Distressed vs. Traditional Buyout

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Maybe a stupid inquiry (I'm newer in the industry) but why do some folks prefer to go the distressed PE route rather than a traditional buyout fund? Is investing in companies at/near bankrupcy more high risk, high reward? Is it the more operational focus, or turnaround-centric strategy?

Just trying to pick someone in the space's brain here. Thanks!

not referring to HF / credit

Comments (20)

 
Most Helpful
Sep 15, 2020 - 12:29am

I've only done 3 turnarounds, and all were relatively small companies where we took something doing $1M - $3M in rev to ~$10M - $15M. Not a vet by any means and definitely smaller deals relative to what some guys I've had the chance to talk to here have done. So YMMV and my experience is not at all like traditional turnaround/PE guys.

The way we play turnarounds is almost as a growth equity play.

Think about it...you can either invest in a Series A ready company at a valuation of $10MM - $25MM or you can use that $3M - $5M you'd be putting into that company to turn a company around and own the majority/entirety of the cap table. After we stabilize a company, we will usually raise additional capital at a much higher valuation or raise at a higher valuation on entry and use the capital to help stabilize/turn the co around.

For example, my partner and I put ~$1M into a company we bought in 2019, then raised at a $4M valuation a year later, and will raise again at a $15M - $20M valuation later this year or Q1 2021. Along the way we sell secondaries - we will have ~70% of the company between us after the Q4 round and have all of our cash back + more after the series A.

We've also done more vanilla deals where we turn a co around/grow it then hold and pull cash generated from growth + levering the company once the balance sheet is healthy again.

The specific area we play in isn't remotely competitive so good deals are easier to come by than say...SaaS.

Beyond the raw mechanics, I like turnarounds because they're satisfying at a personal level, require more thought/maneuvering than vanilla PE, and have way way more upside. Vanilla PE is just too competitive. I'm not smart enough to play against a bunch of Ivy League kids working @ a $250MM fund so I just play in my own sandbox where no other kids will come because it smells like bear piss.

 
Sep 15, 2020 - 1:20am

 Thanks for your insight. Sounds like you have a unique investment focus in early venture "turnaround."

I'm not smart enough to play against a bunch of Ivy League kids working @ a $250MM fund so I just play in my own sandbox where no other kids will come because it smells like bear piss.

I completely agree with this as well^. Feel as if MM/LMM traditional PE is becoming moreso overcrowded now as new spin-offs and search funds continue to pop up and dilute opportunity even further.

 
Sep 15, 2020 - 1:39am

Yes, we're moving upstream to larger deals soon but I need to build out the "infrastructure" a little more. Cash flow from current portfolio companies will allow us to do it but the hiring process is pretty involved/eats up more time than I thought. 

I think having a solid "drop-in" team is huge for turnarounds which is what we're trying to bootstrap.

 

 
Sep 15, 2020 - 12:47pm

There are 3 - 4 firms slightly upstream from us, but I don't consider most of them competition. Three of them aren't really good at anything and one is hyper focused on a specific vertical that I don't want to play in anyways.

 
Sep 27, 2020 - 1:04pm

Spot on. Distressed (be it debt or equity, liquid or illiquid) is a much more intellectually stimulating exercise; super satisfying when your team gets it right; and many of the MF players avoid MM distressed transactions for the exact reasons you describe. sb’d.

From one turnaround guy to another, I hope you’re holding up alright with all the chaos these days.

"In order to be a really good investor, you need to be a little bit of a philosopher as well." -Dan Loeb

 
Sep 15, 2020 - 2:05pm

As to the motivations behind why people choose one or the other, I cannot tell you. I’m in infra PE. I can try to explain why I see the interest in both.

I apologize, the post is long.

I know you said you're not referring to the HF / credit space, but I think it helps the explanation. A week or so ago, someone asked about the differences between credit v. equity L/S in hedge funds. They noted that investing in credit has a capped upside of buying below a bond's par value, reaping the benefits of the fixed coupon for the life of the bond, the bond appreciating to 100 of par, receiving the principal repayment at 100 of par, and no more. I think I read somewhere that credit hedge funds focus in finding value in the 90+ of par area, so not distressed, but I could be totally wrong. Whereas investing in equity L/S, specifically long, has no capped upside as a stock can theoretically rise indefinitely.

