Book: Distressed Debt Analysis
Author: Stephen G. Moyer
Investing in distressed debt is trying to answer the following questions (among others) :
- Will the restructuring occur within/outside of the bankruptcy context?
- Does the process of bankruptcy affect key customers/suppliers/employees? Often, management hasn’t operated a business in Ch. 11 before, and is just making an educated guess through the process.
- What are the tax consequences?
- What is the “controlling” investor, if one, solving for?
LEGAL OVERVIEW OF DISTRESSED DEBT RESTRUCTURING
Broadly speaking, there are two ways of doing restructuring—out of the court, or of course, Ch. 11/7 itself.
Out of Court Process: Ch. 11 is time consuming, administratively expensive, and carries the risk of harming the business (because vendors/customers may not want to work with the co.), so whenever feasible, out of court restructuring is a better option. If this is being initiated by the company, they may consider (a) doing an exchange offer without consulting with the bond-holders first, or (b) inviting key bondholders to negotiate an agreement. In some cases, this may be initiated by bondholders themselves, but this happens only if the company is/about to be in breach of an agreement, because otherwise the bond-holders have no leverage over the company (unless a key group has amassed a large block).
Beginning of the Process: The process begins with a negotiation with “key participants” (agent bank in case of loans, significant bondholders who form an informal bondholder committee—typically at least 25% in aggregate for the management to engage) who come to an agreement to implement/attempt to implement it. Only large bondholders are on the committee given logistical challenges such as setting up meetings, and problems in reaching consensus as the size of the committee grows.
Legal Representative: Technically speaking, the legal representative of the bonds is the indenture trustee (bank acting in custodial capacity), but the trustees tends to be “risk averse”, not proactive, and will act only when it believes that it is acting on behalf of all/majority of the holders, and will do only what they’re clearly obliged to.
Counsel: Once the bondholder committee is formed, it retains financial advisers/legal counsel (at company’s expense) to negotiate an agreement. At this stage, the committee becomes privy to non-public info, which limits their respective abilities to trade (can be done with big-boy letter, which state that the party possesses non-public information w/o divulging the information itself).
Limitations: All that said, one of the key limitations of the out of court process is that the interest of a claimant not participating in the restructuring cannot be changed (i.e. a non-participating bond-holder can continue to hold the bond, and an existing holder of stock will continue to hold stock, albeit much diluted).
This, plus the fact that any restructuring will involve some sort of “sacrifice”, the participants will want almost everyone to share in the “sacrifice”, which is why the process often ends with an exchange/tender offer.
These offers involve certain carrots and sticks to address the “holdout problem”:
- stripping security of covenants (tendering bonds authorize an amendment taking away the protections)
- making the exchange security more senior
- requiring a high minimum tender participation (though the minimums can be waived unilaterally by the co. w/o any notice) OR combining the exchange offer with a solicitation for a prepack Ch. 11.
These tactics are harder when there is a layer-cake of securities and holdout problem can be so severe that an exchange offer is not even attempted.
In-Court Bankruptcy Process: See Ch. 8 of Summary: Distress Investing.
While acknowledging that out-of-court restructuring is desirable, if the company has several on-and-off-B/S-liabilities (incl. labor contracts, LT purchase contracts, legacy post-retirement expenses, superfund liabilities etc.), Ch. 11 process is uniquely able to rationalize these.
OVERVIEW OF THE VALUATION PROCESS
Use of EBITDA metric: The generation rationale for adding back D&A is that these are non-cash, but a stronger rationale is that this represents the effect of company’s previous capital allocation decisions, and that the previous decisions of the management (previous management in certain cases) should not have an effect on the company’s valuation. EBITDA is not sufficient because it does not account for capex and WC requirements, not to mention any addbacks in the metric, and hence these need to be looked at carefully.
Cash Flow Multiples for Various Growth and Discount Rates: Note that the below is a cash multiple (not EBITDA multiple) and [EBITDA – capex] is the appropriate metric from which we use the multiple from (even this ignores WC growth needs).
- Preferred Equity should be treated as debt.
- Debt should be valued as what’s show on the GAAP statement except in 3 conditions:
- if convertible, use face value and in the rare cases where it is in the money, remove it and use it as part of the equity after appropriate conversion
- if debt is obligation of a firm previously gone through Ch. 11 and is accounted for using “fresh-start” accounting at a discount, use the face value
- if the firm is in acute distress, use market value vs. par value.
- Netting cash is okay but make sure not to net the working cash needed to run the company. Just the excess cash should be netted out.
