Article Daily Bankruptcy Review

Amid Turmoil, Opportunity Awaits In Debt-To-Equity Conversions

The current economy and capital markets are in turmoil. Increasing oil and food prices, the bursting of the real estate bubble, the subprime disaster and its cascading effect on financial institutions, a weak dollar and rising unemployment are creating challenges for consumers and corporations alike.

The impact on the credit markets has created a liquidity crisis for a large number of corporations that were able to survive with steeply leveraged balance sheets by tapping into the pre-summer of 2007 robust credit markets.

Now, with financial institutions unwilling to make loans as they attempt to fix their own balance sheets, companies in financial distress are vulnerable. The traditional lending sources for distressed corporations are refusing to increase their exposure or provide new financing.

Distressed companies are seeking partners with capital to enable them to fix their operations and emerge from a restructuring -- either in-court or out -- with strong balance sheets. The paralysis of traditional lenders creates an opportunity for cash-rich investors to purchase good companies cheaply. This opportunity is manna from heaven for private equity funds experienced in investing in distressed companies.

The current credit crisis is also changing the Chapter 11 landscape. It was axiomatic that a company in distress could secure a so-called debtor-in-possession, or DIP, loan. DIP lenders are given first liens on a borrower's assets – senior to existing debt holders – and provided with a super-priority, administrative claim in the borrower's Chapter 11 case.

This means DIP lenders are paid before any other stakeholder, with the sole exception of the estates' professionals. In other words, if the company's assets can be liquidated for more than the amount of the DIP loan, the DIP lender will get paid in full.

As large financial institutions that typically provided DIP financing look to shed assets and make fewer loans, many distressed companies are finding it difficult to obtain DIP financing from traditional sources. Without access to the DIP loan market, distressed companies are struggling to fix their capital structures and operate without interruption in Chapter 11.

But with change comes opportunity, and that opportunity comes in the form of private equity funds investing in distressed companies.

Distressed private equity funds purchase debt in troubled companies with the aim of converting the debt to equity and controlling the companies after they emerge from Chapter 11. While by no means new, these investments are gaining popularity as experienced investors see the opportunity to buy good companies saddled with bad balance sheets by shedding excess leverage through Chapter 11.

This type of investment is not only an opportunity for private equity funds, but also an opportunity for distressed companies looking for a partner with deep pockets to help lead them to the Promised Land -- emergence from Chapter 11 as a stand-alone corporation.

The typical private equity deal is a leveraged buyout. In its simplest form, an LBO involves the acquisition of a company through a combination of equity (cash invested by the private equity fund) and debt (cash borrowed on a secured basis by the target company).

The equity investment and the leveraged loan close simultaneously and are dependent on each other.

In a debt-to-equity conversion transaction, the purchase of debt is paid for by the private equity fund without a commitment for a secured credit facility. The goal of the private equity fund is that upon the conversion of debt to equity, the target company will obtain exit financing.

While these two types of transactions at conclusion look the same, the debt-to-equity transaction is more risky as the bet must be placed before the exit loan is obtained. With this additional risk, however, comes the potential for additional reward.

Distressed investing is not for the faint of heart. Acquiring a bankrupt company through debt purchases in a Chapter 11 case is a complex process, and a complete understanding of this process is critical to success.

Distressed investing may be divided into two stages: the investment stage and the execution stage.

The investment stage begins with what many private equity funds do best -- identifying undervalued companies and assessing what those companies can become with the right balance sheets and operations. However, as noted above, in a typical private equity transaction, the fund does not commit funds until the deal closes.

Not so in a debt-to-equity investment. The private equity fund analyzes the capital structure and makes a determination on which debt, securities or claims to purchase to provide it with the best opportunity to gain control the company. This analysis is complex, requiring a keen understanding of the capital structure, the actual amount of claims at each priority level in the capital structure, litigation risks and the ability to develop a plan of reorganization that will be supported by the requisite classes of stakeholders.

Adding to the complexity is the need to "partner up" with the company and potentially other constituents in the Chapter 11 case, as there will likely be competition from other funds and investors focusing on the same goal or attempting to make money by using litigation and other tactics to delay the Chapter 11 process at the expense of the company and the private equity fund.

