Debt Restructuring - PE owned company

Hello guys,

Real case down below.
Long story short : I am working on a case where a company that is PE owned is close to financial distress because of lower EBITDA and we are reaching the point where the debt service + capex cannot be assumed.

The company has two sorts of debt initiated at the acquisition :

Holding 1 where the PE shareholder is located :
PIK debt owned by third parties
Convertible bonds owned by the PE firm

Holding 2, owned at 100% by holding 1, where the Senior debt is located and which is owned by banks and third party lenders.

I would like to understand how a debt restructuring process works, can you please advise on this ?
Here are below what I would think would be the process :

1) Determine the value of company and so the value of each shares on a fully diluted basis (convertible bonds converted in shares)
=> How is performed the valuation in theory : based on the latest financials of the company or the forecasted ones ?
I would assume to take the LTM EBITDA known and use a classic multiple for such business to get the EV. Based on the actual net debt, I am able to determine the value of the equity and so the value of each share.

2) Determine how much debt I want to swap in equity (in USD) and so the number of shares to be offered to the lenders in exchange.

3) Determine what is the dilution of the PE fund and so the associated equity injection it would need so that it maintains the same % of ownership

4) Verify that the equity injection of the PE fund would be sufficient to cover the cash needs before having the EBITDA getting back to normal

It may be not the process at all, so just let me know. I am putting aside all legal matters for now even if I know that it would constitute the major part of the process.
Thank you.

Comments (7)

  • Intern in IB - Gen
2mo 

I'm a student interested in the space so just wanted to bump. That aside, some thoughts I had;

You've assumed a debt to equity swap - but this would need to be agreed (how much of the debt, pricing, etc) but surely one would have to take a step back and look at where in the capital structure things go wrong? It's not sufficient to say there's OpCo and HoldCo debt. Once you've established which creditors won't get paid, then you can proceed with the proposal of the debt for equity swap.

Are we also assuming no additional debt can be raised? This can be new capital (assuming covenant compliant), or from a group of lenders who may otherwise not have hope of recovering principal, etc. (I remember reading about a company where something like this happened).

Also curious to see if there are any other cases of the business being able to raise non sponsor cash in such cases, the typical costs, etc. please do share any thoughts!

  • 2
2mo 
isgosu, what's your opinion? Comment below:

In our case, no banks are willing to lend further because of the poor financials of the company. Raising debts on the markets is not possible considering the current market conditions and the rating of the company.

Things went wrong because the company had struggle to improve its cash flow generation over the years leading to circa no Senior Debt repayment combined with a PIK debt on the parent holding that is growing well above the target of the PE fund.
PIK debt is not an issue from a cash flow perspective because interets are capitalized on a yearly basis. So the debt service only concerns the Senior Debt.
However, the PIK debt is an issue for the PE fund because year on year, the value of the equity is reduiced because of the PIK burden (EV - Net debt).

The correct arbitrage in this specific situation would be to determine if swapping part of the PIK into equity combined with an equity injection of the PE fund would have more value over time to the shareholders once the EBITDA is improved rather than a sole equity injection from the PE fund.

  • 2
  • Associate 2 in PE - Other
2mo 

This response is assuming an out-of-court restructuring. Equitizing the PIK debt isn't going help the business during the distress given it's non-cash. The most likely restructuring would be to amend the converts to include a cash / PIK toggle to alleviate the cash interest expense the Company is obligated to pay. If the converts aren't a large enough piece of the cap structure, such that the cash interest savings isn't enough to get FCCR >1.0x, the Company would look to amend the Senior Debt. They would likely try to negotiate a cash interest holiday (maybe 1-3 years) where the interest rate would PIK on the Senior Debt instead of cash pay to give the Company time to turn around performance. Or maybe they would amend a portion of the Senior Interest to PIK (e.g., Senior Debt cash interest is 7% today but is the Lender willing to accept 4% cash / 3% PIK until maturity). The equity injection needed would add to the Sponsor's basis so now the returns are based on the initial equity + incremental equity for the turnaround (assuming no historical dividends). The Sponsor will try to keep this number as low as possible given the negative convexity w.r.t returns. It's a lot harder to make 2x MOIC on a $200mm basis vs. $100mm all else being equal. 

The converts would only be relevant for the sake of cash interest alleviation laid out above. The convertible debt owner would much rather sit and collect interest while waiting to see if the turnaround is successful as opposed to exercises since the securities are almost certainly out of the money given the distress nature (depends on the conversion ratio and valuation at exercise). 

Then it comes down to how much additional equity it takes today to get to EBITDA to recover to 75%,90%,100%,+100%, etc. at exit - and when that exit occurs. The longer it takes to execute the turnaround the more time is diluting down your IRR and the PIK debt is growing. If you're exiting at a valuation where the convertible debt is in the money, you'll need to assume the owners of those securities exercise that right which would also dilute equity returns. 

Likely not included in your case, but is certainly relevant in the real world, is all the fees that come with being in distress (e.g., turnaround consultants, RX bankers, amendment fees, etc.). These costs can add millions of dollars that suck more cash out of the business. 

Hope this helps.

  • Intern in IB - Gen
2mo 

Well explained and noted - thank you!

2mo 
isgosu, what's your opinion? Comment below:

Thanks for the input.

In this specific case, the converts are no more an issue from a cash point of view because it does not bear interests anymore.
From a pure cash point of view, the debt service is only composed of the Senior Secured debt + some capex lines but which represent a low percentage in regards of the total outstanding debt of the company.

A dividend as already been done in the years before so the PE has already received part of its return. However and as you have clearly indicated here, the real question is how much equity would be needed to get a proper return given the financial situation of the company.

And well noted for the legal fees, this is indeed something I have in mind but maybe it is worth the price if it allows the company to survive.

  • 1
Most Helpful
2mo 
Lead Left, what's your opinion? Comment below:

You are looking at this from the lens of what the equity owner wants vs. what is needed to get lenders onboard for such a restructuring. 
Why would a senior lender or convertible holder just agree to swap into equity to save the company interest expense? Why would you base your additional PE equity injection needed based on "getting back" your pro forma ownership share?

In this type of situation, the equity owner has already lost leverage and must work around the lender's desire for enhanced protection and find common ground, rather than the other way around. Your equity injection need is equal to the minimum amount of debt paydown that must happen for the lender to grant any amendments to original debt terms - maturity, PIK toggling the coupon, equity swaps. By definition, if you are asking the lender to swap into equity, they will not be looking to allow you to keep any equity interest in the business unless a deal could be struck considering some of the above points. No lender will agree to PIK their current cash interest at the same rate, either. The terms will get worse with tighter covenants and equity interest will have to get significantly diluted either way (i.e through additional equity injection that is used to partially repair debt in an effective value transfer or punitive debt for equity swap terms). Your EV calculation is useful only insofar as to estimating how far out of the money you are and therefore whether you should double down to turn it around or just walk away. No lender in a equity conversion scenario will look at your per share valuation and agree to just invest there as if they were co-investors. 

Ugh the FBI still quotes the Dow... -Matt Levine
  • 5
2mo 
isgosu, what's your opinion? Comment below:

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