Nontraditional Lenders and the Impact of Loan-to-Own Strategies on Restructuring Process

Pawn shops have long managed to
lend a few dollars against the goods they receive as security, charge
high monthly rates and mandate the terms for redemption so they can
sell the goods at market value at their convenience. In many respects,

they provide the model currently being utilized by specialized hedge
funds and hybrid funds pursuing "loan-to-own" strategies in
distressed companies. </p><p>While traditional lenders will press for a
return of capital loaned to a bankrupt enterprise, certain specialized

hedge funds are increasingly pursuing a strategy to take control of
distressed enterprises by lending more money. Much has been written
lately about the convergence of the private equity and hedge fund
models. Acting like sophisticated pawn shops, funds with the appetite
for equity risks and rewards have targeted the loan market as the
route for acquiring control of distressed companies. Acquiring
discounted loans (<i>e.g.</i>, second-lien loans, senior subordinated
notes, etc.) in the secondary market and buying or making
debtor-in-possession (DIP) loans are two of the methods being utilized

by acquirers to get their foot into the door. Targeting the right price
in distressed investing depends on the investor's exit strategy,
timing of the transaction, potential synergies an investor can achieve

within his portfolio companies and the market value of the targeted
assets. </p><p>Recently, second-lien loans have been a hot tool for
loan-to-own strategy investors. Low interest rates and the flexibility

to transition out of the loan/investment with a profit at earlier
opportunities have greatly driven the increase in second-lien loans
from $3.3 billion in 2003 to more than $15 billion in 2005. For
instance, due to the low interest rates (LIBOR + 650-700 basis
points), a second-lien lender had a better risk-adjusted return
profile and less downside risk than any unsecured lender (<i>e.g.</i>,

mezzanine at 13-15 percent interest). In comparison to any outside
investor, the risk-return profile is further skewed due to the secured

lender status of a second-lien lender, which provides greater access
to information concerning market-value drivers. This advantage can be
significant when the company is privately held. </p><p>As the loan-to-own
strategy has become more sophisticated, investors have developed
techniques that allow them to hedge their bets while masking their
ultimate goals from the market. As a consequence, these investors have

developed a "loan-to-maybe-own" strategy. This additional
optionality increases the investors' potential return on investments
in their portfolio and provides them coverage to allow a finding in
the DIP loan context for a good faith finding under §364(e) of the
Bankruptcy Code. </p><p><b>The Process </b></p><p>By becoming a secured
lender, the "investor" gains access to restricted
information. This information advantage is a key value driver and
ultimately influences the decision to either stay put as a lender or
negotiate for equity after the company refinances. In recent years,
second-lien loans have been preferred over mezzanine loans to enter
such strategies. The low-interest-rate environment that has existed
over the past few years has made second-lien loans cheaper than other
forms of junior capital, while providing the investor priority over
unsecured claims. As a result, at both the inception of a case and at
the exit, the second-lien lender is provided additional bargaining
leverage over unsecured creditors and other stakeholders in terms of
slicing up the equity pie and potential leverage over the first
lienholders depending on the extent and scope of the subordination in
the inter-creditor agreement. </p><p><b>The Players</b> </p><p>Nontraditional
lenders, including hybrid and hedge funds with extensive liquidity,
have become highly involved in loan-to-own strategies as their appetite
for corporate control has increased. Motivated by a competitive
buyers' market with too much capital chasing the same deals and low
returns, investors seek better profits through supplying loans with
better risk-adjusted returns and extended options for additional
investment strategies. </p><p>Traditionally, such players could be
characterized as either yield players or investors. Yield players lend

money in the early stages of a restructuring process and exit before a

restructuring takes place, while investors stay through the
restructuring process and target to swap their debt into equity. Today's

investors value their options throughout the process and exit when
they can maximize their return. It is difficult to make distinctions
between yield players or investors, and players will continue to
diffuse their image in the market of distressed lending as it would
constrain their exposure to deal opportunities. As reflected in Table
1, the list of nontraditional lenders that supply DIP financing
includes hybrid and hedge funds across all categories.

