The emergence of hedge funds and other lenders in the middle market has created a new pool of financing for companies in need of cash, but in some cases those loans prolong the inevitable move to bankruptcy and hamper recoveries in the long run, according to panelists at a distressed debt conference last week. Adam Rogoff, partner at Cadwalader, Wickersham & Taft, said a relatively new phenomenon of "deepening insolvency" is taking root and could get worse as struggling companies are increasingly able to access capital. The longer some of those companies push on, the worse it can be for creditors. "During that period of prolonged corporate existence, the company gets worse and worse, the assets are being dissipated and it is to the detriment of creditors," Rogoff said in an interview following a discussion about the middle market at Institutional Investor's Turnaround Management & Distressed Investing conference in New York.
Scott Victor, managing director at SSG Capital Advisors, said hedge fund appetite for lending to the middle market is driving the phenomenon. "The hedge funds have fundamentally changed the restructuring environment in that they have provided a source of funding for distressed middle, to lower middle market companies that was not available 18 months ago," said Victor. As a result, companies in distress or in a turnaround process have greater chances of doing out-of-court recapitalizations and avoiding Chapter 11 filings and even liquidations, he added.
Rogoff noted that corporate bankruptcy filings have been down over the past year and the number of out-of-court restructurings is up. That's fine if the company can successfully negotiate the turnaround. But Victor said many of those companies are not expected to make it. "We expect many of these distressed and turnaround recapitalizations ultimately will not succeed with the fresh new wave of Chapter 11 filings in the next 18-24 months," he said, noting that improved fundamentals have to go along with improved liquidity.
Rogoff defined deepening insolvency as "the artificial and improper prolonging of a company's life beyond a point where it has become insolvent." Some creditors would argue that, outside of bankruptcy, they would not fully know what's going on and could continue to extend credit. Rogoff noted that those creditors are usually unsecured creditors, such as trade creditors, employees and retirees and usually are not bank creditors or bond holders.
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