Waiting For The Keg To Ignite

Turnaround firms have enough dry powder to support a major offensive. Now the question is whether the downturn they’ve been stockpiling for is finally at hand.

Fund-raising by firms that take active roles in distressed situations, either as creditors or owners, has really gathered steam in the last few months. Together such firms have raised well over $20 billion in the first half of 2007, and that tally could easily soar past the $30 billion mark by year-end.

Among well-established players, MatlinPatterson Global Advisers LLC is believed to have secured $5 billion for its third fund. The New York shop is famous for its big bet on the turnaround of WorldCom during the last big restructuring wave earlier this decade. The ubiquitous Cerberus Capital Management, New York, rounded up $7.5 billion for its Series IV fund earlier this year, cruising past its $6 billion target. The firm has spent the last several months buying up troubled automotive companies. 
Oaktree Capital Management, Los Angeles, closed OCM Principal Opportunities Fund IV this spring at $3.3 billion, earmarked for investments where the object is to win control of a company. The firm also appears close to hitting the $3.5 billion mark on OCM Opportunities Fund VII. That pool is tagged for the purchase of distressed credits where the firm believes it can bend the outcome of the restructuring to its advantage. Expect an overflow fund, OCM Opportunities Fund VIIb, to wind up in the $7 billion neighborhood. That pool would be deployed should enough deal flow materialize.

Lesser-known names also are going after their share of the pie. Michael Heisley, owner of Heico Cos., this year joined forces with Jeff McDermott, former co-head of investment banking at UBS, to form Stony Lane Partners. The firm, with offices in Chicago and New York, plans to raise $750 million to buy operationally challenged companies generating revenues of $200 million to $1 billion. Dallas-based Treadstone Partners, whose principals have invested some $350 million in distressed securities over the last 14 years, plans to come to market later this year with Treadstone Capital Partners II LP seeking $300 million. The firm formed a $60 million predecessor in early June backed entirely by fund-of-funds manager Drum Capital Management LLC, South Norwalk, Conn. Its strategy is to invest $2 million to $25 million in companies generating $10 million to $300 million in sales. 
“These guys have been around quite some time and are extremely seasoned in teh distressed turnaround space,” said Scott Vollmer, founder and managing partner of Drum Capital, which has taken in more than $400 million for its latest distressed-debt-turnaround fund of funds.

Will there be enough opportunities to go around? Last week I caught up with Angus C. Littlejohn Jr., founder of 11-year-old turnaround investment firm Littlejohn & Co. LLC, to find out whether tightening credit markets worldwide are translating into investment opportunities. Littlejohn & Co., which buys both equity and debt, likes to invest $50 million to $100 million in mid-sized companies generating $150 million to $800 million in sales. Business has been slow thanks to the strong economy and the ability of struggling companies to borrow their way out of trouble until what recently had been an ultra-liquid market. The firm closed just one deal last year, compared with two or three in a more typical year. 
But the firm at press time had already closed on two acquisitions this year, and was days away from closing a third. In addition, Littlejohn & Co. this month has seen a couple of companies on the brink of default that have run out of financing options. “What [earlier] could have been easily refinanced is suddenly a problem,” Littlejohn said. “That’s going to be an opportunity for people that want to get their hands dirty.”

That said, the firm has yet to see any sign of panic among holders of bank debt used to finance the mid-market buyout boom over the last several years. Much of that paper resides in hedge funds and collateralized loan obligation (CLO) funds, which used the paper as collateral for issuing their own debt and equity securities. By Littlejohn’s reckoning, holders of first-lien and second-lien loans have endured paper losses of around 10 percent in the last few weeks due to the credit market pull-back. So far, Littlejohn said, investors appear to be confining their selling to liquid securities issued by large companies. Those investors putting out feelers in the more illiquid bank-debt market haven’t liked what they heard, and held tight, he said. 
But sell they must if their hands get forced. Hedge funds facing redemption requests or margin calls may have no choice but to begin liquidating their bank loan positions. And CLO funds often have diversification and credit ratings requirements that may compel them to sell riskier loans should their portfolios get hit with downgrades. “There’s going to have to be a rebalancing, and that rebalancing is going to require some of that paper to move,” Littlejohn predicted.

If so, Littlejohn & Co. and other distressed-debt investors will be waiting.