Distress Investing: Crime Scene Investigation

In the underbelly of private markets lies the main culprit behind corporate failures: defective capital structuring.

Frequently the result of human failings, the widespread overcapitalization of start-ups and quasi-universal overleveraging of buyouts have led to a deep-seated zombification of private markets.

With interest rates remaining at or near 20-year highs, ballooning interest expenses will continue to cause cash-flow incontinence. A whole new landscape for private capital fund managers and their portfolios could shape out.

Forensics in Private Markets

In a segment of the economy notorious for its opacity, distressed scenarios are particularly poorly analyzed. Modern investigative techniques applied by turnaround consultants and court-appointed administrators rarely gather sufficient proof of corporate responsibility. This is surprising because Locard’s exchange principle regarding forensic evidence applies to most instances of mismanagement.

While market disruption can be deemed a natural cause of death, especially among start-ups, no such justification can be used to describe the putrefaction of debt-bloated buyouts.

Naturally, failure is part of private markets’ DNA. About one in six leveraged buyouts (LBOs) fail to deliver their financial sponsors’ hurdle rates, and seasoned venture capitalists (VCs) know that seven out of 10 start-ups they back will lose money. But these are averages over the economic cycle. In a recession, more than half of LBO exits could be bankruptcies or insolvencies as happened in 2009, according to data compiled by the United Kingdom’s Centre for Management Buyout Research at that time. And most dotcoms ran out of money or went through a forced sale process during the 2000-2005 market correction.

Live, Die, Repeat

Some sectors of the economy regularly go through turmoil. The mattress industry, for instance, has long been subject to periodic crashes.

In the wake of the global financial crisis (GFC), UK private equity (PE) firm Candover lost control of Hilding Anders when this mattress maker buckled under its debt burden.[1] Following a complex refinancing, KKR Credit diluted Candover’s equity stake before eventually acquiring the business. Partly due to the Covid-19 pandemic, KKR still holds Hilding Anders in its books[2] eight years later.

Other examples of botched buyouts in the sector abound. Last year, Advent-backed Serta Simmons Bedding filed for Chapter 11.[3] It wasn’t a first for Simmons, which had gone bust during the GFC[4] and was then bailed out by credit specialist Ares Management.[5]

What is odd about fund managers’ passion for the bedding industry is that, even without leverage, it is a corporate graveyard. Years of quantitative easing encouraged VCs to back mattress start-ups, granting them the right to sell products at a loss. The practice pushed Mattress Firm, the sector’s largest brick-and-mortar retailer in the United States, out of business.

E-commerce platforms were no disrupters. They simply peddled their wares through online channels. Eventually, they went ex-growth. In the United States, online specialist Casper Sleep’s abysmal post-IPO trading led to it being taken private in late 2021, 18 months after listing, at half the price of its first-day close.[6] The European equivalent is called Eve Sleep. It was rescued from administration in 2022[7] after its market capitalization dived 95% in the five years following its IPO.

The notion that consumers would get into the habit of changing mattresses ever more often was misconceived. Mattresses are typically replaced every eight to 12 years. At the peak of the cycle, consumers renew them more frequently, but when budgets are stretched, they wait much longer.

Anatomy Of a Fall

Case studies of cyclical sectors are instructive because the COVID pandemic turned many opportunist deal doers into special-situation investors and corporate undertakers. Even acyclical industries, however, can suffer from PE fund managers’ slapdash practices.

In recent years, the case of Thames Water, the United Kingdom’s main water and sewerage utility teetering on the verge of bankruptcy, demonstrated the impact that many years of debt-fueled dividend recaps and chronic underinvestment[8] can have not only on water quality and delivery,[9] but also on the viability of a business operating in an industry considered resilient.

A similar homicidal scenario occurred 15 years ago at TXU, a.k.a. Energy Future, Texas’s largest power generator that was taken off the stock exchange by KKR, TPG, and Goldman Sachs during the credit bubble before filing for Chapter 11 in 2014.[10] The autopsy of TXU’s corpse revealed that the cause of death was not due to natural causes, such as infrastructure obsolescence, but rather to excessive leverage when shale gas discoveries brought energy prices to all-time lows.

If the cause of death was not accidental, luckily for TXU’s PE owners, in the business world no distinction is made between suicidal and homicidal motives.

The ability of a hugely cash-generative company operating in a very mature and monopolistic industry to sustain high levels of leverage can help financial sponsors borrow against the terminal liquidation value of the underlying assets. That is the case even if it risks leaving the borrower in distress. If necessary, assets can be realized, either piecemeal or via shotgun disposals.

It is surprisingly easy for financial sponsors to renege on their fiduciary responsibilities as majority owners, even though they dictate how much debt their investees borrow. Hence the PE fund managers’ tendency to become recidivist corporate slayers, turning your run-of-the-mill diseased LBO into a crime scene.

At any rate, in cases where debt-ridden companies provide vital services like utilities or transport hubs, governments usually have to step in, as the UK authorities are expected to do in a potential renationalization of Thames Water.[11]

Debt as the Elixir of Death

The investigation of PE-backed zombies is made considerably easier by the fact that the murder weapon is practically always the same: debt.

