The dicier end of the leveraged finance market is the obvious place to look for distressed debt: maybe it’s just too damned obvious. A number of distressed debt investors and advisers are turning away from it, reasoning that it offers inflated prices and limited value. And there is another, even bigger credit market in transition staring buyers in the face – the $13 trillion European bank loan market, the biggest credit market in the world.
“We have a large team of distressed analysts and they are all incredibly busy,” says Iain Burnett, “but not in the mainstream area of the over-stretched LBO gone wrong. Success in this market is all about the illiquid, private deal flow and we have a sales and sourcing team spending all day talking to hundreds of banks across Europe.”
Burnett, who is executive director and head distressed debt analyst at Morgan Stanley, relates a deal his firm did recently in the bank debt of Ploucquet Holdings, a 150-year-old family-owned German textile firm. It had taken on bank debt to fund a capital expenditure programme that had not performed to plan. “We got calls from a couple of bilateral lenders – this company didn’t even have syndicated loans, let alone LBO financing – to price the debt and then take them out, which we did.” Buying the debt at a discount to par did nothing to resolve the company’s distress, so Morgan Stanley engaged with management, devised a restructuring plan and proposed to other lenders that they either join it or sell out. Most chose to sell out rather than commit new money to a restructured company after having to forgive part of their old loans.
Morgan Stanley converted debt into equity, while also paying a sum to old equity, put in new money and partnered with a Munich-based private equity firm to put the business on a new footing. “It’s a classic hybrid distressed debt-private equity deal,” says Burnett. “It requires a considerable up-front effort.” He declines to say what the rate of return is on the investment, although it’s safe to guess it is in line with private equity returns.
Other distressed debt prop desks and special opportunity funds are seeking similar deals. “Three or four years ago there used to be 10 to 20 situations of interest to us and we analysed these on-the-run deals that were already there,” one portfolio manager told the Euromoney seminars distressed debt symposium in November. “Now there’s a dearth of those opportunities and because we don’t want to style drift into risk arbitrage or long/short equity, we must find our own deals, source them, fund them and structure them privately through friends and family. We’re looking at small deals in the $50 million to $200 million range.”
Investors must be careful, though, not to be seen to tip credits into crisis by providing new loans that only deepen their problems prior to an eventual restructuring and debt-for-equity exchange. “In Germany, if your strategy is ‘loan to own’, my advice is never admit that even to your advisers,” says a leading German insolvency lawyer helpfully.
Aside from distressed prop desks and dedicated investors, this private market can provide good fees to bank advisers. Traditionally, big lending banks worked on the side of fellow lenders in a distressed work-out. Now they do so little actual lending that they are seeking more work representing debtors.
This March, UBS was retained by Italian poultry company Arena to help restructure its debts following the bird-flu scare, which prompted a 50% decline in consumption of its products. It had bonds maturing on June 15 2006 that it could not pay. The deal turned out to be the first consensual bond restructuring in Italy in which a troubled debtor brought its creditors together to address the impending crisis and paid for their advisers. The company was able to convince its bondholders to exchange €135 million of notes falling due for a new bond worth A85 million plus shares and options. UBS was paid a fee as a percentage of the restructured amount. “If this type of consensual process had not been put in place, this company would have been facing insolvency proceedings,” says J Soren Reynertson, head of European Restructuring at UBS.
The European bank is building up its capabilities as an adviser to distressed creditors. “The European Restructuring team has grown significantly this year,” says Reynertson. “If there’s a line running from stressed companies with minor covenant problems all the way to distressed companies facing imminent liquidation, we want to deal with companies in the middle. One way to do that is to watch the secondary markets and work our private network of contacts. For example, if you hear of a bank suddenly off-loading loans at a discount to par, it’s time to pay the borrower a call.”