WHEN BAD THINGS HAPPEN TO GOOD COMPANIES:
THE ROLE OF RESCUE CAPITAL
Rescue capital has a long and occasionally sordid history in the United States, growing out of Gilded Age overreach and finding fertile ground in restructuring best practices. Hugh Larratt-Smith takes a stroll through history as he looks back on rescue capital origins before examining what its role could be in the very near future.
BY HUGH C. LARRATT-SMITH
The Gilded Age
The Gilded Age, which started out of the ashes of the Civil War, was a hotbed of unbridled speculation and rescue capital. Fortunes were won and lost daily in the streets of lower Manhattan where Wall Street was becoming the object of public fascination. Battles for control of emerging corporate goliaths such as The Erie Railroad by Cornelius Vanderbilt, Daniel Drew and Jay Gould in 1869 were the topic of conversation in every corner bar and Gramercy Park dinner table. New phrases like ‘stock-watering’, ‘cornering the market’ and ‘bulls and bears’ were overheard on the street corners of Maiden Lane, Liberty Street and Wall Street. Newsboys brayed the latest headlines about The Erie Railroad War and Daniel Drew as men in frock coats, silver-headed canes and silk top hats hurried by.
Gilded Age barons and Wall Street operators such as E.H. Harriman and James “Diamond Jim” Fisk learned the new ways of rescue financing on Wall Street as young as 13 years old. Many Wall Street operators like Drew, Fisk and Jay Gould were not constrained by today’s securities laws from pursuing “fulcrum - security opportunism” (though Diamond Jim’s Wall Street career was cut short, dying at the youthful age of 37 when he was fatally shot by a jealous rival over his mistress, Josie Mansfield, in The Grand Central Hotel in 1872).
By 1880, the U.S. railroad industry was the nation’s second largest employer. Railroads were the newest supply chain technology propelling the second industrial revolution and required massive capital for their expansion westward. Over the next decade, rescue capital played an increasingly dominant role in consolidating the rail system as over-expansion and stock speculation triggered waves of bankruptcies. The survivors were reorganized as going concerns, and fortunes were made for those who could gain control of the fulcrum security in a railroad’s capital structure.
The Modern Age
In one sense, rescue capital in the Gilded Age and our age has many similarities. Rescue capital can be either debt or equity; the important thing is that it is focused on gaining control of the corporation through the fulcrum security. Webster’s Dictionary defines fulcrum as “something that plays a central role in or is in the center of a situation or activity.” In a corporate reorganization, it can be difficult to tell exactly who in the capital structure is the fulcrum security — many times, this is decided by a judge. Lots of people will argue that they are the fulcrum — that they alone control the process — but no one actually knows until the judge’s gavel comes down.
In the late 1980s, rescue capital in the form of equity was largely in the province of large players like Carl Icahn. It wasn’t until the early 1990’s that lower middle market companies gained access to equity rescue capital. In 1991, one of the first lower middle market rescue capital funds was formed, Recovery Equity Investors in San Mateo, CA, which raised $100 million. This pioneering equity rescue equity capital fund was led by two veterans of the Chrysler “near-death” experience in 1987. One of their early investments was in Foothill Capital. Heller in Chicago followed with an equity fund targeted at ‘broken wing, fallen angel’ companies. Both funds were control investors. In the mid 1990’s, Sun Capital burst onto the scene and seemed to be at every bankruptcy hearing. Summit Investments in Denver was formed in 2002, targeting lower middle market rescue debt bridging deals starting at $2 million.
Basic Strategic Investment
In the early days of rescue capital, one strategy was finding diamonds in the rough. These companies ranged from third generation family companies with country-club owners to corporate orphans. Many were “black swan” companies who had experienced one-time catastrophic events. Another strategy was to fund “buggy-whip” who were in sunset sectors of the economy but could be put on oxygen and life-support long enough to earn a good investment return. Today, with the massive amounts of capital dedicated to buyout financing, these opportunities are difficult to successfully pounce on. When a diamond or black swan is sighted, the competition from strategic buyers and private equity funds drives valuations into the stratosphere.
