Chapter 7 Distressed Debt Investments

STEPHEN G. MOYER
President, Distressed Debt Alpha and Adjunct Professor, University of Southern California and
Pepperdine University

JOHN D. MARTIN
Carr P. Collins Chair of Finance, Baylor University

KEYWORDS: Private equity, distressed debt, Chapter 11, reorganizations.

ABSTRACT

As an asset class, distressed debt is largely a by-product of the expansion of leveraged buyout

transactions that create corporations with high debt levels that are more prone to financial

distress or default. PE firms have grown to be important participants in the sector. Unlike the

traditional buyout investment in which PE firms purchase a business by making a relatively

small equity investment and then borrowing the rest of the capital, in a distressed strategy the

investor purchases the firm’s distressed debt securities and then seeks to gain control by

converting those securities into a controlling stake of the equity of the post-restructured entity.

This chapter contains an overview of the evolution of PE firms in the distressed debt sector, a

summary of the primary strategies and techniques they employ, and some observations on how

their activities have evolved. Finally, the chapter discusses the future outlook of distressed debt

sector regarding PE firms.

INTRODUCTION

The involvement of private equity (PE) firms in distressed debt investment has grown in the last

decade in tandem with the expansion of the distressed debt market. Distressed debt investing

arguably began as a consequence of the adoption of the Bankruptcy Act of 1978, which

introduced a “rehabilitation” ethic into the corporate reorganization process in the United States.

While this development is discussed in more detail later in the chapter, the new legal scheme
essentially fostered a restructuring framework dedicated to preserving the “going concern” value

of bankrupt businesses. It also improved the rights of creditors and simplified the process by

which creditor’s claims could be restructured, often into a controlling share of the distressed

company’s equity.

The rapid development of the high-yield or “junk” bond market followed this legal

development, but this does not necessarily suggest a causal link. The growth of the junk bond

market facilitated two important pre-conditions for what is now a vibrant distressed investment

asset class. First, it created large issues of tradable bonds and later loans that were accessible

investments for institutional investors. Second, it facilitated higher use of financial leverage in

corporations that inevitably increased the likelihood that they would experience financial distress

(Baribeau,1989; Bernanke, Campbell, and Whited, 1990).

As corporate default rates increased, shrewd investors began to realize that

inefficiencies in this nascent market created investment opportunities. Specialized investment

funds were often structured similar to PE funds in terms of the long-term investment

commitment required of investors, and began to post attractive returns. This development

prompted institutional investors to view distressed debt as a separate alternative asset class.

PE funds, particularly those that specialized in leveraged buyouts (LBOs) and thus had

considerable experience with complex debt capital structures, recognized distressed debt

represented an expansion and diversification opportunity. Many established specialized

distressed funds in addition to their core buyout funds. Distressed debt was also extremely

profitable for limited partner (LP) investors based on the PrEQIn Distressed Private Equity

Index, distressed debt was the top performing PE strategy between 2001 and 2011 (Preqin.

2012).

This chapter surveys the role of PE investing in distressed debt markets. First, the

historical evolution of the market for distressed debt is discussed. This is followed by a short

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primer on distressed investing since this type of investing is a relatively new and less studied

than other active investing strategies. Next the primary investment strategies—distressed for

control, loan to own, special situations, and turnaround investing–-employed by distressed-asset

PE firms are reviewed. Finally the current state of distressed investing is analyzed including the

growing efficiency of the U.S. market, the expansion into less efficient markets such as Europe

and the evolution of the buyout PE sponsor as a potentially important player in the distressed

market place.

HISTORICAL EVOLUTION OF THE MARKET FOR DISTRESSED DEBT

Distressed debt investing would not have evolved into a dynamic asset class without an

accommodative legal framework that facilitated the efficient restructuring of financially

distressed corporations. The enactment of the Bankruptcy Act of 1978 (the “1978 Act”), the first

comprehensive overhaul of restructuring legislation in the United States in roughly 40 years,

provided such a construct.

Chapter 11 of the 1978 Act was crafted explicitly for rehabilitating financially distressed

corporations with a goal of preserving businesses and employment while still protecting the

rights of creditors and other claimants (Miller and Waisman, 2005). Among the manifold

changes, Miner (1979) identifies five of the more important changes:

 The 1978 Act eliminated a prior requirement that the debtor must demonstrate it was

insolvent (e.g., miss an interest payment) before it was eligible for bankruptcy protection.

This change allowed firms to voluntarily file for bankruptcy much earlier in their financial

distress allowing them to start the rehabilitation while they were merely wounded, as

opposed to on their deathbed.

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  It established that leaving management in place, rather than an appointed trustee,

better-preserved value by allowing those with the most knowledge of the business to

remain in control.

 The 1978 Act expanded protection against secured creditors seizing their collateral and

thereby effectively forcing a liquidation—consider what would happen to an airline if all

the aircraft could be repossessed by a secured creditor.

 It provided that essentially all debts and claims against the debtor could be compromised

or eliminated, allowing the debtor to have a genuine “fresh start”.

 It exempted securities distributed to creditors from certain provisions of the securities

laws that made reselling the securities difficult in many cases, which substantially

increased risk and reduced returns.

Procedurally, the 1978 Act established a more efficient framework for negotiating and

approving the plan of reorganization (generally referred to simply as “plan”). The streamlined

Chapter 11 process envisioned that the company and an official committee of unsecured

creditors would negotiate a proposed plan and then creditors would vote to accept or reject their

treatment under the plan. This change was a sharp contrast to the process that was previously

followed in many cases where a trustee developed a plan, the creditors were limited to making

suggestions, and the Securities and Exchange Commission (SEC) had an important role in the

approval process (Miner,1979). Taken as a whole, the 1978 Act represented a dramatic

advancement in the U.S. bankruptcy process.

