By Richard Bravo and Elizabeth Hester Sept. 3 (Bloomberg) — The world’s biggest private-equity firms, shut out of the market for leveraged buyouts as banks curtail lending, are turning to bankruptcy courts to make acquisitions. KKR & Co. , the New York takeover firm co-founded by Henry Kravis , is part of a group converting loans made to Lear Corp. into a controlling stake in the bankrupt car-seat maker. Late yesterday, Hayes Lemmerz International Inc. said it reached an agreement with the lenders who financed its bankruptcy, giving them an equity stake in the maker of wheels for cars. This year, 162 companies merged or were bought out of bankruptcy, a 60 percent jump from the same period in 2008 and almost triple the amount in 2007, according to data compiled by Bloomberg. Private-equity firms in the U.S. are finding new ways to invest the $600 billion of capital raised mainly before credit markets froze in 2007. With corporate defaults forecast to reach a record as soon as March, they are making loans to the neediest borrowers and muscling in on turf traditionally dominated by so- called vulture investors. “It’s not a tactic that private-equity firms have historically employed, but it seems to be an idea whose time has come,†said Steven Smith, global head of leveraged finance and restructuring at UBS AG in New York. “This is clearly one of the new and most distinctive features of the current wave of restructurings.†More Opportunities In an LBO, private-equity firms usually put up about one- third of the purchase price and borrow the rest. Lending for those takeovers is down 91 percent from 2007 levels, Bloomberg data show, so buyers are instead making prepetition loans, which is financing before a bankruptcy, and debtor-in-possession loans, or those made in conjunction with a filing. Besides Lear and Hayes Lemmerz, firms are exchanging loans for stakes in Reader’s Digest Association Inc. through the bankruptcy courts, and a unit of Apollo Management LP is in a syndicate doing the same with Lyondell Chemical Co. Moody’s Investors Service said while it’s too early to say if the amount of prepetition debt being converted into equity through reorganizations will exceed the record high of about $52 billion in 2003, it’s “expecting a continuation of the trend.†While the so-called loan-to-own strategy isn’t new, opportunities are rising. Worldwide, 211 companies with bonds and loans missed interest payments in 2009, up from 55 in the same period of 2008. Standard & Poor’s forecasts the U.S. default rate will rise to 14.3 percent in March, from 9.37 percent in July, even as the economy emerges from the worst recession since the 1930s. Fewer Loans The amount of leveraged loans needed by buyout firms has shrunk to $67.7 billion this year from $311.2 billion in 2008 and $962.9 billion in 2007, Bloomberg data show. Leveraged loans are rated below investment grade, or less than Baa3 at Moody’s and BBB- by S&P. The amount of private-equity deals this year totals $43 billion, compared with $569 billion in the same period of 2007. KKR and the other lenders to Lear will get as much as a 26 percent stake, $500 million in preferred shares convertible into an additional 26 stake and a new $600 million term loan in return for their $1.6 billion of debt , according to a reorganization plan filed with the court last month. Lear, based in Southfield, Michigan, is no stranger to private equity. A predecessor was acquired by New York investment firm Forstmann Little & Co. in 1986. Forstmann, which sold off some units before taking the company public in 1994, was one of the biggest rivals of KKR forerunner Kohlberg Kravis Roberts & Co. ‘Enormous’ Returns “There are certain circumstances where we think it makes sense to provide DIP financing that converts to a substantial portion up to 100 percent of the equity post the restructuring process,†said William Sonneborn , head of New York-based KKR’s asset management division. “Lenders end up owning control of the company, and providing a means for a substantial portion of the existing loan-holders to get paid off at par.†Investors in loan-to-own deals may earn an 18 percent annual return on the financing, plus get equity, compared with the potential for 12 percent returns and no equity on DIPs, according to Smith at Zurich-based UBS. “I’m seeing more of these deals now than at anytime in the past,†said Jonathan Landers , head of the bankruptcy practice at New York-based Milberg LLP and co-author of three books on bankruptcy and creditors’ rights. “People are much less risk- averse and the potential returns are enormous. The vulture investors have gotten their courage back.