Restructuring debt - finance concepts

Extelleron:

As discussed in the other thread, I'd recommend reading Moyer's book first. It is a bit of a dense read, but since it sounds like you are just starting out it is worth investing the time if you are really interested in restructuring/distressed. In fact reading the first ~4 chapters will give you a good overview; the rest will fill in the details. But I will try to walk you through how I'd look at the situation you presented.

You start by understanding how the company got into this situation. You ask various questions, i.e. "Why is this company is distress? Is the problem the company, or the industry, or the macro environment, or a combination? Is this a good business with a bad capital structure or is this a poor business? Are the problems temporary?" Those are the first questions you have to ask, and without being able to answer those it is difficult to move forward in advising the company.

So take your example, and let's say that this company is in a cyclical industry that is currently in a downturn - it may produce a commodity product, the price of which has temporarily fallen but is expected to recover. The company was able to take out $100 of debt a few years ago because prices for the product it produces, and hence revenues/cash flows, were expected to be much higher, enough to service the $100 of debt. But now, for the next few years, the company's interest payments are too high given the drop in cash flow generation. It is a good business - it is very efficient relative to its peers and will perform well when commodity prices rise again, but it needs time.

chapter 11 is not necessarily the way to go for this business, at least at first. Chapter 11 should usually be thought of as a last resort, to utilize when negotiating with creditors has failed. A consensual, out-of-court solution is always preferable to a Chapter 11 solution if it is possible to get everyone on the same page, because going to court is very costly for all the parties involved. The company's operations will suffer (management is distracted, reputation with suppliers/etc is tarnished, etc), and fees to advisers and lawyers (the company would in this case be paying for legal/financial advisers for both itself and each distinct class of creditors) will eat up a significant chunk of value. In chapter 11, the pie always gets smaller - however, for certain parties, the prospect of getting a larger chunk of a smaller pie may make forcing bankruptcy worth it.

In this case, the ideal solution is to negotiate with creditors to amend/extend the debt. This would probably involve reducing the cash interest burden on the business for the next few years as well as extending the maturity of the debt so that principal does not have to be repaid over the next few years. This is the ideal solution in this case because this is a good business and cash flow generation is expected to improve within a few years enough to cover the debt burden, so for all parties as a whole, the best solution is to give the company some time.

While this is probably the ideal solution, it may not be what ends up happening. In reality, you have three groups of investors that may have conflicting interests. Depending on how bad the situation currently is, the bonds or even the bank creditors may be able to argue that they are underwater [that the value of the business is less than the value of their claim & all the claims senior to it]. For example, the bonds may have been bought up by distressed funds in hopes of being the "fulcrum security" in a restructuring. That is, the bond holders hope they can make the claim that they are underwater, and that therefore anyone below them gets wiped out. This way, when the company recovers, the bond holders receive all of the residual value of the business below the bank debt (because the preferreds and common are wiped out).

Thus, an out of court restructuring may not be achievable - the company might be forced into chapter 11. And in court, the bondholders will make their argument that they are underwater and that the preferred holders should get no value. If they win, they might get a chunk of debt in the post-reorg company *plus* all of the equity in the new company - while the old preferred holders and common equity get nothing.

Anyways, that's just one possibility - the bottom line is a situation like this can go many different ways. Reading Moyer cover to cover will give you a good idea of all the different levers that an adviser can pull, and many of the different strategies that investors may attempt to make money in these situations.

Thank you very much for this lovely explanation! I have given you "+1" credit and would love to give you another 100 credits if the system allowed (tell me if it really does). Writing 8 paragraphs on this topic with a dedicated effort demands a lot of time from your daily routine. I appreciate your patience and this elucidation! Thanks once again!

mrb87:

*Most* companies which borrow money actually do not generate enough cash to repay the principal amount of their debt obligations (if they did, they wouldn't really need to borrow it since they can just use CFO to fund uses). Rather, they are able to refinance the debt because the value of the business is sufficient to give lenders comfort that the compant went tits up, they could take control of the collateral and end up being repaid that way (either through cash flow as a going concern or in liquidation).

Now assuming you mean neither internal cash flow nor the value of the business is sufficient to cover the lenders' claim, it really becomes complicated. When do each of the pieces come due? Is the bank loan secured by anything? Who are the actual issuers of the debt (holdco, opco, SPV)? Who are the holders of the debt? What are current market conditions? What does the balance sheet look like? Are there any other debt-like liabilities which may pose an issue in restructuring (ie pension deficits)? There's really no blueprint; each situation requires its own unique solution.

Also it's really hard to give you any numerical examples when you don't even tell us how much of each piece of debt is outstanding, what cash flow actually is and what the balance sheet looks like. It's like asking us to tell you what the answer to 3+x=y is.

To give some insights - 1,500 full-time employees (plus 1260 outsourced/contractual employees) public company (market cap: USD 580 million) with a full-fledged sales force and marketing team, 6 global suppliers, 30 distribution channels, tie-ups with 3 major banks (with global presence), and with capital structure of 75% debt and 25% equity (it wasn't that unhealthy until they reach this stage). Working capital = 0.7; quick ratio: 0.2; interest coverage ratio = EBITDA/Interest payments = 0.72 (current, and expected to be 0.3 in the next 6 months at the current pace of cash burn), cash conversion cycle = 30-35 days. Credit from suppliers: 15-20 days

Now to answer your questions -

Is the bank loan secured by anything? Yes, machinery and real-estate worth USD300 million. They can't sell any of them (because of obvious reasons). The bank loan is secured 80% by new machinery. Repayment period: 10 years

Who are the actual issuers of the debt (holdco, opco, SPV)? 25% holding and 75% operating company issued bonds to fund their current project. The bonds matures in 5 years.

Who are the holders of the debt? shareholders. Non-convertible debt

What are current market conditions? It's a manufacturing company supplying goods to domestic (55%) and international market (US - 30% and UK - 15%). Domestic market stock exchange is fluctuating but non-volatile

What does the balance sheet look like? stated above. Tell me if you need more info

Are there any other debt-like liabilities which may pose an issue in restructuring (ie pension deficits)? Yes, they provide health insurance (through third-party) and pension benefits till the death/remarriage of the employee. His wife would receive half his pension till her death if there is no family income. They also have the provision of offering preferred employment to immediate family members (one son only), depending on his skill-set. The outsourced employee do not have such benefits

nitau_gg:

Anybody who would like to make an effort?

I don't think you get it. We need to be able to value the biz first. Then we need to figure out what a sustainable debt load is and what form of consideration current debtholders are willing to accept. Even still, the Company could do a bunch of things. If it were so simple as reading a 3-paragraph WSO post then we wouldn't have guys like Houlihan and Blackstone earning hundreds of millions in advisory fees.

But fuck it, here's a simple example:

Company X has issued $100mm of senior debt and $100mm of sub debt. It generates $50mm of EBITDA. Based on comps, we think a 3x valuation and 1x leverage is acceptable post-RX. Therefore, our new company is worth $150mm and will carry $50mm of debt (and therefore equity cap of $100mm). Senior debt needs to be repaid in full so, for simplicity's sake, they will be rolled into a new $50mm loan and get their remaining $50mm of value in equity. There is only $50mm of value left for sub debt holders, so they will get the remaining $50mm of equity. (This is obviously ignoring treatment of payables/critical vendors, leases, pensions, etc..)

TLDR version: figure out how much the biz is worth, how much leverage it can sustain, and then resize your debt and equity accordingly so that business value = D+E.