Loan-to-own strategies and the private equity investor

The Dechert team routinely advises its clients with respect to loan-to-own transactions. Generally, loan-to-own transactions involve one or more of the following:

• the purchase or provision of prepetition secured debt;
• the provision of debtor-in-possession financing;
• rights offerings or plan funding agreements; or:
• the purchase of the fulcrum security.

In the past, investors specifically targeting distressed debt have been the most active in utilizing these strategies. With the dearth of financing for traditional private equity investments, and the possibility in bankruptcy that some of the bankruptcy constituencies will be forced to take notes for their claims (and effectively provide financing to the buyer), private equity firms have taken a new look at these loan-to-own strategies. While the basics of loan-to-own are as true for private equity investors as the more traditional distressed debt investors, there may be some important issues in execution that are more critical to a private equity investor. Here’s an overview of loan-to-own:

Executing a Loan-to-Own Strategy

Secured Debt

The first strategy that a distressed investor can use to acquire a troubled business is by providing senior secured debt or by purchasing the company’s senior secured debt. By holding a first lien position, the distressed investor will have powerful leverage to influence a restructuring. If the company commences a chapter 11 case, a secured creditor can participate in an auction of the company’s assets by credit bidding the full face value of its allowed secured claim as opposed to the discounted purchase amount of the claim. In addition, the secured creditor will have a leg up over other potential bidders for a company’s assets because it will have superior information about the company and its assets by its position as a secured creditor.

The secured creditor will have significant leverage with respect to the ultimate formulation of the debtor’s chapter 11 plan. The secured creditor will either be able to control the reorganization or receive payment for the full amount of the allowed claim. Specifically, to cram-down a plan on an objecting secured creditor, the company will be required to make deferred payments under its plan of reorganization whose face value equals the amount of the allowed claim and whose present value equals the value of the collateral.

In In re Granite Broadcasting Corp., the court was faced with two competing distressed investors at different levels of the capital structure. One investor was a secured creditor of the company and the other was a preferred stockholder of the company. The company proposed a chapter 11 plan that provided the secured creditor with an 85% recovery including most of the new equity of the company. The preferred stockholders offered an alternative package that would have given the secured lender a 100% recovery in debt and cash and provided the new equity to the preferred stockholders.

In support of the alternative plan, the preferred stockholders argued that because the secured lender preferred an 85% package including the new equity to a 100% package of cash and debt, the secured lender could not possibly believe the valuation proffered by its expert. The court rejected this argument because the issue is not whether the secured lender believes that there may be upside to its investment in the debtor but whether the plan gives the secured creditors value that is more than 100% of their debt. Accordingly, the court confirmed the plan proposed by the company and in favor of the secured lender.

The Granite decision demonstrates, among other things, that a distressed investor using a secured debt strategy has a leg-up on other constituencies at lower levels of the capital structure.

DIP Financing

A distressed investor can provide debtor in possession financing (“DIP financing”) to the company once it commences a chapter 11 case. While the Bankruptcy Code provides that a new lender can prime a prepetition secured lender, i.e., by taking a security interest in collateral ahead of the security interest of the prepetition secured lender, priming can only be accomplished if the debtor is able to provide the prepetition secured lender with adequate protection for the diminution of value of its collateral as a result of the priming loan. Accordingly, in most situations, the prepetition secured lender provides the DIP financing. As a result, if a distressed investor desires to provide DIP financing, holding a position in the prepetition secured debt will make it more likely that the DIP financing is approved by the bankruptcy court because the DIP lender can consent to the priming of its prepetition liens.

There are several advantages to providing DIP financing for the distressed investor. The DIP financing will be subject to approval by the bankruptcy court. Once the DIP financing is approved by final order, the DIP lender will have superpriority claims and liens that are not subject to challenge. The ability to obtain a court order and certainty of legal rights in the DIP financing should provide a distressed investor with substantially more comfort than if it was providing a secured bridge loan before the commencement of a bankruptcy case.

A distressed investor also can use DIP financing to take control of the negotiations concerning the company’s chapter 11 plan or to control the sale of assets to the DIP lender. In Official Committee of Unsecured Creditors v. New World Pasta, both the district court and bankruptcy court held that a DIP financing agreement may provide that any chapter 11 plan of reorganization must be satisfactory to the DIP lender. In addition, bankruptcy courts have repeatedly approved DIP financing agreements providing that the terms of an asset sale under section 363 of the Bankruptcy Code must be satisfactory to the DIP lender.

