Distress investors take private equity cues

NEW YORK Thu Aug 9, 2007 5:50am EDT

The Delphi Flint East assembly plant is seen in Flint, Michigan June 22, 2007. Investors who specialize in distressed assets are taking a page from the private equity playbook in their pursuit of bankrupt companies like auto parts maker Delphi Corp. and power producer Calpine Corp. REUTERS/Rebecca Cook

The Delphi Flint East assembly plant is seen in Flint, Michigan June 22, 2007. Investors who specialize in distressed assets are taking a page from the private equity playbook in their pursuit of bankrupt companies like auto parts maker Delphi Corp. and power producer Calpine Corp.

Credit: Reuters/Rebecca Cook

NEW YORK (Reuters) - Investors who specialize in distressed assets are taking a page from the private equity playbook in their pursuit of bankrupt companies like auto parts maker Delphi Corp. DPHIQ.PK and power producer Calpine Corp. CPNLQ.PK.

The boomlet in distressed financings has much in common with a subsiding wave of leveraged buyouts: it offers options to troubled companies and investors alike, but runs the risk of exuberant pricing and lax terms.

Managers of distressed funds, with assets at a record $91.5 billion in 238 funds according to Hedge Fund Research, are increasingly structuring such investments in novel ways.

"Many components of an LBO could be converted into a restructuring and much of that (LBO type of) financial engineering will be applicable," said UBS leverage finance co-head Steve Smith.

UBS advised ION Media Networks, Inc. ION.AX on a recent restructuring that will leave the struggling television operator privately held by hedge fund Citadel Investment Group and General Electric's (GE.N) NBC Universal.

The company issued convertible notes called payment-in-kind (PIK) that allow it to make payments in the form of still more debt, rather than cash. Such notes can give issuers critical liquidity but may be riskier for lenders than bonds with regular interest payments.

"Certainly the PIK features resemble the type of structures used in LBOs before the most recent downturn," said Smith.

LBO lenders had been agreeable to similar structures, but with mounting concerns over leveraged buyouts, investors have balked at PIK features. Dollar General and ServiceMaster Co., each taken private last month, had to delay or reduce debt offerings with PIK features.

How the current credit crunch will affect restructurings remains to be seen.

But the growing appeal of distressed markets was evidenced last month when Calpine put its bankruptcy reorganization plans on hold to weigh "new alternatives."

Energy companies and financial sponsors like hedge funds or private equity firms had offered to buy enough equity to fully pay off the power producer's unsecured creditors in cash, a person familiar with the proceedings told Reuters.

That's unusual in bankruptcies, which often see unsecured creditors dickering over how many cents on the dollar they will succeed in recovering.

"We're charting new territory here," said Dahlman Rose analyst Daniele Seitz of the potential combination of industry and financial players that could control Calpine.

AVENUE TO LIQUIDITY

Putting new equity in distressed companies gives investors access to potential upside beyond recouping prior investments -- a trend that has been ongoing for years.

As economic woes and uncertain corporate debt markets bear down on companies, this could accelerate.

"A very interesting dynamic in the last twelve months is the use of rights offerings in a restructuring," said Deutsche Bank's Mark Cohen, managing director, head of restructuring. These offerings to existing shareholders, common overseas as secondary offerings, have gained popularity in U.S. bankruptcies.

Rights offerings, if not fully subscribed, allow distressed investors an opportunity to dilute other equity positions.

Delphi, which last month terminated a prior reorganization plan, has proposed a $1.6 billion rights offering. Hedge fund Appaloosa Management is leading an investor group committed to purchasing unsubscribed shares -- and potentially investing a total of $2.55 billion in the restructured auto parts maker.

"It drives resolution of cases because it's an avenue to bring liquidity and equity into a distressed situation," said Cohen of rights offerings, which have recently been used to finance restructurings by Northwest Airlines Corp NWA.N and cushioning manufacturer Foamex International Inc FMXL.PK.

"CHAPTER 22" RISK

An overfunded distressed market runs the risk of aggressive restructurings focused on financing rather than operational issues -- potentially sending the target company back into bankruptcy.

"Years ago distressed companies were looked at as: 'This company is worth a certain amount because it's going to take so many years to be worked out,'" said John Sosnowski, vice president of distressed securities brokerage The Seaport Group.

But now, as distressed investors focus on the potential upside of equity ownership following a resolution, bankrupt companies are being richly valued, he said.

Like debt markets that fueled the leveraged buyout surge -- in which investors are now shying from lax terms -- distressed markets could become overly enthusiastic.

"Financial engineering has a price to it and structures will be scrutinized by different holders as to who bears the risk of a 'Chapter 22,'" said UBS' Smith, using street jargon referring to a company that has filed for Chapter 11 bankruptcy twice.

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