AS ANYONE FROM Main Street to Wall Street might observe, something seems very different about this economic downturn and the resulting fallout not only for distressed businesses but for the private investment community as well. The almost absolute freeze in the credit markets and the unwillingness of even those traditional “lenders of last resort” to make available acquisition financing—on any terms, much less terms that investors find remotely attractive for generating suitable returns—represents this recession’s defining characteristic for private equity investors and has made deal-making in the current economic environment exceedingly difficult.

Without a viable financing market, traditional private equity firms looking to deploy capital have had to become more creative in sourcing, executing on and financing investment opportunities. One of the emerging trends we have seen and explore below is private equity firms providing debt financing directly to their own portfolio companies or acquiring that debt in the secondary market, all in an effort to hedge against losses on their equity investment, as part of a loan to own (or re-own) strategy or a combination of the two. In short, private equity firms looking to salvage existing investments or put additional capital to work have had to depart from their traditional comfort zones and implement these types of alternative investment strategies to stay active in the current environment.

Discussion

In the M&A arena, during economic downticks, there is typically some transition from typical M&A deals to distressed M&A transactions, in which a distressed company disposes of all or part of its business in an orderly manner by way of a sale under Section 363 of the Bankruptcy Code or under a plan of reorganization. A sale conducted under the Bankruptcy Code affords protections to buyers that are not otherwise available outside of bankruptcy and, typically, attracts attention from several prospective strategic or financial buyers seeking acquisitions at a discount. Accordingly, a well-marketed distressed company would have a reasonable prospect of accomplishing a sale in Chapter 11.

There is usually some systemic lag between the beginning of an economic downturn and the first wave of bankruptcy filings. It is also fair to say that not all distressed M&A sales are going to be successful. However, the expectation of successful distressed deals that has been a byproduct of the significant increase in Chapter 11 filings has been called into serious question by a recent flurry of failed sales processes where a frozen credit market has stifled distressed M&A transactions. Whether this is primarily a function of a shrinkage in the pool of prospective financial and strategic bidders with the financial wherewithal to close a distressed deal, given the lack of financing, or a general retrenchment in deal-making in a highly uncertain market for other reasons is largely beyond the scope of this article. Nevertheless, it seems clear to us that the ground rules for distressed M&A have shifted dramatically.

Cases and Businesses Foundering

Most companies that plan to sell themselves in Chapter 11, like their counterparts in a non-bankruptcy setting, start with an auction process. The difference between being in and out of court is that the distressed auction process is subject to court-ordered bidding procedures. In some cases, debtors select a stalking horse bidder and afford them certain negotiated bid protections. Even with a committed stalking horse bidder, however, bankruptcy sales processes can abort, for example, after a failure to obtain a qualified bidder or when a stalking horse bidder’s closing conditions cannot be satisfied.

In some recent bankruptcy settings, attempts to sell the debtor’s assets have been abandoned altogether and the assets liquidated under either a liquidating plan or by a Chapter 7 trustee after the case is converted. The confluence of a tight credit market, depressed real estate values and lagging consumer confidence have hit the retail sector particularly hard, producing a significant number of companies seeking Chapter 11 protection. Recent casualties in the retail sector include household names such as Circuit City, Sharper Image, KB Toys, and Linens ’n Things— companies which, in past down economic cycles, would have generated—and, in fact, did generate—substantial interest from the private investment community but which, in this economic environment, failed to sell as going concerns and have been relegated to liquidation and dissolution.

The saga of Circuit City, once the nation’s No. 2 consumer electronics retailer, illustrates well the current state of distressed M&A. On Nov. 10, 2008, Circuit City Stores Inc. filed for Chapter 11 bankruptcy protection, disclosing that it had, as of Aug. 31, 2008, $3.4 billion in assets and $2.32 billion in liabilities. The company entered into Chapter 11 with the stated goal of selling itself as a going concern. In pursuit of this objective, it successfully petitioned the bankruptcy court to approve its proposed expedited auction process, and obtained Jan. 16, 2009, as the bid deadline.

Three bidders participated in the process. However, it was noted that “[t]ight credit had limited retailers’ ability to reorganize,” and that “[n]o major retailers that have filed for creditor protection since January 2008 have remained in operation.” On Jan. 16, Circuit City notified the court that the auction to sell itself as a going concern failed to produce any bids, and indicated its intent to accept bids from goingout- of-business liquidators to dispose of its inventory in an orderly wind-down liquidation. Since then, the company has ceased operations and engaged in widespread liquidation sales of its inventory, leases and office equipment.

Retail is, of course, not the only sector to be hit hard by the economic crisis and the absence of a healthy financing market. Blue Water Automotive Systems Inc. (“Blue Water”) is another cautionary tale of an auction process gone awry. BWAS was a substantial supplier of plastic components and assemblies to industrial concerns, particularly those in the automotive sector, including Ford, GM and Chrysler. On Feb. 12, 2008, the company filed for Chapter 11 bankruptcy protection in Michigan with the intention of conducting an auction process for the sale of its assets. Consistent with this objective, it obtained a stalking horse bidder, NYX Inc., a parts makers in the automotive sector, which offered to purchase it for $28 million. An auction was scheduled for July 27, 2008. The sale process got off to a bad start when NYX withdrew from the bidding before the scheduled auction took place. Another bidder, automotive parts maker Flex-NGate LLC, offered $22.4 million, but that bid was rejected by Blue Water because Blue Water’s largest secured creditors objected to the price. On July 15, 2008, less than two weeks before the auction was scheduled to take place, Ford Motor Co., Blue Water’s largest customer and the primary sponsor of the auction and sale plan, withdrew its support. Left with no viable alternatives, Blue Water obtained confirmation of a liquidating plan of reorganization to sell off the company piecemeal.

