Q&A: CB -> CIB -> Distressed

So PE firms buy these companies using leverage, and down the line the company has issues leading it to default or break a covenant of the debt, and that's where you step in? 

We step in usually before this happens. Most of the time, our base model implies the company can rebound without going into a RX process. RX processes have a lot of lender on lender violence, in which majority lender groups and equity holders benefit at the cost of minority groups of the same tranche. Our capital is limited and the fund terms dictate that we must have diversification and our broader firm believe in portfolio theory, so concentrated positions aren't in our wheelhouse. This is to say we really can't ensure we'll be able to make it into majority groups in the majority amount of capital structures we invest in. 

What's the intuition behind this strategy? In other words, why don't you guys: search for private companies that are struggling and would be open to taking on your type of debt, focus more on companies with public bonds that are struggling who would be open to refinancing with you, other? 

This is a small portion of our mandate. We're generally not looking to give incremental capital to struggling businesses. This type of investing becomes more interesting in higher rate environments like today, because you can get a good risk premium. When rates are low, risk premiums are low cause everyone is chasing yield and inevitably you're forced to throw good money at shit companies to find a return.

A situation where would do this would be when a good company is in a fucked up, temporary situation - e.g. a company that has seen margin erosion due to inflation, but is strategically position with strong pricing power to recover, but has a liquidity need to buy time to introduce price increases. If we can price this debt at the right price - getting enough return relative to perceived risk, we'll do it but our fund mandate only allows this to be a small portion of our capital.

Along the lines of that last one, when your firm comes in for these secondary positions, are you renegotiating the terms of the debt, and if so, how crucial is this aspect of the deal? 

The secondary opportunities are our wheelhouse. The philosophy behind it is 1) the market is an inefficient at pricing secondary debt opportunities, 2) through extensive diligence and a "propriety" edge our team is positioned to find opportunities where the market is mispricing risk and 3) our team has the industry connections and investment expertise to prosper through RX processes or even to own the business to a successful exit. 

Much like the example above, we're looking for good companies in bad situations. The only difference is we're not expecting to have to provide incremental capital. It starts with valuation, let's say we find a business that's worth 10x and their market implied 1st lien leverage is 5x. This means you have a solid equity cushion of 5x below you and your value is "safe". We think the company has the liquidity to make it through its "situation" and by the time the debt matures, the company will delever to 4x, a level where the primary market will refinance and get us taken out. This yields a 15% return. This is what we're looking for most of the time, but that is a base case situation and we need to get comfortable if shit doesn't goes to plan.

So we'll think about what happens if they don't have enough liquidity. This is when a RX analysis comes in. For simplicity, lets say the equity holders don't want to put in more money, lender on lender violence is avoided, and now as debt holders we take the keys. We own the business, but it still needs liquidity to operate. We bought the debt at 5x, now we throw in another turn of leverage to give the company cash to operate. This means we effectively bought the business for 6x, when its worth 10x. You  rebuild the business for a couple years and exit for a decent return. In these situations, there can be upside convexity - management grows ebitda more than expected and exit we fetch a 12x multiple instead of 10x. For the incremental capital injection to be considered a successful deal, the return must be higher than what the return would have been with no additional capital and the business just sold through a 363 sale.

And what is the general size of these companies in terms of revenue or ebitda? Large range, but usually between $50  (rough minimum needed for broadly syndicated debt at origination) and $300mm in ebita, can go higher depending on the perceived quality of the business, what the docs allow for in terms of dropdowns, sub debt, priming and a whole host of moves the equity holders can do to protect their investment, who the other lenders are etc.
 

Thanks again for your patience and insights. I'm learning so much from this post.

My pleasure.