</p><p></p><center><img src="/AM/images/journal/v&amp;cchart4-06.gif" border="0"></center>

<p><b>Implications for Restructuring Professionals and Their
Clients</b> </p><p>The nontraditional lender profile and the fundamentals
supporting a loan-to-own strategy for distressed companies continue to

change. The investment strategies of hybrid hedge funds and
private-equity investors increasingly converge as they seek to manage
the challenges of decreasing returns and overlapping opportunities.
New entrants in the marketplace driving out pricing inefficiencies and
fewer arbitrage opportunities have compelled hedge fund investors to
migrate into the private-equity space. While these trends have driven
distressed-asset valuations higher and led to increases in available
credit, borrowers have been compelled to accept lenders whose primary
goal is to achieve equity returns while taking secured-lending risks.
</p><p>The fundamental tool used for loan-to-own strategies remains the
second-lien loan. The liquidity and flexibility to transition in and
out of the investment provides the lender significant advantages. The
ultimate question is the impact this trend will have on the private
capital markets and what its long-term prospects are. As interest
rates increase, it is likely that mezzanine and other junior financing

products offered by financial institutions will become more competitive.

Additionally, it is unclear how ownership aligns with investor
capabilities or short investment horizons. Buying equity and managing
a restructuring process do not fall into the core expertise of a hedge

fund. Successful investors will have to partner with professionals
that will manage that process, improve their investment's operational
structure, increase its enterprise value and develop an exit scenario
that will ensure a successful exit and timely transition to new
equity-holders. </p><p>Less certain is the impact of these developments on
the targets of these investments. Inherently, the loan-to-maybe-own
strategy injects uncertainty into the process. As distressed investors

walk the line between the desire for equity returns with lending
exposures, restructuring companies often suffer. At times, the
companies find themselves trapped between the warring factions of
equity/debt around issues of valuation and the meaning of provisions
in subordination agreements and agreements granting authority to
lender agents and indenture trustees. As the process plays out, ad hoc

and official committees are formed, and all of these players have or
retain advisors with an expectation that the restructuring company
will pay their fees. Beyond direct costs, the uncertainty that this
process engenders often causes managers to leave the company, inhibits
investment in product development and capital expenditures, and may
ultimately lead to operational stagnation. </p><p>In some cases, these
dynamics play out in ways that are even more immediately devastating.
Two recent examples suffice to illustrate the point. Recently, the
restructuring of Meridian Automotive Systems Inc., an automotive
supplier that went into bankruptcy in spring 2005, was nearly derailed

as a result of leverage exerted by its second lienholders. During the
pre-petition negotiations for the DIP, Meridian's second lienholders
demanded an increase in the returns on their outstanding debt to LIBOR

plus 11 percent. Needing the second lienholders' consent to the
financing, the company agreed to their demands. It was not until
General Motors Corp. threatened to cancel remaining orders that
management was able to negotiate better terms. </p><p>In November 2005
another auto supplier, American Remanufacturers Inc., was less
fortunate. Black Diamond Capital Finance LLC, which controlled the
senior debt, proposed a DIP financing coupled with a quick asset sale
in which it would be the lead bidder. Two opposing hedge funds, DDJ
Capital Management LLC and Airlie Opportunity Master Fund Ltd., which
controlled the second liens, offered a DIP financing targeting a
rehabilitation of the company. After four days of confusing disputes
about definitions of third parties, priming and subordination, the
company lawyers informed the court that the company had run out of cash

and converted to a chapter 7 liquidation. The increased power given to
a wider group of lenders will continue to influence the outcome of
chapter 11 restructurings. </p><p>As capital structures grow more complex,
the potential for disputes between and among the different levels of
debt and equity will continue to increase. Moreover, as hybrid funds
pursue loan to own strategies, the uncertainties injected into the
restructuring process will likewise increase. Seemingly, this trend
will create more opportunities for restructuring advisors of all
stripes, but often at a material cost to the restructuring company.
Making things even more complicated is the liquidity in the
second-lien market. Unlike the pawnbroker who was typically in his
shop when the borrower returned with his ticket, the holders of
second-lien paper trade in and out of positions daily. Restructuring
companies often wake up to find that the investors with whom they were
negotiating yesterday have sold their positions, bringing new
potential owners to the table. </p>