Bad News Is Good News: 'Distressed for Control' InvestingPublished: April 26, 2006 in Knowledge@Wharton
Michael Psaros, co-founder of the $600 million KPS Special Situations Funds, expects good times to get even better for his investment firm. So does David Matlin, co-founder of MatlinPatterson Global Advisers LLC, a private equity firm that manages nearly $4 billion. Both operate in the still relatively fledgling arena of 'distressed for control' investing, a growing industry that combines elements of both private equity and hedge funds.
Simply put, their line of work is to make a profit from companies that have failed to do so and are on the brink of bankruptcy. Unlike traditional hedge funds, however, their investment doesn't stop at buying significant portions of these companies' debt for pennies on the dollar, tidying up the balance sheet and then selling at a higher price. Instead, KPS and MatlinPatterson get in and stay in -- bringing in new managers, installing a new strategy, renegotiating labor and supplier contracts, and so on. (That's the 'control' part.) It's not an easy task, especially given the state of these companies when they step in.
But bad news for others is the lifeblood of KPS and MatlinPatterson, and both Psaros and Matlin expect a growing wave of it. The reason is an upswing in second-lien loans, which hedge funds -- flush with cash to invest -- have made their specialty in recent years. Essentially, hedge funds are providing financing to prop up troubled companies that nobody else is willing to provide. Traditionally, hedge fund money is not patient money, and Psaros and Matlin are betting that, soon, these funds will lose their patience.
Hulya Eraslan, professor of finance at Wharton, agrees with that assessment. "After the 2000 bubble burst, there were a large number of bankruptcies that opened up room for investing opportunities, and more players came in. Now, there is a rise in second-lien loans. . . . A second wave of bankruptcies is coming, because the debt out there is beyond the capacity of companies to pay back," she says, adding that 2006-2007 could be the "critical" time frame for a shakeout.
Psaros says he and his partners are excited about the prospects. "A confluence of trends will lead to an extraordinary market for firms like us over the next 12 to 36 months." He lists the factors: "[Buyout] firms are paying exorbitant prices for companies today. Pedestrian manufacturing companies are getting bought for 6 to 8 times EBITDA, or cash flow, when the normal level is 5 times. Also, firms are levering against that cash flow for buyouts.
In fact, the first quarter of 2006 has already seen "U.S.-based private equity firms complete at least 225 control-stake transactions for a disclosed total of approximately $42 billion," according to the April 3 issue of Buyout. At that pace, the newsletter notes, 2006 is shaping up exactly like 2005, which was a record-breaking year for these transactions.
"The high-yield market has been on fire for the last three years," Psaros adds. "If you look at a regression analysis, three years after a good high-yield market there is an echo boom in bankruptcies."
Matlin is more circumspect, but reaches the same conclusion. "It's hard to predict the end of the world, but I think there is a lot of leverage building up in the system again." The positions hedge funds have taken in distressed companies through second liens probably have delayed bankruptcies, but not averted them, he believes. By the end of 2007, he expects a repeat of the 2002 flight of hedge funds from the distressed sector.
Psaros explains how the second lien works. "If someone needs to borrow $100 million to buy a company that has $20 million in cash flow, they would lever to five times cash flow. A traditional bank like JP Morgan would give you $60 million. The rest comes from a second lien, usually from a hedge fund. Previously it came from mezzanine lenders or the high-yield market. Now the hedge funds are filling this void for what I believe are excessive levels of leverage," he says.
Psaros expects private equity firms such as KPS to be in good position to catch the falling deals when the hedge funds let go of them. "The guys providing this capital are traders. When these companies get into trouble -- and they will, because the economy will slow down, or buyers will have paid too much -- they don't have a mindset to work out the problems of the company. They are traders by nature and will seek to trade out of the problem. And when they do, there will be few buyers."
That's when firms like KPS and MatlinPatterson enter the picture. For example, in September 2005, in a prearranged bankruptcy transaction, KPS purchased the assets of Jernberg Industries Inc., a maker of automotive power-train parts. In 57 days, Psaros recalls, KPS "negotiated 37 contracts, including 12 with large customers such as Visteon, General Motors and Harley-Davidson; we negotiated new bank agreements, 15 capital leases, and three collective bargaining agreements." During that time, KPS also negotiated five new contracts with key vendors and recruited a new chief executive officer, a new chief operating officer and a new chief financial officer.
KPS accomplished this through a newly created holding company, and -- as it always tries to do -- purchased assets free of all liabilities. The company's operations have been profitable from the first month of KPS' ownership, Psaros says, though he will not reveal financial data for the closely held company.
Wanted: Bad Management
Unlike hedge funds and some other private equity firms that operate in the same area, Psaros says that KPS doesn't try to create value "by playing with capital structures. We believe true value is created by recreating businesses."
Most private equity funds "look for a great company with a great management team" with its own business plan, he notes. The private equity fund then tries to decide how much to invest in and leverage that company.