The next step in the evolution of the distressed market was the expansion of junk bond

financing by Michael Milken and his firm, Drexel Burnham Lambert. Before Milken, the only

below investment grade debt available for distressed investors was from fallen angels (i.e.,

investment grade companies that had fallen on hard times and been downgraded to below

BBB/Baa), which were fairly uncommon. In the mid-1980s, Milken developed the market for high

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yield bonds and issuance grew dramatically. As Figure 7.1 illustrates, between 1980 and 1990

the market grew ten-fold from less than $20 billion to more than $200 billion.

(Insert Figure 7.1 about here)

Since junk bond issues are riskier by definition, corporate default rates started to

increase. Altman and Hotchkiss (2006) document that bond defaults increased from $1.4 billion

in the decade ending in 1980 to $43.3 billion for the decade ending in 1990. As default rates

increased, specialized investors identified opportunities to purchase the bonds of companies

experiencing financial distress. Often the original investors, who initially were insurance

companies and pension plans, had little experience with the corporate reorganization process.

They were often fearful that if the issuer of the bonds filed for bankruptcy, their investment might

be totally lost. As a result, when the original buyer learned that they could mitigate risk by selling

bonds, albeit at steep discounts to the original principal amount, they often “hit the bid.” Initially,

the buyers of this distressed debt were relatively small hedge funds. Their basic strategy was to

identify undervalued bonds and then hope some catalyst would occur to cause the value of the

bond to increase and they would exit. Their skill was identifying the misvaluation and

understanding the workout process. This allowed them to predict events that would result in the

security appreciating in value. Generally buyers did not make the investment with the goal of

owning or controlling the distressed company and they did not have the expertise or resources

to create value through fundamentally improving the company’s economic performance.

Over time some notable exceptions to this generalization emerged. The biggest was

Oaktree Capital Management, founded by Howard Marks. Marks’ “value” strategy was similar to

his smaller predecessors, but Oaktree was among the first that could raise longer-term, locked-

up PE-like capital. This allowed the firm to take large, illiquid positions in distressed firms, often

with the goal of influencing the course of the restructuring process. Capitalizing on the 1990

recession, Oaktree’s 1988, 1990, and 1991 vintage distressed funds posted an average net

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return of 30 percent (Oaktree Capital Group, LLC, 2011). However, Preqin (2011) data indicate

in Figure 7.2 that returns for distressed for the mid-1990s were unexceptional largely because

the 1990s were generally a period of economic expansion with relatively low corporate default

rates. This changed with the turbulence that occurred from 1998 to 2002. Many funds that

focused on distressed investing during that period capitalized on rising default rates and earned

returns in excess of 20 percent.

(Insert Figure 7.2 about here)

Another observation from Figure 7.2 is that fund returns vary dramatically by vintage and

returns are typically best during economic recessions. The basic reason for these observations

is that during a recession valuations decline and investors become cautious, tending to sell

investments that they view as risky. This selling allows distressed-asset investors to acquire

assets at attractive valuations. As Warren Buffet famously said, “Be fearful when others are

greedy and be greedy when others are fearful” (Buffett, 2008). What tends to set successful

distressed managers apart is their contrarian courage is that they are willing to make

investments during bad market environments precisely because they realize that misvaluations

have occurred and they take advantage of them.

The persistence of attractive returns began to draw the attention of institutional investors

who started to recognize distressed investing as a specific asset class or strategy.. This asset

class also had the added benefit of being somewhat countercyclical in that distressed returns

were often best during periods of economic contraction when equity markets typically fell in

value (Stus, 2011). Buyout style PE firms such as Carlyle and Apollo took notice, recognizing

that developing distressed debt focused funds presented a potential growth opportunity. This

ushered in the modern era of substantial PE participation in the distressed debt arena.

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A BRIEF PRIMER ON DISTRESSED INVESTING

Since distressed investing is a relatively new investment strategy and not as often discussed as,

for example, LBO or activist investing, briefly explaining the process used by distressed

investors and how they create investment value could be helpful.

First, funds that have evolved to dominate distressed investing are structured similar to

the well-known buyout PE funds. Managers solicit investments from large institutional investors

or high net worth individuals in a limited partnership. The manager acts as general partner (GP)

and has an investment management contract with the limited partnership. These contracts

typically provide that the manager is entitled to an annual management fee of 1.5 to 2.0 percent

on committed capital and a profit participation (commonly referred to as the “carry” or “carried

interest”) of 15 to 20 percent on investment profits after a minimum investment return (hurdle

rate, typically 8 percent) are reached (DePonte, 2010). The capital commitment made by the

limited partnership is called pursuant to draws made by the manager at intervals dictated by the

pace of investment. The funds usually have a 10-year life with a five-year investment period.

Several practical differences to buyout funds also exist. First, while the classic buyout

fund invests in the investee’s (target) equity—hence the characterization as PE—distressed-

asset funds are investing in the target’s debt securities. Before 2004 this was typically a target’s

unsecured “junk” bonds. However, with the growth of the leveraged loan market over the last

decade, increasingly the investment is made in the target’s syndicated leveraged loan, which is

usually secured by the target’s assets. Investing in debt securities at a discount tends to reduce

downside risk because recoveries on debt investments are not typically zero, whereas they

certainly can be with equity investments in LBOs. A second consequence of investing in debt

instruments is that funds earn interest income for part or all of the investment period. Further,

since the instruments are purchased at a discount to face value (hereinafter “discount”), the

current yield on the investments can be substantial. For example, the current yield on a 10

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percent coupon bond purchased at 60 percent of face value is 16.6 percent. Although since the

target is in financial distress, a substantial risk exists that a default will occur and interest

payments will cease at some point.