At the culmination of the investment stage, the private equity fund must invest its funds before it knows whether it will end up with control. If the fund miscalculates, its investment could be tied up and, at the end of the process, it may simply get a distribution under a confirmed Chapter 11 plan, rather than the ownership stake it desired. That distribution could be less money than the fund invested. This risk makes the execution stage so critical.

The execution stage is about planning, process, negotiation and the courage of one's convictions. In general, the strategy of the private equity fund is for the company to emerge from Chapter 11 with a fixed balance sheet as quickly as practicable. In many situations, the preferred route is a pre-packaged or pre-arranged Chapter 11. In either of these situations, the deal is negotiated out of court and supported by the requisite stakeholders to confirm a plan of reorganization shortly after a Chapter 11 case is commenced.

A pre-packaged Chapter 11 plan is one where the votes on the plan are solicited prior to the Chapter 11 case and the requisite votes are obtained to confirm the plan. The company then commences a Chapter 11 case and the court confirms the plan. A prearranged plan is one where the deal is negotiated and supported by at least one non-insider, impaired class, but the solicitation of votes is accomplished in Chapter 11.

In both situations, if done correctly, the Chapter 11 case is efficient, expeditious and cost-effective, with minimal disruption to the company's operations, employees, suppliers, customers and other stakeholders.

Not all companies, however, have the luxury of time or the cooperation of stakeholders to achieve a pre-packaged or pre-arranged plan. Accordingly, the company will commence a Chapter 11 case without a deal in place – a so-called freefall bankruptcy -- and the entire Chapter 11 process will play out in court. In this situation, a debtor will commence a Chapter 11 case, review and analyze its business operations to determine which assets, contracts and leases to retain, develop a plan of reorganization, solicit votes on the plan, confirm the plan, secure an exit facility and emerge from Chapter 11.

This process is never simple and is always strife with posturing, threats, litigation, uncertainty and delays. Each step requires intricate, complex and, often times, contentious negotiations, deal-making and litigation. As a result, the private equity fund investing in distressed companies needs to develop sound tactics to achieve its desired strategy.

The development of appropriate tactics and the flexibility to change if those tactics don't work is critical. To develop proper tactics, a private equity fund needs to understand the legal issues that will arise and the strengths and weaknesses of its legal positions. The private equity fund also needs to work constructively with the debtor as the debtor will be leading the Chapter 11 process and has the protections of the automatic stay and the exclusive right to file a plan of reorganization.

Moreover, the private equity fund and the debtor need to communicate with the bankruptcy court and the stakeholders to build credibility and a constructive working relationship.

Credibility is key, as the process is iterative and, even if litigation breaks out, the fund's adversaries ultimately need to be able to trust the fund and the debtor for a deal to occur.

Once the investment stage is complete, the private equity fund needs to think like a debtor, act a debtor and talk like a debtor. This means building relationships with friendly stakeholders and isolating or forcing recalcitrant stakeholders to accept the ultimate plan of reorganization. This process is both delicate and aggressive, and requires patience, strong negotiating skills, expertise in bankruptcy law, predictive ability, creativity, flexibility and the constitution to engage in a good old-fashioned street fight when necessary.

Debt-to-equity control investments are an acquired taste. To succeed, the private equity fund needs to be more than a number cruncher, more than an expert in identifying underperforming companies, and more than talented for helping companies operate more leanly and profitably. To succeed, the private equity fund needs to understand the Chapter 11 process, needs to be able to build relationships and be patient, needs to have an expertise in the intricacies of the Bankruptcy Code and needs to be able to think many moves ahead in a proverbial, highly complex game of three-dimensional chess while dissenters jeer, threaten, coerce and attempt to pillage.

If successful, the private equity fund will own a company that has sold non-core assets, shed over-market leases and contracts, reduced its long-term debt obligations and streamlined its operations. For those willing to take the risk and enter the fray well-armed, the reward can be great and the process fulfilling.

REPRINTED WITH PERMISSION FROM THE JULY 14, 2008 EDITION OF DAILY BANKRUPTCY REVIEW © 2008 DOW JONES NEWSLETTERS. ALL RIGHTS RESERVED. FURTHER DUPLICATION WITHOUT PERMISSION IS PROHIBITED