Distressed: Hitting Hard Times Often Means Giving Up Equity

By RiSHAWN BIDDLE
Staff Reporter

Overview: When Korn/Ferry International was looking to shore itself up during its two-year-long restructuring effort, it didn't end up getting help from a bank or by filing for a public debt offering.

Instead, it went to the San Francisco-based private equity firm Fleischman Friedman & Lowe, which poured $50 million into the L.A.-based executive search firm in exchange for a package of warrants and other securities convertible into 11 percent of Korn/Ferry's stock.

With banks tightening up lending requirements and a soft appetite for corporate debt in the public markets, more companies are pursuing alternative financing sources such as the controversial private investments in public equities (PIPEs).

In August, eUniverse Inc. had to approach VantagePoint Venture Partners for a helping hand after suffering a series of reverses related to its earning restatements. The San Bruno-based venture capital firm agreed to invest $10 million in the one-time Internet darling in exchange for Series C stock that would be convertible to 6.7 million shares of common stock, as well as providing a $20 million credit line. The deal could give VantagePoint a 30 percent stake in the business.

Another local firm, Overhill Farms Inc., got a $3 million bridge loan in April from private equity outfit Levine Leichtman Capital Partners, which also helped buy its senior debt from the company's banker, UnionBanCal's Union Bank of California division. With the financing, Levine Leichtman, which already had a 24 percent stake in the company from an earlier financing, expanded its equity position.

Lenders: Traditionally, such distressed financing has been the domain of so-called "hard money lenders" who pull together high-interest, asset-backed loans. The hard money arena is dominated by Wells Fargo & Co.'s Foothill division and GE Capital, which expanded its business when it acquired Heller Financial two years ago.

For companies going into bankruptcy, there's debtor-in-possession financing. A lender often an existing creditor or a potential buyer will provide working capital to the company, secured by assets such as equipment, inventories or even patents on technology.

Another group of lenders, smallish private equity firms, will invest in a firm in exchange for a minority stake. In these deals, the investor gets stock or other securities that can be sold into the public markets. Among the firms that handle these deals is Calpers-backed Levine Leichtman in Beverly Hills.

Yet another category involves so-called distressed debt; among the firms in this group is New York vulture investor Cerberus Capital Management and L.A.-based Ares Capital. These firms buy up busted debt which they try to convert into equity then offer additional financing in order to secure a control position over a company.

Leveraged buyout firms also have gotten into the act, driven by the dry-up in the debt markets that restrict them from financing larger buyouts. One player is Texas Pacific Group, whose past deals include a early-1990s turnaround of Continental Airlines. Now it is attempting a turnaround of America West.

Venture capital firms, too, have been doing some distressed lending. They have few investment opportunities for their $72 billion total in cash hordes.

Borrowers: The companies willing to give up equity in exchange for badly needed money are usually close to bankruptcy or hemorrhaging cash because of economic and market distress. Airlines turned to non-traditional financing after falloff in travel following the terrorist attacks of Sept. 11, 2001. Hospitals and other health care firms hit by Medicare cuts and high debts have also turned to distressed financing.

Rates: The cost of money varies from deal to deal. Hard money lenders typically charge double digit rates plus fees in order to protect themselves in case a borrower goes bust.

In other deals, an investor may get securities convertible to shares in the company, or a dividend. Those dividends are usually paid in additional shares of stock, also known as "pay-in-kind."


Voices

Joel Ohlgren

Partner

Sheppard Mullin Richter & Hampton LLP,

Los Angeles

"There is a difference between the kinds of people who work with distressed deals. People doing debtor-in-possession financing expect to be paid back. They have super-priority over other creditors and they're expecting to be paid first, even if the assets are sold. People who do PIPEs expect that they may lose on some of their investments. The investments may not be worth anything if there ends up being no market for them.

"One of my clients recently did a debtor-in-possession financing. They were a potential buyer of this firm that was going to be a bankruptcy sale, but it was about to go under. So they put in money in debtor-in-possession financing to keep it alive. It wasn't just to salvage the company. If someone else bought it, they would be able to demand immediate repayment, the DIP would be part of the purchase price. Our client ultimately bought it and it's now a freestanding operation."



Dennis McCarthy

Managing Director

The Seidler Cos., Los Angeles

"I was at Roth (Capital) and we represented Egghead, the online computer equipment guys. They were definitely in distress. We tried to raise equity for them. But when companies go into distress, they spiral down further than they would expect. That happened in Egghead. The computer buyers changed and so did their appetites. You have computer makers selling directly, hitting a distributor like Egghead. Their margins were so skinny, there was no business to salvage.

"So we tried to sell to Frys, but it would only do it in bankruptcy. So the company went into bankruptcy. But then Frys backed out. So it ultimately got liquidated."

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