Another investment strategy is to find companies in which all of the goodwill has been eroded from the books, but the company still has decent hard assets. These types of deals can provide alpha returns, but require intense, hands-on management that could be described as practically artisanal. The investment skills that are required are operational, not financial engineering.
Capital markets have a plethora of rescue capital providers of every stripe. Some are seasoned veterans of legacy banks. Others have their roots in the liquidation industry. Some are loan-to-own shops. One fund even buys lawsuits as a way to gain control of a target company.
Neal Legan, who leads CIT Northbridge Credit in Dallas, notes, “Competitive environments and a dynamic economy increasingly require an alternative senior lender who has expertise in cash flow volatility, asset-based structuring and can collaborate with management to work through its borrower’s liquidity needs with a more strategic, flexible structure than many regulated financial institutions. When lending to a troubled business, we need to understand the primary factors negatively impacting operations, the steps needed to improve the business, the ability of management to implement those steps and the liquidity the company needs to achieve its strategic turnaround. In many instances, an alternative lender such as CIT Northbridge can bring a fresh perspective to the business turnaround. We also have the expertise to structure a credit facility that will provide additional liquidity, greater operating flexibility and a longer timeline to implement the turnaround plan.”
A Common Language
With all their differences in investing, rescue capital players speak the same lingo. Their world is filled with arcane jargon and verbal shorthand.
For instance, in the 363 bankruptcy sale of upscale garden furniture retailer Smith & Hawkin in 1999, a strategic buyer backed out of the bidding, saying to the winner of the bidding process, “I’m not comfortable here. Being in this courtroom is like being in Middle Earth. All of you folks know each other and speak this mysterious language that only you can understand.”
All fund managers search for alpha returns as opposed to beta returns. Given the risk profile of rescue capital, fund managers face headwinds in gearing their portfolio with leverage which amplifies investment returns. Unlike a plain vanilla credit fund that can get 2X leverage, rescue capital funds are difficult to leverage, in part because much of their investment return is structured as payment-in-kind. Additionally, the typical life of a fund is five years, and some operational rescue capital investments are not positioned for a liquidity event within a five-year time horizon. In light of this, rescue capital requires investment returns that are well in excess of investment returns on “plain vanilla” debt and equity.
Some rescue capital players like Blackstreet Capital Holdings in Bethesda focus on small to mid-sized companies that are either in transition or are somehow misunderstood. Murry Gunty, CEO of Blackstreet discusses their investment thesis: “We buy what other people don’t want to buy. Capital is a commodity, [and] typically, capital alone doesn’t get a company above the water line. We focus on making sure revenue is profitable; [we] would rather be smaller and profitable than bigger and not profitable. Most struggling companies need significant changes to their operations. We make all such changes immediately — bad news doesn’t get better with age.”
“Rescue capital providers are intensely focused on figuring out whether an opportunity is a ‘broken wing, fallen angel’ company or is actually dying from 1,000 cuts. No investor or lender wants to simply put makeup on a corpse. No one wants to run into a burning building,” says Skip Di Massa, partner at Duane Morris in Philadelphia.
In Chicago, Darren Latimer, co-founder and CEO of Stonegate Capital, provides some color on that idea.
“What we have continued to see in the market are both PE-backed companies and generational companies with a purpose and a reason to exist, but their balance sheets continue to hold years of strain as a result of growth, cyclicality and a couple of hiccups. With positive gross margins and the ability to cash flow, these are good loan customers in need of capital and a larger capital solution,” he says.
Some rescue capital players search for companies that have bad balance sheets but good P+L. This type of company may need the left side of its balance sheet tweaked through more efficient working capital or streamlined fixed assets — but offer real opportunity on the right side of the balance sheet. This may be realized through a refinancing or a bankruptcy to strip away leverage. These “bad balance sheet” types of rescue capital investments are typically shorter in duration than companies that require operational turnarounds.
A rescue capital player needs to be prepared to take the reins of a wild, galloping horse. And sometimes, a rescue capital loan is a small burp away from disaster. Successful rescue capital depends on a tightly calibrated operational turnaround plan for the left side of the balance sheet that is well executed.
