Distressed Buyout Primer

How Does a Distressed Buyout Work

In a distressed buyout – often called “distressed-to-control” (or loan-to-own) – an institutional investor, such as a private equity firm, purchases the debt of the company near or in bankruptcy protection, anticipating conversion into equity as part of the reorganization.

By virtue of being the majority owner in the total equity of the post-emergence debtor, the private equity firm can effectively manage the implementation of the plan of reorganization (POR) and guide the management team in the direction the PE investor assumes would set the company up favorably to achieve real value creation amidst its return to operating on a sustainable basis.

Obtaining a controlling stake is paramount for the private equity firm to “earn” a seat at the table, work closely with the management team, and effectively lead the restructuring process in the direction they sought – akin to how traditional PE firms have full discretion in the operational and financial decision-making of their portfolio companies.

The private equity firm is investing under the assumption that the target’s current valuation is underpriced relative to its future post-reorganization equity value.

Further, rather than being a passive investor on the sidelines, the PE firm intends to help facilitate the desired outcome via “hands-on” active involvement throughout the restructuring process.

What is the Distressed-for-Control Investing Strategy?

Distressed buyouts are oriented around the purchase of debt securities by a distressed issuer, with the objective of obtaining a majority stake in the post-restructuring debtor upon equity conversion.

For private equity firms, the distressed debt of the target represents a unique opportunity to obtain a majority stake in the distressed company (and predominately are purchased from existing debt creditors).

The debt securities issued by the insolvent target can trade below fair value, which permits the pre-petition debt to be acquired at discounted purchase prices (and leads to a greater likelihood of higher exits).

But while debt tranches of higher priority are targeted, it is important for the distressed fund to acquire stakes around debt securities where equity conversion is likely.

The strategy of the fund must strike the right balance between the following two factors:

• 1) Purchase debt securities around the fulcrum security, i.e. the most likely to participate in a reorganization process and undergo equity conversion post-restructuring.
• 2) Avoid the debt tranches near the bottom of the capital structure, because recovery rates come with significant uncertainty and the risk of receiving either no or minimal recovery proceeds.

Since the upside from equity is theoretically unlimited, the PE fund pursues equity-like returns, which requires investing in slightly riskier debt tranches.

Since senior debt at the top of the capital structure is safe, but in exchange, potential returns are low relative to equity from a turnaround (i.e., senior lenders are likely to receive cash or new debt).

Which Types of Firms Perform Distressed Buyouts?

Historically, distressed investing used to comprise mostly hedge funds, but now private equity firms are also major players in the industry – utilizing strategies that converge:

• The traditional LBO business model
• The opportunistic investing approach employed by distressed hedge funds

While distressed buyouts are still considered a niche area and are more specialized, the strategy has caused more PE funds to pursue distressed opportunities in pursuit of high returns and diversify their portfolio holdings in case of a contractionary economic phase.

Because of the typical holding period of PE funds, these investors can hold onto illiquid, distressed investments until the liquidity event (e.g., sale to a strategic or another financial buyer).

The distressed buyout strategy requires an in-depth understanding of the legal framework surrounding the Bankruptcy Code and the willingness to invest significant time, energy, and resources into the restructuring process.

Distressed Buyouts vs. LBOs: What is the Difference?

What are the Value Creation Opportunities in Distressed Buyouts?

Upon emergence from bankruptcy, the goal of the private equity firm is to reduce unnecessary costs and expenditures to improve margins and make operations more efficient. Once in control of the distressed target, the private equity firm can straightaway begin recommending a multi-step process to improve upon the debtor’s profitability and cash flows:

1. “Right-Sizing” the Balance Sheet to Normalize Credit Metrics
2. Hiring Internal or 3rd Party Turnaround Consultants
3. Decreasing the Cash Conversion Cycle (CCC)
4. Cost-Cutting Initiatives Eliminating Areas of Inefficiency (i.e., Removing “Waste”)
5. Closing Unprofitable Store Locations and Redundant Offices/Facilities
6. Adopting a “Lean” Organizational Hierarchy and Reducing Headcount
7. Divestitures and Selling Non-Core Assets

While many of the changes could be put in motion now, if not, they can be found in the POR and implemented later once the company emerges from bankruptcy.

Instead of focusing on rapid expansion and growth or partaking in M&A as a method to drive inorganic growth (and benefit from multiple arbitrage), the initial priority is much more on removing the areas of inefficiencies (i.e., “waste”) from the operations of the company.

This certainly does not mean that expansion/growth is not pursued, but rather, the first course of action is to improve operations and increase the debtor’s margin profile, before concerning themselves with generating more revenue and expansion into new markets.

In other words, the factors that caused distress and the impact of past poor decision-making must be removed to make operations “leaner” with a clear objective and target customer market in mind.

Once operations have stabilized and efficiency has reached an adequate level, then other means for growth, such as add-on acquisitions, can be pursued.

For example, an acquisition of a divestiture that does not contribute enough value to the core operations of the company and serves as a distraction could be sold. Consequently, the sale proceeds could be used to reinvest in the operations.

The common theme seen from these potential actions is that unnecessary expenses are reduced, while the target market representing higher customer demand and profits is identified to direct most future efforts in that direction.

Besides operational expertise, often through in-house professionals with industry expertise or 3rd party turnaround consultants, the distressed buyout candidate effectively becomes a portfolio company of the private equity firm.

What is an Example of a Distressed Buyout?

In September 2020, J.Crew emerged from Chapter 11 after filing for bankruptcy protection due to the negative implications of the pandemic. As part of the restructuring process, J.Crew equitized $1.6bn+ of secured indebtedness, and Anchorage Capital, an opportunistic alternative investment firm specializing in turnarounds, became the new majority owner of the struggling clothing retailer.

J.Crew had previously undergone an LBO by TPG and Leonard Green, but had seen sales struggle from the disruption caused by e-commerce.

In terms of the retail industry, J.Crew actually held up well and had established a brand name – but then the outbreak of COVID transpired, which proved to be the tipping point.

Jan Singer, the CEO of J.Crew, was quoted as saying, “Looking forward, our strategy is focused on three core pillars: delivering a focused selection of iconic, timeless products; elevating the brand experience to deepen our relationship with customers; and prioritizing frictionless shopping.”

In the ongoing changing retail landscape, J.Crew, like many retailers, struggled to adapt. But it was the capital structure that caused it to fall into bankruptcy (i.e., the fundamentals remain largely unchanged despite there being clear areas for improvements, but the brand has retained its value).

The focus will be on relying less on foot traffic in retail stores (e.g., closing unprofitable store locations), and a shift towards creating an immersive brand experience in their online store and other marketing channels. The creation of a well-integrated, smooth online shopping experience is J.Crew’s attempt to catch up to the current standards of the e-commerce industry.

In closing, the returns to the private equity firm are contingent on the actual turnaround of the debtor, making real value creation a necessity to exit at a higher valuation and exceed their minimum returns threshold – which indirectly aligns the incentives between management and the private equity firm.