Part two of our six-part series to guide you through the steps of successful distressed investing.
Once you’ve identified a distressed investment that interests you, it’s time to strategize. While there may be a golden opportunity to get a significant return on your investment, you’ll need to do your homework, ask the right questions and create a sound strategy so you’re confident you can achieve your investment goals. There’s a higher degree of risk with distressed investing—but because of that, it’s usually a less competitive environment for investing.
Get to the question of value
Determining the real value of the business requires coming up with different performance scenarios for the distressed company. Most investors start with an analysis of what the liquidation value of the company is in various situations. This liquidation analysis helps investors understand what recoveries might look like for each creditor group in a worst-case scenario.
On the other end of the spectrum, investors work to determine what fair value might look like under a number of scenarios if the company is expected to continue operating after a restructuring. This going concern valuation often layers on assumptions related to the structural and operational changes that can be made during an organizational or financial restructuring. After a valuation analysis, the investor should know the floor position and potential upside value of the restructured company. This will help the investor determine their margin of safety and at what values a deal provides an appropriate risk-rated return.
Creditors and equity holders often have differing views of value, so getting consensus on a fair value is critical to moving a deal forward. Debt traders will often place too heavy a discount on the value of the debt. The fulcrum security is the last security to recover less than par value in the capital structure, and often some or all of it gets converted into equity during the restructuring. Many distressed investing strategies focus on finding and obtaining the fulcrum security, as this tranche often drives negotiations. Buying too far down in the debt structure based on inflated values can be disastrous for an investor.
Determine the right way forward
One of the first steps of any distressed investing strategy is to figure out how to get a seat at the table. There are a number of ways to do that, and each depends on what you want to achieve through the process.
In distressed investing, the ability to move fast with confidence is important for gaining an advantage. Most successful distress investors get well ahead of the broader groups of buyers. They’ll target a company, gain industry knowledge, arrange the necessary funding and get themselves ready.
A good place to start is by exploring the possibility of buying some or all of the target company’s debt, which may be available at a discount to par value, depending on incumbent creditors’ views of the company and the strength of their desire to exit the credit. Depending on the terms of the debt acquired, this strategy could provide flexibility, control and leverage in a future sales process. Converting debt to equity combined with a rights offering to infuse more money into a company can provide a mechanism for gaining a larger or controlling position. Keep in mind that not all debt is created equal. Understanding the relative priorities of a company’s debt instruments is critical to assessing how best to achieve control or leverage, which is important in a situation where there may be multiple potential buyers.
If control is critical to your investing approach, then you may want to focus on debtor-in-possession (DIP) lending or being a plan sponsor or stalking-horse bidder:
- A DIP lender finances the restructuring process in return for a court-ordered, priority-ranking security interest or “charge” over the restructuring company’s assets. The interest, fees and options of DIP loans are often dictated by the underlying security available and the amount of competition for the DIP lending position. Recent North American DIPs have carried interest rates of more than 10% before including any of the lender fees associated with this class of lending. But DIP loans aren’t risk free. Most DIP loans are fully repaid because of the court-ordered secured position they provide. A key advantage for DIP lenders is access to information and insight into the business.
- Another way to get a seat at the table is to be a plan sponsor. A plan sponsor can become the lead investor in the reorganized company or buy the assets and transfer them to a new company. The sponsor puts up capital to finance a plan of arrangement in return for a healthy position in the new restructured company. The decisions to restructure the existing entity or transfer assets to a new entity will depend on a number of factors, including liabilities, tax considerations and reputational issues.
- A good way to get into the process early is to be a stalking-horse bidder, which comes into play during the auction process. This technique is popular in the United States and has also begun gaining traction in Canada. As the stalking-horse bidder, you’re providing assurance there will be a buyer for the assets in a restructuring process. By taking on this risk, you often get favourable terms in your deal, including a right of first refusal and a break fee. Stalking-horse bidders typically have identified the opportunity early and are first investors to the restructuring.
Turn risk into opportunity
We often see strategy developed without a full picture of potential risks. But it’s important to consider all possible operating issues when you plan your strategy. These can include industry risk, customer and employee retention, inventory, environmental obligations, pensions, supply contracts, leases, litigation risks, intellectual property non-arm’s-length transactions, customer concentration and tax considerations. It’s also important to ask what relationships, contracts and people are critical to the success of the restructuring.
Figuring out how to deal with trade debt and other liabilities is another part of the discussion. While you may create more value by eliminating trade debt and other liabilities, you can also damage a business’s ability to operate as a going concern. The key when evaluating trade debt and other liabilities is to understand which parties are critical to the go-forward operations of the business.
Armed with experience
One of the keys to honing your strategy is to ask the right questions and consider all the angles. Talk to someone who has been through these types of transactions before and can help you see what the restructured company will look like on the other side and how much of a return on your investment you can expect. Is there a union? What about contract issues or other hidden liabilities? Are there government regulatory issues, and what are the government’s rights and positions in a distress or default situation? Depending on the industry, regulators can have a significant impact on restructuring events. Regulators that can impact a company’s access to licensing and permits, such as the Alberta Energy Regulator, can become critical stakeholders in restructuring negotiations.
Distressed investing can be a creative and strategic way to achieve superior returns, but it’s important to make sure your projections and risk analysis are reliable. Risk is manageable—as long as you can see it coming. By using an effective strategy, you can improve your chances of making the most of your investment.
Once your strategy is sound, it’s time to perform your due diligence, which we’ll cover in our next post.