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September 2010 
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Restructuring In The Private Equity Market |
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Muazzin Mehrban, August 2010 |
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Operational restructuring is a constant part of the private equity process. Portfolio companies benefit from creating cash flow and improving efficiency to enhance margins. That said, the onset of the financial crisis in late 2008 prompted firms to switch their attention to debt restructuring, typically aimed at extending terms with current lenders and recapitalising their highly leveraged portfolio companies, especially in struggling sectors. Organisations which successfully restructured their debt bought themselves additional time to rationalise their businesses and make operational improvements where possible.
However, even firms that acted early cannot be certain about the industry rebound or their own future success, points out Cyrus Pardiwala, a partner at PricewaterhouseCoopers. “The size and complexity of some recent debt restructurings seem to indicate that the uncertainty regarding how quickly the economy will recover from the so-called Great Recession is increasing,” he says.
“In addition, there is a growing willingness by lenders to waive covenant defaults, for a fee, and extend loan terms. Most traditional lenders have been willing to restructure terms, but not put in new money.” He adds that it is sometimes hard to understand the rationale behind a lender’s willingness to amend debt terms. In reality, amending terms in some cases can, at best, defer some of the difficult decisions to be made and the problems that need to be addressed down the line but it does little to actually alleviate them.
Nonetheless, effective or not, such restructuring activity has increased in the private equity market over the past 18 months, in relation to both distressed portfolio companies and their owners. Despite activity dipping slightly since the turn of the year, restructuring is expected to pick up once more, as there are a number of over leveraged companies that will be unable to service or refinance their debt in the coming years. According to Partha Kar, a partner at Kirkland & Ellis International LLP, the refinancing ‘time bomb’ is expected to peak in 2014, when lenders are expected to require repayment in full, making the current practice of delaying interest or amortisation repayments usually unfeasible.
An active response
Given the approach of this brewing storm, few private equity firms are delaying or ignoring the need to restructure underperforming portfolio companies. Fund managers that are addressing leverage issues within their portfolios, by focusing on internal workout resources or bringing in external expertise to provide solutions, will in the long run be able to deliver better results for their investors. Previous experience suggests that many executives are unable to effectively manage through both a growth cycle and a downturn. Understanding the degree of overly optimistic business forecasts may require the use of experienced independent outside professionals who can act as support to existing management teams at portfolio companies. Private equity firms that have such resources in-house, or that hire such expertise, often outperform those who do not.
The downturn has served to educate most PE companies on restructuring issues, according to Mr Kar. Fund managers are revising expected returns for LPs and factoring this into their strategic thought process, rolling up their sleeves to improve underperformance where they can. “In the current PE market, a lot of PE firms have turned to the distressed or restructuring market for opportunities. This may include effectively reinvesting into companies that they are already sponsoring after potential deleveraging,” says Mr Kar. “Certainly, where a portfolio company owned by a PE firm is or is expected to become stressed or distressed, they have little choice but to get involved and do what they can to maximise their position as shareholders. This should lead to PE firms looking to ideally, get more actively involved with management earlier in order to try and turn things around and identify the causes of the problems before there is a covenant or payment default that may lead to a restructuring.” Such issues are critical to PE fund managers in the current climate and can have a significant effect on the future prospects of their portfolio companies and even their ability to raise funds in the future. Buyout firms should not rely solely on the expectation that traditional PE opportunities will increase.
Indeed, private equity firms are having to act on several fronts to protect and build value for their investors. Such efforts are taking place at the portfolio company level, across portfolio companies, and at the fund level. This has forced financial sponsors to consider an array of strategies when implementing restructuring initiatives. “Each situation is different, and therefore the efficacy of any strategy is situation-dependent,” says Mr Pardiwala. “That said, one of the more innovative strategies utilised recently is the recapitalisation of a portfolio company through a pre-packaged cram-up. Cram-ups are in effect the opposite of cram-downs, where junior creditors try to force a plan on more senior creditors by either reinstating their debt or providing them with a modified debt instrument that can be argued is equal in value to their secured claim,” he explains.
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