Fulcrum Security

The second strategy for a distressed investor is to determine which layer of a company’s capital structure is the “fulcrum security.” The fulcrum security is the security that is most likely to receive equity in the reorganized company after confirmation of a chapter 11 plan. Whether a particular security will be entitled to equity will be determined by the enterprise value of the company. For example, if a company has an enterprise value of $150 million, $100 million in secured debt, and $100 million in unsecured bond debt, the holders of the secured debt will be paid in full, and the holders of the bond debt will receive equity in the reorganized company. Existing equity will be cancelled. In this example, the bond debt is the fulcrum security.

If the fulcrum security is an unsecured obligation of the company, the distressed investor can band with other similarly situated investors to form an ad hoc committee and pursue restructuring negotiations with the company. In addition, the distressed investor also may be able to serve on an official creditors committee once the company commences a chapter 11 case. By serving on either an ad hoc or official committee, the distressed investor will be able to obtain material non-public information from the company. However, by receiving such information, the distressed investor’s ability to trade its securities in the company may be significantly limited.

Rights Offerings and Plan Funding Agreements

To increase its holdings in the new equity of a reorganized company, a distressed investor may participate in a rights offering to purchase the new equity either as part of the chapter 11 process or before the commencement of a chapter 11 case in the context of a prepackaged bankruptcy. For example, in Curative Health Services, Inc., the company permitted certain large bondholders to participate in a rights offering for additional equity in the reorganized company in connection with the formulation of its prepackaged chapter 11 plan. By participating in the rights offering, large bondholders were able to obtain additional equity in the reorganized company at a discount in exchange for making the cash available to the company during the chapter 11 case.

Similarly, a distressed investor can choose to be a plan sponsor. In this capacity, the distressed investor agrees to contribute liquidity to enable the company to make distributions under its chapter 11 plan. In the Loral Space bankruptcy, for example, MHR Fund Management supported a plan of reorganization that rendered MHR the reorganized debtor’s controlling stockholder by, among other things, backstopping a substantial rights offering of senior secured notes by a Loral subsidiary.

Flexible Approach

Distressed investors can invest in various parts of a company’s capital structure. For example, a distressed investor can have both debt and equity positions in a company. In this instance, the distressed investor must be careful to distinguish between its role as equity holder and its role as debt holder. This means not only executing separate documents respecting debt and equity investments but also acting like a debt holder when the investor monitors the loan and responds to a default. In addition, if the distressed investor has representatives on the company’s board of directors, those directors should avoid any conflicts of interest that may arise if the investor enters into negotiations with the company to refinance its debt obligations.

Win Board Support

To maximize a loan-to-own strategy, the distressed investor should work with the company’s board of directors. This emphasis on a cooperative approach with the board is consistent with the general approach of most private equity investors in transactions. A company’s board of directors has significant flexibility in choosing the course of a restructuring or a preferred bidder for the company’s assets whether or not the company commences a chapter 11 case. In North American Catholic Educational Programming, Inc. v. Gheewalla, Delaware’s highest court held that (a) a creditor cannot assert a direct claim for breach of fiduciary duty against the directors of a solvent or insolvent company, and (b) a creditor cannot assert a derivative claim for breach of fiduciary duty against the directors of a solvent company. It remains unclear whether a creditor can assert a derivative claim for breach of fiduciary duty against the directors of a company in the zone of insolvency.

Traditionally, private equity investors have relied on a cooperative approach to maximize the information they get from the target company. This is true as well in a distressed or bankruptcy context, although a bankruptcy court will typically try to create a process that aims to give all interested parties access to a common set of information.

The inability of a creditor to pursue a direct claim against the company’s board of directors for breach of fiduciary duty when the company is insolvent (and potentially a derivative claim when the company is in the zone of insolvency) provides directors with a basis to resist activist distressed investors.

Role of Management

The most significant set of issues that are specific to a private equity investor involve the role of management. Private equity investors traditionally hold tightly to three ground rules for their investments: (a) they are friendly with and aligned with management, (b) management invests a significant amount of their personal net worth in the transaction to focus their attention, and (c) an equity plan is set up to give management a significant stake in the upside of the target, assuming the target hits its objectives.

