Harvard Business School Working Knowledg e Archive

Distressed Private Equity: Spinning Hay into Gold

2/16/2004
The marketplace for rebuilding troubled companies has perhaps never been as fertile as today, but competition in the distressed private equity field is increasing. What separates the winners from the losers?

Once seen as greedy corporate raiders, a new day is dawning for firms that specialize in rebuilding troubled companies.

There was standing room only at a panel discussion on distressed private equity at the 10th Annual 2004 Venture Capital & Private Equity Conference, held at Harvard Business School on February 7.

One of the new themes at this year's conference was the idea that while venture capital hasn't been bringing the returns it used to, other parts of private equity investing have come into play. Distressed private equity is now seen as a necessary component of the business environment and a viable investment category.

Edmund Feeley, managing director at Littlejohn & Company, said the key to his business is determining between the "train wrecks and the company that is just underachieving but has lots of potential." This might seem simple enough, but in fact it takes tremendous skill to correctly assess the lost cause from the salvageable. Correct pricing of the deal is a crucial factor. And because of increased fluidity in the markets, there is less arbitrage opportunity in acquiring a distressed company than there was ten years ago.

Given the overflow crowd in the room, one student commented on the interest in this topic, and asked whether investing in distressed debt might be the next bubble to burst.

Richard P. Schifter, managing director of Texas Pacific Group, acknowledged that more firms are getting into the market. But several recent blow-ups suggest that some of these new entrants don't understand the market well. Once it's well understood how tricky this business is, and that it is not a quick turnaround investment (one shouldn't expect a return before five or more years), the sector will thin out, Schifter said.

Feeley said that hedge fund over-investment in distressed debt has created an over-valuation in this asset class.

But even if the bubble did burst, all the panelists agreed, there would still be investments in this area. Good times or bad, there are always companies that are inefficient and not realizing their potential.

The key is determining between the train wrecks and the company that is just under achieving but has lots of potential.

On top of that, there's no guarantee that a management team replaced by a special situation firm at one company won't move on and reduce value at another company, said Bhavin B. Shah (HBS MBA '98), principal/vice president at Carlyle Management Group. In other words, there will always be work to do.

Other opportunities abound
Opportunities in distressed private equity go beyond bringing a company out of bankruptcy, which is highly labor intensive. All the panelists mentioned that a good deal of their time includes working with spin-offs; often quite healthy companies that for some reason don't fit with the strategy and goals of their parent. These investments tend to be less labor intensive than a complete turnaround.

Questioned on how exactly they approach a turnaround and whether a complete replacement of management was always required, the responses varied.

While a complete replacement of upper management is sometimes necessary, some panelists said they follow a very deliberate process in identifying the right person for the job. And since these deals can often take up to a year-and-a-half to complete, work begins early to identify the right personnel required should they get the deal.

But replacing management is not always the best approach. Ralph Lynch, managing director at Sun Capital Partners, said that sometimes it's merely a question of coaching and advising key players. He's worked with companies that had tremendous talent but lacked guidance to utilize it effectively. "You don't want to lose the positives that are already there," he said. Many on the panel concurred, indicating that very often only a certain percentage of the management team will be replaced rather than a full execution.

Asked about global market opportunities, the panel agreed that in terms of spin-offs, particularly in Europe, there are good possibilities. But working outside the U.S. can be a more challenging and riskier environment for complete turnarounds because most countries don't have the legal framework and bankruptcy regulation that are available in the States. Also, restrictive employment codes in many countries can hinder the ability to make the drastic personnel changes needed.

The panelists came from a diverse range of backgrounds that included operations, consulting, banking, and law. In commenting on the background needed for this business, all agreed that personality fit was important because the work is often done in small teams. Other necessary attributes include being a creative thinker, being flexible, and having the stomach for taking risks.

Schifter identified two types of people who do well in this field. First are those people with good analytical skills who can tear apart financial statements and analyze a company's cash flow to see where the trouble spots lie. The second group is people with strong operational skills, which allow them to understand whether and where repairs are possible.

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.