Alex Hart Brandon Smith Kevin Cooney Alexandros
Case: Cengage
1. In November 2012, Apax is considering a sizeable purchase of Cengage’s debt; what are the pros and cons of this investment strategy?
Apax’s consideration to purchase a significant portion of Cengage’s debt comes with many benefits, however, there are also many consequences they must address. Pros – By purchasing a significant block of debt, Apax increases its chance of retaining ownership of Cengage after a debt for equity exchange. Due to Cengage's debt being traded at a significant discount, there is potential opportunity for substantial profits. – If Apax were to purchase a sizable portion of Cengage's debt, it would give Apax a seat as a creditor at the negotiating table, enabling the firm to influence the progression of the bankruptcy restructuring. Having this additional control will allow Apax to have a larger influence in the rehabilitation of Cengage, allowing them more control to capitalize on their investments. – If Cengage recovered, Apax could earn a substantial return on its debt investment. If Cengage performs well in the future, there will be room for significant upside because of the new received equity to Apax. This equity received would allow opportunity for substantial upside because of the significant debt discount. Cons – A PE firm might worry that they are doubling down on a bad investment or “throwing good money after bad”. Apax has already invested $1.8 billion in Cengage, and it may be hard to convince the partners to invest even more money in a distressed company. Cengage was already performing poorly since the original investment, so some might think that there is better opportunity in investing in other companies. – The creditors and Apax may have differing goals in mind because the potential upside for the creditors is capped at the value of the bond, whereas Apax has unlimited potential. As a result, the creditors may believe that Apax is forcing the restructuring in an attempt to capitalize on the debt purchased. If the creditors and Apax have different goals in mind, the creditors may raise suspicion causing friction within the company. – Cengage creditors would likely view Apax’s bargaining incentives with suspicion, aware that its position as an equity holder might conflict with its objectives as a creditor. If the creditors believed that Apax had too much power and control over the business, they could threaten legal action against Apax.
2. What issues are raised by buying only senior debt versus allocating some funds to purchase junior debt?
When looking at the capital structure of a firm, the senior debt holds the highest priority in a firm’s capital structure. Junior debt lies below senior debt and is repaid after all of senior claims have been settled. Thus, the junior d ebt is trading at a substantial discount (21% of par) to face value reflecting the lower likelihood relative to senior debt th at its creditors will be repaid in full. There is no point in buying debt that has a zero percent probability of being repaid. The issue is predicting the lowest level in the capital structure, be it debt or equity, that still holds value. This the fulcrum security and is the most likely to be awarded new equity in the event of a restructuring. The more senior claims are likely to be repaid in cash or new debt. Apax must try and determine which level in the capital structure the fulcrum security lies, which will be based on Cengage’s future valuation. If the valuation of Cengage were to be high enough to cover all of the senior debt, than Apax could be losing on equity allocated at the junior level. In addition to this, the junior debt is significantly cheaper compared to the senior debt (21% of par value versus 78% of par value), and Apax will lose out on the significant upside had they purchased the cheaper debt. On the contrary, if Apax believes that the valuation will be lower, such that the junior debt will be wiped out, than there is no incentive to purchase to junior debt. The goal for Apax is to come out of the restructuring with equity. Their returns are determined both by their investment decision (mix of senior and/or junior debt purchased) and the valuation determined in bankruptcy negotiation/court. Assume that Cengage exits the bankruptcy process at the midrange enterprise value of $3,438 million in June 2013. Please analyze the following two debt investment strategies: Strategy 1: Apax uses $750 million of its funds to purchase exclusively senior debt trading at 78% of par value. Strategy 2: Apax uses a portion of the $750 million to purchase 25% of the junior debt trading at 21% of par value and uses any remaining funds to purchase senior debt. !
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3. What are the estimated returns on Strategy 1, assuming that the bankruptcy court follows absolute priority in settling the claims and Apax is able to exit its investment in Cengage at 7× adjusted EBITDA in 2018?
See analysis below – Exhibit #3
4. What are the estimated returns on Strategy 2 if absolute priority is violated , the court awards the junior debt holders $250 million in equity in the reorganized firm, and Apax can achieve the same exit in the previous question?
See analysis below – Exhibit #4 If the court awards the junior debt holders $250 million in equity in the reorganized firm, Apax cannot achieve the same exit if the bankruptcy court follows absolute priority in settling the claims. In the later situation, Apax would receive proceeds after the debt issuance of $332.5 million at an IRR of 14.7%. In the situation where absolute priority is violated and the court awards the junior debt holders $250 million in equity in the reorganized firm, Apax would receive proceeds of $300.7 million at an IRR of 12%. The potential upside of Apax’s investment is determined by the ability to successfully turnaround Cengage's performance. If Cengage is able to exit at a more attractive multiple and generate a higher EBITDA, the valuation of the firm will be higher, and as a result will lead to significantly more junior debt to be paid off as equity. In this debt for equity situation, the drastically discounted junior debt will benefit Apax to achieve a higher exit compared if they only purchased the senior debt. 5. Do you believe that the returns on the debt investments are high enough to justify Apax proceeding with the purchase of Cengage debt? If not, how high a return (level of year-end 2018 adjusted EBITDA and exit multiple) would be needed to justify the investment?
Considering that expected returns on private equity investments as measured by IRR generally are north of 20%, the forecasted returns ranging from 12-14% with the current assumptions fall short of that standard. That said, Apax’s returns are closely tied to the valuation of Cengage at their eventual exit. If Apax can successfully turnaround the firm’s recent performance woes (i.e. generating higher EBITDA) and exit at a more attractive multiple, a 20% return would be well within reach. [Using a 20% return as a benchmark for example, Apax can reach this by achieving a 2018 EBITDA that is 20% higher at $805.7M and an 8.5X exit multiple] The risks of the debt purchase lie in the difficulty in predicting Cengage’s future earnings recovery and exit multiple. All things considered, Apax has already sunk $1.8 billion into Cengage’s original equity investment. Their decision to move forward with a purchase in Cengage’s debt should rest on their own confidence in the firm’s turnaround ability in order to ultimately walk away with a satisfactory return to investors.
6. Should Apax proceed with the debt investment?
As noted above, the answer to this question is largely dependent on the future performance of Cengage. There, however, are encouraging factors that could make such a recovery possible. Excess leverage was identified earlier in the case as a potential issue that could be corrected in a restructuring. Hopefully, the elimination of this issue would allow Cengage to focus on improving its operations and gain back market share against the fierce com petition in the digital materials market. Even with the possibility of a successful recovery in emergence from bankruptcy, we believe Cengage’s problems go beyond capital structure. The Higher Education materials market has undergone somewhat of a technological revolution and continues to adapt and grow with the dynamic needs of students in today’s world. We do not feel confident in Cengage’s ability to offer products that can compete with the likes of Pearson and McGraw-Hill and more broadly keep pace with the technology and advancement of the industry. These problems threaten the viability of Cengage’s business model and will not be resolved merely by a reorganization of the firm. Considering that the current projections anticipate a modest return (12-14%) on the debt investment, Apax may better allocate its time and resources to a different project all together and let Cengage go. It’s also worth noting that the forecast assumes a very expedient bankruptcy process. Were there to be issues in the negotiations that delay progress, Apax’s return would further suffer. Considering the challenges ahead and the difficulty of realizing our estimated future returns, Apax would be better off cutting their losses on their original investment and moving on to another project.
Exhibit #3
Exhibit 4
