Private Equity Is Raising Its Bets on Distressed Positions

In a casino, doubling down can be dangerous. But in private equity, it’s increasingly becoming the best way to eke out a profit on a bet turned bad.

From Apollo Global Management LP to Bain Capital to Thomas H. Lee Partners, investors have bought hundreds of millions of dollars of debt in struggling businesses they took private, giving them positions as both stockholders and creditors.

The benefits of the strategy are baked into distressed investing, where Apollo’s considered the most shrewd player in the arena. When companies falter and the equity becomes drained of value, holding the right bonds can allow private equity sponsors to control the restructuring and potentially regain ownership after converting debt into new equity.

Now, more investment firms have taken notice and are starting to use the strategy as they desperately seek to salvage investments that are at risk of turning sour amid rising interest rates.

“We are seeing growing interest among more and more investors to pursue the tactic this year,” said Lewis Grimm, a lawyer at Jones Day, who specializes in risky companies. “People have been looking opportunistically for creative moves when they saw how relatively aggressive approaches have proven to be successful in recent cases.”

Apollo Pioneer

Neiman Marcus Group Inc. is among the companies potentially setting itself up to use the strategy, according to Noel Hebert, an analyst at Bloomberg Intelligence. The upscale fashion chain, reeling from slow mall traffic, gave some subsidiaries a designation that “provides sponsors Ares Management LP and the Canada Pension Plan Investment Board with options,” he wrote in a recent report.

“Neiman could be an interesting candidate for that tactic. If Neiman’s unsecured bonds go through another correction, you could see sponsors looking to buy the junior debt,” Hebert said in an interview. “Guitar Center is another name that sponsors can do something like that if things were to deteriorate materially.”

Guitar Center Inc. was bought by Bain Capital for $2.1 billion in 2007 and then acquired by Ares in 2014 in a debt-for-equity swap. Another example would be the buyout of iHeartMedia Inc. in 2008, in which Bain Capital and Thomas H. Lee Partners also acquired the company’s senior debt.

For Apollo, the strategy’s in its genes. In the wake of the last financial crisis, the firm purchased or bought back nearly $20 billion of debt in companies it owns — including CEVA Logistics, Caesars Entertainment Corp. and Realogy Holdings Corp. — for an average price of less than 50 cents on the dollar amid a broad market downturn.

To manage its position in the real estate holding company Realogy, which owns Century 21 and other well known brands, Apollo doubled its $1.34 billion investment by scooping up junior notes and converting them into shares before taking the company public in 2012, salvaging $920 million of equity it sank into the 2007 leveraged buyout.

Piling On

The strategy works in multiple scenarios. Bondholders profit as debt prices rise through exchanges. And equity values increase as the debt load is reorganized.

Take Claire’s Stores Inc. The retail chain owned by Apollo for 10 years has lost millions and is struggling under $3.1 billion of debt. Last year, the private equity firm bought most of the junior debt at less than 60 cents on the dollar. Then, after a series of exchanges, it converted $184 million of subordinated notes into new secured debt, bumping it to second in line in a prospective bankruptcy proceeding. In addition, by pushing out the maturity it bought the company time to turn around the business and kept its equity value from disappearing.

“Buying time can truly be valuable for an investor with a troubled situation when the delay creates a runway to actually improve performance,” said Cynthia Romano, a performance improvement and turnaround adviser at CR3 Partners. “Sometimes, though, delaying can look merely like the ‘extend-and-pretend’ strategy used commonly by lenders during the last recession.”

Representatives for Apollo, Bain, Thomas H Lee Partners, Ares and CPPIB declined to comment.

Potential Conflicts

There are caveats for this method, however.

A conflict of interest can arise as creditors and shareholders often negotiate against each other in a restructuring, and the conflict can become particularly acute when a firm holds stock in one fund and debt in another. In addition, these moves can be controversial because they often hurt other creditors. In the case of Claire’s, other bondholders were pushed down in rankings as Apollo rolled up its stake.

Still, none of this is stopping private equity firms from spending more to protect their positions.

“Private equity sponsors are going to use all of the legal levers available to them in order to preserve their investments,” said Keith Wofford, a bankruptcy partner at law firm Ropes & Gray in New York. “They will not allow a short-term downturn to prevent them from getting full value.”