While several common investment strategies are outlined in the following section, the

basic process is to identify a target whose valuation has declined; resulting in its capital

structure concurrently declining in value. To be more realistic about the process, the manager

observes that the target’s bank loans and/or bonds (sometimes collectively referred to as “debt

securities”) trade at large discounts, and analyzes the potential returns from alternative

scenarios, including a restructuring. Large companies with complicated, multi-layer capital

structures (e.g., secured bank loans, senior unsecured notes, and subordinated unsecured

notes) may present the distressed-asset investor with multiple investment choices.

Illustrating the Distressed Debt Investing Process

A simple hypothetical example illustrates the investment process and strategies. Assume that

two years ago an LBO of TargetCo took place. At the time of the deal, TargetCo’s last 12

months’ earnings before interest, taxes, depreciation and amortization (EBITDA) was $200 and

comparable companies were trading at 7.0x EBITDA so the LBO price was $1,400. The

acquisition was financed with $400 in equity and $1,000 in debt as detailed in Table 7.1. Now

the economy is in recession and TargetCo has additional firm specific challenges. Its EBITDA

falls to $150 with a negative trend. Further, market comparables now trade at 6.0x to 6.5x

EBITDA. Reflecting these changed circumstances, assume TargetCo’s debt securities are

trading at the discounts listed. The rationale for why any of these prices may or may not be

appropriate is beyond the scope of this overview. Securities generally tend to reflect their

collateral and contractual rights. Moyer, Martin, and Martin (2012) provide a more complete

discussion. Here bank loans may be adequately secured so holders are unwilling to sell at too

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big a discount. Conversely, given that the current value of TargetCo may be $975 (6.5 x $150)

at best, its subordinated note holders might be concerned that TargetCo will go into bankruptcy,

and they will not recover their investment. In fact, if EBITDA were to further decline to $130,

using the more conservative valuation metric of 6.0x EBITDA the implied value of TargetCo will

only be $780 (6.0 x $130) and the subordinated notes might not receive any recovery

considering the priority status of the aggregate $800 in bank loan and senior notes.

(Insert Table 7.1 about here)

A distressed-asset investor analyzing TargetCo might see several opportunities. An

investor with a very negative outlook might want to be risk-averse and invest in the bank loan. If

the bank loan only had a three-year remaining term, the expected return would be around 13

percent. Yet, a more optimistic investor who perceived ways of improving TargetCo’s

performance might conclude attractive investment returns are achievable by purchasing control

of TargetCo at its current valuation. In simple terms, one strategy to accomplish this would be to

aggressively purchase the senior and/or subordinated notes and then devise a way to

essentially force TargetCo into a bankruptcy or other restructuring. During this restructuring

process, the investor would seek to convert or exchange the distressed fund’s senior and/or

subordinated notes for a controlling share of the equity, thereby reducing TargetCo’s debt load

to perhaps only the bank loan and improving its financial viability. If the reorganization is done

within a bankruptcy context, the new equity is referred to as the “post reorganization” equity.

After attaining control, the investor will then apply performance improvement and financial

engineering skills to enhance TargetCo’s value and then exit, perhaps via an initial public

offering (IPO) or sale of the company. This scenario is essentially the classic buyout PE

strategy, except instead of gaining control directly by purchasing TargetCo’s equity, the

distressed investor does it indirectly by first investing in the target’s debt securities and then

using the reorganization process to convert the debt into equity.

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 Regardless of strategy, distressed-asset investors need to be flexible in their approach

because many aspects of the investment process are often outside of their control. For

example, since relatively small issues of debt securities are often fairly illiquid, the manager

might start purchasing notes but quickly push up that market price such that the risk-adjusted

investment return is no longer attractive. As was increasingly the case in the 2009 distressed

cycle, the original PE firm that sponsored the LBO might get actively involved, financially and

otherwise, and effectively thwart the distressed fund’s efforts to force a restructuring. While the

returns can be very attractive, distressed investing is a complex, volatile, and risky process.

STRATEGIES USED BY PE FIRMS FOR INVESTING IN DISTRESSED SITUATIONS

PE firms use several strategies in the distressed-asset arena. Sometimes funds specialize only

on one approach that the manager believes may be a special aptitude for the fund. In other

instances, funds engage in multiple approaches. Still other times, one strategy may be initially

attempted, but later combined with other approaches as the situation evolves. The four main

strategies explored here are (1) distressed for control, (2) loan-to-own, (3) special situations,

and (4) turnaround investing.

Distressed for Control

Distressed for control is a strategy in which a fund purchases a target’s existing debt with the

intent of controlling the target at the conclusion of the investment/workout process. This strategy

is analogous to a hostile takeover except that instead of purchasing the target’s stock and then

perhaps launching a tender offer to acquire the majority of the shares, the PE firm purchases

the target’s debt securities with the aim of converting the debt securities into a large or

controlling interest in the target’s post-reorganization equity. An important advantage distressed-

asset funds have in their quest for control versus an equity hostile takeover is that they do not

need to disclose their accumulation of debt securities to the market (Harner, 2011). After gaining

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control, the PE firm then applies its normal strategic, financial engineering, and process

improvement skills to attempt to improve the valuation of the target before exiting. This strategy

was illustrated in the previous section.

Distressed for control has had more investment dollars allocated to it than any other

distressed strategy and tends to involve the largest funds (Preqin, 2011). This is partly driven by

the funding requirements of the strategy. To achieve control over a target, particularly a large

target, often necessitates purchasing more than $100 million in face amount of securities which

requires a substantial amount of investment capital. If the fund intends to remain reasonably

diversified, it usually must be larger than $1 billion in size. However, smaller distressed for

control funds can exist. These funds usually target smaller, middle market companies that do

not require as much capital in order to apply the strategy.

