The arrival of private equity and hedge funds into the US restructuring and insolvency markets is last year’s news. How these funds are transforming the restructuring markets in the United States and exporting these transformations to Europe is what’s of interest now. Keen on making higher and higher profits in a low interest rate environment, funds are directing vast amounts of their liquidity into purchasing and trading distressed bond debt, bank debt and trade debt in restructurings and in insolvency proceedings in the United States.
With so much liquidity in the United States, investors are directing the overflow to Europe. Insolvency schemes, whether in the United States or in Europe, were not intended to provide a speculative market for profiteering, so just as private equity and hedge funds are changing the way companies restructure under formal insolvency proceedings, these proceedings are changing how funds invest and operate. This is most apparent in the blurring of the distinctions between traditional lenders, private equity funds and hedge funds.
Tradition in Transition
Traditionally, the secured lender financed a company’s debt, seeking a negotiated return over the life of the loan, private equity firms invested in equity, seeking to increase the value of that equity in the long term. Hedge funds invested in secured debt, unsecured debt or equity, seeking extraordinary returns. As a result, hedge fund activities in distressed debt markets were limited to trading liquid debt securities that were depressed by the threat of or actual insolvency. Private equity funds, focused on financially distressed companies in need of restructuring by acquiring large amounts of debt in the hopes of massaging the restructuring process or renegotiating the company’s indebtedness out of formal proceedings.
With the inflow of money to investment funds and the need to use that cash to feed the increasing appetite of investors for greater returns, funds are taking a broader view of investments and a more active role in restructurings. Indeed, many funds are investing far earlier in the process to “lock up” a company and preclude investment by other funds. With this increase of buyers in the market looking to purchase bank debt, banks are now often simply selling at discount to avoid the cost and time involved in a restructuring. Hedge funds and private equity funds are slipping into a new role in the process, altering the landscape of the traditional restructuring or insolvency.
Many funds are now appearing as leading members on creditors’ committees, often sitting in the secured lender’s seat through the purchase of bank debt or through the making of strategic debtor in possession loans.
In 1991, the US secondary loan market was trading debt at par at a volume of US$3.6 billion and distressed debt at a volume of US$4.40 billion (Source: Reuters LPC Traders Survey). In 2005, this volume jumped to US$135.52 billion of par debt and US$40.82 billion of distressed debt with the most significant gains accruing since 2000. The 2006 numbers are on a similar scale with first quarter volumes of US$43.94 billion of par debt and US$11.76 billion of distressed debt trading hands. In Europe, the secondary loan market has seen similar growth.
The European distressed debt market is not as transparent as the US market. Until the recent revisions of national insolvency laws away from “private clubs” towards transparency, as in the United Kingdom and Italy, high levels of distressed debt remained outstanding with no formal restructuring schemes available (as opposed to liquidation). Insolvency proceedings were therefore avoided at all costs.
The Loan Syndications and Trading Association (LSTA) in the United States and the Loan Market Association (LMA) in Europe can take partial credit for fostering this growth. This is because of their promulgation of a standardised documentation and market practice guides for use in the origination and trading of syndicated loans in the primary and secondary markets.
In the United States, insolvency proceedings are conducted under the US Bankruptcy Code. Chapter 11 of the Code is the predominant scheme for dealing with insolvent or financially troubled businesses. Insolvency petitions can be made voluntarily or involuntarily. By filing an insolvency petition, the bankruptcy estate is created.
The “property of the estate” includes all property of the debtor wherever located and by whomever held. This is significant as such property is protected from creditors by an automatic stay. The most significant change in the United Kingdom, the adoption of the Enterprise Act in 2002, replaced administrative receivership (effectively liquidation) with a collective administration procedure, similar to the US approach. The Enterprise Act introduced an alternative out-ofcourt administration for the company and effectively abolished Administrative Receivership in all but limited circumstances. Additionally, the Enterprise Act allows for a Company Voluntary Arrangement, where the company and its creditors can negotiate under the supervision of an experienced insolvency practitioner.
These significant changes and trends are the primary drivers of US hedge funds into this market. Based on experience in the US insolvency markets, these funds have viable investment opportunities in the European markets to exploit their leverage, expertise and experience. However, as Europe’s financial markets remain primarily based on relationships, there remains friction in the interactions between US funds and European banks and investors.
Controlling or influencing an insolvency proceeding by sitting on a creditors’ committee or holding secured debt brings substantial leverage but also responsibility. Committees and debt holders may be privy to financial information, takeover offers, earnings announcements and other developments that affect the debtor’s value prior to public disclosure. Funds will therefore have to institute blocking systems to prevent inside information from being disseminated to their trading divisions or be precluded from trading in these assets. This type of information can preclude the purchase of public debt at a time when a fund might want to increase its position to better control the debtor.
Other aspects of risk involve fiduciary obligations to other creditors and the necessity of separating the management of different levels of claims. While administrative perils exist due to conflicts, the greater threat is the subordination of a superior claim as a result of wrongful or simply injudicious conduct. Thus, while profits in trading and managing these claims may be considerable, the risks are also substantial.
Insolvency systems exist to promote the effective reorganisation of companies that can return to profitability and to provide an orderly liquidation for those that cannot. In contrast, investment funds exist to create profits for their fund investors. While these goals are not necessarily mutually exclusive, these divergent interests can cause substantial friction in an insolvency. The influx of hedge fund and private equity money into the restructuring arena, both in the United States and in Europe, is having a profound effect on the manner in which claims are traded and restructurings proceed. It provides an exit strategy for incumbent institutions, liquidity for debtors and an opportunity for the yields funds require, but it also adds levels of complexity to an already complicated process. An awareness of the disparate agendas of the constituents, along with an understanding of the substantial regulation in the restructuring and insolvency process, is paramount to success.