Opportunities in Private Market Special Situations
By The DuPont Capital Management Private Markets Team
April 2013
SPECIAL SITUATIONS DEFINED
“Special Situations” is a commonly used term to describe a subset of the investment opportunities within private equity that fall outside of traditional leveraged buyouts and venture capital. It is helpful to
discuss Special Situations in two broad categories: Credit Strategies (“SS Credit”) and Equity Strategies
(“SS Equity”). This paper describes several variations within each category.
SS Credit strategies include:


Carmen J. Gigliotti, CFA
Managing Director
Daryl B. Brown, CFA
Director, Portfolio Manager
Credit Strategies

DuPont Capital Management
Private Markets Team
Credit Trading, which typically involves acquiring a credit instrument (e.g., an issuer’s bonds) trading at a price that the investor believes presents a compelling value, perhaps because the overall
market may be misjudging the ability of the issuer to meet its debt obligations.
Direct Origination or Capital Solutions, which are focused on making direct loans to companies that
cannot access traditional credit due to financial or operational challenges. Investors can originate a loan with strict covenants and at an interest rate well above those of typical bank loans to
help a company refinance existing debt. Another term often used for this strategy is “Loan-toOwn” as the lenders structure the credit to allow them to gain control if the borrower misses
any of the covenants.
Eric A. Wilcomes
Director, Portfolio Manager
Howard F. Searing III, CFA
Director, Portfolio Manager
David W. Julier
Director, Portfolio Manager
Kevin P. Campbell
Director, Portfolio Manager
Christopher D. Pettia
Portfolio Advisor
Distressed-for-Control strategies, which invest in corporate credit with the objective of gaining control of a company through a debt-for-equity restructuring. In order to achieve control, the strategy requires acquiring significant positions in the credit in order to play an active role in any restructuring.
Equity Strategies
The SS Equity strategy may be best described as deep-value buyouts or distressed private equity. The strategy seeks controlling investments in companies undergoing financial and/or operational distress, often referred to as turnarounds or restructurings.
In the case of a financially distressed company, the restructuring generally refers to the reworking of the company’s balance sheet. This
is typically required because there is too much debt in the capital structure. Financial distress can often lead to operational distress as
balance sheet concerns limit investment and force the company to defer simple maintenance and capital expenditures. Operational
distress can also result from poorly executed growth strategies or inefficient capital expenditures. For example, a company dedicates
time and resources to a new product while the core business suffers.
The investors that execute SS Equity strategies should have many of the basic credit and balance sheet restructuring skills that SS Credit
managers utilize; however, there is a greater emphasis on operational expertise for this strategy. Operational expertise is important because many of the investment opportunities are with companies that have experienced deep operational distress and require significant
restructuring of the business.
The SS Equity strategies can often overlap with Distressed-for-Control credit strategies. In fact, many managers may execute both of
these strategies. This can happen as SS Equity managers try to acquire the debt of a company in order to gain control. A distinguishing
feature between the two strategies is that the SS Equity strategies generally invest capital for a controlling interest in a company at the
point of a financial restructuring, whereas a Distress-for-Control credit strategy can make initial investments in the credit and then wait
for the debt-for-equity restructuring.
(Please see Appendix A for a breakdown of all the Special Situations Strategies)
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FACTORS THAT DRIVE THE OPPORTUNITIES IN SPECIAL SITUATIONS
SS Credit Strategies
Opportunities in SS Credit strategies will largely be driven by the cost and availability of credit. A good proxy to determine the availability and cost of credit is the issuance and yields in the leveraged loan and corporate high yield markets. The typical credit cycle will
see large levels of credit issued at increasingly lower spreads 1 and lower default rates. The cycle turns as defaults increase, issuance
slows, and yields widen. The charts below demonstrate this relationship among issuance, yields, and default rates.
One of the possible risks for investors in credit funds is that the cycles are generally short in duration. The U.S. debt capital markets
are large and tend to react when yields are elevated. For example, the graph below demonstrates this as high yield spreads returned to
historical norms roughly one year after the peak was established in November 2008.
High Yield Spreads (bps)
1,800
1,696
1,600
1,400
1,200
1,000
800
600
618
627
400
200
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Source: UBS
The tighter spreads should reduce the expected returns for investors deploying capital in that environment. Given the relatively short
credit cycle, some credit funds may have terms that reflect the investment horizon. A shorter investment period, such as two years,
may be preferable to the standard private equity fund’s investment period of five years. Management fees on invested capital instead
of committed capital is another term that is helpful with this opportunistic strategy.
Yield-to-Maturity (“YTM”) – The internal rate of return an investor would earn on a fixed-income security if the security is held to its maturity date (assumes all coupons are
reinvested at that internal rate of return)
Yield-to-Worst (“YTW”) – Commonly used for fixed-income securities with call provisions; YTW is the lowest yield an investor can earn comparing YTM and the yield generated if
the security was called prior to maturity by the borrower
1,2,4 “Spreads” refer to the difference between the yield (YTM or YTW) on the fixed-income security and the yield on U.S. Treasuries (“risk-free yields”) of similar maturity dates
3 LTM Default Rate – The par value of all bonds that defaulted in the last twelve months as a percentage of the total par value of all outstanding bonds at the start of the twelve
month period
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SS Credit Strategies (continued)
It is important to note that the U.S. High Yield market is generally available to larger companies with annual Earnings Before Interest,
Taxes, Depreciation and Amortization (“EBITDA”) at or above $50 million. Smaller companies cannot access this form of capital and
therefore could face challenges accessing credit. This should present opportunities for funds focused on smaller, less liquid companies.