“We look to provide rescue capital to middle market companies that have a good reason to exist. As a non-bank ABL lender that is not associated with a liquidator or interested in owning the company, we have to be comfortable with the company’s turnaround plan, coupled with adequate time and liquidity so they can execute their strategy,” says Lori Potter, managing director of Originations at Great Rock Capital.
What May Lie Ahead
Many industry observers think that the next recession will be triggered by corporate debt, with agriculture loans as the tip of the spear. A wave of bankruptcies is sweeping the U.S. Farm Belt as trade disputes add pain to the low commodity prices that have been grinding down this sector. Steven Petrie, COO of Summit Investment Management in Denver, notes that they bought ag loans from four different lenders in the fourth quarter of 2018.
Recently, J.P. Morgan Chase projected about a 40% chance for a recession in the next 12 months, up from about 33% last fall. Recessions bring many rescue capital opportunities to the surface. This could be a rich vein of ore for rescue capital players to mine. But what will the tipping point be?
According to LCD, a third of all leveraged loans issued in 2018 have leverage above six times. Investment banker George Psomas from Brooks, Houghton in New York comments, “When a balance sheet is leveraged six times, the cap structure is fragile and any slippage in performance will be amplified. Plus, with so many deals whose leverage is based on pro-forma EBITDA, everything needs to click. Leverage is a two-way street.”
At the end of last year, roughly 27% of first-lien loans were issued by companies that didn’t have junior debt outstanding, according to S&P. That was up from 18% in 2007, at the height of the last economic expansion. Junior debt can provide senior lenders with a welcome cushion in a meltdown.
The U.S. default rate for leveraged loans is currently 1.6%, well below the historical average of 3.1%. Some 80% of leveraged loans are deemed to be cov-lite, according to LCD. These loans do not have the covenants that were once considered scared.
“This low default rate is, in part, because covenants are so loose. Covenants are the canaries in the coal mines. Cov-lite structures take away the canaries for lenders,” explains Di Massa.
In a recent paper entitled Bankruptcy Hardball, Professor Jared Ellias at the University of California at Hastings and attorney Robert Stark argue, “The norms that used to restrain managers from declaring all out war on creditors has faded since the financial crisis.” Just ask the unsecured creditors of Sears, who allege in a recent bankruptcy court filing that the controlling shareholder deployed stock buybacks, spinoffs and dividends to rake in billions of dollars while stripping the 126-year-old company of assets and cash since 2005. Indeed, “fulcrum - security opportunism” may be making a comeback from the robber baron days of the post-Civil War era.
Some leveraged lenders may find themselves forced to become rescue capital providers during restructuring amendments to the original deals. Why would they find themselves in this unforeseen and uncomfortable position? Simply because too much leeway was given to management and ownership in the first place, who then proceeded to drive the company into the ditch. The canaries were nowhere to be found.
A big unknown is the direction of interest rates. But some market watchers are saying that the massive debt overhang of China’s corporate borrowers and the U.S. government deficits will drive interest rates up over the next five years, dulling the blade of the Fed. All this to say that rescue capital opportunities will proliferate as the bull credit cycle draws to a close.
The Panic of 1893 was the deepest economic downturn at that point in U.S. history, triggered by railroad overbuilding and shaky railroad financing that set off a series of bank failures. One-quarter of railroads had failed by mid-1894. Rescue capital provided by financiers such as J.P. Morgan and E.H. Harriman led to consolidation and the stabilization of the railroads by the turn of the twentieth century. Some of the winners who emerged from the financial maelstrom — Reading Railroad, Pennsylvania Railroad and B&O — were immortalized in the Monopoly board game. Gone were the stock-watering, short-selling corporate speculators like Daniel Drew who drove companies into the ground only to turn around and buy the remnants out of bankruptcy. To his credit, Drew is best remembered by his immortal quip about short-selling: “He who sells what isn’t his’n, must buy it back or go to pris’n.” •
Hugh Larratt-Smith is a regular contributing author to ABF Journal. He is a managing director of Trimingham Inc. He can be reached at Larratt@trimingham.com