FORUM: Outlook for distressed investing in 2015
January 2015 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
FW moderates a discussion on the outlook for distressed investing in 2015 between Martin Gudgeon at Blackstone, Leif Zierz at KPMG, Louis Gargour at LNG Capital, and Jamie Constable at Rcapital Partners LLP.
FW: How would you describe the climate for distressed M&A and investment activity heading into 2015? Is it a competitive market?
Gudgeon: 2015 and beyond will be characterised by bond restructurings rather than loan restructurings. By definition, many capital structures do not have maintenance covenants and their restructuring may be later in the default cycle. Distressed investing opportunities may arise through bond trading and rescue liquidity facilities, but this latter new money opportunity will only manifest itself with companies that are prepared to develop contingency plans.
Zierz: Based on what we are seeing, the market for distressed M&A and investment remains highly competitive heading into 2015, with a significant amount of money chasing a very small number of opportunities. Those funds that have a limited time period in which to invest are chasing these deals, while many of those that are more open-ended are choosing to conserve their cash and wait. These market conditions have clearly been exacerbated by a variety of factors, including the continuing low default rate environment, an abundance of liquidity sources and a lack of near-term maturities, to name a few. And with interest rates continuing to remain low, there is ample opportunity for leveraged financing. Accordingly, companies that might have otherwise found themselves in financial difficulty in a different interest rate environment are finding it relatively easy to refinance or to find another solution that will help keep them out of the ‘distress zone’. Indeed, distressed investors are consistently reporting a dearth of traditional ‘good company, bad balance sheet’ acquisition opportunities, particularly at valuation levels that would produce what would be considered acceptable levels of financial return.
Gargour: The current environment for distressed is robust. Deflationary pressures in Europe have been the catalyst for significant price moves and re-evaluation of the sustainability of capital structures principally in retail and consumer cyclicals. While expected defaults will not necessarily rise quickly in 2015, expectations of restructuring have risen. There are a number of situations that merit attention in the European sub investment grade market, with a UK insurance company, a South African retailer, a Dutch clothing retailer and a UK entertainment company currently being evaluated as distressed investments.
Constable: The market has become incredibly competitive. The vintage years of 2009-13, where distressed assets could be bought for distressed prices, are very much behind us. Activity seen in the second half of 2014 suggests that the prices of distressed assets have increased substantially, and we suspect that trend will continue into 2015. The liquidity in the market will help to drive prices upwards.
FW: Are banks still willing to ‘amend and extend’ or is there an increasing inclination for lenders to recognise losses and offload distressed assets?
Zierz: The credit markets, and in particular the large banks, continue to provide borrowers with opportunities to amend covenants and extend maturities. However, the volume of these amend and extend events has declined – the ‘maturity wall’ has already been pushed out to 2016 and beyond. Generally speaking, the majority of leveraged finance transactions over the past several years have contained few, if any, maintenance covenants. And while banks appear to have thinning patience for smaller troubled credit, non-bank finance companies are stepping in to service the lower end of the market. In the middle market credit sector, the banks have been willing to accommodate borrowers in the pursuit of alternative financing and sale options. In situations in which these alternatives have not proven feasible, however, we are seeing an increased tendency for these banks to sell their loan positions to special situation investors. However, in core markets and with core clients, banks will typically adopt an ‘amend and extend’ solution when a firm first experiences financial difficulty. Banks do not want to have to recognise provisions until they absolutely must, so any talk of debt-to-equity conversions or of slicing the debt into senior and junior usually only happens when an ‘amend and extend’ has not solved the situation.
Constable: Banks’ expectations around prices have become more realistic, but also the prices people are willing to pay to the banks have increased, meaning that there are a lot more opportunities for banks to sell assets. Also, the banks’ provisionary policies are such that they are able to sell those assets without them incurring the losses that they might have had to take in 2009-12. There has been an increase in activity, although most of the main high street banks have sold off the majority of their distressed assets and, as a result of the lack of lending in the sector over the last five years, we feel that 2015 will not see many transactions coming out of the main UK clearing banks. However, many of the purchasers of these assets are big portfolio buyers who we do see offloading assets back into the market.