As alluded to previously, distressed for control managers face challenges and risks. The

first is accumulating a sufficient amount of the appropriate debt securities to gain control. This

can be challenging both because most bond issues are inherently less liquid than stocks and

because more than one fund may be pursuing the same distressed target. This often leads to a

competitive situation in which neither manager can accumulate as much as they would like

without driving up prices. Often, if the styles and objectives of both managers are compatible,

they may informally partner and agree on a common strategy. If they are successful in forcing a

reorganization, the managers may be jointly involved in the restructuring negotiations and

subsequent rehabilitation of the target. The partnering, or club, approach has the added benefit

of allowing managers to mitigate risk through reducing the level of financial exposure in a single

investment.

Adding to the challenge of accumulating enough securities is the problem of determining

which securities will receive the post-reorganization equity. Referring to the TargetCo example,

if the manager chooses to accumulate the cheaper subordinated notes assuming potentially

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more upside opportunity, but instead valuations and EBITDA decline, in a subsequent

reorganization the subordinated notes may be deemed worthless (sometimes referred to as

“out-of-the-money”). Even if the result is not that draconian, the equity may be allocated

between the senior and subordinated notes such that the investor only has a minority equity

position. In fact, junior securities are sometimes given non-equity forms of consideration as their

recovery expressly so that a control-minded creditor in a more senior class does not have to

dilute its position (Wachtell, 2013).

Finally, some catalyst is needed to effect the reorganization. Management and equity

owners of the distressed firm often have incentives to delay a restructuring as long as possible.

The equity holders, often a buyout PE fund, realize that if the restructuring is done at a low point

in the company’s operating performance—whether due to weak economic conditions or firm

specific issues—the equity may be out-of-the money and the restructuring would likely result in

a transfer of ownership to the distressed investors. Of course, the distressed investors would

view this as the optimal time for the restructuring to occur. For distressed-asset investors to

force a restructuring process, they need some type of negotiating leverage, such as a default in

the bond or loan that will give them the right to accelerate the debt. Therefore, an important

strategic consideration for the distressed investor is when and how the investor will be able to

influence the target’s behavior (Moyer, 2005).

Loan-to-Own

Loan-to-own is a recent distressed investment strategy in which the distressed investor intends

to own the target. However, instead of purchasing the existing debt securities, the distressed

fund makes a new loan, typically with very expensive and onerous terms, to the target. For the

target to be enticed into this deal, it needs to be in severe distress, with few alternatives.

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 Returning to TargetCo, assume that operations continued to deteriorate and that

TargetCo is running out of cash to continue operating. TargetCo will likely have breached

covenants in its bank loan making the lenders nervous and unwilling to extend any more credit.

While normally waivers of a covenant violation are negotiated during the early stages of such a

decline, the lenders effectively retain the power to declare a default, which would cause a

bankruptcy. The PE sponsor is now well out-of-the-money and might deem any more

investment as throwing good money after bad. The distressed-asset fund manager in the

example, which for current purposes is assumed not to have purchased any notes, might

approach TargetCo with the following proposal. It offers TargetCo a new 15 percent secured

loan in the amount of $550. Of this total, $500 will be used to pay off the existing bank loan (this

is essential in order for the new loan to have first-lien collateral rights) and the incremental $50

can be used to save the business. This type of funding is sometimes called a rescue loan.

TargetCo and its PE sponsor accept the loan in a last ditch effort to save the business.

If management can turn things around, they will refinance the rescue loan with something more

reasonably priced at the earliest opportunity. In that event, the distressed-asset manager fails to

gain control but earns an attractive 15 percent or higher return for relatively little work. However,

if the business does not sufficiently recover, then the terms (e.g., an interest coverage or

leverage covenant) of the rescue loan will likely be breached and the distressed-asset manager

will have the power to force a restructuring. Except, in this scenario, the distressed-asset

manager will be arguing that TargetCo’s value is much lower and that both the senior and

subordinated notes are out-of-the-money and together with the prior equity should be

extinguished. Even if some recovery needs to be given to some other creditor constituencies,

the distressed manager is likely to end up with control and start the process of value

enhancement in an effort to exit later with a substantial gain.

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Special Situations

The term special situations is used in many contexts other than distressed debt such as in

equity and real estate contexts. Even within the distressed arena, funds that label themselves

as special situation funds engage in a broad range of investments. For example, a fund rarely, if

ever, labels itself as a “loan-to-own” fund. However, many, if not most, special situation funds

would include “rescue type” loans as “special situations” they identify for their investors.

For purposes of this discussion, the term special situations is analogous to what in the

equity context, especially merger arbitrage, is usually labeled “event driven” strategies. The

essence of this strategy is to identify securities that are misvalued—for reasons other than a

misperception about the underlying value of the issuer—with a theory for what event might

occur in the near-future that would cause the security to be properly valued. This subsequent

event is sometimes referred to as the “catalyst.” It is distinguished from distressed for control

and loan-to-own by the fact that the distressed manager is not trying to obtain the post-

reorganization equity. Instead, the strategy is to profit from buying the misvalued security,

waiting for or causing the catalyst to occur and then exiting the investment with a profit.

Usually the situations are highly technical—otherwise the average market participant

would recognize the misvaluation and drive the price to fair value. Returning to TargetCo,

perhaps the distressed-asset investor during due diligence, identifies an error in the legal

documentation relating to the collateral pledge such that the manager concludes the bank loan

is effectively unsecured. Then the investor might invest in the senior notes on the theory that

when the restructuring event (the catalyst) subsequently occurs, the unsecured creditors will

challenge the validity of the liens and the value of the senior note will increase once the bank

lenders are shown as not being entitled to a priority recovery. In other words, the bank loan and

senior notes are pari passu or on an equal footing. A challenge similar to this occurred in the

2012 restructuring of Hawker Beachcraft (Declaration of Robert S. Miller, 2012).

