Private Equity Newsletter

Loan-to-Own Strategies and the Private Equity Investor

by Craig L. Godshall and H. Jeffrey Schwartz

The U.S. economy is currently in a severe credit crunch as a result of the sub-prime mortgage crisis. While the downward trend of the credit markets poses a serious threat to the U.S. economy and existing investors in troubled companies, substantial opportunity exists for investors to acquire good businesses with bad balance sheets at distressed prices by executing a loan-to-own strategy.

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; n 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.

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^.1 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., ² 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, ³ 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.⁴

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.,⁵ 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,⁶ 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, ⁷ 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; n 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.),⁸ 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.

Footnotes

_{1) See Cohen v. KB Mezzanine Fund II, LP v. Cohen
2) 369 B.R. 120 (Bankr. S.D.N.Y. 2007).
3) 322 B.R. 560 (M.D. Pa. 2005)
4) See, for example, the court-approved DIP agreement in In re Phoenix Information Systems Corp., Case No. 97-02498 (Bankr. D. Del.).
5) In re Curative Health Servs., Inc., Case No. 06-10552 (Bankr. S.D.N.Y.).
6) In re Loral Space & Commc’ns Ltd., Case No. 03-41710 (Bankr. S.D.N.Y.).
7) 930 A.2d 92 (Del. 2007).
8) 353 B.R. 820 (Bankr. D. Del. 2006).}

Private Investments in Public Equity

by Brian D. Short and James A. Lebovitz

In the past, when private equity investors invested in a public company, they were typically taking the company private. Recently, private equity sponsors have been investing more frequently as minority holders in public companies through PIPE (private investments in public equity) transactions. Private equity sponsors have been reluctant to make these “passive” investments. However, with the current disruption in the credit markets and the record amounts of capital in private equity funds, PIPE investments have become a more attractive means for private equity sponsors to deploy their capital.

The Changing PIPE Market

PIPE transactions have traditionally been used as financing vehicles for public companies wishing to avoid the time and expense of an underwritten offering. The sale of securities to an investor is done as a private placement to sophisticated investors without any general solicitation or marketing efforts by the issuer or its placement agent. The securities are subsequently registered with the Securities and Exchange Commission by the issuer for resale by the investors.

The companies tapping the PIPE market have traditionally been smaller and in industries that require frequent funding (e.g., biotechnology companies). In the current market, more and larger companies across different industries have entered the PIPE market. Some recent PIPE transactions involve Legg Mason, Lenovo, Sun Microsystems, and Palm Inc. According to industry sources, the total value of closed deals more than doubled from approximately $39 billion in 2006 to approximately $84 billion in 2007.

Many of these recent larger deals have been so-called “Sponsored PIPEs”—i.e., one investor takes all or substantially all of the securities sold in the placement. Sponsored PIPEs are attractive to private equity sponsors because purchasing the entire investment permits the investor to exert more influence on the structure and investment terms of the purchased securities.

Transaction Process and Structure

The transaction process in a PIPE transaction is streamlined. Due diligence is typically expedited because the issuer is a public company with publicly available information. The negotiation of the security and the transaction documents is also expedited due to the speed of the due diligence and the desire of the parties to keep the transaction confidential. The closing is usually a T+3 closing, as most transactions are structured so that stockholder and other third party approvals are not required.

Many traditional PIPE transactions are structured as a sale of common stock. In these transactions, the securities are usually offered at a discount to the current trading price. The issuer may also issue warrants as a “sweetener” in these transactions. Under the listing rules of the New York Stock Exchange and the NASDAQ Stock Market, stockholder approval is generally required for sales of 20% or more of the issuer’s outstanding common or voting stock when the securities are issued at a discount to the trading price. Most deals are structured to avoid crossing this threshold, as closing speed and certainty are crucial advantages of a PIPE transaction to an investor and an issuer.

Most investments by private equity sponsors are structured as convertible preferred stock or convertible debt. These structures provide some downside protection to the investor and may also provide some control features. Due to the convertible nature of the securities, the underlying common or voting stock in many instances can be deemed to be issued at or above the trading price. This allows issuers to sell more securities in these transactions without the need for stockholder approval.

Unique Concerns of Private Equity Sponsors

Control

Unlike private equity sponsors’ typical investments, PIPE investors will not control the board or the liquidity events of the company. In some cases, an investor may be able to negotiate for the right to designate a director or directors to the board and even some limited blocking rights. However, these provisions are far short of the control to which private equity sponsors are accustomed.

Liquidity

In most instances, PIPE investments offer short-term liquidity through the resale registration process. However, in some Sponsored PIPE transactions the issuer has required that the investor be restricted from selling for a specified period of time.

Transaction Fee

Infrequently, transaction fees are paid to the investor from the proceeds of the financing. Based on a review of PIPE transactions completed in the last two years involving private equity sponsors (and with proceeds greater than $25 million), we found only three transactions that included transaction fees to be paid to the investor. In each case, the fee was 1% of the gross proceeds.

Conclusion

As the PIPE market continues to grow, there are increasing opportunities for private equity sponsors to invest in a broad range of companies. PIPE investments offer many advantages to investors. Private equity sponsors
should also be aware of the issues presented by these investments, as the issues are in many cases significantly different from those dealt with by private equity sponsors on their typical investments.