What Role Can Private Equity Play?

While private equity firms have been no less impacted upon by the credit crisis than have any other financial or strategic acquirers, we are seeing private equity firms, particularly those with flexible investment strategies, implement less orthodox financing and acquisition plans in an effort to increase returns on their existing distressed private equity investments and/or to simply deploy capital and “get back in the game.” Among others, Sun Capital Partners Inc. (“Sun”), Irving Place Capital Management LP (“Irving Place”) and Oaktree Capital Management LP (“Oak Tree”), prominent hedge funds and private equity funds, have each recently implemented clever, but slightly different, investment strategies that have become popular ways for private equity firms to exert significant influence over the future of distressed companies and to deploy capital in a difficult environment.  

Fluid Routing Solutions (Sun)

Fluid Routing Solutions Inc. (“FRS”), a designer and manufacturer of fuel management systems, fluid handling systems and hose extrusion products, was a portfolio company of Sun that, on Feb. 6, 2009, filed for protection under Chapter 11 of the Bankruptcy Code, having fallen victim to the downturn in the global economy, a steep decline in sales in the automotive industry and its own excessive cost structure. In addition to owning a controlling interest in the equity of FRS, Sun had, prior to the filing, also made a $10 million senior subordinated loan to FRS (subordinated to FRS’s approximately $4.23 million in senior secured debt).

As it likely became clear to Sun that FRS could not, in the current environment, meet its continuing obligations and presumably as part of Sun’s strategy to seek some return on its prior debt and equity investments, Sun, at the same time as the Chapter 11 filings, agreed not only to provide FRS with debtor-in-possession funding during the pendency of its proceedings but also to serve as a stalking horse bidder for the company’s hose extrusion operations, fuel hose assembly and power steering services business in a Section 363 asset sale transaction. Sun agreed to pay $11 million for these assets through a credit bid of their DIP obligations (and cash if the purchase price exceeded the DIP loan), subject to any higher or better offers that might come along in a bankruptcycourt sanctioned auction for the assets. Ultimately, the auction produced no other qualified bids and the transaction promptly closed despite a number of objections to the sale process lodged by FRS creditors.

In so doing, Sun afforded itself the opportunity to own the only part of the FRS business that FRS has claimed in court filings to be viable, streamlined due to the stripping of substantially all liabilities and unprofitable contracts as part of the 363 sale process for what is likely an attractive price. Alternatively, it may well be that Sun did not desire ultimately to own this business again—even the slimmed-down version— but stepped in as stalking horse to generate interest in the business at a premium to Sun’s bid sufficient to not only pay off any of its DIP loans, but to potentially achieve some level of return on its pre-petition secured debt and, albeit unlikely, its equity position. In either case, through its participation as a DIP lender and stalking horse bidder—not traditional roles for private equity players, although one in which Sun does have experience—Sun has created multiple avenues to recover on its original investment with presumably limited risk as a super-senior secured DIP lender.

Chesapeake Corporation (Irving Place, Oaktree)

Unlike the relationship between Sun and FRS, the acquiring private equity funds in the Chapter 11 case of Chesapeake Corporation, a packaging company, did not own any of the equity of Chesapeake prior to the commencement of the Chapter 11 case in December 2008. Irving Place and Oaktree, however, had acquired some portion of Chesapeake’s notes and were members of an ad hoc committee of note holders that had engaged in workout discussions with the company pre-bankruptcy. The two funds joined forces to propose a stalking horse bid for an asset sale to be completed as a sale under Section 363 of the Bankruptcy Code. On Jan. 20, 2009, the bankruptcy court, over the objection of the creditors committee, approved the bidding procedures, which included a $16 million breakup fee, minimum overbid requirements and other protective provisions. On March 17, 2009, after receiving no competing bids, Chesapeake declared the funds to be the successful bidder and, on March 23, 2009, the court approved the sale. The committee complained of the restrictive time frame, claiming that the terms of the DIP (which was filed under seal) mandated an expedited process designed to ensure the success of the stalking horse bid. The funds’ pre-petition investment in Chesapeake’s distressed securities, which, in turn, yielded their seats on the ad hoc committee, undoubtedly had some significant influence on the auction process result.  

Conclusion  

The current economic malaise, the fear that the “bottom” has yet to be found, and the absence of meaningful third party financing alternatives has made traditional private equity leveraged buyout activity scarce. The general consensus, however, is that there are compelling investment opportunities for the careful and creative private equity investor to obtain valuable businesses at severely depressed prices if they are willing to step out of their normal investment program and into the distressed investment world. While the large-cap victims of the economy may not be good candidates for credit-bidding and other novel “loan to own” investment strategies due to the need for third-party financing to operate the business, the strategy it employed in FRS and Chesapeake may be the wave in private equity investing for the foreseeable future.