Gargour: We believe that the amend and extend days in the case of smaller issuers without a proven track record are beginning to be more and more infrequent. Specifically, banks are concerned that an extension of the firm’s restructuring as a result of the loosening of covenants can lead to situations where assets become significantly impaired and recoveries, even at the most senior part of the capital structure, can be much smaller than is acceptable. Therefore, we are beginning to see potential restructurings happening quicker. We are seeing loans being sold, intermediaries getting involved, and the transfer of risk between banks private equity sponsors and others as a result of bank unwillingness to amend and extend.
Gudgeon: Banks are generally deleveraging. Amend and extends (A&Es) will always be popular for situations that offer the correct pricing of any extended risk. For an A&E to be agreed there needs to be a demonstrable route to refinancing: if it can be shown that it is easier post A&E, then there is no commercial reason to reject, subject to the appropriate economic and credit quality terms being acceptable.
FW: What strategies and techniques are distressed investors employing to get deals done?
Gargour: Strategies include capital structure arbitrage, opportunistically controlling a company through large proportions of a share class of its debt, and other situations where distressed investors want to control the outcome of restructuring negotiations. Specifically, in several distressed situations in Europe, distressed investors are targeting the most senior part of the capital structure in order for recoveries to be high, and a number of short positions have been established in some of the more subordinate parts of capital structures across European corporates in order to generate trading profit until a restructuring is announced.
Constable: Buy and build strategies are becoming more frequently used, especially in industries with fundamental problems, such as the care home industry. The consumer credit market has also created buy and build opportunities. To be able to take advantage of the current market, we are finding that we have to become a trade buyer with a distressed mindset so we can deal with the higher prices being paid.
Gudgeon: We are seeing a greater acceptance from secondary debt investors to reach agreement with sponsors to effect a smooth handover of equity. Essentially, this means agreeing upfront a payment for the equity in order to gain access to management and due diligence.
Zierz: One of the techniques we are seeing distressed investors employing with greater frequency is seeking out non-core divestitures from large corporations. Many of these investors view this as an opportunity to acquire an attractive asset that has received too little attention and too little investment from its corporate parent. In many instances, corporate sellers may be more inclined to sell non-core assets at a price below market value, since these assets are no longer considered strategic to the organisation. Another trend we are seeing is an uptick in the number of distressed investors exploring cross-border transactions. This is particularly prevalent in Western Europe, where bank restructurings have provided opportunities to acquire a wide range of assets, such as distressed loan portfolios, operating companies, and so on. There has also been an increased willingness by select US special situation investors to acquire the assets of middle market companies via an ‘Assignment for the Benefit of Creditors’ (ABC)/Article 9 State foreclosure process, rather than the traditional Chapter 11 Section 363 sale process. Many are choosing to employ this tactic because of the lower transaction and professional costs and the increased speed to closing.
FW: In general, how do you expect valuations and pricing for distressed assets to influence investment activity?
Constable: Pricing is definitely increasing. As liquidity in the market is also increasing, we expect pricing to continue to increase throughout 2015. We believe that most of the real value deals have been done and we anticipate being more of a seller into the market than a buyer. We are also seeing leverage getting back to 2006-07 levels. Given the changes currently occurring in the sector, as a firm we will be looking to keep our powder relatively dry for the next two to three years in anticipation of those opportunities unfolding.
Gudgeon: As the valuation an investor is prepared to pay is a function of the investor’s cost of capital, you may see certain assets, such as long term yieldco-type assets, attract higher values if they are be able to be financed by longer term capital.
