Distressed Investing — COVID-19 Virtual Roundtable 

Our third COVID-19 virtual roundtable focused on distressed investing. Nine Axial members, including lenders, family offices, private equity firms, and advisors came together on Zoom on Wednesday, April 1 to discuss how deals are progressing (or not) in a very uncertain environment. How soon will we see an uptick in distressed activity? Are there ways lower middle market firms can get creative and find opportunities in the recession? What are the biggest deal stoppers — obvious and not — and will firms get around them? 

Watch the video on Vimeo below. Based on your feedback, we’ve also uploaded the audio of the roundtable to a streaming service; find the link below.  

Thanks to our attendees for a great discussion:

• Noah Cutler, Managing Director, North Fork Partners
• Carle Felton, Director, Goldman Sachs Specialty Lending Group
• Phil Kain, Managing Partner, Rush Street Capital
• Ira Perlmuter, Founder & Managing Director, JSPI Capital Partners
• Roger Puccio-Johnson, Managing Director, BRG Capital Advisors
• Gus Phelps, Principal, Summit Partners
• Karen Small, Partner, Sterling Commercial Credit
• Jason Whitt, Managing Director, Sand River Capital Advisors

Video:

COVID-19 Virtual Roundtable: LMM Distressed Debt from Axial on Vimeo.

Audio:

https://soundcloud.com/user-313239390/axial-covid-19-virtual-roundtable-distressed-debt

Show Notes 

Introductions – 00:00-10:35

March Deal Update – 10:35

• Axial had every deal that was set to close in March pushed back
• JSPI Capital Partners (family office) has seen a significant drop in revenue in all four companies they’re looking at, and all companies have turned to crisis management
• Sterling Commercial Credit (lender) is under LOI on a deal with Rush Street Capital and the valuation will now have to be assessed and come down 
• The idea that a company may recover in 60 days is not likely because the country is going through ebbs and flows of COVID-19 at different times, so we’re likely looking at least 6 months out before things start to change
• BRG Capital Advisors (M&A advisor) is in the healthcare space and is in closing with one company that is planning to proceed; a lot of companies in the telehealth space are also coming to market right now; the healthcare space could be a good leading indicator of recovery
• For transactions that are in progress, both parties need to be willing to look at things creatively, but there is no reason that they cannot close.

Emerging Transaction Structures – 21:00

• Rollover Equity – you can tie performance to any period, which allows you to get away from the rigidity of looking strictly at current performance
• You should be thinking about risk sharing around the performance of the business; you may be making decisions that are different than you would have ever considered 3 months ago, but they’re necessary
• Purchase at a lower EBITDA with a clause that you’ll buy up if the performance improves in later quarters

Opportunity for Lower Middle Market Deal Professionals – 24:00

• Goldman Sachs Specialty Lending Group has closed multiple deals over the past few weeks because they already had term sheets submitted and didn’t want to walk away
• Focus needs to stay around protecting and preserving value of existing portfolio
• Price discovery is really tricky, but there isn’t an issue around the availability of capital like there has been in the past
• There’s a whole new language that starts to become important in these situations: if you say you’re funding a deal during a crisis, that’s the strongest statement you can make and it’s a good opportunity to make a name for yourself
• In 2008 small banks and businesses were hit very hard, and this is a different environment because now smaller companies are being favored
• While deals are going to take longer to close, this is the opportunity for middle market investors to get them done and help companies that previously would not have had a chance in a downturn

SBA and Treasury Loans – 30:57

• A lot of the information that’s coming out right now is a distraction for businesses who need to be focusing on amending payments, adjusting cash flow, refinancing, etc.
• The SBA CARES Act has more to do with current portfolio (things that are getting harder hit like fitness, restaurants) but in looking forward at new deals, that’s just one more unknown that is causing more murkiness 

What Businesses Are You Looking at Coming Out of This? 37:35

• Companies that were previously going to banks that now aren’t eligible for that capital
• Some lenders are having serious issues with their current portfolio and are going to have to unwind 

