Distressed debt buyouts by Private Equity – A “New” Approach

Prequin is a provider of information on private equity, hedge funds, and venture capital, and they estimate that across the globe, Private Equity firms are sitting on $1 trillion dollars of “dry powder” -defined as commitments currently available to be called up and invested.  The tried and true private equity strategy of making  leveraged buyouts using huge debt-to-equity ratios seems a long way in the future. So how do these firms get back in the game?  Many large private equity firms have changed their focus from making equity-based investments to buying distressed debt at a discount as a way to take over desirable companies.

What’s new is that our recent conversations here in Chicago confirm that middle market firms are considering the approach too. These firms are looking for opportunities to buy solid companies with challenged balance sheets, and this is a way to do it at a discount.  There is no shortage of companies to look at - Standard & Poor’s expects the U.S. default rate on corporate debt to skyrocket this year to an all-time high of 13.9%. In December 2008, the default rate was 4.02%. It’s not just distressed debt that is available either. In some cases, banks and other lenders are willing to sell performing debt as well, as they make decisions on which industries and markets they want to concentrate their often tight capital reserves. 

On the face of it, this approach seems like a great way for savvy private equity firms to potentialy earn the strong returns they promised the investors of all that dry powder.  The debt buyout strategy is particularly promising if the PE group has the operating strength to quickly improve the companies they are acquiring.  Of course, there are huge inherent risks, and in a debt purchase situation investor/lenders seek seniority above all else.  According to the 2009 Debtwire Distressed Market Outlook, an overwhelming 78% of respondents considered first lien bank debt to be the instrument of choice for debt investors, while senior secured bonds came in second at 68%. 

The question today is whether the Chrysler bankruptcy has created new rules for the game. Creditors are arguing that the proposed reorganization sets a terrible precedent, with the rules about creditor preference suddenly looking flexible when the going gets tough. The Treasury has argued that looking after the company’s workers and suppliers disproportionately is the best way for Chrysler to survive in a non-liquidation scenario. In any event, it is certain that some secured creditors with first liens don’t feel so secure – or first in line anymore. It will also be interesting to observe whether companies with ties to the government and/or a strong unionized workforce will now become “radioactive” and unable to secure necessary financing in the future.  

It’s too early in the game to predict the final outcome, but our guess is that the Chrysler bankruptcy – and perhaps GM soon - are unique situations that are not going to change the rules for every debt holder. This is particularly true in the middle market.  Although private equity groups might think twice about getting involved in certain situations, there will be too much pressure to put all that money back to work. With the playbook having been altered – maybe forever – the opportunity to buy debt of solid companies at discounted prices seems to be too great to pass up.