M&A Alerts, February 26, 2010

Private Equity firms should approach their own distressed investments with thorough and thoughtful analysis, as spelled out by David A. Gerson, Partner at Morgan, Lewis & Bockius LLP. David is also one of the leading panelists at our upcoming 4th Annual Distressed Investing Conference and Turnaround Gala.

M.A.: What should PE first consider when wanting to leverage new distressed investment opportunities?

D.G.: While the current downturn is certainly generating opportunities for new investments in distressed businesses, the first task for most private equity sponsors is to preserve the value inherent in their existing portfolio companies. To do so, sponsors will want to engage in honest triage of their portfolios, undertake defensive planning to preserve value through any legal restructuring of their investments, and consider active measures that can enhance value or produce an appropriate liquidity event.

M.A.: Is the coast clear? Have most distressed companies been through the worst, and if so what should PE firms consider at this point?

D.G.: At this point in the cycle, most of the triage has already happened, but if somehow the downturn is only now affecting your portfolio, then you need to take a cold, clear, dispassionate look at which investments simply cannot be saved, and at what cost the others can be saved, and allocate resources – not just additional capital, but also management time and attention – appropriately.

From a legal perspective, triage would include an analysis of where each portfolio company is bumping up against contractual limitations – covenants in debt documents, performance thresholds in commercial contracts – as well as consideration of the critical path, complexity, likely costs and probability of success of remedial actions – workouts and contract renegotiations, asset sales, out-of-court restructuring, reorganization in bankruptcy – and the downside risk and consequences of failure. From a business perspective, then, triage is really a form of sunk-cost analysis, with a detailed and nuanced view of what additional costs and benefits further action may entail.

M.A.: In light of valuation stresses, how can PE firms plan defensively for the future?

D.G.: In considering restructuring or exiting an investment through bankruptcy, you will want to anticipate all of the arguments that can be made by creditors and other claimants to try to reduce or eliminate your recovery, formulate a defensive strategy, and estimate both the costs and the outcome.

If you hold debt of the portfolio company, then consider the arguments that will be made to try to recharacterize that debt as equity; if your debt is secured, then make sure you understand whether and how your interest in the collateral has been perfected and what challenges can be made to your liens. If you have taken a return on your investment, through dividends from operations or from cash made available through asset sales or sale-leaseback transactions, consider what challenges will be made to those payments, including to the corporate formalities and discharge of fiduciary duties, as well as to the underlying economics.

If companies in your portfolio have engaged in transactions with one another, then examine those transactions for good hygiene and economic soundness. You can't change the past, but you can understand what has taken place and anticipate the challenges that can be made, and marshal both your facts and your arguments to weigh the relative costs and benefits of various alternative approaches to restructuring or exiting your investment.

In addition, now is a good time to take a thorough look at your directors' and officers' liability insurance and indemnification provisions at the portfolio company level and across your entire portfolio, to see that they are harmonized and prioritized correctly with any similar protections that may be provided for your deal professionals at the sponsor level, so that you can try to avoid a hole in coverage.

M.A.: What types of active alternative investments are out there, when it comes to distressed investments?

D.G.: While M&A activity is low, it is not nonexistent, and an acquisition or disposition might be a terrific way to improve the value of a distressed portfolio company, or gain unanticipated exit value under the right circumstances. Add-on acquisitions of product lines or whole businesses may be available as a result of the stresses that competitors are feeling; if you have some dry powder, then this may be the time to consolidate and rationalize your portfolio company's industry a bit more.

On the sell side, strategic buyers are more active than financial ones in the current environment, and a sale to a strategic purchaser often garners a somewhat higher price or some more favorable terms; an exit may become an attractive alternative at an earlier point in your investment period than you otherwise might have expected, if a strategic acquiror takes interest.

Finally, the downturn has released an enormous amount of talent into the marketplace; you may be able to enhance your portfolio companies' management with selective recruiting at a reasonable cost in what is now a buyer's market.

M.A.: Thanks David. We look forward to your additional insights!