Debtors' prison looms

A recent phenomenon in Dubai has generated worldwide attention – as many as 3,000 cars have been abandoned at the emirate's airport, most of them left by foreigners skipping town out of fear that their mounting debts will land them in a debtors' prison. Many of them arrived during the boom, paid too much for an apartment, ran up a credit card bill, and then lost their job. Some left letters of apology taped to the windshield.

Insolvent portfolio companies in the US don't have the option of fleeing the country, and they therefore face their own version of debtors' prison – being snatched out of the custody of their GP sponsors and placed in the senior lender penitentiary.

Once a company is in payment default on a loan, the lender's power to “get medieval” on the financial sponsors becomes fearsome. And based on some very well-known statistical projections, there may well be a significant number of private equity-backed companies that can't pay back their loans in the coming months.

According to Reuters/Thomson, the amount of leveraged loan re-financings is expected to nearly double in 2010 and then nearly double again in 2011. Guess who's backing the bulk of those issuers? When these loans were first underwritten, there was usually an expectation that a swift exit event would negate the need to refinance, and in any event no one thought that it might be impossible to get a new loan on attractive terms. Without a doubt, some of these borrowers will be unable to pay back their loans.

What's more, and setting aside the issue of refinancing, many portfolio companies are going to default well before their loan comes due, thanks to the slumping economy and their overleveraged balance sheets. When this happens, GPs may have to “turn over the keys” to the lenders. One GP I spoke with saw this happen recently to his own portfolio company. The company in question went into a payment default and the credit committee decided to reduce the debt load but seize 95 percent of the equity from the consortium of private equity owners. The company remains under the ownership of the bank. “In the past, the banks would look to an asset sale,” says the GP. But in this case, with no attractive sale price in sight, the lenders see optionality in their new prisoner. “The bank said, ‘Hey, we own this. Why don't we keep the upside?’”

To keep the nearly wiped-out GPs somewhat interested, the credit committee has offered an equity sweetener if the company ends up generating a certain return for its new majority owners.

Every restructuring is different, of course. Some bankrupt companies continue to generate robust cash flow and simply can't service their debt, while others are corporate basket-cases with no assets of value and no cash flow. On top of this, some private equity sponsors wouldn't dream of investing in a reorganised company after losing their shirts the first time around. Others view these otherwise unfortunate situations as valuable opportunities to redeem themselves by recreating a company they already know intimately at a bargain price.

Right now, GPs with portfolio companies on the brink of insolvency are feverishly trying to determine where the tipping point is that causes the senior lender to demand the keys of ownership. It is not the case that every bank that has the right to get medieval will get medieval. They may be willing to alter terms of the loan so that the GP group remains in charge, albeit with a smaller equity percentage. Banks will certainly look for “equity cures” from the original sponsors when negotiating restructurings. They may be eager to have GPs step forward as providers of debtorin-possession financing after a bankruptcy, thereby positioning the GPs to be the owners again.

Among the many wildcards in this complex, unpredictable process looms the issue of who ultimately owns the debt. Hedge funds in particular – many of them owners of LBO debt – may step forward with loan-to-own ambitions that will lead to epic battles between lender and equity holder.

Equally unknown is the LP factor – anecdotal evidence paints a divided community, with some LPs urging buyout GPs to be opportunistic and re-enter through the back door (debt) after getting kicked out the front door. Other LPs are less flexible, and feel a GP who lost money in the LBO game has no business doubling down in the debt game.