Distressed Private Equity

Distressed private equity refers to an investment partnership that involves firms investing in the equity or debt of companies confronting financial difficulty. Such firms aim to seize control of the latter during restructuring procedures or bankruptcy, conduct a business turnaround, and eventually launch their initial public offering or sell them.

This investment partnership can help turn a distressed company into a profitable organization. Moreover, it allows investors to buy shares of a company at a cheap price and sell them for significant profits when the assets regain their value. One can invest in distressed private equity utilizing different strategies, such as turnaround and distressed non-control.

• Distressed private equity is an investment partnership in which a private equity firm buys equity stake and debt in a company that is struggling financially. Oaktree, Cerberus, and Apollo are some of the popular distressed private equity firms.
• The private equity firms take control of the company during bankruptcy or the restructuring procedure. Lastly, it sells the organization or takes it public and generates substantial returns.
• Distressed private equity firms use various strategies. Turnaround, distressed debt trading, and distressed debt non-control are some of them.
• Investments made by hedge funds are more liquid than those of distressed PE firms.

Distressed private equity refers to firms investing in the equity or debt of a troubled company. They aim to take such companies public or sell them to earn substantial returns. Usually, distressed private equity always rises whenever a pandemic, recession, or war happens.

Distressed private equity investors are neither purchasers of companies generating stable flow, nor they are short-term debt traders. Besides analytical and bankruptcy-specific skills, they require a leveraged buyout investor’s board-oversight skill. Moreover, they must be able to drive restructuring procedures while an organization goes through a crisis.

Hence, investing in troubled companies requires investors to have specialized skills. Additionally, the fund managers must allocate significant energy, resources, and time into the restructuring procedure – inevitably at the cost of working on different opportunities.

A distressed private equity position involves a significantly illiquid investment where the exit procedure’s management and timing are essential to the returns. Forcing a sale prematurely to fulfill investors’ liquidity could significantly impact the investment’s performance.

That said, one must note that the ideal entry strategy for distressed private equity investments often involves purchasing into a minimum of one debt class, which comes with a certain influence and specific rights in negotiations concerning restructuring.

Persons with the following backgrounds can find it easy to become distressed private equity investors:

• Restructuring investment banking
• Distressed debt desks in trading and sales
• Bankruptcy and corporate law
• Credit-focused groups, such as direct lending and leveraged finance
• Turnaround and restructuring consulting

Some of the best distressed private equity firms are as follows:

• Cerberus
• Ceterbridge
• Apollo
• Oaktree
• Brookfield Blackstone

One must note that these firms also engage in traditional private equity investing.

Some smaller firms using distressed private equity strategies are as follows:

• Crestview Partners
• MatlinPatterson
• Tennenbaum Capital Partners
• Avenue Capital Group
• Third Avenue

Let us look at some popular strategies used by distressed private equity firms.

• Distressed Debt Non-Control

It involves firms looking to engage in debt trading at significant discounts. Nevertheless, they purchase the debt to have influence over the bankruptcy or restructuring process. They bet they can negotiate terms to significantly increase the debt’s market value.

• Distressed Debt Trading

This strategy is similar to that of various distressed credit and hedge funds. They purchase the debt trading at a significant discount to the value at par and sell it after the price increases. Alternatively, they may bet against that debt with a CDS or credit default swap.

• Turnaround

With this strategy, a private equity firm purchases equity in a company rather than debt, usually prior to the start of the bankruptcy procedure. Then, it tries to restructure that company to escape from the distress.

• Distressed Debt Control

This involves purchasing the debt to convert it into equity and having a controlling stake in the troubled company once the restructuring process is over. Then, the private equity firm operates, manages, and controls the company, makes improvements, and takes it public or sells it.

• Mixed Strategies

Also known as special situations, this involves combining at least two strategies in a certain deal. For instance, a firm first purchases a distressed company’s debt and then utilizes the distressed debt control strategy to acquire the controlling stake and ultimately gets involved in operating and managing the troubled company.  

Let us look at a few distressed private equity examples to understand the concept better.

Example #1

Suppose company ABC took on significant debt to grow its business. However, it could not allocate the funds efficiently. As a result, the organization incurred substantial losses because of which it could have gone out of business. That said, it raised funds from a distressed private equity firm to power through the phase. The firm conducted a turnaround and took ABC public to generate substantial returns. This allowed the company to raise more funds and grow its operations further.

Example #2

Suppose Company XYZ, a tire manufacturing company, grew quickly in its early years and recorded revenue worth $2 billion. That said, the organization aimed to grow too quickly and availed of a significant amount of debt to achieve the objective. Then, multiple competitors entered the market and snatched market share from XYZ as the company struggled to repay the debt while continuing to grow.

Before entering the stage of financial distress, XYZ’s financial profile looked like this:

• Equity Value: $800 million
• LTM EBITDA: $300 million
• Enterprise Value: $2 billion
• Secured Notes: $400 million
• Mezzanine financing: $300 million
• Unsecured Notes: $400 million
• Cash: $100 million
• Preferred Stock: $200 million

The company was about to violate multiple covenants on its borrowings. Moreover, its junior debt tranches started to trade at a discount to the par value. That’s when a distressed private equity firm invested in the company to get it out of financial distress. The investment partnership led to a strong recovery and substantial growth. Later on, the distressed private equity firm sold its shares in the XYZ and earned significant profits.

Prospective distressed private equity investors must know the benefits and limitations of such an investment partnership.

#1 - Pros

• For several reasons, distressed opportunities will always be present in an expanding economy.
• The total compensation in the case of distressed private equity is very high because of the complexity and stress faced by the investor.
• Distressed private equity firms offer an extensive range of skills and experience, which are usually applicable to various exit opportunities, even though persons may find it difficult to break into such exit paths.
• Arguably, the work in the case of distressed private equity is more interesting than in traditional private equity.
• Persons can work on an extensive range of firms, depending on what strategy they use.

#2 - Cons

• Distressed private equity investors usually have to face significant stress as the majority of the deals are emergencies.
• The broad skillset one acquires here is relevant to only specific exit opportunities.
• A risk remains if distressed companies carry out operations in non-optimal durations in a business cycle.

Individuals new to finance tend to find the concepts of traditional private equity, hedge funds, and distressed private equity confusing. To steer clear of any confusion and understand their meaning clearly, one must know how they differ. In that regard, people must be aware of their distinct features.

This has been a guide to what is Distressed Private Equity. We explain its strategies, examples, pros, cons, & differences with traditional private equity. You can learn more about it from the following articles -

• Hedge Fund Strategies
• Private Equity ETF
• Private Equity Associate