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 The special situation investor in credit related contexts often needs to resort to litigation,

either in or outside of bankruptcy court, because the benefit that has been identified is hotly

disputed by the other party. In this example, the bank lenders would certainly assert the validity

of their liens on various theories. Several recent, fairly high profile examples of litigation-driven

special situation investments have occurred. For example, in the Lehman Brothers bankruptcy,

John Paulson and other investors purchased certain bonds within the Lehman Brothers capital

structure and argued that a relatively obscure legal doctrine called “substantive consolidation”

should apply. In simple terms, the thrust of this claim was that various subsidiaries within

Lehman should be consolidated and all creditor claims paid from a common pool (Ryan and

Freed, 2011). Under this approach, Paulson’s bonds, which related to “weaker” subsidiaries,

would benefit from sharing the assets of “stronger” subsidiaries. Naturally, the creditors of the

stronger subsidiaries argued separate treatment was more appropriate. Paulson’s group

ultimately prevailed and their bonds, which they reportedly purchased for as low as 7.5 percent

of face value received 24 percent of face value under the final plan of reorganization (Wirtz and

Spector, 2011).

Turnaround Investing

Turnaround investing is another label that has been applied to a broad class of investment

strategies. Some use it to describe the simplistic strategy of identifying a cheap stock of a

struggling company and purchasing it in anticipation that operations will “turn around” and its

price will rise. As used in the distressed context, the process is more analogous to classic PE

investing in that the turnaround investor identifies a distressed target and offers to make a direct

investment in new equity capital to shore up finances and give the company a second chance.

Of course, this investment offer typically incorporates a very low valuation for the

company so the equity infusion substantially dilutes existing equity holders and leaves the

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turnaround investor with substantial influence if not control. Funds that do these types of

investments tend to view strategic and operational improvement as their core competence and

rely on this rather than financial engineering to make the investment successful. The typical

target tends to be a small or middle-market private business in which operations can be easily

revamped by the fund’s professionals.

TargetCo would be an unlikely candidate for a turnaround investor because of its high

leverage. A new equity investment in TargetCo could easily be lost if operations did not improve

sufficiently to make the debt serviceable. Also, the turnaround investor would view most of the

“value-added” of improved operations as benefitting the creditors rather than the fund’s equity

investment.

While most television and movie depictions of the investment process are unrealistic,

The Profit, a reality television series that chronicles turnaround investments by Marcus Lemonis,

generally depicts how institutional turn-around investors function. In the show, Lemonis

identifies real businesses (generally fairly small companies such as pet grooming stores or wine

bars) that are struggling, often because of the owner’s mismanagement. After spending time

analyzing the business, Lemonis makes the owner an offer to purchase a substantial equity

stake so long as the capital is invested in the business as opposed to being taken by the owner.

Lemonis gets to take charge of the operating turnaround.

In the institutional turnaround investing context, the companies and corresponding

investments are larger and the formalities surrounding the investment much more legally

rigorous, but the general process is similar. Since the companies are larger with more complex

operating problems, up-front due diligence is done to thoroughly understand the relevant

operational, marketing and strategic challenges. After conducting its due diligence a firm will

evaluate how much time and capital is required to determine if it will pursue the investment.

This process differs substantially from the previously discussed strategies because

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management fully cooperates with the turnaround investors in order to obtain capital. A

negotiation will occur to determine the businesses “value” and what percentage of equity the

turnaround investor will receive. The investment agreement also includes provisions designed to

allow the fund to influence an exit process so that it can monetize its investment and return

capital to its LPs.

CURRENT STATE OF THE DISTRESSED-ASSET PE MARKET

Distressed-Asset PE funds have burgeoned since the tech bubble burst and institutional

investors began to recognize it as an investable, distinguishable, and counter-cyclical asset

class. As Figure 7.3 illustrates, during 2007 and 2008 (the lead up to the 2009 financial

collapse), distressed funds raised $86 billion. This amount was more than what was collectively

raised in the prior decade (Preqin, 2012).

(Insert Figure 7.3 about here)

This fund raising success reflected a growing conviction on the part of institutional

investors, based in part on the well-crafted “pitches” of distressed-asset PE fund managers, that

distressed investment opportunities would be plentiful. The perception of an attractive potential

investment opportunity set was, at its core, grounded on the argument that credit markets go

through credit underwriting cycles. The basic thesis is that low default rates coupled with an

expansion of capital allocated to credit markets, leads to declining underwriting standards. This

results in an increase in overall credit risk. When such cycles end, a sharp uptick in defaults

usually occurs and leads to a widening in credit risk spreads and a decline in credit availability.

This perfect storm tends to create fertile distressed investment opportunities. O’Keefe (2010)

provides a detailed analysis of this phenomenon.

In 2000 and 2007, all the preconditions for a buoyant distressed market were in place. Formatted: Indent: First line: 0.5"

Figure 7.4 shows the aggregate merger and acquisition (M&A) transaction value ($ billions)

16
involving North American based firms in each year from 1995 to 2009. Over this period, two

M&A boom cycles are apparent: . fFirst, , the M&A transaction value increased from 1995 to

2000, and then reached low in 2003. Next, values started to rise infrom 2004 to , peaked in

2007, and then started to decline.. Commented [SM1]: To describe the M&A activity as
rising then falling doesn’t really connect the dots the way we
(Insert Figure 7.4 about here) want—there is a boom leading to increasingly risky
transactions that ends in a bust illustrated by rising default
fates.
In 2000 and 2007, all the preconditions for a buoyant distressed market were in place.