Rules of Thumb for Business Owners – 39:59

• Labor-intensive businesses have to deal with things very differently than those who don’t have the same considerations with their workforce
• Educate companies around the trends that came out of past economic downturns, because trends are likely to repeat to a certain extent
• SBA Cares Act (Paycheck Protection Program) is something that can be looked at optimistically, but won’t be turned on until April 3rd
• Work through each industry (and client) separately and often 
• Cannot be overconfident in industries that are seemingly doing well, because you need to be very cognizant of customer contracts in the case where consumers are not able to or stop paying for services

Stoppers: Pricing, Travel, Diligence – 47:05

• Any lender/investor needs to ask themselves “what is the market?” even if they feel comfortable with the risk in their existing pricing. 
• If you’re totally offset with the current market pricing, that’s not necessarily good, whether you’re bidding under everyone else or not.
• Being unable to fly is actually a bigger issue than pricing, because if you can’t visit your clients, that oftentimes can prevent a deal from closing, regardless of other factors. 
• Everyone agrees that you just can’t close deals without in-person management meetings.
• It’s now a certainty-to-close exercise: who can I count on to get this done?
• You can get creative with some diligence if you’re able to get boots on the ground, whether it’s a consultant, an auditor, etc.
• Firms are starting to do Zoom diligence sessions in an effort to be open minded about how to get things done in this environment, and it will at least keep the process moving in the right direction; this is especially interesting if it’s a company you have worked with or met before

A Deeper Dive into Diligence in Relation to the Duration of the Pandemic – 56:18

• Underwriting becomes difficult when assets are devalued, cash flow is impacted, etc. 
• You can’t put an end date on a diligence process when there is so much uncertainty.
• Some states are already deep into this and others are just getting started, so that makes it very complicated to lay out a reliable timeline.
• There are multiple things going on with the global economy outside of just the health concerns: oil could be going down to single digits per barrel, entire cities are totally shut down, we were also at a place in the cycle where this was bound to happen
• Historically, investors have been homogenous, specific, and unwavering in their mandates, but now there is all of this capital that still needs to be sent, so firms are going to have to go back to their LPs and diversify their investment criteria
• The capability of the market clearing in a market like this comes down to a lot of creativity and necessity to put capital to work
• If you look at the cash burn for the next 3-6 months you can think about how much you’re willing to write off if you’re comfortable with the strength of the business in an otherwise normal economy.
• It won’t take long for the pickup in distressed activity; the second half of the year there will be a huge uptick in deals. Owners still need to sell and companies will need capital, so this won’t persist for the remainder of 2020.
• We need to overcome fear in order to get the market to start moving, and the way to do that is to get deals moving.
• Expectation is that there will be a huge spike in dealflow in the second half.
• Business owners should start to get their heads around the fact that it will be more expensive, but it’s worth it to take the initial liquidity.

Deployment of Capital – 1:12:52

• There’s a huge amount of dry powder, but many firms have committed to investing that capital in healthy businesses
• There have been a lot of PE firms creating sidecars to invest in distressed deals
• When the opportunity set changes, you need to get on the phone with your LP and have the conversation with them around how to adjust 
• Piper Jaffray recently put content out around how we’re better equipped to handle this downturn than we were before because there used to be very few alternative lenders and little capital raised for distressed deals, and that is no longer the case
• In the second half of March, LPs were likely on the phone a lot, both to talk through portfolios, but also trying to figure out how to mitigate reduced returns — a major opportunity to do so is via picking up distressed companies

Axial Concord *virtual edition* will be taking place on May 7th. If you’d like to register for 8-12 one-on-one meetings scheduled by the Axial team, please email [email protected]. Due to COVID-19, we’re offering special discounted pricing of $995.

If you’re interested in learning more about Axial’s new Slack community, Axial Insiders, please email [email protected] or visit axialinsiders.com 

Find previous roundtables here: 

• Roundtable 1: How Coronavirus Is Impacting Lower Middle Market M&A Activity
  • Video
  • Audio
• Roundtable 2: Portfolio Company Crisis Management
  • Video
  • Audio