SS Equity Strategies
Opportunities in SS Equity strategies are generally less dependent on the credit markets and are therefore less cyclical. However, distressed credit cycles should improve overall deal flow potential for these strategies. As stated previously, the distressed equity or restructuring approach can overlap with the Distressed-for-Control credit strategy. SS Equity strategies are generally less cyclical because operationally challenged businesses can present themselves at any point in an economic cycle. A company’s financial condition
can be impacted by the results of poor management decisions, such as inefficient cost structures, costly acquisitions, or unsuccessful
capital expenditure campaigns.
The period leading up to the 2008 financial crisis saw an elevated level of acquisitions, particularly in the private equity market. This
was a result of an abundance of credit from the lending community and enormous amounts of capital committed to private equity
funds. The increased deal activity resulted in higher purchase prices paid for companies relative to EBITDA. The chart below shows
how the increasing availability of credit influenced valuations paid and leverage utilized:
HY and Leverage Loan Issuance Drive Leverage and Pricing
($s in Billions)
$600
$500
$400
6.6x
7.1x
8.4x
7.7x
7.3x
$325
6.0x
4.1x
$200
3.5x
$34
$54
$47
2000
Source: UBS and S&P LCD
3.9x
4.1x
4.6x
$184
$90
$58
$95
$68
2001
2002
High Yield Issuance
6.1x
$154
$152
2003
$158
2004
Leveraged Loans Issuance
$189
2005
4.8x
5.1x
$106
Leverage (Debt/EBITDA)
6.0x
4.0x
$148
$72
$53
2006
8.0x
$388
5.0x
$300
$0
10.0x
9.1x
8.4x
$100
12.0x
9.7x
2007
2.0x
0.0x
2008
Purchase Price Multiples
The global financial crisis and the ensuing economic slowdown put pressure on these highly leveraged capital structures. Valuations
for most middle market companies have not recovered to pre-crisis levels. The residual effect is that numerous private equity companies remain unrealized and overleveraged. According to Pitchbook, a data provider, there are 6,538 private equity-backed companies
that remain unsold as of November 30, 2012 (see chart below). In addition, roughly half of these unrealized deals (47%) were acquired between 2005 and 2008. This is driving the median hold period for private equity-backed companies to 5.3 years in the first
half of 2012 from 3.5 years in 20075.
5Q4
2012 Private Equity Company Inventory Report, Pitchbook
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SS Equity Strategies (continued)
How can this help distressed equity strategies going forward? Many of these companies still have highly leveraged capital structures
with debt maturing over the next several years. The companies will likely have been operating for several years under strict cash management policies, limiting working capital, and deferring capital expenditures. The elongated hold periods may eventually approach
the end of a fund’s term. The general partners of such a fund will eventually have to sell some of the companies or risk hitting their
debt maturities. Thomson Reuters6 estimates $400 billion of middle market loans are set to mature by 2015. Recall that many middlemarket private companies cannot access the robust high yield market.
These conditions should set the stage for operationally focused managers that can help turn around distressed companies. As mentioned previously, the strategy relies heavily on operational resources to help the companies return to profitability. This often means
consolidating production facilities or closing down unprofitable lines of business. This is not a “good company/bad balance sheet”
scenario.
Conclusion
There are many strategies outside of the traditional leveraged buyouts that could present interesting risk/return profiles. They can be
cyclical in nature, as with some of the credit trading strategies, or require very specific skills to effectively execute, as with restructuring
and operational turnarounds. The complexity or distress in some of these opportunities offers value to investors capable of sifting
through and working out those issues.
Appendix A
Strategy
Distressed Credit
Distressed-for-Control
Distressed Equity
Origination/Acquisition Capital Markets
Capital Markets
Value Creation
Price appreciation - “On the Buy”
Purchase price; Financial
Purchase price; Operational
restructuring; and/or oper- turnaround
ational turnaround
Realization
Capital Markets
Capital Markets/M&A,IPO M&A, IPO
Reward
Good downside protection, quick
deployment which mitigates the JCurve effect.
Good entry price for equity
control, potential for high
ROIs post restructuring.
Create value in operations
post-restructuring.
Good entry price, potential
for high ROIs. Operational
turnaround demonstrates
value-add. More efficient
deployment of capital.
Risk
Upside is limited, volatility in capital
markets. Competing against other
liquid investors. No real value-add
other than on the buy. High IRRs
can get diluted over 4-5 year investment period.
Pursuit of “Fulcrum” security lowers downside protection, less capital efficient
with many “toeholds” and
only a few restructurings.
Equity return means equity
risk – less downside protection. Timing of process
often compressed requiring
speedy due diligence.
6Financial
Investment Banks/
Restructuring Advisors/
Bank Workouts/Capital
Markets
Services, Raymond James U.S. Research, April 25, 2012
Investments in Private Equity Fund of Funds are illiquid, considered risky, and may lose money. The information contained in this memorandum is intended for the sole use of prospective investors
in understanding and evaluating the impact of market events and is not designed or intended to be used for any other purpose. The document may contain forward-looking statements, which are based
on current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in
forward-looking statements. As investment in securities includes risk of loss. There is no guarantee that any investment in the securities mentioned will be profitable. This document is not intended as
an offer or solicitation for the purchase or sale of any security or financial instrument or as a recommendation to invest in any of the securities or financial instruments discussed herein.
April 2013
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