Of these three fundamentals, only the third carries over easily into the bankruptcy context. (A bankruptcy court in approving a reorganization plan will typically permit option, restricted stock and other equity plans as an incentive for management post-bankruptcy). The other two fundamentals, however, can be more problematic. For the first—collaboration and alignment with management—the position of the private equity investor depends greatly on the point in the process in which they invest. If they are investing at a time when the incumbent management team that presided over the deterioration of the business is still running the business, there could be some real issues. The new private equity investor, for example, might be supportive of the incumbent management. It would not be uncommon and, in fact would be very common, for disgruntled creditors to be very unhappy with management. The management team the private equity investor invests with may or may not be the management team that survives the bankruptcy. A separate issue arises if the private equity investor invests when there is a restructuring team in place—a team brought in to replace the incumbents to try to fix the problems or at least halt the deterioration. Putting aside the turnaround specialists who only expect to work during the restructuring itself, it is not necessarily clear that a team whose strengths are cost-control, cost-cutting, and capital preservation is the same team that would be ideal for growth and development in a post bankruptcy environment.

Finally, it will often be the case that management in a distressed entity will simply not have the financial wherewithal to make a significant investment. If the target is currently owned by a private equity sponsor, chances are the management has lost their investment that they made with that private equity sponsor. If the target is a public company, chances are that the significant portion of their compensation tied up in options and restricted stock grants is now worthless. While some managers in a distressed scenario might indeed have the liquidity to make a significant investment, this will often not be the case.

Most private equity firms see their most critical role as evaluating management talent; in a distressed setting, this role is more critical than ever. Private equity firms take great pride in their ability to evaluate talent. The dynamics of loan-to-own investing truly puts this skill to the test.

Risks of a Loan-to-Own Strategy

Risks of Liquidation

While most high-profile bankruptcies often result in a reorganized company staying in business post-bankruptcy, the overwhelming majority of Chapter 11 filings result in liquidation. There is nothing magical about a bankruptcy filing; while it gives the company room by staying claims of prebankruptcy creditors, the poor financial performance that precedes the bankruptcy filing is often predictive of poor financial performance post-filing. When combined with the extraordinarily high cost of operating in bankruptcy the result is often liquidation.

This risk is present in almost every distressed company. In evaluating the right loan-to-own strategy to employ, the private equity investor will need to carefully evaluate the downside of the different strategies. A plan funding agreement is obviously the safest—if there is no reorganization, there is no funding (subject to the litigation risks described below). Providing the DIP financing also tends to leave the investor in a much better position in liquidation. In choosing its investment strategy, the private equity investor will need to make a careful analysis with its bankruptcy advisors of the right place in the capital structure to effect a loan-to-own strategy. The rules can be quite complex and the outcomes not always intuitive.

Litigation Risk

Distressed investors may face litigation from other constituencies seeking control or greater recoveries from a bankrupt company. Some of the claims that can be asserted against a distressed investor include:

• aiding and abetting breach of fiduciary duty;
• equitable subordination of the investors’ claims;
• recharacterization of the investor’s claims; and
• preference or fraudulent transfer claims.

However, a well-advised investor can structure the investment and related course of conduct to minimize the risk of such litigation.

In Official Committee of Unsecured Creditors v. Tennenbaum Capital Partners, LLC (In re Radnor Holdings Corp.), a distressed investor successfully thwarted claims asserting recharacterization, equitable subordination, and aiding and abetting breach of fiduciary duty with respect to secured loans made to the company before the commencement of its bankruptcy case. The Radnor decision provides some guiding principles:

• It is reasonable for a lender to provide additional credit to a distressed borrower before the commencement of a bankruptcy to protect its existing loans;
• An investor is not an insider even if the investor controls some, but not all, of a company’s board seats, has the right to acquire additional board seats, and has access to non-public information; and
• A board of a highly distressed company may incur additional debt in an effort to rehabilitate the business.

Competing Investors

To ensure the success of a loan-to-own strategy, the distressed investor should be prepared to offer a superior apples-to-apples offer when confronted with competing investors at different levels of the capital structure. For example, if a secured lender attempts to control the restructuring process, distressed investors at lower levels of the capital structure can attempt to work with management and present a competing bid. The ensuing competition, and any associated legal fight, may produce a variety of benefits: (a) the competing bid may prevail, (b) the secured lender may make a significantly better offer that provides more value to distressed investors at lower levels of the capital structure, and (c) the value of the securities at different levels of the capital structure may temporarily spike because of perceived upside.

Conclusion

The current credit markets have created a wealth of opportunity for distressed investors to obtain strong returns by purchasing good businesses with bad balance sheets at distressed prices. Before making a loan-to-own play, the distressed investor should carefully determine which strategy to implement, determine the value of the company, properly document the transaction, and act in good faith.

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