Have some extra cash lying around and want control of a company? Invest in the right distressed debt securities, and you could end up at the helm of a business. Many recent reorganisations in the oil and gas industry have been structured to resemble these types of investments, loosely defined as ‘loan-to-own’ transactions.
When oil prices began tumbling two years ago it crushed energy companies’ balance sheets, but opened the door to a series of restructuring deals that involved oil and gas sector lenders trading their debt for shares in the reorganised company. These are referred to as debt-for-equity swaps.
“Generally in energy, it is loan-to-own,” says Jeffrey Schwartz, a Robins Kaplan attorney who has written on loan-to-own transactions. “[Distressed investors] are not taking positions for incremental gains. They’re buying debt as a takeover strategy.”
Investors can end up as creditors of a company by making a direct loan or buying up debt in the secondary market. Obligations picked up either way could be part of a loan-to-own strategy.
Multiple oil and gas firms have initiated Chapter 11 cases to implement debt-for-equity swaps. Swift Energy, which filed for bankruptcy on 31 December and listed $1.2 billion in liabilities, was a notable example. Holders of the Houston company’s senior unsecured notes and holders of contract rejection claims received 88.5 percent, on a fully diluted basis, of the reorganised Swift Energy’s equity. The company emerged from bankruptcy on 22 April.
A restructuring agreement in January showed DW Partners and multiple Strategic Value Partners funds as holding senior notes. Both companies engage in distressed investing, according to their websites. Spokesmen for SVP and DW declined to comment on the deal.
“It’s the fulcrum security that is the one that would generally control the equity coming out of a reorganisation plan,” Schwartz says. The debt ranking of the fulcrum security can vary depending on the debtor company’s capital structure but is more likely to be second- or third-lien debt rather than first.
There’s a certain attractiveness to loan-to-own situations because it keeps options open for the distressed company while it tries to figure out what its future with less debt may look like.
“Courts and even creditors want [loan-to-own investors] to come in,” Oscar Pinkas, a Dentons US partner who has executed and written on loan-to-own transactions, says. Doing so helps “preserve pathways to reorganisation”. “But there’s a natural tension between letting those guys come in and how much power they get.”
Pinkas points to the deadlines that must be met in a debtor-in-possession loan agreement, a facility the company can access while in bankruptcy, as a way for the distressed investors to exert control over the case. The deadlines, while not uncommon, can be demanding.
In the Swift Energy Chapter 11 proceeding, funds affiliated with DW and SVP were among the lenders of a $75 million debtor-in-possession (DIP) loan that let the debtor receive the necessary cash to continue operations, court documents filed in January showed.
Along with the money, though, came deadlines the company had to meet or it would default on the facility. The agreement required Swift Energy to win approval of a plan outline by 15 February, a feat it achieved on 5 February. The DIP agreement also required confirmation of the debtor’s restructuring proposal by 30 March and to exit bankruptcy by 19 April. Swift Energy was one day late on its confirmation deadline and three days late on its exit, though its restructuring plan still took effect.
Secured creditors, especially, are often in a strong position to push the case forward.
“Unlike before, virtually all funded debt is secured,” Schwartz says. “Generally, there’s never unencumbered operating assets. The significance of this is that debtor control over the path of the reorganisation is diminished; the secured creditors can in effect dictate” the in-court restructuring.
Another type of loan-to-own transaction can come in the form of an asset acquisition after a lender credit bids for the company’s assets, Pinkas says. The credit bid allows lenders to end up subtracting their bid from the amount they are owed by the debtor company.
Though not the ultimate acquirer, the senior secured noteholders in American Eagle Energy’s Chapter 11 case, initiated in May 2015, credit-bid more than $52 million for the debtor’s assets. Resource Energy Can-Am ended up the ultimate purchaser with a winning offer of $36.8 million.
“The cash purchase price is more in line with recent [transactions] and now high given the continued fall in oil prices without recovery in sight,” Resource Energy president and chief executive Paul Favret says. Debt-for-equity swaps alongside asset sales, often done through an auction procedure, can both constitute loan-to-own transactions, Schwartz says. “All those transaction forms include a change of control,” he explains.
Once a distressed investor acquires the company, Pinkas says it may try to sell the company after revamping it, sometimes making management or operational changes. “Think of it as stock – these distressed investors are just trying to buy low and sell high,” he says.
That is one of the strategies Greywolf Capital Management uses when investing and it employed this strategy in the Chapter 11 case of Chesterfield, Missouri-based K-V Pharmaceutical.
A source said that Greywolf and other investors bought K-V debt in the secondary market, which gave the investors a majority stake in the company once K-V emerged from bankruptcy. In November 2014, AMAG Pharmaceuticals bought K-V’s successor, Lumara Health, for $600 million upfront cash, with the possibility of another $350 million, and 3.2 million shares of AMAG common stock.
Damon Krytzer, a managing director at the fund, declined to comment on the K-V investment. He did, though, detail the firm’s investment strategy, which includes buying corporate debt in the secondary markets.
“Compared to loan-to-own, we are generally looking at something in true distress and have historically been more active in the secondary debt markets than in providing primary debt capital,” he says. “We are proactive though across the opportunity set and moving forward that certainly could change.”
Schwartz notes that loan-to-own transactions are not strictly limited to the energy industry. “There’s nothing new under the sun [about loan-to-own transactions],” Schwartz adds. “This is just part of industry rotation.”
Pinkas says financial firms, as opposed to strategic buyers, generally carry out loan-to-own transactions.
“That may just be a function of sheer numbers” of firms, Pinkas says, explaining that strategic buyers often have less experience or are more cautious of the Chapter 11 bankruptcy process than financial buyers. This is especially true if strategic buyers are in the same depressed industry or sector.
“I think you’ll see that strategic buyers are less inclined to push the envelope,” Pinkas says.
Loan-to-own transactions are likely to continue being a plausible reorganisation tactic in the future, as Krytzer expects more corporate financial distress.
“Across the board, we expect more volatility in credit,” he says. “We expect stress and distress to be there. Maybe it’s not a V-shape, maybe it takes a while.”