The coronavirus pandemic has resulted in some economic
turbulence which has businesses of all sizes under a certain amount
of pressure. Many businesses, from those adversely affected to
those experiencing growth in the current climate, are looking to
access capital in the short term or are looking for longer term
partnerships.
The pandemic provides unique opportunities for private equity,
venture capital, private debt managers and other alternative assets
managers while providing the commercial ecosystems in which they
operate much needed relief by way of access to capital.
We have compiled the following series of frequently asked
questions regarding setting up fund structures in this
environment:
What are distressed asset funds, opportunistic asset or special
situations funds?
During times of economic strain and uncertainty, investment
opportunities for asset managers often come in the form of
investments in “distressed assets” or “opportunistic
investments”. Distressed assets are generally assets that are
experiencing some form of adverse financial pressure or strain,
including credit default, insolvency or bankruptcy.
Broadly, the strategy employed by these funds falls within a few
categories:1
(a) Distressed Debt Trading – where the fund
purchases debt that trades at a considerable discount to fair value
and sells it when the price rises;
(b) Distressed Debt (Non-Control) – where the
fund purchases debt that trades at a considerable discount to fair
value but seeks to influence the restructuring or insolvency
process to heighten the value of the purchased debt;
(c) Distressed Debt (Control) – where the fund
purchases debt that will be converted to equity post-restructuring
and that will provide the fund with a controlling stake in the
restructured portfolio company;
(d) Turnaround – where the fund purchases
equity in the portfolio company prior to its restructuring and
influences the restructuring process to maximize the value of the
portfolio company;
(e) Special Situations / Opportunistic – where
the fund takes advantage of an opportunity that arises during a
special situation (positive or negative) including insolvency,
bankruptcy, litigation, shareholder activism, stock buybacks or
other events that may influence an asset or portfolio company’s
short-term prospects.
The current pandemic and the response from governments,
institutional investors and public markets creates a turbulent
economic environment where otherwise performing assets can face
short-term pressure. Like previous periods of economic uncertainty,
savvy asset managers and investors alike are undoubtedly going to
look for opportunities created by this economic turbulence.
Have investors shown interest in investing in distressed /
opportunistic funds?
The Financial Post recently reported the chairman and chief
executive office of Onex Corp., Gerry Schwartz, as stating that new
opportunities in private equity are likely to come in more
distressed situations.2 Similarly, Brookfield Asset
Management’s CEO, Bruce Flatt, mentioned on the company’s
first-quarter earnings call on May 14, 2020, that we were in
“one of the great environments, possibly, to buy distressed
debts that may have ever been in existence”.3
The current market is buzzing with high net worth and
institutional investors looking for investments in distressed or
opportunistic funds across different asset classes (debt, private
equity, real estate). According to the data provided by Preqin, in
2008, firms raised US$44.7bn in capital to take advantage of the
financial crisis.4
For example, Probitas Partners, a US-based placement agent, has
reported an influx of investors looking to invest in distressed
debt or special situation funds. In a turnaround to normal
practice, Probitas reported that in March, institutional investors
have been reaching out to Probitas looking for
distressed/opportunistic funds rather than the other way
around.5
Barron’s reports that many of the large US asset managers
are seeking to or have raised significant amounts of capital in the
last few months.6
While slower in its response than their US counterparts,
Canadian asset managers and institutional investors have been
active in trying try and take advantage of the opportunities
created by the Covid crisis.
What is the principal difference between distressed /
opportunistic funds and their “regular”
counterparts?
In comparison to their non-distressed counterparts, funds with
distressed or opportunistic strategies are required to respond
rapidly to opportunities and provide to investors higher risk and
reward.
As these strategies can expose investors to higher risks than
their traditional counterparts, it will be important for the fund
documents to accurately describe the investment strategy (including
providing a clear description of the type of opportunities the fund
will be looking at) and adequately describe the risks.