Zierz: Valuations are always at the heart of any restructuring. They are key to understanding where value ‘breaks’ and to determine who the fulcrum stakeholders are. They are also critical from a pricing and returns perspective. If we look at the market today, with its buoyant conditions, multiples are significantly higher, which means there are considerably fewer opportunities. Those opportunities that do exist are being chased by multiple distressed investors, all of whom are competing for the debt. Accordingly, what we are seeing is that situations that might otherwise have been priced in the 70s based on risk/return analysis are being bid up into the mid-80s. As a result, returns are substantially lower. On a risk-weighted basis, we are likely to see certain funds struggle to meet investor expectations. In this competitive market landscape, there are many distressed investors sitting on a lot of ‘dry powder’, waiting for the inevitable increase in interest rates and a steepening of the default curve.
Gargour: Valuations have been moving quite quickly and my expectation is that if a large number of companies are for sale in any one sector, the overall valuation for companies in that sector will have to readjust based on the supply/demand imbalance. Therefore, corporations seeking sale or breakup will, in my opinion, increase, as a means of avoiding restructuring or bankruptcy. Keep a close eye on European consumer cyclical, retail oil and gas related industries, and specialty chemicals, as the current deflationary environment may cause a number of restructurings in the sectors in 2015.
FW: Could you provide an insight into some of the key legal issues that tend to arise when acquiring distressed assets?
Gudgeon: The key legal issue is the implementation mechanism and the degree of certainty that can be assumed in delivering the proposed deal. There are different implementation mechanisms for different European countries, and jurisdiction-hopping to minimise implementation risks will continue to be a factor in European restructurings.
Zierz: Due in large part to the heightened costs and time durations associated with bankruptcy proceedings, more and more distressed investors are opting to consummate these transactions out of court where possible. In addition to translating into significant time and cost savings, these out of court deals can also help to minimise unwanted competition for assets that may appear in a bankruptcy auction scenario. Another key legal issue facing many distressed investors revolves around the creation of strategies for minimising or eliminating legacy liabilities, such as pension or healthcare obligations. For example, with the increased prevalence of non-core divestitures, buyers need to consider whether the operating subsidiary may have exposure – control group liability, for example – to the parent company’s underfunded pension plan.
Gargour: Key legal considerations include jurisdictional issues, country of operation, bondholder rights, and recoveries. There has been an increasing amount of discussion concerning nonstandard terms in the company indentures. A number of phone deals this year have also been done with very light covenants, and aggressively drafted portability clauses which in some cases can adversely affect investors. And of course, your relative seniority – that is, which part of the capital structure you are involved in – as always is very important.
Constable: In SMEs, often the onerous employment contracts of directors or previous owners can make a deal impossible to do. Equally, a lack of clarity on ownership can be an issue in such transactions, and we often see poor internal financial controls and compliance. Furthermore, poor security can make debt difficult to buy and opportunities are also lost as a result of an inability of the current debt holder to move at the speed required to deliver the solution to the company.
FW: What is your advice to investors on adequately managing risk and potential liabilities in order to drive future returns?
Zierz: There are a few key strategies for managing risk and liabilities which can help to drive returns. The first has to do with the reasonable use of leverage against the backdrop of a potentially increasing interest rate environment. It is important that investors do not get caught in the trap of having too much debt in the early stages of a turnaround. The second piece of advice would be to focus more on improving top and bottom line results through a focus on operations, rather than relying on financial engineering, such as dividend recapitalisation to generate returns. To help reduce post-closing integration risks, investors should consider partnering with a strategic buyer. When entering new jurisdictions, investors must take the time to properly understand the legal framework and local insolvency laws, as well as what can and cannot be done. At the end of the day, it is really about sticking to the fundamentals. Understand the asset, the jurisdiction, the valuation, the liabilities that exist, the potential increase in value going forward and what it will take to unlock it, and then factor that into the pricing and stick to it. Do not get into a bidding war and risk losing your return profile just to win the deal.
Constable: Firstly, don’t overpay on distressed assets. Distressed assets are distressed for a very good reason; consequently, we are quite surprised at the fees being paid for some assets in the current market. Additionally, it is very unusual to buy a distressed asset that doesn’t have something unexpected; accordingly, it is imperative that companies ensure they have some headroom built into their pricing. Finally, buying a distressed asset without being hands-on into the business is fraught with issues, since being able to make fundamental change to the business is essential in managing investment risk.
