'True Turnaround Specialists' Are Poised to Survive in Today's Challenging Private Equity MarketPublished: July 23, 2009 in Knowledge@Wharton
As the economy erodes and bankruptcies rise, private equity is turning away from traditional leveraged deals and toward investment in distressed companies, according to speakers at the 2009 Wharton Private Equity & Venture Capital Conference, "Multiplicity Without Rhythm: Investing in Chaotic Markets."
Private equity specialists in distressed businesses, speaking on a panel titled, "From Vultures to Saviors: How Distressed Investing Is Helping to Shape Tomorrow's Economy," said they expect a tidal wave of private equity deals made in 2006 and 2007 to go bad in the next few years. Given the number of opportunities and the lack of bankruptcy credit, many restructurings will occur outside of bankruptcy court and could result in swift liquidation. Kyle Cruz, managing director at Centerbridge Partners, explained that during the private equity boom, many deals were structured with loose covenants and too much debt.
John Caple, a principal at Bayside Capital, said the volume of impending credit defaults will make lenders more inclined to restructure deals outside of the bankruptcy courts, if only because it would be impossible to work through all of the court system's cases in a reasonable time frame. He said that if a lender has 20 companies in a distressed situation and 10 are making some payment, the bank may ask the private equity sponsors of those companies to put more into the deal rather than pursue the company in court. "It might not be the right thing to do," he said, "but it is the right thing to do given everything else they have to do."
Panel moderator David Gerson, a partner at the global law firm Morgan Lewis, asked how distressed deals differ from traditional private equity transactions that are based on leverage and the promise of unlocking value through operational expertise.
Michael Psaros, managing director at KPS Capital Partners, pointed out that cash usually isn't available to leverage in distressed situations. Most of the companies that his firm looks at have managers who are "catastrophic failures" and need to be replaced with new leadership, or a chief restructuring officer, to begin to create value. "That's our world," said Psaros, who added that after 20 years in the corporate restructuring field he had never seen so few true competitors in the business. "That's because it is hard. It is as different from the traditional LBO model as you can imagine."
Cruz pointed out another reason why distressed transactions are often more difficult to structure: A company's debt is frequently controlled by many parties that may have their own agendas, and distressed times can place more pressure on agenda differences. For example, lenders holding the primary debt may be more inclined to hold out for a better price than those who took on debt in the secondary market and are looking for a quick way to monetize their investment.
'Top Lines Getting Crushed'
Gerson asked how the panelists begin to think about valuation, given that prices have been dropping "like a sharp knife." Cruz acknowledged that valuations are challenging because it is unclear where the market bottom is, and it is increasingly difficult to forecast the future.
Psaros agreed that the biggest problem facing the industry in 2009 and 2010 will be falling demand. He described how a senior debt lender invited his firm to look at a deal for an RV manufacturer. The company produced 1,000 units in 2008 but had no orders backlogged for the first quarter of 2009. "What keeps me up at night?" he asked. "It's this whole 'catching a falling-knife' concept. We're seeing top lines getting crushed like I've never seen before." No matter how much a private equity firm paid for a company, he said, or how the deal is structured or how well the company is run, with revenue declines like those at the RV company, it is impossible to make money for investors.
Another problem, according to Michael Fieldstone, a principal at Sun Capital Partners, is that vendors are no longer as willing to prop up their customers. For the last 18 months, he said, many companies have taken it for granted that vendors would extend generous credit terms to keep their own products flowing. As credit markets weakened and financial firms pulled back, eroding balance sheets prevented companies from continuing to provide cheap credit to customers. The liquidation of Circuit City, he said, is an example of a company that went under quickly primarily because vendors stopped supporting the business.
The panelists stressed that in today's environment, with little or no leverage available, a buyout's success depends on operational basics. According to Caple, obvious, easy-to-correct problems must be present to justify keeping a company afloat. "In distressed situations, you are finding businesses that are wildly under-promising and spending money in really silly ways."
Existing management is more likely to be replaced in a distressed situation than in a typical buyout deal where the company has positive earnings. Psaros said that before his firm takes on a distressed asset, it often installs a chief restructuring officer to ensure that honest and competent management is in place. He said his firm pulls from a network of individuals it can rely on for the job. KPS has a small, in-house "best practices" group, but appoints managers on a case-by-case basis. Fieldstone said his firm, too, has a pool of experienced former corporate executives that it draws on when a new management team is necessary. "This is a tough business. It's not for the fainthearted. This is complicated, and even more complicated with the liquidity crisis."