When considering the fund’s strategy, asset managers may
also seek additional flexibility when it comes to the type of
assets it can invest in (corporate debt vs. equity) and how much
control the fund will seek when investing in specific portfolio
companies (buyout vs. minority stakes). The purpose of the added
flexibility is to provide the asset manager with access to as many
tools as possible to respond to the opportunities.
Depending on the asset class, the asset manager may also seek to
reduce the drawdown notice period in order to allow the fund to
respond more rapidly to opportunities.
Other terms which asset managers often consider in the context
of opportunistic funds include the shortening of the fundraising
period, the investment period and life of the fund.
The amount of work required to manage distressed assets can be
significant – are the management fees higher in a distressed
fund?
Many asset managers have inquired whether
distressed/opportunistic funds warrant higher management fees due
to the increased complexity of managing distressed assets. Indeed
managing distressed assets may call upon a wider range of skills
from the asset management team including expertise in the areas of
corporate restructuring, debt financing (and restructuring) and
insolvency.
Asset managers will ultimately need to make the case with their
investors but if the funds established during the 2008 financial
crisis are any guide, the fees will probably remain within the
range of their traditional counterparts.
To what extent can a manager use an existing fund to take
advantage of distressed opportunities?
Some asset managers with existing funds have shifted from a
traditional strategy to one taking advantage of distressed assets.
On a recent earning call, Apollo Global Management, a leading
global alternative asset manager, said they expected to switch the
strategy of the firm’s US$24.7bn flagship fund from traditional
private equity to a more distress-for-control private
equity.7
An asset manager wishing to use an existing fund to invest in
distressed assets should carefully review the fund’s governing
documents to ensure notably that the investments it wishes to make
fall within the investment objective of the fund and are not
prohibited by the investment restrictions or parameters of the
fund. Investment restrictions that could limit a manager’s
ability to invest in distressed assets include limitations
regarding the industry, concentration limits and limitations
follow-on investments.
Even if the investment strategy is wide enough to allow for
opportunistic investments, we would recommend discussing the shift
with the fund’s limited partners or the fund’s advisory
committee. As distressed and opportunistic investments may increase
the risk profile of the fund, such discussions would ensure that
the investors are onboard with the shift in strategies. This is
especially true if statements have been made in any disclosure or
marketing document (e.g. offering document, private placement
memorandum) which would be inconsistent with the making of
distressed / opportunistic investments.
If the investment strategy or investment prohibitions are too
prohibitive to adequately effect the distressed or opportunistic
strategy, amendments could be proposed to permit the asset manager
to make such investments. Such amendments would normally require at
least a majority in interest of the limited partner to agree with
the proposal.
Of course, the asset manager will need to ensure that the fund
(i) is still in its investment period (i.e. is able to deploy
capital) and (ii) has sufficient capital commitments to fund the
investments in distressed assets (and potential follow-on
investments).
What are the principal things a manager of an existing fund
should consider prior to launching a distressed / opportunistic
fund?
The first item to consider prior to establishing a distressed /
opportunistic fund is whether the asset manager is restricted by a
covenant from establishing “competing funds”. Normally,
fund documents will restrict the asset manager from establishing
funds with similar strategies during the investment period until
most of its committed capital (75% or more) has been deployed.
Even if the asset manager is not subject to such restrictions,
it should remain cautious as the establishment of a new fund while
an existing fund is not fully deployed may cause investment
allocation and conflict of interest issues as some investments may
(or may be perceived by investors) be eligible for investment in
both funds.
Another restriction to pay close attention to the existing
fund’s key person provisions. Specifically, key persons subject
to such obligations will want to ensure that they are not breaching
their obligations to devote a certain amount of time by providing a
competing time commitment to another fund.
Our team would be happy to discuss this topic further with you.
Do not hesitate to reach out to us if you have any other questions
that you would wish us to address or any opportunity that you would
like to talk over with us.
The authors wish to thank Gesta Abols, Grant McGlaughlin and
Caitlin Rose for their
contribution.
Footnotes
