Corporate distress is rarely a surprise to participants in the capital structure, and it usually rears its ugly head over a series of unfortunate events. Customer losses, an unfavorable shift in industry dynamics, delayed G&A cuts, covenant breaches, and dwindling liquidity are just a small subset of the many adverse outcomes that can lead a company to a rocky landing at the gates of the zone of insolvency.
In this zone are found frustrated vendors, nervous management teams, impaired lenders, fatigued equity investors, and anxiety-ridden employees jostling for the dwindling resources of capital, strategic influence, and, most importantly, time. For the credit investor in the face of such distress, the fulcrum security holder has a handful of options, from selling the position to a distressed debt buyer (most certainly at a discount to par) to leveraging the bankruptcy process and partnering with a distressed private equity fund as a stalking horse bidder (likely in a minority equity position post-restructuring).
But what happens when time is of the essence, and the senior lender is unwilling to overadvance to provide the company with the liquidity needed for survival? What are the options when a portfolio company requires additional capital, and the owner is unwilling to invest additional equity? The profile of a tapped-out equity investor can range from the family of a multigenerational business that has exhausted its financial resources to a private equity fund that has lost all conviction in its original thesis and thus is willing to surrender control to the impaired second lien holder. Creditors faced with these situations must embrace their new role as distressed investors and welcome a distressed lens into their underwriting and portfolio management philosophy dubbed “downside distressed investing.”
Downside distressed investing is an investment and portfolio management philosophy for direct lending that is used by mezzanine and other private credit funds that expands their ability to maximize recoveries when previously underwritten healthy credits become distressed, ultimately translating to the lender taking control. While controlling a company is never a desired outcome for a direct lender at the original underwriting, this distress-oriented philosophy empowers credit teams to be thoughtful about tactics and strategies to manage, prepare for, and assume the role of owner if the downside scenario previously outlined in the underwriting memo comes to fruition.
This article explores distressed investing from the perspective of the original underwriting lender whose worst fears have come to pass and who now holds the fulcrum security in an underperforming portfolio company running short on liquidity and lacking the support of the original equity owner. While the decision to invest incremental capital is a less preferred form of distressed investing, it is sometimes a necessary one and one that credit investors should be keen on, particularly as the U.S. economy prepares for the next phase of the economic cycle and what many believe will be a rising interest rate environment going forward. The article offers some best practices and insights to consider when investing through the lens of a downside distressed investor.
One of the key dimensions of this philosophy involves the underwriting team acquiring a deep understanding of the drivers of free cash flow and enterprise value. The underwriting team must be vigilant in modeling the fixed and variable cost structure of the income statement during the diligence process. In a private equity sponsor-backed financing, it is common practice for lenders to inherit a sponsor’s model and run P&L sensitivities to arrive at various covenant metrics. The downside distressed investor’s perspective takes the analysis a step further and takes into consideration not only the impact of operating leverage on profitability and covenants but also the liquidity and capital needed if the downside scenario were to materialize.
As an example, in a business that derives revenue through long-term contracts, sensitivities can be run on each contract by date and revenue magnitude to estimate the corresponding P&L, covenant, leverage, and liquidity impact. This approach allows the fund to answer deeper questions like, “What is the company’s EBITDA, leverage, cash flow, and liquidity position if three of its largest customers, representing more than 25 percent of its revenue, do not renew their contracts over the next 18 months, and no replacements are secured?” In the downside distressed investing approach in this example, team members could at the very least quantify a range of additional capital a lender would need to invest to keep the enterprise operating in the absence of the common equity holder’s participation.
Additionally, by modeling out the working capital assets in tandem with the P&L, investment teams can have a view of the company’s leverageable working capital assets in the downside scenario, as the incumbent senior lender often will want to be refinanced in an out-of-court restructuring, especially if it knows the fulcrum security lender has capital. Lastly, the downside distressed investor is thoughtful and proactive about the high-level courses of action to take from an equity holder’s perspective if this downside scenario results in controlling equity ownership. Thinking like an equity investor and adopting a value creation lens to maximize recovery early in the diligence and underwriting process introduces a few important questions that the underwriting team should consider:
Underwriting and diligence from the downside distressed investor’s perspective involve quantifying and high-level game planning early before the downside case becomes a possible reality during the life of the investment.
The financial cost of a debtor’s team of lawyers, unsecured creditors’ financial advisors, investment bankers, and turnaround consultants, along with adequate protection payments and DIP loan interest, can create a tremendous burden on a company’s liquidity during a Chapter 11 restructuring process. A 13-week cash flow model is not necessary to know that, with all else held constant, an out-of-court restructuring is less costly than one contemplated in Chapter 11.
Almost without fail, lenders require a 13-week cash flow forecast to be performed and then updated on a weekly basis in the eighth or ninth inning of a company’s journey toward the zone of insolvency, which, unfortunately, is often too late to prevent the inevitable trip to Delaware or another bankruptcy venue of choice. A 13-week cash flow analysis is certainly helpful in understanding the true flows of cash within the company, and a downside distressed investor would find it useful to jump-start the credit team’s understanding of the company’s detailed cash flow profile and treasury management competencies by requesting such an analysis during the first 100 days post-close.
Developing a 13-week cash flow forecast in the early stages of a transaction encourages the treasury and accounting functions within the portfolio company to think about optimizing cash management, working capital, and administrative processes that sometimes are suboptimally managed by middle market companies experiencing rapid growth. The investment professionals, whether it be the original underwriting team or an internal team specifically assigned to manage the credit post-close, can resurrect the 13-week cash flow analysis to better understand a company’s liquidity much earlier in the stages of a company’s potential distress and run a high-level in-court versus out-of-court liquidity analysis.
Lastly, this helps to inform important questions from the downside distressed investor’s perspective before, during, and after the deal:
The adage “what gets measured gets managed” could not be more applicable than in a distressed operating scenario. However, to ensure optimal management of what is measured, investors must be able to leverage the best managers to do so. The downside distressed investing perspective goes beyond leveraging industry experts’ calls during the confirmatory due diligence process. This philosophy inspires investment professionals within the firm to proactively grow and maintain an informal network of experts and former executive managers that can be leveraged when early signs of underperformance begin to surface.
Investment professionals can maintain an active dialogue with turnaround consultants and ensure that teams are up to speed on the latest trends in distress across various industries that may have interdependencies to companies in the portfolio. In times of crisis, too often lenders are reactive in their management of distress, resulting in feverish searches for turnaround consultants and management experts during the days and weeks when the rate of enterprise value erosion is at its highest.
A downside distressed investor anticipates distress ahead of time and is proactive about managing its position with insights gained through its expert and management networks. At early signs of underperformance, expert insights can help provide hypotheses into the best course of action and provoke proactive and early key thinking on important questions along the way, such as:
While this commentary does not provide an exhaustive list of the downside distressed investing best practices for lenders in a controlling context, it addresses the growing need for credit providers to be proactive, thoughtful, and resourceful in anticipation of unforeseen credit events that lead to a controlling ownership stake in a portfolio company. Investment firms must maintain investment discipline and process consistency regardless of the investment situation, and this call to action is certainly true when lenders find themselves investing from the philosophy of the downside distressed investor.