LBOs: A Simpler System with Greater Influence

by Graham Defries

As UK law becomes more liberal, Germany and France may grow restless. Leveraged buy-outs (LBOs) with UK target companies will soon be easier to complete. Forthcoming changes to UK company law affecting LBOs, which the Companies Act 2006 brings in, will permit a company or its subsidiary to give financial assistance to acquire the company’s shares or to reduce or discharge a liability incurred for that purpose. The new law differs from the German and French position on the acquisition of a target company incorporated in either of those jurisdictions.

Whitewashing

In October 2008 the Companies Act’s rules on financial assistance will take effect. The law on financial assistance currently prohibits assistance being given for the proscribed purposes for both public and private companies, subject to a variety of exceptions (some of which are broadly considered unreliable in practice). It grants an exemption for private companies in certain circumstances. This is called the whitewash procedure. Public to private deals have been able to be completed by employing a whitewash before giving security to a lending bank after the public target has been reregistered as a private company. The lender’s ability to perfect its security over the target’s assets is delayed. This prohibition has become a problem for LBOs because it creates extra cost, complexity and delays. The Law Commission estimated that the whitewash procedure cost the UK economy £20 million ($39.45 million) in 2000; and with the explosion in leveraged buyout activity since then, that sum must now be much higher.

A whitewash cleanses what would otherwise constitute the giving of unlawful financial assistance by a private company. In the whitewash procedure, before the assistance is given, the directors satisfy themselves that the company giving the assistance is solvent. They swear a statutory declaration, backed up by an auditors’ report, confirming that the company will be able to pay its debts for at least 12 months after providing the assistance. These requirements cost money. And if it emerges that the statutory declaration was not based on a reasonable belief held at the time it was given, the directors are exposed to personal liability. The risk of personal liability can cause nervousness among management buyout teams, which may not be intimately involved in the structuring of the loan—the incident that will need to be whitewashed.

Fewer Restrictions

The new law will now allow UK companies to give financial assistance, removing the need for the whitewash procedure. But it will still not be possible for a private company to grant financial assistance for the proscribed purposes in an acquisition of shares in its public holding company, or for a public company to grant financial assistance for the proscribed purposes relating to an acquisition of shares in its private holding company. The prohibition on the giving of financial assistance by public companies remains in place. It is likely that this would have been removed as well, had it not been that EU law—ironically heavily influenced by UK company law—prevents its removal. At the EU level, proposals now exist to relax the prohibition on public companies when the amount of financial assistance does not exceed the company’s distributable reserves, and when certain other requirements are also met.

Three aspects of a typical deal reveal the practical impact of this legislation for leveraged buyouts. First, regarding the target company’s granting of security over its assets to secure the bank loan that makes an LBO possible, the new legislation will remove the restriction preventing a private company from giving financial assistance, in many circumstances, from October 2008. Thus, it removes the need for the whitewash procedure.

This development has advantages in the context of LBOs. It eliminates the need for the complex structures that have been employed to avoid problems relating to financial assistance. It also reduces the legal and audit fees associated with the whitewash procedure and compliance with the legislation. Some commentators have speculated that banks will ask companies engaged in a leveraged buyout to go through a process as cumbersome and expensive as the whitewash, even without the formal need to do so. But banks do not require such procedures for other loans, and it seems unlikely that they would require it for a leveraged buyout in the absence of the legal requirement.

Second, the issue of what amount (if any) might not be considered material for the purposes of the statutory prohibition as a proportion of a private target company’s net assets, and therefore might be paid towards the LBO team’s professional fees without whitewash, no longer exists. Last, the lifting of the restrictions on financial assistance for private companies will solve the often highly contentious issue of the directors’ declarations that have been required under the whitewash procedure.

And on the Continent

The new UK law is much more liberal than German and French legislation. Some similarities exist between legislation for German limited liability companies (GmbHs) and limited companies in the UK. But in the past the UK need for the whitewash procedure made its laws more cumbersome than those of Germany. Under German law the key factor is the maintenance of equity capital (nonfreely available equity of the company). This is reflected in the requirement that the assets of a GmbH cannot be reduced by the grant of financial assistance to below the level of free equity capital. The definition of financial assistance under German law includes the grant of security over the company’s assets for the liability of shareholders to a third party. Following the implementation of the new law in the UK, the German stance will seem much more restrictive. For German public companies (AGs) the prohibition covers all the company’s assets. As with UK laws on public companies, it is possible that the German public companies position will be amended as a result of any change in European legislation.

French legislation states that a company may not advance funds, grant loans or give guarantees in view of the subscription or the acquisition of its own shares by a third party. This general prohibition applies to French sociétés anonymes (SA), sociétés en commandite par actions (SCA) and sociétés par actions simplifiées (SAS). The prohibitionon financial assistance applies to all schemes that could be directly or indirectly considered as granting a loan or giving guarantees by the company for the purpose of the subscription or the acquisition of its own shares. Some legal exceptions to this prohibition exist, and there are practical ways of dealing with it, subject to certain conditions. But unlike the UK, France does not have the equivalent of the whitewash procedure, making the French position more restrictive. As with Germany, the UK’s new stance on giving financial assistance will be substantially more liberal than that in France.

The impact of the removal of the prohibition of financial assistance by private companies will be positive for the LBO industry in the UK, reducing the costs and complexity of leveraged buyouts. It remains to be seen whether the increased permissiveness of UK law will result in calls to reform the laws in Germany or France, to bring them in line with the UK position.

A version of this article authored by Graham Defries, Olivia Gueguen and Kristina Karbach appeared in the January 2008 edition of the International Finance Law Review (IFLR) Private Equity and Venture Capital Review supplement.

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