Gudgeon: Investors need to correctly price the risks involved. There is usually more bad news to come out in a newly uncovered distressed situation. Make sure you assess all non-financial indebtedness, contingent liabilities and other off balance sheet creditors. For example, long term lease agreements and hedging facilities can create significant contingent liabilities.
Gargour: Managing risk requires limitation of position size, modelling the risk rewards carefully, and assuming that there will be very high volatility and decay in valuation over time. The other key element that I believe the market will begin to focus on is cash burn at companies, creating a situation where asset valuations and breakup are lower than expected due to ongoing financial deterioration of the company prior to insolvency.
FW: What final advice can you offer to distressed investors on navigating the distressed market over the coming months?
Gargour: Every situation is different. There is no right and wrong way of approaching investment in this area. We definitely think 2015 will create opportunities, as a result of economic headwinds, leverage and execution by companies. Therefore, stay nimble and seek opportunities as they arise.
Constable: My advice would be to keep your cash in your pocket and wait for three years.
Zierz: As we embark on 2015, distressed investors would be well-served to focus on select industries where secular trends will drive distressed opportunities. For example, there is the coal mining industry, which has been impacted by competing energy alternatives. The healthcare sector has been heavily impacted by a changing regulatory environment and the aerospace and defence industry has been dramatically hurt by government cutbacks. Investors should also take the time to understand companies in niche industries that are not subject to secular downturns, but which may be temporarily in distress due to one-time events. Sectors can be impacted by a number of one-off incidents, such as regulatory sanctions or fines, shareholder disputes, litigation, product recalls and supplier constraints. Seek out opportunities where operating cash burn will lead to a near-term distressed event, despite longer-term maturities and lack of financial covenants. Do not get caught up in a bidding war. Do your return analysis and understand the parameters of the pricing. And finally, be patient, as increasing interest rates will place a significant cash burden on over-levered borrowers with floating rate debt structures. A higher interest rate environment will provide other attractive return opportunities to fixed income investors, which will inevitably result in a tightening of high-yield market demand and less flexibility for distressed borrowers.
Martin Gudgeon is head of Blackstone’s European Restructuring Advisory Practice. Prior to joining the firm in 2007, he was chief executive and head of Restructuring at Close Brothers. Mr Gudgeon is a qualified Chartered Accountant and a member of the Chartered Institute of Electrical Engineers. He undertook his training as a Chartered Accountant at Price Waterhouse and received his BSc in Engineering from Durham University. He can be contacted on +44 (0)20 7451 4398 or by email: email@example.com.
Leif Zierz is the Global Head of Transactions & Restructuring (T&R) within KPMG’s Global Advisory practice. T&R is a global network of advisors working together with member firm client boards through the full deal cycle, offering holistic solutions that deliver real results. During his 22-year tenure with KPMG, Mr Zierz has led more than 50 high-profile deal transactions with a total value in the billions of euros and has established a reputation as a leading deal adviser. He can be contacted on +49 69 9587 1559 or by email: firstname.lastname@example.org.
Louis Gargour has 30 years of corporate bond experience, including 15 years of portfolio management experience. In 2001, Mr Gargour joined RAB Capital and built and ran their fixed income department, launching and managing one of Europe’s first credit funds. At RAB, Mr Gargour was the head of Fixed Income and also served as a member of the investment committee and board of directors. In 2007, Mr Gargour left RAB to found LNG Capital. He can be contacted on +44 (0)207 839 3456 or by email: email@example.com.
Jamie Constable is a specialist in corporate restructuring and turnaround. His expertise has earned him a place in Credit Today’s Top 50 influencers list and Rcapital’s winning an Insolvency and Rescue Award for Best Rescue Funder. A qualified accountant and Fellow of the Chartered Institute of Certified Accountants, Mr Constable trained with Touche Ross and went on to found an award-winning firm of Chartered Tax Advisors and Accountants, RJP. He can be contacted on +44 (0)845 293 9888 or by email: firstname.lastname@example.org.
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