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Nontraditional Lenders and the Impact of Loan-to-Own Strategies on Restructuring Process

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Pawn shops have long managed to lend a few dollars against the goods they receive as security, charge high monthly rates and mandate the terms for redemption so they can sell the goods at market value at their convenience. In many respects, they provide the model currently being utilized by specialized hedge funds and hybrid funds pursuing "loan-to-own" strategies in distressed companies.

While traditional lenders will press for a return of capital loaned to a bankrupt enterprise, certain specialized hedge funds are increasingly pursuing a strategy to take control of distressed enterprises by lending more money. Much has been written lately about the convergence of the private equity and hedge fund models. Acting like sophisticated pawn shops, funds with the appetite for equity risks and rewards have targeted the loan market as the route for acquiring control of distressed companies. Acquiring discounted loans (e.g., second-lien loans, senior subordinated notes, etc.) in the secondary market and buying or making debtor-in-possession (DIP) loans are two of the methods being utilized by acquirers to get their foot into the door. Targeting the right price in distressed investing depends on the investor's exit strategy, timing of the transaction, potential synergies an investor can achieve within his portfolio companies and the market value of the targeted assets.

Recently, second-lien loans have been a hot tool for loan-to-own strategy investors. Low interest rates and the flexibility to transition out of the loan/investment with a profit at earlier opportunities have greatly driven the increase in second-lien loans from $3.3 billion in 2003 to more than $15 billion in 2005. For instance, due to the low interest rates (LIBOR + 650-700 basis points), a second-lien lender had a better risk-adjusted return profile and less downside risk than any unsecured lender (e.g., mezzanine at 13-15 percent interest). In comparison to any outside investor, the risk-return profile is further skewed due to the secured lender status of a second-lien lender, which provides greater access to information concerning market-value drivers. This advantage can be significant when the company is privately held.

As the loan-to-own strategy has become more sophisticated, investors have developed techniques that allow them to hedge their bets while masking their ultimate goals from the market. As a consequence, these investors have developed a "loan-to-maybe-own" strategy. This additional optionality increases the investors' potential return on investments in their portfolio and provides them coverage to allow a finding in the DIP loan context for a good faith finding under §364(e) of the Bankruptcy Code.

The Process

By becoming a secured lender, the "investor" gains access to restricted information. This information advantage is a key value driver and ultimately influences the decision to either stay put as a lender or negotiate for equity after the company refinances. In recent years, second-lien loans have been preferred over mezzanine loans to enter such strategies. The low-interest-rate environment that has existed over the past few years has made second-lien loans cheaper than other forms of junior capital, while providing the investor priority over unsecured claims. As a result, at both the inception of a case and at the exit, the second-lien lender is provided additional bargaining leverage over unsecured creditors and other stakeholders in terms of slicing up the equity pie and potential leverage over the first lienholders depending on the extent and scope of the subordination in the inter-creditor agreement.

The Players

Nontraditional lenders, including hybrid and hedge funds with extensive liquidity, have become highly involved in loan-to-own strategies as their appetite for corporate control has increased. Motivated by a competitive buyers' market with too much capital chasing the same deals and low returns, investors seek better profits through supplying loans with better risk-adjusted returns and extended options for additional investment strategies.

Traditionally, such players could be characterized as either yield players or investors. Yield players lend money in the early stages of a restructuring process and exit before a restructuring takes place, while investors stay through the restructuring process and target to swap their debt into equity. Today's investors value their options throughout the process and exit when they can maximize their return. It is difficult to make distinctions between yield players or investors, and players will continue to diffuse their image in the market of distressed lending as it would constrain their exposure to deal opportunities. As reflected in Table 1, the list of nontraditional lenders that supply DIP financing includes hybrid and hedge funds across all categories.

Implications for Restructuring Professionals and Their Clients

The nontraditional lender profile and the fundamentals supporting a loan-to-own strategy for distressed companies continue to change. The investment strategies of hybrid hedge funds and private-equity investors increasingly converge as they seek to manage the challenges of decreasing returns and overlapping opportunities. New entrants in the marketplace driving out pricing inefficiencies and fewer arbitrage opportunities have compelled hedge fund investors to migrate into the private-equity space. While these trends have driven distressed-asset valuations higher and led to increases in available credit, borrowers have been compelled to accept lenders whose primary goal is to achieve equity returns while taking secured-lending risks.

The fundamental tool used for loan-to-own strategies remains the second-lien loan. The liquidity and flexibility to transition in and out of the investment provides the lender significant advantages. The ultimate question is the impact this trend will have on the private capital markets and what its long-term prospects are. As interest rates increase, it is likely that mezzanine and other junior financing products offered by financial institutions will become more competitive. Additionally, it is unclear how ownership aligns with investor capabilities or short investment horizons. Buying equity and managing a restructuring process do not fall into the core expertise of a hedge fund. Successful investors will have to partner with professionals that will manage that process, improve their investment's operational structure, increase its enterprise value and develop an exit scenario that will ensure a successful exit and timely transition to new equity-holders.

Less certain is the impact of these developments on the targets of these investments. Inherently, the loan-to-maybe-own strategy injects uncertainty into the process. As distressed investors walk the line between the desire for equity returns with lending exposures, restructuring companies often suffer. At times, the companies find themselves trapped between the warring factions of equity/debt around issues of valuation and the meaning of provisions in subordination agreements and agreements granting authority to lender agents and indenture trustees. As the process plays out, ad hoc and official committees are formed, and all of these players have or retain advisors with an expectation that the restructuring company will pay their fees. Beyond direct costs, the uncertainty that this process engenders often causes managers to leave the company, inhibits investment in product development and capital expenditures, and may ultimately lead to operational stagnation.

In some cases, these dynamics play out in ways that are even more immediately devastating. Two recent examples suffice to illustrate the point. Recently, the restructuring of Meridian Automotive Systems Inc., an automotive supplier that went into bankruptcy in spring 2005, was nearly derailed as a result of leverage exerted by its second lienholders. During the pre-petition negotiations for the DIP, Meridian's second lienholders demanded an increase in the returns on their outstanding debt to LIBOR plus 11 percent. Needing the second lienholders' consent to the financing, the company agreed to their demands. It was not until General Motors Corp. threatened to cancel remaining orders that management was able to negotiate better terms.

In November 2005 another auto supplier, American Remanufacturers Inc., was less fortunate. Black Diamond Capital Finance LLC, which controlled the senior debt, proposed a DIP financing coupled with a quick asset sale in which it would be the lead bidder. Two opposing hedge funds, DDJ Capital Management LLC and Airlie Opportunity Master Fund Ltd., which controlled the second liens, offered a DIP financing targeting a rehabilitation of the company. After four days of confusing disputes about definitions of third parties, priming and subordination, the company lawyers informed the court that the company had run out of cash and converted to a chapter 7 liquidation. The increased power given to a wider group of lenders will continue to influence the outcome of chapter 11 restructurings.

As capital structures grow more complex, the potential for disputes between and among the different levels of debt and equity will continue to increase. Moreover, as hybrid funds pursue loan to own strategies, the uncertainties injected into the restructuring process will likewise increase. Seemingly, this trend will create more opportunities for restructuring advisors of all stripes, but often at a material cost to the restructuring company. Making things even more complicated is the liquidity in the second-lien market. Unlike the pawnbroker who was typically in his shop when the borrower returned with his ticket, the holders of second-lien paper trade in and out of positions daily. Restructuring companies often wake up to find that the investors with whom they were negotiating yesterday have sold their positions, bringing new potential owners to the table.

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Saturday, April 1, 2006

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