As Figure 7.5 illustrates, a large increase inthese spurts in LBO activity occurred that wasere

financed, in part, by expanding issuance of B-rated or lower debt securities.

(Insert Figure 7.5 about here)

In 2000 and 2007, all the preconditions for a buoyant distressed market were in place.

As Figures 7.4 and 7.5 illustrate, a large increase in LBO activity occurred which was financed

by expanding issuance of B-rated or lower debt securities.

(Insert Figures 7.4 and 7.5 about here)

An increase in overall credit risk in the market accompanied this expansion of credit

market activity. The ability of LBO sponsors to access increasing amounts of below investment

grade debt, in turn, contributed to a steady increase in the is relationship is illustrated by the

growth in issuance of bonds and loans with lower credit ratings at issuance as Figure 7.5

shows, and the higher debt multiples used in LBO transactions as illustrated in Figure 7.6. In

simple terms, buyout managers were paying higher prices for companies and financing more of

their purchases with risky debt securities.

(Insert Figure 7.6 about here)

Such trends cannot last indefinitely. Figure 7.7 documents the sharp increase in default

rates starting in 2000 and 2009, respectively. Note that the more extended default cycle which

occurred in the 2000 – 2002 period reflected a prolonged recessionary environment that peaked

17
with the bursting of the tech bubble in 2001. In contrast, the sharp uptick in defaults in 2009 can

be attributed to the shock to the capital markets caused by the sudden collapse of Lehman

Brothers.

(Insert Figure 7.7 about her)

These high-default periods created an excellent distressed-asset investment

environment that allowed funds to deploy significant capital and realize attractive returns as

Figure 7.2 illustrates. However, the expansion in capital to distressed-asset funds between 2007

and 2008, as Figure 7.3 shows, was so large, that even the robust investment environment that

followed the 2009 financial collapse could not absorb all this supply. As of 2013 when default

rates had fallen to below average levels, $34 billion in committed capital, or “dry powder,” still

remained in distressed-asset PE funds that were searching for investments in a shrinking pool

of opportunities—at least in the United States (Preqin, 2014).

Geographic Expansion of Distressed Investing

As the high return potential for investing in distressed-assets began attracting increased

competition in the United States, investors began to look to other markets for distressed

investment opportunities. Besides nearby Canada, managers quickly identified Europe as

another large potential market. Various countries in Europe have well developed capital

markets. As Deva (2010) chronicles, the European market for LBOs developed robustly in the

2000s as Figure 7.8 shows.

(Insert Figure 7.8 about here)

As discussed previously, successful distressed investing requires the proper legal

environment. In this regard, some considered Europe a minefield for distressed investors until

the early 2010s (Khosla, 2013). One major reason is that Europe had no recognized common

forum in which to complete restructurings, particularly if the target had operations in several

18
sovereign jurisdictions. In the latter case, an investor faced the risk of having to manage multiple

legal actions in different forums under different legal regimes (DePonte. 2010). This situation

alone was a severe deterrent. Even if a target operated primarily in one country, laws relating to

creditor rights could wildly vary from creditor friendly to debtor protective. Even if creditor rights

were strongly respected, this did not necessarily lead to a constructive workout process.

For example, in Germany if a company’s board of directors concludes that the company

was insolvent, the board has the legal obligation to immediately file for bankruptcy or the board

members themselves can be personally liable. This framework tends to constrain the

negotiations that a company might have with creditors before an insolvency process. Once the

filing occurs, secured creditors are often allowed to immediately enforce their lien rights, which

typically lead to a quick liquidation. While this result may be acceptable for secured lenders, it

typically provides little recovery to unsecured financial creditors because the “going-concern”

value of the company is essentially lost (Rkollp, 2013).

Finally, many European cultures have a much different ethos on the role of government

in protecting local companies and local employment than in the United States. Thus, the

distressed-asset investor has to weigh the risk that even if it manages to gain control of a going-

concern business, it might be unable to restructure a target’s operations in a way that would

maximize its potential value (Khosla, 2013).

Structural issues also made investment more difficult. In Europe, banks play a more

central role in capital markets. They provide a much greater percentage of financing relative to

the role of bond capital markets. Until recently, European banks retained a much larger portion

of the loans they underwrote on their balance sheet, limiting the secondary market for these

securities. In contrast, banks in the United States typically syndicate the loans they underwrite

providing a more liquid market in which distressed investors can accumulate positions.

Compounding the problem of purchasing European loan interests, European banks often delay

19
making aggressive loss reserves for under or non-performing loans. Thus, a sale at a material

discount would effectively result in a substantial charge to capital, which puts a crimp in the

liquidity of European distressed debt (Ernst & Young, 2013). Depending on the country,

regulatory constraints also limit the type of entity that can purchase a distressed claim thus often

barring a traditionally structured distressed-asset PE fund (Rkollp, 2014).

Since the mid-2000s, several major developments have improved the climate for

distressed investing in Europe. One important legal development involved the European

Commission adopting a rule to determine the appropriate forum for a restructuring proceeding

depending on a company’s “center of main interests” (COMI) (Weil, 2013). The legislation

provided market participants with guidance on where restructurings should take place. The

effect, however, was broader. With some planning and organizational changes, companies

could shift the COMI from one jurisdiction to another. This effectively allowed forum shopping,

which means in some cases the debtor could move to the most favorable jurisdiction for a

restructuring. The jurisdiction of choice quickly became England, which had several

reorganization friendly legal regimes (Weil, 2013; DePonte, 2010). On the structural side, the

syndication of European loans has broadened with the growth of a local collateralized loan

obligation (CLO) market and banks have aggressively improved their capital positions such that

loan sales are more feasible at appropriate discounts.

