Private Equity by Default, Not by Design
A Discussion of Workout Strategies from a Direct Lender
Hunting Dog Capital has been a lender to lower middle market companies since 2004. From experience, we have learned that borrowers operating to plan is not the norm. Even with the most detailed diligence and rigorous underwriting processes, unforeseen or unanticipated events often necessitate the need for us to take action to protect our loan. In the best-case scenario, a minor amendment or waiver can be enough to enable a borrower to navigate an unexpected event or short-term issue.
Mo’ Money
Sometimes, amendments or waivers are not satisfactory solutions. Often times, borrowers represent that additional capital can fix everything. More money may be part of the solution, but usually more drastic steps are required.
While every situation is unique, our experience has taught us that one common contributor to financial distress is the CEO’s attraction to revenue over profit. Typical rationales include:
“This gets us in the door. We will make it back over time.”
“Best we could do without losing the business. It is a competitive market.”
“It’s the price you pay for being a small supplier.”
Not having the systems in place to collect accurate and timely data to determine a pricing strategy to assure minimum profit contribution on every sale can be fatal. It is not uncommon for us to see our clients negotiating a price and not realizing they are losing money. Over time, there inevitably will be a covenant breach.
Take Action
We learned quickly that before a loan closes, you need a sound plan of action to minimize losses. Borrowers will always provide reasons and sometimes threats as to why a lender should stand still. When there is a loss of faith in the management, delay will only make a bad situation worse. When more drastic steps are required, a lender can pursue one of the following courses:
Debt-for-equity conversion
Foreclosure
Receivership
Bankruptcy (Chapter 7/11)
Forced/Orderly sale
Selecting a course of action is dependent on each unique set of circumstance. Sometimes, the best decision is to do nothing. Losses occur when making risky investments, but it can be better not to compound the pain with more time and capital. Alternatively, and under the right circumstances, taking control of the situation, can not only increase the likelihood of recovering your investment, but also potentially generating a return well in excess of the original loan amount. In other words, private equity by default.
Private Equity by Default
A lender can take control through the remedies described above, such as a receivership sale, bankruptcy proceedings or a debt-for-equity swap. Each has advantages and disadvantages. For example, a receivership sale or bankruptcy will “cleanse” the acquired assets of past liens and most potential liabilities, but can be time consuming and expensive. While there is more certainty with respect to process, a bankruptcy or receivership can be extremely disruptive and uncertain for all stakeholders – employees, vendors and customers. Under a debt-for-equity swap approach, a lender converts a portion of its debt into equity of the borrower. Not only does this relieve the borrower of some, if not all, the debt service and is less disruptive to the borrower, it can also provide the lender direct operating control and the ability to instigate real change. Unfortunately, a debt-for-equity swap does not “cleanse” the assets and requires borrower cooperation.
When faced with the prospect of a lender enforcing its rights, borrowers/owners often threaten to quit, which they assure will cause irreparable harm because the employees will quit, customers will refuse to do business with the company and many other horrible consequences will transpire. While this can be true, our experience has been that the vast majority of employees, suppliers and customers prefer to work with stable partners that pay and perform as promised.
Before seeking control, a lender must consider the following:
Are the challenges faced systemic or company specific?
Is there potential to turn around the company and is it worth it?
Is current management willing and able to make the required changes?
What outside resources are required – legal, industry consultants, HR, recruiters?
Can risks be properly identified and mitigated? In other words, as skeletons surface, can a lender adequately protect itself?
What are critical first steps to enhance probability of success?
The importance of messaging a common goal to all stakeholders – employees, vendors and customers