Investing in Distress: The Story of Two Case Studies

With recessions expected in many economies this year or next, distressed positions will be an important source of deals for potential investors.

But what matters is whether the targets are permanently disabled or can be flipped. Two realistic scenarios of an early debt bubble and ensuing credit crunch provide useful guidance.

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Periodic fluctuations or dislocations

British investment firm Candover bought health products maker Ontex for €1 billion, or 8.1 times EBITDA, in 2002. The debt package, made up of large loans and record mezzanines, was worth six times earnings.

Despite strong economic growth, Ontex’s EBITDA margin fell from 17% to 12% in three years, largely due to high oil prices. Oil is a major component of the absorbent powder in Ontex diapers, and the company cannot pass the costs on to customers because their products are distributed by Walmart, Tesco, and other price-setters with oligopolistic attitudes. Unable to ship directly to consumers, and as a private label manufacturer without a dominant brand name, Ontex is a price pro.

But this was not a new development. In the past, Ontex’s profitability declined whenever oil prices rose. However, excessive leverage didn’t make Ontex a bad investment. Instead, its debt package was characterized by a rigid structure with a set repayment schedule and tight interest margins when market cyclicality demanded more flexible lending terms.

When TPG and Goldman Sachs bought Ontex from Candover in 2010, cov-light loans became simple tools that give borrowers the flexibility to adapt to this economic turmoil. This was what Ontex needed. With crude oil prices surging more than 160% between early 2016 and late 2018, EBITDA margins have fallen from 12.5% ​​to 10.2%.

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structural change or disorder

But there is another type of crisis scenario where market shifts are more comprehensive.

Private equity (PE) Terra Firma executed the leveraged buyout (LBO) of record company EMI Music, worth £4.2 billion, in 2007. In contrast to Ontex’s debt structure, EMI offered all the tricks in PE’s toolkit, including A generous cov-lite package with unlimited rights to equity treatments and generous EBITDA adjustments. However, the deal proved disastrous.

The Internet revolution has shaken up the recording industry, and for years, EMI has struggled to adapt. To turn EMI’s fortunes around, Terra Firma planned to raise capital in the bond markets and insure it against the recurring cash inflows of EMI’s music catalogs. It also hopes to restore margins by shrinking the workforce, outsourcing some activities, renegotiating artist contracts, rationalizing the property portfolio, and shrinking expense accounts. Likewise, Terra Firma has been eyeing new revenue streams – concerts, online services, promotion and artist management – and has sought to bring in new technology talent to implement digital transformation.

However, despite multiple equity treatments, EMI’s only lender, Citi, acquired the company in 2011 and hastily sold it in lots. It turned out that the EMI was not a short dislocation but a permanent dislocation. Due to online piracy, US CD shipments collapsed by fifty percent between 1999 and 2007. In the fiscal quarter leading up to the acquisition, EMI’s CD sales fell 20%. Paying more than 18 times EBITDA for such a business proved unwise.

It was not advisable to add leverage to a company facing such severe challenges. The ratio of net debt to EMIs remained above 8 during the LBO period. The turnaround strategy did not improve profitability enough to keep pace with mounting debt obligations.

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Risk pyramid

EMI’s experience shows how large execution risk does not mix well with leverage during major restructuring. Cost reductions, asset disposals, contract renegotiations, refinancing, securitization, and other traditional strategic and operational tools are no match for disruptive innovation.

This is why dislocation cannot be confused with disorder. The first is temporary and cyclical – it can be managed, even when it is recurrent in nature. The disorder, on the other hand, is permanent and structural; For many companies, he is an ultimate threat. While dislocation requires adaptation and can be addressed by gradually changing the company’s strategy, disruption requires reinvention, in which case the company must re-engineer its operations. In such a basic scenario, heavy use of debt is a very bad idea.

The risk pyramid below visualizes this dilemma: Leverage is on top of many other risk categories. Companies have little scope for financial risk — that is, debt — when faced with market, operational, and strategic headwinds. Under the weight of so much uncertainty, the extra financial leverage can crush any borrowing company.

risk pyramid structure

The big glut

Unprecedented monetary stimulus in the aftermath of the Global Financial Crisis (GFC) and during the pandemic should provide fertile ground for distressed investment in the years ahead. Too often excess capital is misallocated and leads to waste and unwise investments. Revenue can kill.

Indebted takeovers and over-capitalized startups abound, but thanks to the accumulation of capital — $12 trillion in assets, including $3 trillion in dry powder — private markets may take a long time to adjust. After peaking in March 2000, the Nasdaq didn’t hit bottom until October 2002, and many dotcoms were still reeling when the GFC broke out. Today’s particular market shake-up may lead to a similarly long wait. Private equity and venture capital (VC) firms would rather hang on to weak assets and continue to earn fees than acknowledge the true state of their investment portfolios. But with the recent banking meltdowns, the bridge funding startups need to put off any downturn may well dry up.

Through their heavy use of leverage, financial sponsors can still manage their downside risk by negotiating more flexible loan agreements and crunching the numbers. However, too much debt can leave borrowers comatose and make it difficult for distressed investors to step in. They may have to wait as Citi did amid the inevitable EMI breakup in the wake of the GFC.

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Dealing with a market crash

The financialization of markets raises a broader question: Does the build-up of debt represent a temporary disruption or a radical disruption to modern economies?

The cost of a stretched balance sheet varies: companies reduce investments; downgrades lead to lower earnings on equity; Corporate executives are looking for alternative employment; workers become uncooperative; suppliers apply stricter payment terms; customers switch to more reliable service providers; Lenders raise the cost of debt or cut off access to credit altogether.

Even if endemic excess does not lead to widespread economic destruction, industries prone to dislocation may eventually become permanently more vulnerable. Today’s high inflation, for example, can be seen as just a small hurdle for Ontex: With oil prices rising from less than $0 a barrel in 2020 to more than $120 two years later, the company’s EBITDA margins have fallen from 11.2%. % in 2020 to 5.5%. last year. Leverage is now more than 6 times earnings, as in the days of Candover LBO 20 years ago, when EBITDA margin was 17%.

But the COVID-19 pandemic has triggered demographic instability that could have much deeper ramifications for companies like Ontex, which serve both the young and the elderly by selling diapers and incontinence products. Excess death rates jumped in Europe and the United States. This trend may be short-lived, but it follows a halt in life expectancy in the United States, the European Union, and England and Wales. The benefits of improved sanitation and public health may have, for a while, reached their limits.

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The pandemic has also led to another demographic development. Rather than the predicted baby boom of COVID-19, lockdowns may have contributed to the “baby meltdown.” While the post-COVID-19 economic stimulus has helped birthrates rebound to pre-pandemic levels, demographic challenges remain. In struggling economies like Japan, Spain and Italy, low fertility rates have long been the norm. But if changing birth rates and flat-line life expectancies become more entrenched, they will represent not just disruptions, such as the cyclical spike in oil prices, but more severe market cracks affecting long-term demand for health products.

Clearly, the ramifications will extend far beyond any one company or sector. Herein lies the investment problem. Markets are dynamic: Macroeconomic turmoil and socio-demographic shifts can turn value plays into distressed assets.

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All posts are the opinion of the author(s). As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Photo credit: © Getty Images / SDI Productions

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Sebastian Kandel

Sebastian Kandel is a private equity advisor. He worked as an investment executive in several fund managers. He has several books debt trap And The good, the bad, and the ugly of private property. Kandrell also lectures on alternative investments in business schools. He is a Fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from the Wharton School.

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