Alexander Neumann
December 5, 2024
Loan-to-own transactions are increasingly the subject of discussion in connection with restructurings. Under this model, which originated in the US, financial investors in particular deliberately acquire claims against debtor companies in order to take them over in pre-insolvency restructuring negotiations or in the course of insolvency proceedings. enomyc author Alexander Neumann explains the role the instrument plays in the German market, the benefits such transactions offer banks and investors – and, where applicable, the entrepreneurs concerned – and what needs to be considered.
Loan-to-own transactions are enjoying growing popularity in the German market as well. They give activist investors the opportunity to take control of a target company with little capital outlay and to actively shape its restructuring. For banks, they open up new ways to reduce risk and to focus on their core business.
Two approaches to loan-to-own transactions are particularly common:
Investors, mostly activist players such as hedge funds and/or debt funds, acquire debt capital during a corporate crisis, for example on the distressed debt market, with the aim of converting it into equity and thereby taking control of the company.
Another variant is lending in advanced stages of a crisis, when companies usually no longer have any other access to the capital market. The loan is often even granted in a position subordinate to the existing financing. As security, the pledging of company shares is agreed within a regularly tight covenant framework. In the event of default, the company shares pass to the creditor.
In Germany, loan-to-own transactions gained momentum in the years after the financial crisis. In addition to the possible compulsory binding of dissenting creditors, restructuring law (ESUG, among others) also focuses on the problem that veto rights of existing owners often hinder or thwart swift restructurings. As a result, investors have become increasingly active in the restructuring market after a number of “pilot projects”.
Loan-to-own transactions can be roughly divided into two phases: before insolvency and during insolvency plan proceedings. Both windows offer different opportunities and risks for investors, but also for banks and other creditors. What unites all phases is that the use of this instrument is often associated with the provision of new liquidity, in order to finance the operational restructuring and thus the increase in value of the company.
Before insolvency, activist investors try to acquire non-performing loans (NPLs) from banks or other creditors on a sufficiently large scale. These loans are often heavily written down, so that investors can buy them for a fraction of their original value.
The investors' goal in this phase is to convert the loans into equity in the event of a corporate restructuring or insolvency. This is often accomplished through a so-called debt-to-equity swap, in which the investor converts its claims into company shares. This usually takes place as part of an out-of-court restructuring in which the company and its creditors agree on a conversion in order to avert insolvency. The investor thereby gains not only a direct stake in the company but also influence over its management.
Another common pre-insolvency option for investors is lending to companies that, because of the crisis, have no further access to the capital market. Security is provided by the direct pledging of company shares by existing shareholders, mostly combined with covenants whose breach results in the transfer of the shares. This approach represents the two sides of a bet on the company's short-term restructuring prospects: while the debtor hopes for a turnaround with the funds of the “lender of last resort” and its subsequent replacement, investors see the loan, based on an opposing assessment, as a path into equity. Recently, such an approach has been observed particularly in the real estate sector, because companies were partly unable to service the debt on high-volume financings of, in some cases, prominent commercial properties as interest rates developed. In the absence of regular alternatives, activist investors ultimately met the additional financing need.
In the event of insolvency, investors can also pursue loan-to-own strategies during insolvency plan proceedings. Here, too, debt-to-equity swaps play a decisive role. By controlling a sufficiently large portion of the claims, investors can influence the restructuring of the company in insolvency plan proceedings. Within the framework provided by the provisions of the ESUG and, for example, the German Bond Act (SchVG), the complete takeover of companies (debt-to-equity swap after a capital reduction) is also often achieved without (possibly even restructuring-willing) existing shareholders.
In recent years, the number of loan-to-own transactions in Germany has risen significantly. This is due to several factors. Changes in insolvency law play a key role. In particular, the introduction of the ESUG (Act for the Further Facilitation of the Restructuring of Companies) in 2012 has made it significantly easier for investors to acquire company shares through debt-to-equity swaps and to actively intervene in the restructuring process. The ESUG enables creditors to play a greater role in insolvency plan proceedings and to significantly influence the fate of the company. The ESUG aims to improve companies' prospects of restructuring and to ensure a balanced satisfaction of creditors. Here, dealing with the implications of the recoverability of claims when converting them into equity is not the result of a clear valuation method but is regularly embedded in a (consensual) overall concept.
A second factor favoring loan-to-own transactions is the growing activity of activist investors. The environment for this investor group in Germany has improved significantly in recent years. Activists are increasingly willing to invest in distressed companies and, through loan-to-own strategies, to take an active role in their restructuring and long-term preservation. These investors see opportunity in crisis and use their financial resources and negotiating skills to gain control of struggling companies. In doing so, they offer existing shareholders at least the prospect that their company – and often their life's work – can be saved from insolvency and continue to operate, albeit under new ownership.
Finally, the retreat of traditional banks from financing distressed companies has created a field of activity that is being served, for example, by activist investors. Reasons for the retreat include stricter regulatory requirements and the high servicing effort of such engagements, combined with limited capacity for intensive account management.
For banks, selling non-performing loans to activist investors has several advantages. By selling NPLs, they can clean up their balance sheets and minimize the risk of further losses. In an environment in which regulatory requirements for equity ratios are rising, this is a weighty argument. In addition, such transactions offer the opportunity to focus more strongly on the core business instead of investing extensive capacity in the restructuring and turnaround of troubled companies.
For activist investors, the appeal of loan-to-own transactions lies in the possibility of acquiring larger stakes with a comparatively small capital outlay and thereby gaining control of the company concerned. Through their active role in the restructuring, these investors can increase the company's value and later achieve a profitable exit.
Despite many advantages for all parties involved, loan-to-own transactions are no sure thing in the currently complex market environment. For many shareholders, the entry of an activist investor in an already challenging situation is an additional stress factor, not least because such transactions require a high degree of strategic expertise, practical restructuring experience and communicative tact.
These competencies are rarely all present in the company. It is therefore advisable for investors to seek advice on strategies for the acquisition and subsequent value enhancement of a company. This includes analyzing the financial situation, assessing restructuring options and negotiating with creditors and other stakeholders.
Carrying out a loan-to-own transaction also requires a deep understanding of the economic environment. Experts can support you in structuring the debt-to-equity swap and ensure that all regulatory requirements are met. A successful restructuring ultimately stands or falls with the ability to convince different stakeholder groups – from creditors through management to employees – of the concept and to bring them to a common denominator. A competent advisor can credibly take on a neutral mediating role here, ensure smooth communication and thereby significantly increase the chances o