"We are completely different. We are looking for a great set of assets or a great company that has ended up in extremis through bad management, or terrible cost structure, poor strategy, bad collective bargaining agreements and usually excessive leverage," he says. Then his firm goes in with a business plan it has developed and brings in a management team to execute its own vision. Unlike the typical middle-market leveraged buyout firm, "we de-leverage the company," he adds.
Along the way, KPS has acquired the reputation of being a fund that is unusually sensitive to labor unions. Psaros credits unions for providing KPS with a significant part of its deal flow, and he calls them "a critical constituency in turning around a company."
A Tangled Thicket
Matlin says distressed for control investing "can be a dangerous game if you don't know what you are doing." He notes that practitioners have to juggle three balls -- "a bankruptcy ball, a process ball and a company in free fall." The rescuers must have the ability not only to bring in new capital and management, but also a new strategy for growing the business, he adds.
Those who are successful have a thorough knowledge of the legal rules, Wharton's Eraslan says. "They can maneuver well within the bankruptcy law." Their names are well known to the other players, though competition has grown. "If a bank wants to sell its claim against a firm, they will call Oaktree, for example," she says, referring to Oaktree Capital Management, a high-profile name in the distressed-investing industry whose $30 billion in assets under management include $2.5 billion in controlling positions.
David K. Musto, professor of finance at the Wharton School, agrees that a distressed investor must negotiate a tangled legal and financial thicket to make money.
"You get bargaining power over a distressed firm by purchasing its debt," Musto says. Typically, a bankruptcy plan groups classes of creditors by similarity of claims. For instance, all banks would belong to one class, and all senior secured bonds in another, and all senior unsecured bonds in yet another, and all trade creditors would be a separate group. Because Chapter 11 reorganization proceedings hinge on their approval by each "class" of creditor, investors in distressed debt aim to buy enough of a class of credit to influence the outcome.
"If you own more than a third of a class of debt then you can make it difficult for debtors to confirm the bankruptcy plan they want because they need two-thirds approval of each class of debt," Musto says. "If [the debtor] doesn't get two-thirds approval then he can potentially get the judge to cram it down the throats of the class that refused. That is much harder to do than just to get the class to approve it." The debtor can also try to shape classes in ways that would dilute the creditors' clout, he adds.
The bottom line, Musto says, is that investors in distressed debt who acquire blocking positions gain negotiating power and get more favorable settlements as companies emerge from bankruptcy. It's also a key path to control for such investors as the debt they have acquired often is exchanged for equity in the company.
The process has been so fine-tuned since the 1990s, says Musto's colleague Eraslan, that very often distressed companies now come up with "prepackaged bankruptcy plans" that have the prior blessing of all participants. This practice has grown essentially as a way to get over a huge hurdle presented by the U.S. Trust Indenture Act, Eraslan notes. According to that law, "if a company wants to change the maturity, principal and interest on a bond, each and every bondholder must agree, so it is essentially impossible," she says.
The law was passed in the late 1970s; it took the players a decade or so to learn the game, Eraslan adds. Now in many cases, most negotiations are held outside bankruptcy proceedings and prior to a Chapter 11 bankruptcy reorganization filing. This process gives comfort to investors such as KPS which seek to minimize their risk of acquiring the distressed company's liabilities along with their acquisition of its assets. Existing labor contracts and loans and vendor deals often are revised long before such investment firms commit themselves to acquiring the company's distressed debt.
Speaking at a Wharton Private Equity Partners conference in New York last year, Matlin noted that there has been "a sea change" in the distressed-investment climate in recent years as larger pools of money have come into the space.
"The whole community has grown up and become a lot more sophisticated, not just investors but also the body of professionals who surround them, like turnaround management teams, specialized bankruptcy counsel, auditors -- the whole professional swath that follow distressed investing. That has made it a lot easier for people who maybe did not have as much experience in the business to get involved, investors as well as sellers of these securities, such as mutual funds and bank workout departments," he said.
But smarter as all the players may have gotten, that does not guarantee success for a distressed deal.
A few years ago KPS created Republic Engineered Products L.L.C., a company that took over from bankrupt Republic Steel. The turnaround was going well, Psaros says. The predecessor company had 15 plants and 4,000 employees manufacturing about one million tons of steel. About six months into the transaction, the company was down to six plants and 2,200 employees but was making about 20 percent more steel, he says. "Things were going great. We had a superb CEO and model collective bargaining agreements and built a new finishing plant. The restructuring had gone very well," he says.
Then the lights went out -- literally. And it was a disaster. A multi-state blackout on August 14, 2003, caused a blast furnace to blow up at one of Republic's facilities, in Lorain, Ohio. No one was hurt, but the company urgently needed $5 million to $10 million to bring the critically essential blast furnace back on line. The bank refused a loan, Psaros says. Six weeks later, the company filed for bankruptcy. Investors lost $42 million.