Opening the door for distressed debt funds

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ustralia has enjoyed 17 consecutive years of economic growth with the result that distressed debt funds have had comparatively few opportunities in this market. This is set to change dramatically.

Corporate Australia has now begun to experience systemic financial distress, which will be deep and protracted. Traditional merger and acquisition activity in 2009 and 2010 will be light and the deal landscape will be dominated by distressed acquisitions.

Distressed debt funds or special situation funds from Asia and the US are at our corporate gates, cashed up and biding their time. Domestic distressed funds are also setting up and many local private equity funds are looking at transforming themselves into funds that acquire distressed enterprises.

Distressed funds globally have hundreds of billions of dollars under management, and there is also increasing interest from fund of funds globally, including Australia’s superannuation funds, to invest in the top distressed investment fund managers in order to take advantage of the expected very significant counter cyclical returns.

Return targets for these funds often exceed 20 per cent, and historically, the greatest returns from these funds have been generated from their investments at the bottom of the economic cycle.

These are not the corporate vultures of old looking to profit from breaking up companies that might otherwise survive.

Rather, these are funds that profit from the restructuring or turnaround of a business using their highly specialised skill set combined with significant capital resources.

They are sophisticated funds with highly skilled managers who, quite distinct from primary lenders such as banks, look at a distressed situation as a value creation opportunity rather than an exercise in loss mitigation.

Ultimately, if the distressed company emerges as a viable enterprise, its once distressed debt will either fetch a considerably higher price on the market, or may be capable of being repaid in full by the company.

Most commonly, distressed investors will recapitalise the balance sheet of a company by converting some of the acquired debt to equity, which more closely aligns the outcomes for the distressed investor with the success it achieves in restructuring the business.

The beauty of distressed debt investment, handled correctly, is that everyone benefits: the banks have a new, viable borrower; the management team works with a fresh and experienced partner; new capital is provided to expand the business; suppliers are assured of payment and ongoing business; and many employees will stay on and share in the growth of the company.

It does, however, involve the existing lender(s) selling debt at a discount that realistically reflects its value. It also often involves substantial equity dilution, but the reality of a distressed company is that shareholders would almost certainly be faced without any return if the company was allowed to continue down the ‘death spiral’ to a formal insolvency process.

The process of agreeing on a realistic assessment of value from the existing stakeholders (whether debt or equity) can be particularly problematic; there is always a tendency towards denial of the extent of the problems. This denial is particularly prevalent in Australia at present.

Overcoming this denial through a realistic appraisal of what will happen to the distressed corporate without restructuring is critical to enabling a distressed or special situations investor to deploy their capital and expertise into restructuring the corporation in question.

In the late 1990s, the UK experienced a similar situation when US distressed debt funds moved into London to invest in distressed companies. This had a profound effect on the way in which corporate distress was dealt with across Europe and led to a move away from a traditional lender enforcement approach to a more value enhancing, restructuring approach.

After 17 years of entrenched ‘good times’ behaviour and unrealistic expectations regarding the valuation of companies, there is a question of whether corporate Australia and Australian lenders are ready for distressed debt funds.

There is also a question mark over our regulatory framework and whether our corporate and financing culture reflects a readiness for this change.

Of concern are our insolvent trading laws. Unlike other developed countries, Australian directors are pushed by the threat of personal liability to put financially distressed companies into an insolvency process far too early, thereby removing the option of a substantially less value destructive ‘informal restructuring’.

Also, on the lending side, to date the banks have been reticent to engage with distressed investors to actively explore selling distressed or non-performing debts at realistic values. Capital adequacy standards and provisioning requirements on deposit-taking institutions in relation to distressed or non-performing loans, combined with the resourcing difficulties in managing an unprecedented wave of corporate failure, may change that approach.

The exodus of foreign banks from our credit markets is also likely to increasingly drive opportunities for investors to buy into stressed or distressed loans at substantial discounts to face value.

Our corporate landscape is entering a period of unprecedented change and Australian companies should ready themselves for the entrance of the specialist distressed debt investor onto our corporate scene. They should not be avoided and dismissed as simply vultures.

On the contrary, these sophisticated, activist investors have the experience and financial resources to deal with the difficult dynamics of restructuring and recapitalising a company’s balance sheet, injecting expertise and structuring a company for growth.

Just as they do in the northern hemisphere, these funds will provide a very important and credible option for many companies trying to navigate through this difficult time.

Highly leveraged Australian companies, of which there are many, have been and will continue to be hit hard by the global financial meltdown.

Many will not survive, but options that maximise the prospects of rehabilitating distressed businesses that should survive, and minimise the value destruction to its stakeholders, must be pursued.

In times like this, we should be learning from other developed nations how businesses and lenders in those markets have embraced activist distressed investors to help drive a true restructuring culture.

Nicholas Dunstone is a restructuring partner at law firm Henry Davis York.