Angels on your shoulders: observations on private equity involvement in Australian distressed debt scenarios
October 2021 | SPECIAL REPORT: RESTRUCTURING & INSOLVENCY
Financier Worldwide Magazine
October 2021 Issue
In Australian distressed debt scenarios, large private and listed companies teetering on the verge of insolvency generally face two options: (i) refinancing their debt and securing (further) outside investment for working capital; or (ii) resolving to put the company under external administration in the hope of executing a restructure via deed of company arrangement, failing which, the company will be liquidated and sold for parts. This article is focused on the first option, giving specific consideration to the benefits (and accompanying risks) of engaging with private equity (PE) firms as an alternative to external administration.
Regarding the Australian insolvency regime, this article will highlight how the combination of: (i) directors duties imposed on ‘de facto’ (shadow) and ‘de jure’ (validly appointed) directors; (ii) a creditor-friendly insolvency landscape; and (iii) the safe-harbour rules, provide a natural canvas for PE firms (particularly those with a focus on distressed debt) to profit substantially from insolvency scenarios.
PE: corporate insolvency’s Formula 1 team
PE firms are generally renowned for their aggressive, albeit sophisticated, approach to corporate acquisitions and investments, in both the equity and debt spaces. This is especially true in respect of distressed debt scenarios, with PE firms colloquially referred to as ‘vulture firms’ in this context. Given the genuine appetite for risk, balanced against the potential for significant returns, competition between PE firms is especially fierce in Australia, proffering a playground in which the kids are not accustomed to sharing.
The benefits for distressed corporates are easily stated. PE firms run acquisitions with an expediency rivalled only by Formula 1 teams. Rather than changing four car tyres in less than two seconds, however, they sweep through financials and can put in place reorganisations with terrifying and ruthless efficiency. They see things and trends that business owners, particularly those in distress, simply cannot see. Their ability to be agile and move quickly, responding to an ever-changing landscape, can serve as a veritable life raft to businesses.
Some commentators suggest that the benefits of lightning-fast corporate resurrection timelines must be weighed against the risks of subsequent corporate collapse flowing from the ‘money on money’ objectives of PE firms. It has been said that this can lead to rash commercial
decision-making processes on the company’s part, where the terms of a restructure focus on
short-term profitability, without necessarily considering medium to long term downstream consequences.
Take, for example, the spectacular collapse of the Dick Smith Group. While (strictly speaking) not in a distressed state at the time of acquisition, in September 2012, Dick Smith was acquired by Anchorage Capital Partners from Woolworths for a practical pittance, and just 15 months later was floated for a colossal sum. In an oft-quoted article, Matt Ryan of Forager Funds Management called Dick Smith’s initial public offering (IPO) “one of the great heists of all time, using all the tricks in the book, to turn Dick Smith from a $10m piece of mutton into a $520m lamb”. However, a focus on maximising vendor rebates, which can lead to an increase in apparent earnings before interest, taxes, depreciation and amortisation (EBITDA), initiated under the reign of Anchorage-appointed chief executive Nick Abboud, ultimately resulted in the company being significantly overstocked with practically unsaleable inventory. In Dick Smith’s case, this led to the company’s lenders losing confidence in the business and appointing receivers and managers, with the consequent result of the directors placing the company into administration in January 2016. All this less than 16 months after Anchorage had divested the remnants of its post-IPO holdings in the business.
The collapse of Dick Smith led to significant shareholder class actions being brought against the company, its executive directors and its auditor, which litigation was ultimately settled for A$25m. While the Anchorage transaction was hailed as an extraordinary PE outcome, its subsequent float was obviously a disaster for Dick Smith’s new shareholders.
Safe harbour rules, directors’ duties and related risks in the PE context
In Australia, directors are afforded a significant level of protection during potential or actual insolvency scenarios, by virtue of the still nascent safe harbour provisions of the Corporations Act 2001. Pursuant to section 588GA of the Act, the insolvent trading prohibitions placed on directors under the Act do not apply where, at a particular time after the directors start to suspect the company may become or be insolvent, the directors start developing one or more courses of action that are reasonably likely to lead to a better outcome for the company. An example of such a course will likely include engaging with PE firms with a view to obtaining additional capital investment to ameliorate any state of financial distress. In this scenario, PE firms are often fast-moving white knights, with extraordinary access to capital, albeit on their terms.
When directors are leading a distressed company through near insolvency, it is not unusual for interested PE players to stipulate accelerated timetables, seek exclusivity or engage in tactics that deliver both (such as buying distressed debt to ‘get a seat at the table’). In such a situation, directors are placed under significant organic and manufactured pressure to pursue the PE path.
