• Sharebar

Since my understanding of private equity is pretty limited, this might have an easy answer that I'm just missing. Sorry if it's a dumb question.

In general when a PE shop acquires a target, the lenders have a stipulation that if payments are missed (or that they are just uncomfortable with the investment), they can go after the assets and the target firm itself. My question is why don't more lenders capitalize on this and actually try to take the firms from the PE shops? Since many banks have in-house PE groups, they could essentially takeover the target companies as soon as the original shop had trouble with payments, give the company to the in-house PE and end up having paid less for it than a full buyout would cost. Understandably, doing so would limit the business that lenders would get in the future (and might not be ethical/legal), but it seems like the there is a huge upside for the lending banks.

The WSO Advantage - Private Equity

PE Interview Prep Pack

9 LBO Tests, Get an Edge, 200pgs+ Learn More.

Comments (13)

  • jjpp18's picture

    It's a dumb question. You can't repossess because you 'are just uncomfortable with the investment'. How would that work under the law?

    The answer is fairly obvious if you think about standard loan/bond covenants (read some docs) as well as the bankruptcy and resolution of distress system in the US.

    Work through what would happen if the borrower was technically at fault if you have multiple debt tranches and many creditors.

  • ehf3660's picture

    I don't agree that it's a "dumb" question but you need to have more familiarity with the process to understand the answer. Let's assuming a simple capital structure with one bank lender and one series of debt. In the event of a technical default (trip a covenant etc.) the lender needs to weigh the payoff of forcing the company into bankruptcy and recovering as much as possible, or allowing some leeway so the Company can turn itself around - which may ultimately lead to better recoveries for the lender. No rational lender provides a loan hoping the company will go into distress/bankruptcy and they can hopefully own the equity post-reorg. That situation would leave them with some equity ownership but not necessarily 100% recovery. The lender would also look bad within his firm for lending to a company that ultimately fails. Much better that the Company thrives, the lender gets its coupon and is repaid at maturity or earlier.

  • sanjose04's picture

    Check out some recent bankruptcy filings and see what the recovery rates are for each creditor. Second lien and subordinated bondholders' recovery rate is extremely low in many cases. You wouldn't want to be one of them.
    Also, let's say that debt-for-equity swaps has undergone. It would take years to revitalize the company in its original shape. A short-term investment suddenly changes into a long-term investment. Why would you even bother lending in the first place with worrying about all these knotty reorganization issues? I would rather take part in the equity at the inception of deal...

  • MezzKet's picture

    That's not even the point, the merchant bank (bank's internal PE) has the fiduciary resposibility to manage the fund's money, not turnaround the bank's flailing investments... Bank's have recovery / workout groups that evaluate and maximize recovery whichever way seems most feasible... try to "accelerate" - as it called in legalese - the debt won't result in the bank taking over the asset, it'll just file an involutanry bkptcy petition and if approved, it'll force the company into bankruptcy officially... otherwise if the lenders are inflexible and threatening and predatory, the equity owner will just file for protection under chp. 11 blocking any acceleration... the only way to avoid any of this is if the equity owner hands over the keys to the bank and looses any potential recovery, no matter how minute (rarely done)...

    last thing is bank's don;t want equity... equity means increased risk to it's balance sheet and makes it more susceptible to write-downs... banks also dont want to take a lending activity and turn it into a turnaround equity practice... it costs alot of time, money and effort to manage a team like this, one which isnt anywhere near the core of lending and advisory services... the effort / cost of such an activity well outweighs a 70 cents on the dollar recovery that can be attained through the process... most prefer selling the debt at lets say 40-50 and getting rid of the headache and legal fees, etc...

  • drexelalum11's picture

    The above responses touch on most of the problems; the other thing they don't mention is bank's reputation risk. If a bank went around pushing every PE investment they could in to bankruptcy, not only would they lose money, they'd also lose a shot at any repeat business with that firm, whether advisory or loan syndication, and pretty soon any firm. No customers, no more bank.

  • jmcfadden's picture

    "Loan to own" is becoming more common

  • Marcus_Halberstram's picture

    Loan to own is primarily a strategy implemented by purchasing fulcrum securities in the secondaries and is not a lender looking to provide new issue 'loan-to-own' debt.

