Finding a Back-Door Solution to M&A
As the credit markets wallow, dealmakers with an appetite for distress are expected to seek out acquisitions through a company’s debt.
June 19, 2008
Traditional acquirers may see it as a back-door method of gaining control, but as the debt markets continue to wallow, buyers may increasingly turn to loan-to-own strategies as a way to wrest control of troubled companies.
It’s not necessarily a new phenomenon. In the beginning of the decade groups such as Oaktree Capital regularly acquired businesses by first accumulating positions in a company’s debt. Oaktree’s buyout of Regal Cinemas in 2001, for instance, was cinched through stockpiling significant stakes in the company’s bank loans and junk bonds.
So how popular is the loan-to-own strategy today? It can be difficult to quantify, exactly, although HIG Capital recently capped off its latest distressed debt fund at $3 billion, signaling that institutional interest certainly exists. The fund exceeded its $2 billion target, and corralled more than six times the amount HIG was able to collect for its predecessor Bayside Capital debt fund in 2004.
While the fund is not exclusively dedicated to loan-to-own strategies, Bayside managing director John Bolduc notes that the receptiveness investors exhibited displays a heightened interest in the opportunity.
"Given the broader economic circumstances going on," Bolduc says, "it creates a very good backdrop for distressed investment."
Josh Harris, a founding partner of Apollo Management, reportedly told an audience at the SuperReturn conference in early June that his firm has been regularly pursuing these types of investments. “You can buy chunks of bank debt, buy chunks of bonds, work the company through the restructuring process, de-leverage these companies and end up with appropriate capital structures,” Thomson Reuters quoted Harris as succinctly describing.
It’s not just buyer creativity that is spawning loan-to-own strategies. Changes in the bankruptcy law in 2005 are also helping to facilitate dealmaking among distressed businesses, as opposed to a restructuring that doesn’t involve a change of control. According to Arthur Perkins, a director at Deloitte Financial Advisory Services and president of the Turnaround Management Association, the new bankruptcy code makes it more difficult for companies to be granted extensions and exclusivity to remedy their ailing books.
"That's the difference between this downturn and other downturns," he describes. "There's going to be more sales [and] fewer reorganizations."
In addition to HIG’s Bayside fund, a number of new distressed vehicles are also either in the works or have already been closed. Angelo, Gordon & Co. secured $2 billion for its fourth AG Capital Recovery Partners Fund, while Oaktree Capital Management pulled in $10.9 billion for its OCM VII B distressed vehicle.
Meanwhile, Perkins notes that he is currently working on a new fund that will utilize a loan-to-own strategy, although he declined to identify the manager of the vehicle as the fund has not yet closed. Craig Godshall, a partner at law firm Dechert LLP, confirms that he too is working with groups looking to become more aggressive investing on the debt side of the capital structure.
"I don't think you've yet seen the real fallout from the credit crunch," Godshall warns.
Part of the interest in loan-to-own strategies stems from the difficulty finding and closing deals using traditional means. Without a robust debt market, PE firms are having trouble arriving at bids that reach seller expectations, which haven’t come down to the extent investors had hoped.
“It’s been hard to do deals since last August,” Jeffrey Schwartz, also a partner with Dechert, says.
The loan-to-own strategy, however, allows investors to take advantage of the dislocation. And if a position in a company’s debt doesn’t translate into a control stake, investors will often make out with a small profit for their efforts, should another suitor come through with a topping bid.
Jeffrey R. Manning, a managing director in the special situations practice at Trenwith Securities LLC, says he would prefer a distressed M&A situation over an ordinary deal.
"Buying is a lot cheaper," Manning says. And he estimates that there are about 2,000 companies, largely mid-market situations, with loans that would now be characterized as poorly structured and ripe for restructuring. Manning notes that as many as 80% of these businesses could become targets for debt investors with an eye toward ownership.
He cites that opportunities already abound in areas such as housing, building materials, and retail, and Manning anticipates that it won’t be long before investors start targeting financial institutions and mid-market banks.
One recent deal observers have taken note of was the acquisition of Movie Gallery. Hedge fund Sopris Capital Advisors had accumulated a position in the company’s second lien debt and used that, along with additional exit financing, to gain a control stake in the company’s equity after Movie Gallery emerged from bankruptcy protection in May.
Still, Perkins notes that while it’s a trading mentality that can spot value in a company’s debt, it’s an operations focus that should drive these decisions. “You have to look carefully at the business,” he says noting that buyers should be ready to own these companies for the long haul.
"You had better be assuming you're going to have to hold onto it for awhile," he adds.
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