However, recent Australian jurisprudence (including the Arrium litigation) suggests that, depending on the context, directors may be afforded a reasonably extended degree of leniency with respect to the length of time within which pre-insolvency decisions may be made regarding the future of the business. Creating various restructuring options and keeping them alive while exploring the best one, including options that cram down existing financiers, may provide directors with significant breathing space to explore a variety of options, before the threat of actual insolvency constrains them. While this may suggest that some chapters in the PE playbook have been lost, we disagree.
In any changing space, PE is uniquely placed to both offer and execute on solutions in a manner that adapts to the circumstances. Take, for example, Bain Capital’s recent A$3.5bn acquisition of Virgin Australia, which had been placed into voluntary administration by its directors in April 2020 with debts of $6.8bn. Bain readily adapted to the changing landscape within a COVID-19 world and saw off both industry players and other consortia in an accelerated transaction process finalised in less than six months. Against a backdrop where Virgin Australia’s biggest stakeholders, including Richard Branson’s Virgin Group and the Australian federal government, declined to give additional funding to save the airline, Bain’s acquisition kept thousands of jobs, honoured employee entitlements and carried forward all travel credits and frequent flyer booked flights. A flagship PE deal if there ever was one – indeed, the very nature of PE is that it will adapt its playbook to suit the conditions to achieve the desired outcome.
Where a company in financial distress is already PE-owned, either partly or wholly, different challenges arise, particularly where certain of the company directors are PE nominees. Under section 181 of the Act, directors and officers (D&Os) of a corporation must exercise their powers and discharge their duties in good faith in the best interests of the corporation and for a proper purpose. The ability of a (‘de jure’ or validly appointed) PE nominee director to properly discharge this duty is sometimes questioned where their PE firms are perceived to be ‘pulling the strings’ from behind the scenes with a view to maximising their return on (or rescuing) their investment, often because of rights engrafted into funding documents. Where such ‘controls’ are in place (and are utilised), it also puts at risk individuals representing the PE firm’s interests (often the investment managers themselves). This is because the definition of ‘director’ in section 9 of the Act is sufficiently broad to capture ‘de facto’ or shadow directors, who, while not validly appointed to that position, act in the position of a director or place themselves in a position where ‘de jure’ directors are accustomed to acting in accordance with the relevant individual’s instructions or wishes.
Despite this perception, our experience is that sophisticated PE firms are very alive to these issues, often appointing independent counsel to advise their nominee directors on the duties and conflicts arising in such scenarios. In some cases, PE nominee directors are replaced with experienced industry non-executive directors to minimise the perception of conflict, thus expediting and enhancing restructuring or recapitalisation.
Indeed, the ‘control’ or veto rights often found in distressed lending documents, especially where they contain equity-like rights, may create additional risks, both for corporate investees and the PE investor. A recent ruling by the High Court of Australia (the BHP decision) would tend to indicate that where a foreign-incorporated PE firm can be shown to have “sufficiently influenced” the investee’s decisions, the firm may be held to be an “associate” of that investee for the purposes of the Income Tax Assessment Act 1936. Such an outcome has implications for both the company (particularly on withholding tax) and the PE firm. While this risk is not strictly insolvency related, directors of a PE-funded company in financial distress looking down the barrel of a ‘loan to own’ solution being executed under ‘guidance’ of its PE funder, should consider the potential tax risks arising from the implications of this decision.
Conclusion
The benefits of angel PE investors swooping in to rescue corporates from the throes of insolvency are self-evident and, in many respects, now comprise a permanent aspect of the financial landscape. While directors of distressed companies considering PE options for restructuring would do well to examine the lessons (both good and bad) from Dick Smith and Virgin Australia, the agility and flexibility of PE firms to deliver bespoke solutions continues to evolve, even during a global pandemic. As does the PE market, where just recently, CVC Capital Partners announced its intention to re-enter the Australian market after a nine-year absence.
Of course, with benefits, come risks, for both directors (including PE nominee directors) and for stakeholders. And as this article makes clear, these risks also continue to evolve.
Beau Deleuil and Elan Sasson are partners and Jack Oakley is an associate at Quinn Emanuel Urquhart & Sullivan, LLP. Mr Deleuil can be contacted on +61 2 9146 3777 or by email: beaudeleuil@quinnemanuel.com. Mr Sasson can be contacted on +61 2 9146 3543 or by email: elansasson@quinnemanuel.com. Mr Oakley can be contacted on +61 2 9146 3567 or by email: jackoakley@quinnemanuel.com.
© Financier Worldwide
BY
Beau Deleuil, Elan Sasson and Jack Oakley
Quinn Emanuel Urquhart & Sullivan, LLP
Q&A: Tackling post-pandemic corporate zombies
Chapter 11: an increasingly popular tool for foreign companies seeking to restructure or liquidate
Canada’s highest court upholds the priority of financing charges in restructuring proceedings
The rise of the reverse vesting order in Canada
Over a year on – the new restructuring plan in action
A year in review: the Part A1 moratorium
Identifying early signs of distress and taking action