Insights

Insights series / 15 July 2021

Debt for control strategies

To control or not to control

To control or not to control

By Alex Di Santo

The accumulation of debt as a strategy to establish control of the borrower is on the rise. With the end aim of turning a struggling company into a profitable business, asset managers will deploy private equity-like management capabilities – and have access to experts in company bankruptcy law to ensure success.

Investors seeking new opportunities have been fuelling the rise of debt for control – also known as loan-to-own – strategies.

Under this strategy, managers seek to take control of a distressed company by investing in its debt, typically a senior debt tranche secured on the company’s assets, with the ultimate goal of converting it into equity at a later date. Managers carefully plan where the fulcrum security is in a company’s debt structure in order to successfully execute this strategy. The fulcrum security is the amount and type of debt most likely to convert to a controlling equity stake by the end of the strategy.

Debt to equity conversions can take place through a consensual out of court process, bankruptcy proceedings or local law processes binding to creditors. If the manager’s claim to the equity is successful through one of these routes, the debt is then converted to equity under its plan of reorganisation (if in the US) or the jurisdiction’s relevant restructuring or insolvency frameworks, through which third-party equity and (usually unsecured) creditor positions are usually exited.

In each scenario, managers need to have a clear path to a controlling equity stake to ensure success as they could find their plans thwarted if their position is less than 100% of the outstanding debt or they fail to establish a majority stake at all. Without a controlling interest in a debt tranche, managers may seek to convince other holders in the tranche to adopt its restructuring plan.

 

Debt for control

Sources: Cambridge Associates, Crestbridge

Figure 1 above demonstrates that managers will have to solve a myriad of questions on their path to value, not all of which can be answered a priori given that vastly different companies can be the target of a debt for control strategy. For example, a small senior debtholder may not be so co-operative if they have a large junior debt holding. An investor who bought in at par will have different objectives to one who did so with a deep discount in the secondaries market.

Despite this, the framework of a loan to own strategy is tried and tested, so there is a common process. This includes understanding the extent of the target’s cash runway, the fulcrum debt, composition of other creditors and the details in the terms of debt, public perception where relevant, the scope of a deal, whether all liabilities are resolved through the process or not and whether the company will need to be restructured (if solvent) or insolvency proceedings started. Wherever issues can be looking into in advance, they need to be thoroughly investigated before any investment is made in a potential target company's debt, though some managers do take tentative “toehold” positions that can be grown in the future. 

Either way, debt for control is a viable and successful strategy that can be used by managers to gain control over a company’s equity, especially in a world of high valuations and a competitive issuance market. It's a manager strategy that has been rising in prominence for some time and one that we are seeing more regularly.

In Europe, past high profile examples of targets of debt for control strategies, with varying degrees of success, include Countrywide in the United Kingdom, Belvédère in France and Monier and Almatis in Germany, following the Global Financial Crisis in 2009. More recently, high profile examples can be found with Tacit Capital’s $80m debt to equity exchange for control over US gym chain Town Sports in December 2020. Another with Cirque du Soleil’s creditors led by Canadian fund Catalyst Capital Group, who injected around $350m into the circus and agreed to reduce its debt from $1.1bn to just $300m. In each of these high profile examples, the companies were allowed to move forward, putting their past financial missteps behind them.

Given the nature of debt for control strategies and the possibility of insolvency proceedings or corporate restructuring, where expert knowledge and speed is of the essence, managers will want to work closely with advisers who are knowledgeable and have experience in the space. Such partners need to be able to collaborate closely with other advisers and stakeholders to manage key processes, ensure deadlines are met and regulatory requirements are satisfied. 

Skilled lawyers but also skilled fund administrators have much to offer managers pursuing this strategy: during the restructuring planning process, around court dates, in taking direct control of the company, its assets, remaining debts and responsibility for employees and of course future exit - all of which will have to be provisioned for.

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