Overleverage leading to bankruptcy is akin to the old medical practice of bleeding patients. Debt commitments force an unreasonable amount of operating cash flows away from the core activities of a corporation. Just like bleeding made the human body invariably weaker, when interest rates rise, LBOs run through cash at a faster clip.

The main consideration for borrowing is to allow financial sponsors to reduce the equity portion of a transaction, which mechanically boosts an investment’s prospects.[12] But leverage is a double-edged sword, producing superior returns on the upside and heightening financial risk  when plans miscarry — in which case all of the equity could be wiped out, providing further incentive to minimize the equity portion.

In the years preceding the collapse of a buyout, leverage often inflicts spectacular collateral damage, leading to desperate attempts at operational turnarounds. These include cost-cuts, layoffs, and asset hive-offs — the sort of harm forensic examiners commonly call perimortem injuries.

The cost of distress also includes endless negotiations with lenders, as well as the loss of suppliers and customers concerned about the company’s creditworthiness or its ability to survive.

Even if overleverage turns out not to be fatal for the borrower, it can impact the health of a company in ways similar to what overeating does to the human body. Excessive weight, especially morbid obesity, can lead to chronic illnesses like hypertension and respiratory disorders. Too much debt makes the borrower less agile and more vulnerable to external forces like high interest rates, technological change or intense pricing competition.

In both cases, pathological symptoms like sluggishness and underperformance are prevalent, as can be seen in the following table, which includes a subset of distressed LBOs that failed to recover from the GFC.

Examples of Capital Structures and Deal Outcomes During the GFC

Source: The Debt Trap[13] by Sebastien Canderle

Diagnosis and Restructuring

Anyone acquainted with toxicology will find zombie LBOs excellent case studies. Most buyouts that struggled during the Credit Crunch had a debt-to-equity ratio in excess of 60-40. Steep leverage cannot therefore be deemed coincidental but rather at the root of the problem. That explains why, in today’s high-interest climate, many PE portfolios have become funerary chambers.

By diverting management time and resources toward the primary task of maximizing short-term cash flows to meet loan commitments, the PE playbook introduces bureaucratic dry rot, rendering businesses inflexible and unable to adapt to change. Organizational entropy leads to decline and, at times, even failure in the long run.

Post-mortem examinations of bankrupt LBOs by insolvency practitioners and other corporate coroners indicate that the financial statements are the organs that best retain evidence of the cause of death.

Regardless of the corporate diagnostic, there are two types of financial restructurings. One deals with the asset side of the balance sheet. The other one aims at realigning a company’s liabilities.

Asset restructurings include disposals of non-core or easy-to-liquidate assets, especially to repay loans reaching maturity. Other kinds include write-offs and write-downs, frequently of impaired assets like acquisition goodwill, but these do not help reset the borrower’s capital structure.

The goal of liability restructurings is to determine the borrower’s debt capacity under new market conditions. Pertinent measures can take the form of refinancings, debt renegotiation, equity injection, and debt-for-equity swaps.

Restructurings can occur through out-of-court workouts, when creditors consent to amendments and extensions to the loan agreements. Such processes typically require the majority approval of each class of lenders. When negotiations fail, filing for Chapter 11 reorganization, Chapter 7 liquidation or similar administrative procedures is often the only option.

Even if leverage is the ultimate murder weapon and financial sponsors the main culprits — particularly when debt is issued to upstream dividends[14]  — the bankruptcy administrators’ and other expert pathologists’ task of investigating LBO failures remains daunting.

Knowing all that, claimholders and borrowers are encouraged to work it out among themselves. That makes sense. After all, the central role that debt plays in this drama makes the lending community an accessory to the crime.

[1] https://www.fnlondon.com/articles/candover-keeps-control-of-bed-maker-as-mezzanines-circle-20091030

[2] https://www.hildinganders.com/our-owners

[3] https://www.axios.com/2023/01/24/mattress-maker-serta-simmons-bankrupt

[4] https://www.reuters.com/article/simmons-idUSBNG35582120091116

[5] https://money.cnn.com/2009/09/25/news/companies/simmons_bankruptcy/

[6] https://edition.cnn.com/2021/11/15/business/casper-sleep-private/index.html

[7] https://www.expertreviews.co.uk/mattresses/1417104/eve-sleep-rescued-from-administration-by-bensons-for-beds

[8] https://www.theguardian.com/business/2023/jun/30/in-charts-how-privatisation-drained-thames-waters-coffers

[9] https://www.ft.com/content/240742e1-9e46-4570-abdf-68ee36b4bd62

[10] https://lawreview.law.lsu.edu/2018/06/13/energy-future-holdings-corp-the-second-largest-public-utility-filing-ever-poised-to-finally-exit-bankruptcy/

[11] https://www.theguardian.com/business/2024/apr/18/whitehall-blueprint-for-thames-water-nationalisation-could-see-state-take-on-bulk-of-15bn-debt

[12] https://blogs.cfainstitute.org/investor/2022/10/21/tricks-of-the-private-equity-trade-part-2-leverage/

[13] https://www.amazon.com/Debt-Trap-leverage-private-equity-performance/dp/0857195409/

[14] https://www.wsj.com/finance/investing/private-equity-firms-desperate-for-cash-turn-to-a-familiar-trick-95368c27