Taken together, along which numerous other evolutions, the result has been a

considerable pick-up in corporate distressed-asset investing in Europe. As Figure 7.9 shows,

distressed funds raised substantial capital targeting Europe. European managers lead several

of these funds with the majority being U.S.based distressed-asset funds. They have

aggressively moved into the market in an effort to diversify away the dependence on U.S. credit

cycles.

(Insert Figure 7.9 about here)

20
Buyout PE Firms Go on the Offense

A description of PE involvement in distressed investing would be incomplete without discussing

the evolution of the LBO sponsor as a potentially important player in the distressed market

place. In the TargetCo example, the impression may be that distressed PE funds hover over the

mortally wounded company like vultures deciding how to dissect a helpless cadaver. The vulture

analogy might be apt, but increasingly, distressed targets are hardly helpless.

Distressed investing is not a win-win game for all participants but involves winners and

losers. On one side a distressed-asset firm is attempting to own the target, and on the other

side a buyout PE firm is trying to retain control and not lose its original investment in the target.

Particularly in the 2009 distressed cycle, many buyout PE firms were aggressive in countering

different approaches used by distressed-asset investors to gain control of targets. Sometimes

these techniques involved redesigning the terms of the financing instruments—such as the

development of payment in kind (PIK) toggle notes (Brittenham and Selinger, 2104) or equity

cure provisions (Mincemoyer, 2011)—to limit or delay the distressed investor’s opportunity to

threaten a default and thus add risk and/or lower prospective returns.

Other strategies involved financial engineering, such as the coercive exchange offer. In

an exchange offer, the company offers to exchange one bond for another bond or a package of

securities that have an expected value greater than the bond being exchanged. This attempts to

entice participants to willingly choose to exchange. In a coercive exchange offer, the deal is

structured such that the original holder is potentially worse-off if it does not participate—

essentially coercing participation (Moyer, 2005). The typical mechanism involves the distressed

company creating a new second lien bond and offering to exchange these secured bonds, often

at substantial reductions in face value compared to the existing unsecured notes, to existing

holders. For example, in 2009 Harrah’s Entertainment, faced a series of near-term bond

21
maturities aggregating over $1 billion. It offered holders of its senior notes maturing in 2013 the

opportunity to exchange into new second lien notes but at a dramatic discount of only 50

percent of face value (Caesars, 2009). Why would the holder “accept” such an offer? The

answer lies in the fact that Harrah’s bankruptcy was a significant risk and the second lien bond

was senior in recovery rights to the existing unsecured senior notes. The implicit threat was that

if the holder “held out” and did not exchange and Harrah’s subsequently filed for bankruptcy, the

unsecured note’s recovery might be deminimus after the second lien notes received a full

recovery. The coercive exchange offer was a particularly powerful tool for sponsors because it

allowed them to extract considerable reductions in debt principal claims, which inherently

increased the value of the sponsor’s equity position.

Lastly, the LBO sponsor, or in some cases its affiliate, would compete with the

distressed investor and start purchasing the distressed company’s bonds at steep discounts for

its own account. Multiple rationales underlie these purchases. Most directly, if the sponsor

subsequently contributed the notes to the company and they were cancelled, the value of the

sponsor’s equity would increase. Such a cancellation also effectively lowered leverage, which

might avoid the breach of a covenant that would give distressed-asset investors negotiating

power. Second, the sponsor’s purchases inherently prevent a distressed investor from acquiring

the same bonds, which increases the difficulty for the distressed-asset investor to amass a

potentially dominant or controlling position. Finally, in the worst-case scenario from the

sponsor’s perspective, if the target has to restructure and the sponsor’s equity position is wiped

out, its distressed bond position may give it means to retain an equity share and attempt to

recoup some of its earlier loss.

A primary benefit attributed to LBOs is that they reduce agency costs. When early

distressed–asset investors targeted publically held “fallen angels,” they preyed upon an

organization where the equity class often could not organize to protect its interests. Now the

22
dynamics of the game have fundamentally changed with sophisticated and deep-pocketed

buyout PE firms challenging distressed-asset PE firms in their efforts to create and control a

restructuring.

THE OUTLOOK FOR DISTRESSED PE INVESTING

As markets mature, pricing tends to become increasingly efficient. This increases the difficulty of

finding positive risk-adjusted returns. Distressed debt investing by PEs or others is arguably

entering this stage of evolution, particularly in the United States. In the 1990 cycle, distressed

investing was essentially a new discovery. In the 2000 cycle, people remembered the 1990 era

but the market remained relatively inefficient due to few experienced investors and relatively

little dedicated capital. Since the 2009 recession, distressed investing has matured. Currently,

much more dry-powder exists in committed capital than opportunities. Scores of dedicated

funds with hundreds of experienced analysts hold this capital. These analysts pore over the

outlook for any bond or loan that trades at even a modest discount. This level of attention and

scrutiny leads to more efficient pricing and makes earning surplus returns more challenging, a

condition which could persist even if an increase in the default rate improves the supply of

distressed opportunities.

Beyond the near-term supply/demand technicals, the intermediate-term environment

also seems challenging. During the prolonged period of historically low interest rates that has

persisted since the Federal Reserve’s quantitative easing policy beginning in 2008, more

corporations have been able to refinance their debt capital structures at comparatively low

interest rates. For example, according to Bloomberg, the average coupon on a triple-C rated

bonds issued in the first quarter of 2014 was approximately 8.50 percent, almost 50 percent

below the same figure in the first quarter of 2004. Further, the aggregate amount of below

investment grade bond debt maturing before 2017 represents less than 75 percent of all such

23
debt outstanding (Guggenheim, 2014). In other words, interest expense burdens on internal

cash flow are low, as is exposure to refinancing risk. The implications of these statistics are that

high yield companies have never had less burdensome debt capital structures in their history.

