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Distressed Buyout Primer

Step-by-Step Guide to Understanding the Distressed Buyout Strategy

Last Updated February 22, 2024

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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?

Distressed Buyouts Traditional Leveraged Buyouts (LBOs)
  • The debtor is already leveraged to the point that the capital structure is unsustainable, so rather than buying out the equity, the debt is purchased (and the preferred consideration will be equity)
  • The acquisition target’s capital structure, for the most part, does NOT matter because it will be wiped out and the post-LBO capital structure replaces it
  • The purchase prices paid are discounted significantly, especially for securities lower in the capital stack, because the number of potential buyers is limited and there are fewer strategic acquirers active in distressed assets (i.e., the deal dynamics are skewed heavily in the favor of buyers)
  • While in traditional buyouts, the pre-LBO capital structure has minimal impact on the returns to the funds – for distressed buyouts, the existing creditors, claim amounts, and the terms are crucial factors in diligence, as it is technically not a “buyout” but a significant stake
  • The amount of dry powder and investors in traditional PE continue to accumulate, creating a crowded environment consisting of high valuations – whereas distressed buyouts are a niche, specialized area that most firms, such as family offices and middle-market funds, avoid
  • The existing equity will be bought directly to own all or most of the equity in the post-LBO entity, and the existing debt can be refinanced, but in most transactions will be the seller’s responsibility.
  • Once an LBO closes, the PE firm becomes the majority owner and can decide the operational and strategic decisions of the target. But in the case of distressed buyouts, the other claim holders still have some minor say in the internal matters
  • While a purchase premium is expected in most LBOs to encourage shareholders to sell or from the competitive aspect of auction processes, the opposite is seen in distressed buyouts, as purchase prices are made at steep discounts.
  • Distressed buyouts are very cyclical, and more opportunities appear during economic downturns, which is why the area will likely remain a niche strategy – and the performance of the fund is more tied to the recovery of the debtor.
  • Traditional LBO funds generally perform in line with the broader economy, as inexpensive funding is readily available, and portfolio companies tend to perform better throughout these periods (and valuation multiples increase as strategics are more active in pursuing M&A)

What is the Investment Criteria of Distressed Buyout Firms?

Before committing to a distressed buyout, the PE firm must perform extensive diligence to ensure adequate downside protection, given the high-risk nature of the transaction.

Traditional LBOs, in general, look to acquire a controlling stake in the equity of a target with a proven track record of stable free cash flows (FCFs). The predictability in its future cash flows is of utmost importance given the highly leveraged post-LBO capital structure.

For the most part, the ideal attributes for an LBO remain the same for distressed scenarios, such as the company being cash flow generative with high-profit margins and the product or service being offered to be “critical” to their customers.

One of the more important diligence areas is identifying the cause of distress to determine the reasoning behind why a turnaround could be viable. The preferred catalyst is related to short-term trends such as cyclicality or poorly timed decision-making, as these issues tend to be more “fixable” and within the control of the debtor and the creditors. In certain cases, debt restructuring or an equity injection could be all the debtor needs to get back on track.

In contrast, the riskier catalysts are tied to secular disruption affecting consumer demand within an industry, whereby the business model of the debtor has become obsolete. To adapt to the new competitive landscape, the debtor would need to undergo significant changes.

Even if low-cost capital funding were to become abundant and readily available suddenly, the problem being faced would still remain.

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.

Cerberus Investment Criteria Example

In the distressed buyout space, many of the PE firms using the strategy consider themselves to be “operational private equity” because they are adept at value creation through improvements that focus on increasing profitability and FCFs.

Cerberus Distressed Buyout Investment Critiera

Operational Private Equity Strategy (Source: Cerberus Private Equity)

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.

J.Crew Chapter 11 Press Release

J.Crew / Anchorage Chapter 11

J.Crew Group Emergence from Chapter 11 Bankruptcy (Source: PR Newswire)

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.

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