While private equity encompasses a wide range of different types of transactions, many people associate it with distressed funding. This approach to private equity involves investing in a company that is not performing according to its potential. Investors often make various changes to management and operations to turn the company around, or they may decide to sell off some assets.

Due to the COVID-19 pandemic, the distressed funding approach has grown in popularity. Private equity investors are targeting companies that are struggling yet have significant potential to recover with some financial support and expert guidance. Interestingly, several strategies fall under the umbrella of distressed funding. Read on to learn about four of them.

  1. Insolvency sale

The most basic form of distressed funding is when the target company has already engaged in the formal insolvency process. Investors often have the opportunity to purchase the assets of the company from an insolvency professional. This approach can be difficult since insolvency damages the reputation of the company. Often, the key contractors have been terminated as a result and any goodwill between the company and its customers is likely diminished. However, at a deep enough discount, this deal can be hard to resist. Before buying the assets of an insolvent company, investors should be sure they understand the local rules and procedures and that they time the sale correctly to avoid entering a business with extremely deteriorated value.

  1. Pre-packaged insolvency

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Sometimes the creditors behind a target company will agree to sell the company or its assets before engaging in the formal insolvency process. Once the agreement has been arranged, the bankruptcy filing is made and the purchase is finalized.

In this situation, the package is arranged beforehand and due diligence needs to be done before an official bankruptcy filing. The seller does not provide any sort of transitional support or services, and insolvency lawyers oversee the entire process.

Finding this sort of arrangement can be difficult, but it is usually beneficial for all parties involved. The company can appease its creditors while the investor assumes control of the organization at the moment of the bankruptcy, so there is less work in terms of damage control. Importantly, the rules about pre-packaged insolvency deals can vary quite a bit between jurisdictions, so it is important to know them before formulating a deal.

  1. Negotiated deals

Distressed funding does not always involve companies that officially go bankrupt. Investors can often negotiate deals with companies that are in distress, although the outcome of such negotiations generally depends on the level of distress and the likelihood of insolvency. Sometimes, the timeline of these negotiations can be rushed, keeping investors from taking the time they need to conduct full due diligence. Even in this situation, it is essential to review key risks like termination rights. A good approach is to figure out whether the company or the seller is distressed. Sometimes, both are facing financial difficulties. If the seller is distressed, any warranties offered by that individual are of little real value, so purchasing warranty and indemnity insurance and making escrow arrangements is wise.

The transaction in a negotiated deal can be challenged in a variety of ways depending on the jurisdiction. Some common challenges include fraudulent conveyance, unlawful preference, or transaction at an undervalue. Investors can pay market value for the company as a way of mitigating this risk, or they can look to a qualified financial advisor for a fairness opinion or to run a competitive sale process.

In the current economic environment, financing acquisitions of this nature with debt can prove challenging. If the proceeds of a sale will not pay the lenders of the target company in full, it may be possible to roll the debt into a new structure that provides added liquidity and increases the chances of recovery. This sort of debt roll requires the consent of all existing lenders.

  1. Loan to own

The loan-to-own strategy involves the acquisition of secured debt from the target company along with a plan to convert it to equity. This conversion plan may be consensual, but it can also happen through a formal insolvency procedure. The latter approach binds creditors and removes the possibility of challenge.

In these types of deals, investors can only do their due diligence using publicly available information and the financial documents provided to the lenders, so there is some risk involved. Investors should focus on the capital structure of the target company and the terms of its current debt financing, which includes the rights of various creditors. Understanding this information helps create a clear path to the desired level of equity. Investors should pay attention to voting thresholds, inter-creditor agreements, and rights to release the claims of other creditors.

Investors taking a loan-to-own approach define the fulcrum credit, or the amount and type of debt most likely to be converted into equity. In general, investors want to achieve a blocking stake in the fulcrum credit so that a vote is required for any financial decisions. Also, investors should pay close attention to the creditor composition as lenders will have varying interests. Understanding these interests can give investors greater insight into the deal.