This suggests that default rates could remain subdued for some time.

While the U.S. market is now fairly efficient, many other markets, both in Europe and

emerging economies, are not as efficient. Some evolution of the legal structures is necessary in

these countries to facilitate distressed-style investing. As these evolve, decades of opportunities

may exist for such investing.

SUMMARY AND CONCLUSIONS

This chapter reviews the evolution of distressed-asset PE firms following the passage of the

Bankruptcy Act of 1978 and the development of the high yield bond market. Popular distressed-

asset investment strategies are analyzed and the expansion of the investing scope from

primarily the United States to Europe is explored. Finally, the conflicts between buyout PE

sponsors and distressed PEs are outlined. Clearly, distressed PE has had an important role in

making the distressed investments an identifiable, counter-cyclical alternative asset class that

has attracted growing interest from institutional investors. Less clear is whether the class can

continue to post strong risk-adjusted returns in an increasingly efficient U.S. market and a

substantially different European market.

DISCUSSION QUESTIONS

1. Discuss how the passage of the Bankruptcy Act of 1978 set the stage for the growth of

distressed debt investing.

2. Compare and contrast the main strategies used by distressed debt investors.

3. Explain whether distressed investors can add alpha if their returns tend to depend on

favorable market environments,

24
4. Explain why distressed debt investors are sometimes characterized as “vulture Investors”.

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yield-and-bank-loan-outlook-january-2014.

Harner, Michelle M. 2011. “Activist Distressed Debtholders: The New Barbarians at the Gate.”

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J.P. Morgan. 2013. 2013 High-Yield Annual Review. New York: J.P. Morgan.

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ACKOWLEDGMENTS

The authors are grateful for the capable research assistance of Dan Mayer in preparing this

chapter.

ABOUT THE AUTHORS

Stephen G. Moyer is the President of Distressed Debt Alpha, a consulting firm that focuses on

distressed debt investing. He is also an Adjunct Professor at the University of Southern

California and Pepperdine University. Before forming his consulting firm, he spent 30 years in

investment management and banking at such with notable firms such as PIMCO, Tennenbaum

Capital, Imperial Capital, Drexel Burnham, and First Boston. He is the author of Distressed Debt

Analysis and other publications. He holds a JD from Stanford Law School and an MBA from the

University of Chicago.

John D. Martin is the Carr P. Collins Chair of Finance in the Hankamer School of Business at

Baylor University where he has won numerous awards for both teaching and research. Before

28
moving to Baylor he was the Margaret and Eugene McDermott Professor of Finance at the

University of Texas at Austin. His research interests in finance include valuation, organization

theory, and investment management. He has authored numerous textbooks in finance including

Valuation: The Art and Science of Corporate Investment Decisions published by Prentice Hall,

and more than 60 scholarly papers published in both academic and professional journals. He

holds an MBA from Louisiana Tech University and a PhD from Texas Tech University.

29
Figure 7.1 Size of the Early High Yield Market

This figure shows the amount of high yield (HY) bonds between 1980 and 1990 based on data
from Credit Suisse.

30
Figure 7.2 Median Distressed Fund Return

This figure shows the median cumulative IRR return for distressed funds by vintage from 1997
to 2008. The median cumulative return for a fund launched in 2002 was about 27 percent
compared to a fund launched in 2006, when it was less than 10 percent.

Source: Preqin (2011).

31
Table 7.1 TargetCo Capital Structure

This table provides pertinent information about the debt capital structure of the hypothetical
TargetCo used to illustrate various aspects of the debt investment process.

EBITDA 150
Amount Coupon Leveraged Leveraged
($ millions) Yield (%) Face Market
Coupon Security Price

L+3% Bank loan 500 80 6.3 3.3x 2.7x

7.00% Senior notes 300 50 14.0 5.3x 3.7x
9.00% Subordinate notes 200 20 45.0 6.7x 3.9x
Total debt 1,000

Source: Authors.

Source: Authors.

32
Figure 7.3 Distressed PE Funds Raised in North America

This figure shows the aggregate amount ($ billions) in capital raised by distressed-asset PE
funds from 2004 to 2011.

Source: Preqin (2011).

33
Figure 7.4 M&A Transaction Value: 1995-2009

This figure shows the aggregate M&A transaction value ($ billions) in involving North American
based firms in each year from 1995 to 2009 based on data from Bloomberg.

3000

2500

2000

1500

1000

500

0
199519961997199819992000200120022003200420052006200720082009

M&A Transac on Value ($B)

34
Figure 7.5 Low Rated High Yield Issuance: 1995-2009

This figure shows the aggregate issuance, excluding refinancings, of bonds rated B or lower in
each year from 1995 to 2009.

Source: J.P. Morgan (2013).

35
Figure 7.6 Acquisition Debt Multiples

This figure shows the average debt multiple used in LBO transactions between 2000 and 2010.
The bars show the composition of the debt between senior and subordinated (sub) debt.

Source: Bain (2012).

36
Figure 7.7 Leveraged Finance Default Rates

This figure shows the percentage (as a percentage of the aggregate principle amount
outstanding) of high yield (HY) bonds and leveraged (Lev) loans that defaulted each year
between 1998 and 2012.

Source: J.P. Morgan (2014).

37
Figure 7.8 European LBO Volume

This figure shows the aggregate transaction value (€ billions) of LBOs completed in Europe for
each year between 1997 and 2008.

Source: Deva (2010).

38
Figure 7.9 Fundraising for European Distressed-Asset PE

This figure shows the aggregate amount of capital raised by distressed-asset PE for each year
between 2004 and 2010.

Source: Preqin (2011).

39