†Vulture investors historically bought distressed bonds and exchanged them for controlling stakes in troubled companies. ‘Hugely Advantageous’ Lyondell filed for Chapter 11 on Jan. 6 and received a record $8 billion DIP loan. Members of the senior lending group included Apollo’s LeverageSource SARL unit, which is the largest owner of the Houston-based company’s secured debt , KKR, and Los Angeles-based Ares Management LLC, according to court documents. Steven Anreder , an Apollo spokesman, declined to comment. “Having available capital for these types of deals is hugely advantageous,†said Jason New , the head of distressed investing at GSO Capital Partners LP, a unit of New York-based private-equity firm Blackstone Group LP. “I don’t think the banks will be active in the DIP market anytime soon. New financing is difficult to find.†Banks, the traditional providers of bankruptcy loans, are unwilling or unable to provide the credit because their capital is constrained, creating opportunities for the funds, New said. The world’s largest financial institutions have taken $1.6 trillion in writedowns and losses since the start of 2007, Bloomberg data show. Tighter Standards The Office of the Comptroller of the Currency said in July that its survey of 59 banks holding $3.6 trillion of loans on Dec. 31 found that 86 percent of lenders toughened lending standards, up from 52 percent in 2008. DIP financings fell to about 23 percent of companies defaulting this year as of July, the lowest since at least 2003, according to Jeffrey Rosenberg , a strategist at Bank of America-Merrill Lynch in New York. Private-equity firms in the U.S. have $609 billion of available capital, compared to $281 billion in December 2004, the lowest amount in the past six years, according to London- based researcher Preqin Ltd. With banks pulling back, the loans are becoming costlier even as credit markets open up. Companies raised at least $904 billion in the U.S. corporate bond market this year, a record pace, according to Bloomberg data. Costlier Loans The interest payable on DIP loans this year has averaged 7.25 percentage points more than the three-month London interbank offered rate for dollars, up from 5.3 percentage points in 2008. In previous years, the margin has never exceeded 4 percentage points more than Libor , according to Rosenberg. Three-month Libor was set at 0.33 percent yesterday, down from 1.425 percent at the end of last year. Eaton Vance Corp., a mutual fund company in Boston, said in May that it was raising $1 billion to invest in bankruptcy loans. Sankaty Advisors, also in Boston, announced last month it was raising a $400 million DIP fund. The downside to the loan-to-own strategy is that it may put private equity firms in competition with lenders seeking the interest payments on DIP loans, not longer-term equity investments. “We would be suspect if there was extensive involvement from hedge funds or private equity firms looking to acquire control of a company through the DIP,†said Neal Neilinger , vice chairman of Stamford, Connecticut-based Aladdin Capital Holdings LLC, which has started a fund for DIP financing. “We expect our DIPs to have a tenure of between 6 to 18 months. We are not looking to hold the equity of the company.†Lawsuit Threat Lawsuits are another obstacle. Litigation has plagued Lyondell’s reorganization. In one suit, a committee of unsecured creditors is suing lenders over alleged fraud in the 2007 buyout that saddled the company with $22 billion in debt. That isn’t the case in Lear’s reorganization. U.S. Bankruptcy Judge Allan Gropper , in approving a bonus payment last week to Lear’s executives, noted how quickly the case was proceeding. According to the company, holders of 68 percent of Lear ’s secured debt support the restructuring plan. “We wanted the opportunity to participate in the recovery in the automobile supplier market,†KKR’s Sonneborn said. “The DIP lenders will also own some of the company post restructuring, which in theory, after our DIP and exit financing loans are paid off at maturity, we can hold for a long period of time.†Ownership Transfer A majority of Reader’s Digest’s lenders agreed to a Chapter 11 reorganization that would swap what it called a “substantial portion†of $1.6 billion in senior secured debt for equity and transfer ownership of the Pleasantville, New York-based media company to the group. The lenders are led by JPMorgan Chase & Co. in New York and include Eaton Vance and Ares Management, said Kathy Fieweger, a spokeswoman for Reader’s Digest. Hayes Lemmerz , the world’s largest maker of automotive wheels, filed for bankruptcy protection in May. Its workout plan called for the lenders who financed the reorganization to get 84.5 percent of the equity. The Bankruptcy Court for the District of Delaware approved the reorganization yesterday, the company said in a statement. In a May 12 filing with the bankruptcy court, lawyers for the Northville, Michigan-based company wrote that a debt-for- equity conversion was a last resort for distressed companies trying to navigate Chapter 11. The loan-to-own structure “has emerged as one of the few viable mechanisms for lenders to allow major U.S. businesses, particularly those in the depressed automotive sector, to survive the current world-wide crisis,†the lawyers said in the filing. To contact the reporters on this story: Richard Bravo in New York at rbravo5@bloomberg.net ; Elizabeth Hester in New York at ehester@bloomberg.net .
