Spinning Hay into Gold
Growth in assets under management and competition for attractive investment opportunities have not only caused hedge and private equity fund managers to broaden the range of prospects they pursue, but also to converge their investment styles. How this union works in practice has been exemplified by the emergence of distressed private equity.
Investors in distressed private equity are neither short-term debt traders nor buyers of stable, cash generative companies. The strategy, also known as ‘distressed-to-control’ or, less eloquently ‘loan-to-own’, involves the purchase of troubled company debt with the aim of converting that debt into a controlling equity stake in the restructured business. The position might be sold soon after the debt-for-equity exchange (which itself could take one year or more), or held for longer – perhaps through an operational restructuring, to allow the equity to appreciate. Either way, the distressed private equity investor needs the analytical and bankrupcty-specific skills of the distressed trader, the medium-term business planning and board-oversight skills of an LBO investor, and the ability to drive a restructuring process (either in or out of court) while a company is going through crisis. Thus the strategy requires not only deep specialist skills, but also the ability for the fund manager to invest significant time, energy and resource into the restructuring process – inevitably at the expense of working on other opportunities.
While the returns of more traditional private equity fund types such as buyout and venture capital are generally positively correlated to economic growth, the reverse is true for distressed private equity funds; the constriction of the credit markets and slowdown in economic growth in general has equated to an abundance of viable distressed private equity investment opportunities for fund managers.