    As to the OP's question...

    #1- banks are primarily in the business of underwriting capital, not principal PE investing. If banks behaved as you described above, it wouldn't take long for them to be excluded from financial sponsor deals. It will also be a 'fool me once' kind of situation. If this were even possible (which its really not), a PE sponsor would only be dumb enough to let a clause like this into a contract once.
    #2- the clauses you describe don't exist. If a bank is 'uncomfortable' with an investment, they wouldn't lend money into it. And a borrower would/should be very skeptical of a contractual clause that allows the company to bring all the debt due if their risk appetite happens to change somewhere along the maturity of that debt. The actual reason for these clauses is VERY specific and limits the recourse a lender can take in the context of the those VERY specific reasons why the clauses have been created. Lenders and borrowers negotiate very competitively on terms such as capex spending, principal repayment, % of FCF which MUST be used for debt repayment and covenants.
    #3- It is almost ALWAYS in the lenders interest to avoid entering any type of default/distress recovery process, which is typically very expensive, messy and generally results in recoveries significantly under par... thats why you see so many lenders (especially in recent economic conditions) offering a host of concessions, forbearance, and covenant relief to avoid entering this process. This process would be VERY VERY litigious (read: long, drawn out and expensive).
    #4- If it is proven that a lender issued a loan with the intention of the company to be unable to pay its debts, this itself would cause a whole shitstorm of problems, primarily for the lender. Reason being... this would imply that the loan caused the company to be insolvent. If on June 30 I issue a Super-Duper-Senior-Loan to X company, and its proven that the company was insolvent when it took on this debt. Its much more complicated than this, but in a nutshell I now become an unsecured-lender, and X-Company's debt/creditors which preceded my loan (on June 30) are senior in recoveries to me. Therefore a literal Loan to Own strategy is -- absent pulling a fast one on every other stakeholder (nearly impossible) -- pretty much impossible.

  • Sterling Archer's picture

    Even ignoring the hassle of the litigation involved in such a situation, PE firms are large and recurring fee payers. Generally speaking banks will do whatever they can to keep PE firms happy because they're often among the bank's best clients. Would be very, very bad business to try to screw over a client so blatantly.

  • RestructuringGuy's picture

    Weak documentation is another major issue. 2006/2007 deals have usually weak documentation which was generally drafted in a very borrower friendly way. Banks were very keen to do deals (as long as the music was playing) back then and thus accepted most of the legal asks (PE funds were very aggresive in negotiating the docs) or simply didnt bother double checking. In the end its the banks that got screwed.

    It does make sense to go for a debt for equity swap (loan to own) strategy, but only if you bought the loans/notes at a massive discount in the secondary market, i.e. when the firm was already distressed.

  • restructure-this's picture

    With today's capital structure's, it's expensive as heck to go through a bankruptcy. You'll have so many constituents (CLOs, hedge funds, private equity, specialty finance funds, etc.) with ulterior motives (some were in a at part; others at say 70) that it will delay the restructuring process, which will have a negative effect on enterprise value, and be costly for the bank.

  • restructure-this's picture

    Also, it's difficult to prove any malfeasance on the lenders part, spurring the judge to recharacterize a bank / fund's debt to equity.

  • thenutz's picture

    The problem with your argument is that it would create more legal problems then it solves. First issue being is the lenders equity great then the existing shareholder equity? Second Issue being that I don't see how any other PE firm / Customer would ever do business with you ever again. Third, The lender could be dragged into Bankruptcy court along with the target and PE firm challenging your rights. I can see no good that can come of this but I can see years of legal bills in your future.

    Funniest thing of all is you yourself used the word "Predatory". "Predatory Lender Capital Inc."

  • In reply to jmcfadden
    antmavel's picture

    To unlock this content for free, please login / register below.

    Connecting helps us build a vibrant community. We'll never share your info without your permission. Sign up with email or if you are already a member, login here Bonus: Also get 6 free financial modeling lessons for free ($200+ value) when you register!

What's Your Opinion? Comment below:

Login or register to get credit (collect bananas).
All anonymous comments are unpublished until reviewed. No links or promotional material will be allowed. Most comments are published within 24 hours.
WallStreet Prep Master Financial Modeling