order to revitalize it. As a result, the outlook of the distressed manager is less fixated on pinpointing “favorable” qualities but rather applies more weight to areas of possible improvement.
- The distressed fund is opportunistic.
Of course conventional sponsors consider market timing when entering investments otherwise they would not be earning (and would not deserve) the double digit yields in carry on top of regular management fees. Nevertheless, distressed funds must act quickly because the valuations of distressed targets are far more volatile. Action may also be necessary before the company is liquidated, dismantled or otherwise salvaged by creditors.
- Acquisition methods are craftier.
The acquisition of distressed firms at a significant discount requires covert action. This is because fire sales and post-bankruptcy auctions can rapidly accelerate into bidding wars which significantly increase entry multiples and, by extension, eat into ROI. Therefore, to avoid unwanted buy side competition, the fund needs to subtly maintain control of the takeover process. The typical practice involves the fund purchasing existing debt of the company in order to position itself to have the strongest claim on its assets; this in turn, is converted into equity via a debt-to-equity swap. Other methods include acquiring equity or buying a bankrupt company’s assets directly.
Not all firms are economically viable if salvaged. Like in any business, the fund managers must identify positive NPV projects, or targets that can yield a profit. For instance, a distressed company with an obsolete business model must either be flexible enough to pivot to an in-demand service or have significant assets that can be sold off in order to justify an acquisition. The conventional distressed target should be operationally sound, just with a bad balance sheet.
Also, financing the purchase of distressed debt or equity is difficult. Imagine if you asked your father for cash to buy your friend’s bicycle with a broken chain; he might do so because it is relatively inexpensive to repair and more economical than purchasing a new bike – this is traditional private equity. Now if instead you asked him for money to buy a totaled Ferrari he would be less likely to provide the funds because, although it is relatively cheap, there is only a slim chance that you can restore it – turnaround private equity. Therefore, unless the sponsor is large and reputable, it can prove to be a challenge to raise the necessary debt funds. Because of this, many turnaround companies engage in unlevered initial investments and then pursue dividend recapitalizations once the company is no longer distressed. Yet this requires larger investments and more committed capital.
To date, the largest sponsor specializing in distressed investments is Oaktree Capital which has experienced much success in investments entered during the financial crisis (including the 23x exit of AdvancePierre Foods in 2017). Other notable players include Cerberus Capital Management and MatlinPatterson Global Advisors while mega-funds such as Carlyle and Blackstone (GSO Capital Partners) also invest in distressed entities.
So how do these funds perform?
As one can imagine, during the financial recessions, distressed funds outperformed other private equity investment strategies by displaying a strong median net IRR of c26% on targets entered in 2002 and a less remarkable, albeit leading, c15% in 2008.
The appetite for distressed debt, including NPLs, remained sizable during the recent bull market, offering the largest returns within private debt. This strong track record is because distressed debt can be purchased at large discounts to par – and existing bondholders are willing to liquidate their positions – allowing for the possibility of high returns. Preqin cites an 18% increase in demand for such assets from 2017 to 2018.
The primary limitation for distressed debt investors lies in number of opportunities; while investors want distressed debt, there exists a finite number of distressed targets that can reliably be invested in. Preqin notes that distressed funds (including hedge funds as well as private equity) sought out only 47% in fundraising of the $77bn made available globally by distressed debt investors through Q2 in 2018.
How are these funds generating such highly demanded returns and what will the future of distressed private equity will look like?
A study by McKinsey & Company has revealed that firms with financial sponsors at the helm outperform public companies with traditional management in times of distress by recovering EBITDA margins faster. These findings can be linked to the strong corporate governance that a private equity involvement inherits as well as the concentrated shareholder structure which improves consensus and expedites decision-making. A distressed private equity fund also offers a dedicated ‘crisis mode’ of management in which actions are taken quickly and decisively in line with explicit objectives. This is helpful when revamping the organizational side of a business that is looking into the abyss.
Useful operational private equity practices further support the control of distressed situations. For example, a chief priority when acquiring a distressed company is to simplify its operations and focus on the core activities of the company. A private equity fund with a portfolio of distressed companies or a track record in that field can leverage successful strategies utilized on previous investments. An experienced management team in special situations thereby limits the guesswork involved in a turnaround.
These tools make distressed private equity firms a viable partner in times of crisis. However, are they able to go from a niche in the broader industry to a more mainstream source of investing?
Somewhat frighteningly, yes.
The extraordinary levels of debt being used to finance buyouts and the corporate M&A market, coupled with loose covenants on indebtedness and cyclically lower levels of bankruptcy act as signs that the heyday of distressed opportunities for private equity investors has yet to come. Furthermore, the increasing complexity of leverage structures can make the next wave of restructuring projects different from those observed in past, and this may call for even more advisory support. Overall, global levels of dry powder continue to pile up, with totals in distressed private equity growing by 7% from 2017 to 2018; this proves that funds are available to seize opportunistic investments.
So what does a successful turnaround look like?
To fully capture the value added by distressed private equity managers, take the turnaround of US-based Hostess, a sweets manufacturer, by Apollo – a renowned special situations investor.
In 2013, Fund VII acquired a majority in the Hostess brand snack business out of bankruptcy. Apollo invested approximately $150 million to purchase the assets of the brand which at the time had over 100,000 retail customers and currently includes brands such as Twinkies, Ding Dongs and Ho Hos in its portfolio. This asset deal provided the advantage of acquiring the business without incurring the pre-existing liabilities that had pressured the company financially. The necessity to completely reposition Hostess’ manufacturing and distribution activities drove away a substantial part of the bidding competition. This created a lower entry and the opportunity to invest additional Apollo funds into the new business at attractive multiples. Hostess was subsequently able to reopen three upgraded bakery plants and relaunch its snack cake line. This success was reflected in its operational performance, as Hostess achieved its projected year 5 EBITDA in year 2 of operations. Apollo was ultimately able to fully monetize its divestment of Hostess at more than 10x entry to Gores Group which acquired the company via a SPAC in 2016.
A more recent example features turnaround firm Cerberus, which has been tasked with the leading position of the overhaul of Deutsche Bank. While Deutsche is not exactly teetering on the brink of bankruptcy, it has observed consecutive annual losses and incurred continued legal fines. In order to restore its business, Deutsche Bank appointed Cerberus to improve profitability and restructure the bank’s balance sheet. The conversation of a tie-up with Germany’s second largest bank, Commerzbank, is in vogue; this can be a logical solution for Cerberus which holds minority stakes in both banks. In any case, whether Deutsche’s white knight can successfully rehabilitate the bank remains to be seen, however Cerberus will not have the license of a controlling stake, and therefore will take on an advisory capacity as opposed to a managing role.
Nevertheless, these recent activities demonstrate how vital a skilled turnaround fund can be in order to help corporations regain healthy financial and market positions. And healthy corporations imply a stronger economy and increased employment. So if the money does not interest you in a career at a distressed fund, perhaps that will.
Or not, in any case this concludes our primer on distressed private equity so for those interested: proceed with caution and burn, baby burn.
Editor: Stefan Larsen
Authors: Chris Khoury, Eric Peghini