I see the inverse to be true when comparing distressed v. buyout in PE. In distressed situations, a company can have a negative enterprise value. The equity is almost or actually worthless. The company needs to restructure its outstanding debts, leaving many of the creditors and all equity holders with significantly less, or zero, of the value than they hoped for when they first invested into the company. If the company has existing infrastructure to rebound, but just needs to restructure its debt, managerial improvements, cuts to wasteful spending, negotiate vendor discounts, streamline inefficiencies, and a cash injection, the upside is almost unlimited since you are growing from a nearly worthless enterprise value. I say "just" sarcastically, as distressed investing and restructuring are complex processes that take a level of sophistication and legal understanding not as necessary in the buyout world. The downside can often be no return and no return of capital.

A buyout firms fundamental model isn't much different. They purchase a company that they see to be undervalued. The difference is where they think they can add value. The company isn't in distress, but can gain value from improving its operating efficiency. So a buyout fund will purchase a company, in what they believe to be below market enterprise value (but not a company in distress), make managerial improvements, cut wasteful spending, negotiate vendor discounts, streamline inefficiencies, etc.. They are purchasing at a much higher enterprise value than distressed investors do. But, they understand there is a capped upside their improvements can make, due to restrictions like the life of the current fund. The downside is capped as long as the investors don't load up too much debt, forcing the company into distress, that the company's cash flows cannot pay down. In all likelihood, if the buyout fund makes no return, it can likely, at least, get its capital returned.

Distressed and buyout PE investors both purchase companies, who they believe to be undervalued, through debt and/or equity. Distressed investors are focused on finding value in the restructuring of obligations, cash injections, and turnaround. Buyout investors are focused on adding value by improving a company's operating efficiencies and rate of growth.

Both are trying to do what every investor does, buy low and sell high. Both add value, just in different ways. It's just about finding what you're better at / more interested in.

The reason you pick one or the other is because they are different skillsets. Specialization is key to generating the best results. That's why many investment companies are siloed by industry/strategy. Clayton Kershaw and Aroldis Chapman are both dominant, hard-throwing, left-handed pitchers. But Kershaw's value would be limited as a closer, and Chapman's value would be limited as a starter.

 
Sep 15, 2020 - 4:47pm

Thanks! Very high quality explanation of the difference between the two. Appreciate the insight on the credit vs. equity analogy also (& the baseball).

the upside is almost unlimited since you are growing from a nearly worthless enterprise value.

I'm surprised to hear this. A significant discount is obviously expected if the company is truly in/nearing "distress," but is it common to invest at an EV of ~0?

 
Sep 15, 2020 - 5:44pm

Not really in the equity, but in the credit. The investor could speculatively purchase debt trading way below par and trade places with the big creditors who will likely end up owning the majority of the equity when the restructuring is complete. Not typical, but possible.

 
  • Associate 2 in PE - LBOs
Sep 15, 2020 - 11:47pm

I can add some perspective as someone who works at a MF which focuses on distressed (wild guess..). The superficial appeal to this is that from an investor perspective, a distressed PE guy gets to value LBOs from a different perspective in that you are often bridging seller expectations with an inadequate upfront value / heavy contingent value structure etc. But one of the biggest things that sets a distressed mindset in terms of recruiting and people deciding what they want is the operational aspect. A distressed role POTENTIALLY offers the chance for a sponsor to bring in a better management team / operational advisor or partner and make magnitudes of a difference to a portco as compared to the difference one could make with a vanilla buyout. This is more akin to the turnaround strategy you were mentioning. There will often be a restructuring / cost-out plan which accompanies a buyout for distressed guys and is often a critical component to the IC meetings leading up to transaction consummation. 

 There are a few counterpoints to being in distressed that I could name but let me know if that is helpful context which is needed - I think I answered your question otherwise at a high level

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