Intro to Restructuring II

Recap:

• In the last post, we covered capital structures and some basic terminology
• Absolute Priority Principle: in a distressed/bankrupt situation, a company's capital structure determines the order of claims on a company's assets. This order is: 
• Secured Debt
• Unsecured Debt
• Subordinated Debt
• Mezzanine Debt
• Equity
• Bonds vs. Loans:
• Bonds: source of funding that can be obtained from the public and usually have a par value of $1000
• Loans: obtained through bank, more restrictive covenants and not as liquid as bonds
• Types of secured (senior) debt:
• Revolver:
• Secured, 1st lien
• Corporate credit card
• Floating interest (LIBOR+spread)
• Term Loan A:
• Secured, 1st lien
• 5 Year Term
• Amortizing - payment schedule over time
• Term Loan B:
• May be 2nd or 1st lien
• 5-8 Year Term
• No amortization - bullet maturity (lump sum in the end)
• Types of unsecured (junior) debt:
• Mezzanine:
• Mix of debt and equity, e.g. convertible debt, convertible preferred stock
• PiK interest

Reasons for Financial Distress:

1. Bad management (e.g. failed LBOs or rollups AKA small acquisitions to benefit synergies, causing too much leverage)
2. Economy/Macro factors
3. Uncompetitive product/service
4. One-time events (e.g. lawsuit, maturity wall)
5. Unrealistic business plan

Signs of Distress:

1. Limited liquidity
2. High leverage ratios (debt/EBITDA)
3. Low interest coverage ratios
4. Maturity walls that are unlikely to be refinanced
5. Decreasing share price
6. Butting up against covenants
7. Low secondary pricing across capital structure
8. Increasing number of distressed debt hedge funds buying up debt

Incentives of Creditors and Shareholders:

• Senior creditors:
• incentivized to argue for low valuation to retain larger % of enterprise value
• notable exception: not the case for traditional banks as they will not hold volatile securities like post-reorg equity
• Junior creditors:
• will argue for high valuation
• senior unsecured creditors will argue for low valuation ONLY IF there is minimal secured debt in capital structure
• shareholders will typically argue for high valuation but often receive nothing

Out of Court Restructuring Alternatives: (most to least preferred)

• Amend and extend (push back maturities, add PiK interest or collateral):
• Used when company has liquidity issue
• Pros: quick and easy if debtor has lots of bank debt
• Cons: not possible if most debt is in form of bonds (bonds=high number) or if value of debt is greater than assets. Lenders may not want to amend and extend if there is a maturity wall
• Buy back debt at market price:
• Used when company has insolvency issue
• Ways to buy back:
• Tender Offer (company public announcement to buy bonds at certain date): allows the debtor to purchase larger % of total bonds outstanding but announcement will drive up prices of bonds
• Open Market Purchase: discreet and therefore cheaper but debtor will only be able to buy back a smaller % of total bonds outstanding
• Pros: cheaper due to depressed market prices. At risks of default, price of debt decreases
• Cons: only works if company has liquidity
• Asset Sale/Distressed M&A:
• Pros: faster payout, equity holders could get larger payout, provides stability which appeases creditors, beneficial if company has many non-core business lines
• Cons: typically lower valuation
• Equity Sponsor/Secured Financing:
• Pros: Quick and easy if debtor has lots of bank debt
• Cons: usually only possible when sponsor owns 50% of company as any financing provided by equity holders will immediately be used to repay creditors
• Debt Exchange 
• Exchange existing debt for new debt or equity
• Pros: private affair, company image will stay intact
• Cons: need high creditor cooperation (90%+ creditors need to agree)
• Liability Management Exercises
• Raising secured debt using loopholes in documents

In-Court Restructuring Alternatives: 

• Chapter 11 (Reorganization):
• Pros:
  
• Debtor-in-Possession (DIP) financing: super priority debt
• company now has money to operate during bankruptcy
• Automatic Stay: freezes all creditor claims
• lender can't collect payment or seize collateral once company is under court supervision
• Reject uneconomic leases and executory contracts with court approval
• Cram down existing creditors 
• force plan on other creditors
• Cons:
• expensive, time-consuming (6 mos to 3 years)
• Chapter 7 (Liquidation):
• Last resort when believed that company can no longer operate as a going concern
• No need for RX advisor - US Trustee will take over by selling assets and repaying creditors in order of seniority

In-Court Restructuring Terminology:

• Types of Chapter 11 Filings:
• Pre-pack Chapter 11: pre-petition arrangement between debtors and creditors where Plan of Reorganization (POR) is agreed upon 
• Pros: save time and fees but still allows company to receive benefits of filing such as lease rejection or DIP financing
• Cons: requires creditor cooperation prior to filing
• Free-fall Chapter 11: debtor enters bankruptcy without any restructuring arrangments in place
• Cram Downs:
• DEF Cram down: when POR is forced upon creditors that have voted to reject it
• Because cram downs are difficult and expensive, senior creditors might give junior creditors a modest recovery to avoid added cost and uncertainty
• Absolute Priority: higher claims must be paid in full before less senior claim can receive anything; cram downs will allow creditors to circumvent absolute priority

Court Approval in Chapter 11 Process:

• Bankruptcy court will need to approve any PORs put forth by debtor or creditors
• The court will then assess POR using:
1. Best Interest Test: all creditors must accept POR or receive as much as they would in a liquidation
2. Feasibility Test: POR must demonstrate that the company is unlikely to reorganize or liquidate again after emerging from bankruptcy
3. Cram Down Test: in the event that not all impaired creditors agree to POR, and court still thinks POR is fair, POR will be forced on them