Turnaround Management poll: Hedge funds key to economic change, late-decline restructuring

By Caroline Salls

Pittsburgh, June 22 - Hedge funds continue to assert a powerful influence in credit markets and reflect an institutional shift that is likely to become permanent, according to Turnaround Management Association's 2006 Trend Watch Poll on credit availability.

The poll showed 73% of respondents believe the expansion of nontraditional lending and capital sources is driving a fundamental change in the economic landscape, while 44% think hedge funds are a significant factor in restructuring companies in late decline but do not play as prominent a role for companies in mid-term and early decline, for which lower-cost private equity funds, tranche B/C loans and high-yield debt are more easily secured.

"Hedge funds are often willing to take on extra risk in a 'loan to own' deal, taking an equity position and then flipping the company," attorney and TMA Trend Watch committee chairman Tom Henderson said in a news release.

"In the past two years, turnaround specialists have become affiliated with hedge funds assisting in due diligence to evaluate the company's chances of being turned around and then staying on to enhance the turnaround process."

Although underperforming companies are staying afloat currently through an infusion of cash, TMA reported that their ability to obtain credit could change dramatically if interest rates rise.

In the poll, 90% set the tipping point for some tightening of credit when the Prime rate hits 9.5%, and at 10% and above, 65% thought a substantial credit tightening would occur.

Default rate increase on horizon

TMA members also see debt default rates increasing in the near term for underperforming, highly leveraged companies, as 90% of the poll respondents expect that rude awakening by the end of 2007, with 60% believing a blow-up could occur as early as mid-2007.

Edward I. Altman, professor of finance at New York University Stern School of Business and chair of the TMA Academic Advisory Council, said he foresees an even more rapid escalation in defaults.

Based on his research in the dynamics of high-yield and distressed debt markets, Altman said he expects default rates to increase significantly in the first quarter of 2007.

"Debt to cash flow ratios have risen to above six in some of these transactions," Altman said in the release.

"Our research has shown that unless debt is reduced to manageable levels in two to four years after the highly leveraged transactions, we could expect similar firm meltdown to what we observed in the 1990-91, 10% default years.

"This is even more likely as the economy experiences a coincidental slowdown and interest rates rise."

TMA president Colin Cross, managing director for Crystal Capital in Chicago, said he also thinks turnaround work will pick up within the next year.

"The combination of high leverage multiples with an expected increase in default rates indicates that the credit markets are in for a major correction by the end of 2007," Cross said in the release.

"This will result in a tightening of credit and an increase in restructuring activity."

The 2006 poll indicates credit availability may already be leveling off, as 43% of the respondents thought more credit was available currently than one year ago at this time, down from 58% in the 2005 poll.

The 22% of those who thought credit was tighter this year was double that of last year's 11%.

In both the 2005 and 2006 polls, about a third said available credit was about the same as the previous year.

Over-leveraged companies in danger

Two TMA board members said they are not optimistic that over-leveraged companies will recognize the danger in time.

"As long as companies have relatively easy access to capital sources eager to deploy funds, it's hard to get them to face up to reality," executive committee member and Carl Marks Advisory Group LLC managing director Patrick Lagrange said in the release.

"Moreover, the longer both borrowers and lenders delay addressing the underlying problems, the greater these problems become."

J. Scott Victor, Philadelphia TMA chapter president and managing director of SSG Capital Advisors LP, said in the release, "The current drop in Chapter 11 filings can be primarily attributed to the unprecedented liquidity in the marketplace.

"When the cash dries up, these companies will be in such severe distress, they will have no choice but to prepare for a sale or a liquidation. A turnaround will no longer be an option."

TMA is an international non-profit association dedicated to corporate renewal and turnaround management.

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