"We're not actively going into the DIP business," says David Blechman,
a Sun principal. Rather, he says, the firm will go in where it thinks
it wants to buy or continue owning a particular business,
post-bankruptcy.
Sun may not be alone. Increasingly, signs point to investors turning
private equity conventions on their head. Taking their cues from
distressed debt specialists, intrepid investors appear to be drawn to
loan-to-own strategies by buying debt in troubled businesses that may
or may not be their own. This is clearly nontraditional terrain for
private equity, and certain funds have been hurt by going in too early
in this cycle, but investors believe there are attractive gains to be
made through substantially discounted debt and DIP financings,
especially when investment opportunities are few and far between.
"As this recession drags on, there aren't that many alternatives to
make deals happen, but there are some very good businesses that are
just overlevered that will become targets," says Edward Reilly Jr., a
partner at New York law firm Goodwin Procter LLP. "People are going to learn how to play in this space."
Any number of firms -- mostly distressed experts such as Oak Hill Advisors, Oaktree Capital Management LP and Angelo, Gordon & Co., for now -- are trying to raise capital for distressed-debt activity, lawyers and investment advisers say. Blackstone Group LP's
GSO Capital Partners LP is in the market for a large debt fund, GSO
Capital Solutions Fund LP. Its offering documents don't specify the
target size, but reports have pegged it at $3 billion. The GSO vehicle
is structured as a private equity fund, says a source who requested
anonymity. Its focus is defined broadly as providing liquidity to
companies, including those in capital-structure transformations due to
pending covenant violations, debt maturities and cyclical downturns.
Blackstone declined comment, citing regulatory constraints.
Others are wading in, in some cases carving out existing pools of capital. Goldman, Sachs & Co. hopes to invest as much as $4.5 billion in distressed corporate debt, about half of the remaining $9 billion in its 2007 fund. New Mountain Capital LLC of New York and at least two others, JLL Partners Inc., also of New York, and Leonard Green & Partners LP of Los Angeles, have similar approaches.
"Many private equity firms, particularly in the middle market, are
considering how best to take advantage of opportunities in the
marketplace today and the opportunities which they expect to arise out
of the current market dislocation," says Peter Von Lehe, managing
director at NB Alternatives, the alternatives business of Neuberger Berman Management Inc.
With the enormous void in the markets, DIP lending is
particularly attractive because the spreads, or yields, on the
securities are at all-time highs. "Without even trying, you're in the
midteens, but they go well into the 20s," says one private equity
investor. "The liquidity premium on this product is unprecedented."
Aladdin Capital Management LLC, a little-known investment
firm in Stamford, Conn., is trying to raise $500 million to invest
solely in DIP financings. The firm declined comment, but in January,
Aladdin, known primarily as an asset manager active in collateralized
loan obligations, announced a shift away from CLOs, moving broadly into
asset-based lending, starting with DIP loans. It enlisted two ex-DIP
veterans, Victor Russo and Luke Gosselin, formerly with CIT Group Inc.,
to coordinate investments. Unlike Sun, however, Aladdin isn't looking
to own but to reap gains from facilities in the $75 million to $150
million range.
Traditional buyout firms don't usually invest in debt securities,
something of no small concern to limited partners in PE funds. "It's a
question of whether the activity is a logical extension of a manager's
investment skills while adapting to current market conditions, or
whether it's strategy drift.
"There's always a fine line between those two points," says Von Lehe.
For Sun Capital, Blechman argues, DIP lending isn't that much of a
stretch, given its turnaround record. Its participation in DIP loans is
"purely strategic," he says, a means toward ultimately achieving the
best returns for LPs. The firm, whose current $6 billion fund is still
largely uninvested, has a broad mandate to invest in a range of
securities, including bridge loans.
Like a few other players, Sun has a loan-to-own approach, where it
may offer DIP loans selectively to portfolio companies as well as
companies it doesn't already own. Judging from its two recent
experiences, one of its strategies is to go into prepackaged bankruptcy
restructurings as the DIP sponsor, with hopes of delevering the
business and eventually gaining equity or acquiring the bankrupt assets
in a sale.
In the case of Fluid Routing Solutions, Sun agreed to provide as
much as $12 million in DIP money as part of a Chapter 11 filing with
the U.S. Bankruptcy Court for the District of Delaware in Wilmington.
It also expected to be a stalking-horse bidder in the auction of the
company's fuel-systems business. Two separate DIP loans paid off the
$3.4 million in first-lien debt owed to senior lender Wells Fargo Foothill Inc.
Other unsecured creditors may end up seeing some recovery eventually.
Since Sun Capital was the sole bidder, the company canceled the
scheduled auction, and the sale was approved March 24.
"Three of FRS' four plants are profitable, and the bankruptcy
restructuring gave us flexibility to save about 900 jobs," says
Blechman. "We wanted to support the company, and the only way to do it
was through a DIP loan inside a Chapter 11 restructuring."
Sun acquired FRS in 2007 as a portion of Mark IV Industries Inc.'s
Dayco Products Inc. division, which included six factories. The
Rochester Hills, Mich., company manufactures power steering, radiator
hoses and transmission oil cooler assemblies for automakers.
More recently, it offered Big 10 Tire Stores up to $27.9 million in
DIP financing in preparation for an auction in which it also hopes to
be a stalking-horse bidder. The DIP, consisting largely of a rollup of
prepetition debt due Sun Capital, is coming from Sun Capital affiliate
Sun BT Finance Holdings LLC. The Mobile, Ala., company suffered from
the recession as well as steep commodity prices that it was largely
unable to pass on to its customers.
Things aren't always as straightforward in bankruptcies, however.
Courts aren't usually predisposed to grant DIP lenders prior lien
position, so DIP loans are typically done consensually, lawyers say.
"With specific prepackaged filings, you can at least see where you
expect to come out in the plan, but in a Section 363 sale, someone else
may come in and that can create uncertainty," says Goodwin Procter's
Reilly.
Both LPs and their general partners have additional worries. In
situations where there may be cross-fund investing -- when a PE firm
invests in the same securities out of two distinct funds at different
times, creating an anomaly -- there's an inherent conflict of interest.
"The challenge for both the GP and LPs is to ensure that any conflicts
of interest are being appropriately managed and that no LPs on either
side are put at a disadvantage," Von Lehe says.
Having the right sort of expertise is another major concern. "It's a
very niche market, and you really need to know what you're doing," says
one debt expert. "You need to make sure you don't fall into traps,
because there are definitely traps in there."
Sun Capital Partners Inc. has proven its bona fides as a turnaround and distressed specialist since inception in 1995, but its mission of snapping up struggling businesses is running into daunting challenges. In the past 13 months, the Boca Raton, Fla., firm has had 10 portfolio companies land in bankruptcy, five in the past three months. Many of them were in vulnerable sectors and were strained by lack of liquidity amid unprecedented economic conditions.
