Insolvency: Turning point
2 July 2007
The most significant thing to happen to the world of business restructuring in the mid-market is the rise of the turnaround fund. This can be seen in recent transactions such as RCapital's acquisition of Little Chef. The distressed funding market is becoming more and more mature as there is an increased number of genuine funds specialising in this. The model has in part come out of the US.
The maturing of this market has in no small part been brought about by the willingness of the major financial institutions to trade their mid-market distressed debt and distressed debt portfolios. This started on an ad hoc case-by-case basis and is now maturing into the selling of significant portfolios of distressed debt. This used to be the preserve of the multi-bank, multijurisdiction loans in which there were many other stakeholders, including bondholders and mezzanine funders, wherein the debt traded was for £50m-£100m.
The move down the value chain to trading sub-£50m debt has seen better returns being realised by the clearing banks and other financial institutions. The returns to the stakeholders are made greater by them trading their position, compared with the more traditional methods of working them out (including formal insolvencies). This has in no small part been the catalyst for the rise of the turnaround funds. These funds are prepared to buy this debt and drive through restructurings; they are willing to utilise their own money and skills to achieve their restructuring goals.
The banks are seeing that trading their position to turnaround funds is an attractive alternative to the traditional tools for restructuring businesses. A number of clearing banks now stipulate that, when an insolvency practitioner undertakes an independent bank review, they must advise on whether or not the bank's distressed debt could be traded. The financial institutions are seeing greater value paid for their distressed loans.
Turnaround funds are able and prepared to pay more for a distressed loan. The reason for this is that they will price into the purchase of the debt an 'enterprise value' when purchasing the distressed loan that would not be achieved through traditional insolvency processes.
The turnaround fund is usually purchasing the debt with a view to obtaining an equity stake in the business. The turnaround fund is therefore pricing an equity upside into any debt purchase. Taking an equity upside is usually undertaken with the support of existing management, in which case the reputational issues that the major financial institutions crave to avoid is substantially achieved.
The impact of Basel II has hastened the shift of banks to sell their underperforming loans. The reason for this is that there is a cost for all banks to comply with Basel II. These costs are significant. It is not only the management time and infrastructure costs, but there is also the need to ensure that their capital adequacies comply with Basel II. With the costs of maintaining a recoveries unit and capital adequacies and associated compliance issues in relation to Basel II, many professionals in the turnaround/ insolvency market see that the UK and European financial institutions will follow the lead of the major clearing banks in the US, where as soon as a loan is in default it will be traded.
Buying debt at a discount or acquiring a business at a discount is only half the story. Most business failures are directly attributable to poor management. The management - not always, but sometimes - recognises its own shortcomings and the need to obtain assistance and advice in relation to managing a crisis in the business.
Turnaround funds are bringing not only liquidity, but also management skills, to help incumbent management drive through the necessary restructuring. These funds are better placed to deal with key stakeholders. They are able to have those difficult discussions with key stakeholders and more often than not persuade them to support a restructuring. Incumbent management has usually lost creditability with the key stakeholders in their business, including key suppliers and key customers.
It is much easier for turnaround funds to have those discussions with, for example, key suppliers on the basis that they are investing new monies into the struggling business along with new management. But the turnaround fund will only introduce new monies, thereby securing the payment of the supplier, with the support of the programme of restructuring. A turnaround fund puts its money where its mouth is and in most cases delivers substantial and sustainable change. This is essential when trying to change the hearts and minds of a business's key stakeholders, which will include employees, suppliers and customers.
Looking to the future
Turnaround funds are here to stay and this is reflected clearly in the fact that the clearing banks, trade insurers, asset-based lenders and other major stakeholders are opening dialogues with the respectable turnaround funds and see them playing an essential, if not critical, role to assist in the restructuring of distressed businesses in the future.
A successful restructuring gives rise to opportunities for the asset-based lenders, trade insurers and other stakeholders. Some trade insurers and asset-based lenders have recognised that a joined-up approach, as opposed to an adversarial approach, can realise tangible benefits and gains to all stakeholders. Lawyers need to recognise that a restructuring requires this non-adversarial approach.
They must view a restructuring as a problem-solving, coordinated management of various stakeholders' roles. Lawyers need to understand the commercial reality of each of the relevant stakeholders who will be key to the restructuring of the distressed business. Far too often lawyers take on an adversarial role and in such circumstances a successful restructuring of a distressed business will fail. Such a failure will ultimately be detrimental to their clients' interests.
Lawyers are well placed to take advantage of the rise of the turnaround fund, particularly given that there is a greater number of stakeholders now involved in a restructuring that need to be advised. Typically this will include management, clearing banks, trade insurers, bondholders and, of course, turnaround funds.
•Bryan Green is head of restructuring at Salans