Psaros notes how, in many cases, a management change can drastically alter a company's prospects. "Sometimes all we have to do is change out a CEO and everybody below him just blossoms. On the other hand, we have literally had to fire everybody down to the shop floor level. Those two extremes are fascinating." He warned against buying into stereotypes about the management style of turnaround specialists. "Most people assume that the successful manager of a turnaround is a high-testosterone, chest-pounding professional. We have seen individuals with that kind of personality be successful, but we have also seen bookish, cerebral and methodical managers be equally successful. There's really no pattern." The key to managing a turnaround, he said, is to develop a plan and stick to it day by day, to ratchet up expectations. "Big-picture professionals have no place in a turnaround."
Obstacles to Exits
Even if a company can be restructured successfully, private equity firms face enormous obstacles in exiting investments today, the panelists said. Caple explained that in private equity's boom years, investors could exit deals in just a couple of years. Now the time frame is more likely to be five years. "So we will see very few exits in the near future," he said, referring to deals completed shortly before the credit crunch. "The market to sell businesses is nonexistent."
In the beginning of 2008, Fieldstone noted, buyers from India, China and other Asian nations did allow for some private equity exits, but that was because the dollar was weak. Now, with a stronger dollar, at least for the moment, even that exit door is closed.
According to Cruz, the private equity market is in the early stages of the distress cycle after an explosion of buyouts that peaked in the summer of 2007. Activity fell to more rational levels in 2008, then ceased in mid-September of 2008, when Lehman Brothers filed for bankruptcy. "In this kind of macro-environment, by fall and for the next 12 to 24 months, you will see increasing true-distressed situations at companies that are coming back to lenders seeking relief," Cruz said. "We've seen some, but there is a lot more to come."
Karl Beinkampen, managing director at Morgan Stanley Alternative Investment Partners, predicted a bifurcation in the distressed market. He suggested that some buyers could handle deals for midsize firms when they run into trouble, but it isn't clear who would step in to take over the large companies that went private in the boom years and that may fail to meet loan covenants in 2012 and 2013.
The sharp economic downturn and tight credit markets are likely to lead to increased asset sales under Section 363 of the U.S. Bankruptcy Code. The panelists outlined strategies for acquiring distressed assets through bankruptcy. Sometimes it is best to take a "toehold" position in firms through debt to have more say in the firm's disposition, Caple said. Other times, it is best to stay on the sideline, especially as valuations fall fast. Psaros recommended basing strategy on the distressed company's capital structure. It is easier to do an out-of-court deal for a company with only one or two major lenders, he said. "If they have widely syndicated credit it is much harder to get together to do something out of court, especially in the environment today."
At the heart of the problem are the artificially high levels of credit and consumption in the last 24 months. "Much of what we have been using for historic reference was fundamentally flawed," Cruz noted. "We all wish we had a crystal ball, but all we can do is be extra conservative and wait."
While the downturn is likely to generate "extraordinary opportunity," private equity firms that, early in the crisis, stepped into purchasing corporate debt at "low valuations" in the secondary market "got killed" as valuations kept on falling, Caple said. It is hard for a private equity firm to go back into this market if it has been burned recently. "How do you step in and say, 'Now is the time.' I think it is, but it's a tough thing to say."
The industry's tone, added Psaros, has changed dramatically with the disappearance of young "cowboys" working at hedge funds who rushed in and bought companies or their debt with little due diligence and loads of leverage. "It was nuts what happened in 2006, 2007 and early 2008 with these hedge funds."
Longer Investment Horizons
Gerson asked the panelists to describe the future of private equity finance. Caple responded that future deals will be all-equity transactions with an investment horizon of five to eight years, not the recently common three to five years. Psaros added that debtor-in-possession financing now lasts only six months with an up-front fee, and sometimes an additional exit fee, which he said is a recent development.
Gerson wondered whether difficulty arranging debtor-in-possession financing to carry companies until they can restructure would result in increasing "fire sale" liquidations, while Caple pointed out that, despite the economic downturn's severity, lenders are not forcing as many companies into bankruptcy as might be expected because they know debtor-in-possession financing is hard to arrange. "Many banks are being extraordinarily patient now. It's better for them to hang out and hope it gets better." Even if the economy recovered in two to three years, he said, the distress cycle will take five to seven years to complete given the financial markets' weakness.
According to Fieldstone, the economic collapse may be good in the long run because it can clean out the overcapacity and inefficiencies that had been generated, "like a forest fire that needs to happen." Investors have to be especially careful about selecting companies this year and next, he added, but good companies should survive and reap big returns when the economy recovers because there is significant investment capital on the sideline.
"I'd be hard-pressed to say I'm excited about the recession," Beinkampen said. But in a Darwinian view, today's business climate will winnow out less-focused private equity firms, leaving greater opportunity for those that survive. "Private equity won't disappear because of the restructuring," he noted. "But there's going to be a lot fewer folks overall, and that will be good for the buyout business."