CAPITAL STRUCTURES and ALLOCATION AND MANAGEMENT of CREDIT RISK
There are three sources of credit risk: leverage, priority and time. Below, we will focus on priority.
There are 4 sources of distinguishing priority –
- Term Structure: Obvious—earlier maturity beats later maturity.
- Grants of Collateral: Per the Security Agreement that is signed alongside the Credit Agreement. The secured creditors must take certain additional steps to “perfect” the security otherwise this grants the unsecured creditors leverage in the workout process. This is important because without a valid security interest to give priority, a lender would have a claim just against the estate (and would have to share the value with all other claims of similar seniority) But when a lender has a broad lien of debtor’s assets, the lender has effectively assured that no other claim will be honored before the secured lender is full repaid.
- Contractual Provisions:
- The most straightforward way to assign priority is via contractual provisions such as subordination (which can occur only through an express provision in the doc for the debt being subordinated; some other debt cannot assert priority over your debt in their doc). The key thing to think about is that all liabilities of a firm are equal unless the holders of those liabilities explicitly subordinate their claim.
- In reviewing subordination provisions it is important to see which specific claims the obligation in question has agreed to be be subordinated to. One key item here is often non-debt claims (e.g. trade claims). Normally, the subordinated debt would claim a narrow provisions (sub only to certain debt), but this should be carefully examined.
- Let’s say a company has $75 in assets, $50 in bank debt, $50 in trade claims and $100 in sub notes. Note that, in this simplified particular example, we will assume that bank debt does NOT have a broad lien against the assets, and the bank debt is an unsecured claim.
- If the sub notes are subordinated to both the bank debt and trade claims, recovery for the subs is 0%, and recovery for both the bank debt and trade claims would be 75%, calculated as $75 / ($50 + $50).
- BUT, let’s say that the sub debt is not subordinated to trade claims. Now, the calculation of recovery gets complicated (it is very important to note that the recovery is NOT ($75 – $50) / ($50 + $100), or 16.67% recovery for the sub-debt. Obviously, in this erroneous calculation, what we’re erroneously doing is paying the $50 bank debt fully and then distributing the remaining asset ($75 – $50) between the $50 trade claim and $100 sub note. The correct way to calculate the recovery is as below:
- We add up all the claims ($50 + $50 + $100) = $200 and calculate the pro-rata recovery, which would imply recovery of $50 x $75/$200 = $18.75 for bank debt and trade claim each, and recovery of $100 x $75 / $200 = $37.5 for the sub note.
- Now we say that the bank debt gets paid in full (i.e. $50), which is $31.25 ($50 – $18.75) more than the pro-rata recovery we calculated earlier.
- We take out $31.25 from the sub-debt pro-rata recovery ONLY and give it to the bank debt (we do this because in this example, ONLY the sub-debt is subrogated to the bank debt, and trade claims are not explicitly subrogated)
- This leaves sub debt recovery at $37.5 – $31.25 = $6.25, which is 6.25% recovery.
- Note the somewhat amazing thing here that the unsecured bank debt’s recovery changes from 75% to 100% from one case to the other because of a provision in doc of the subordinated debt.
- Corporate Structure: encompasses things such as structural subordination and guarantee (the opposite of non-recourse provision)
Covenants are basic tools of credit risk management, and these include:
Restricted Payments: These provisions exist to prevent (a) straight-forward transfers such as dividends and repurchases, (b) loans to affiliated companies, (c) treats unrestricted subs as 3rd parties, and (d) in case of secured loan docs, limits transfers, even interest payments, to junior creditors when borrower begins to face financial distress (called blocking).
Negative Pledge Clause: An unsecured note-holder, to protect against the company giving security interests to prospective creditors (1st/2nd/3rd lien etc. depending on the capitalization), states that if the borrower gives a security interest to any of its creditors, it must add the unsecured debt as a beneficiary too.
OPTIONS FOR ALLEVIATING FINANCIAL DISTRESS: COMPANY’S PERSPECTIVE
Wait and See: Okay, genius.
Asset Sales: A key feasibility issue is whether a potential purchaser of company’s assets will be willing to complete a transaction with the distressed company, in light of the fact that if the company files for Ch. 11, the sale could be unwound as a fraudulent conveyance. This factor often causes prospective buyers to insist that the company files so that they can purchase the asset in a transaction approved by the bankruptcy court.
- In case of fallen angels, one needs to worry about the negative pledge.
- In case of historical issuers of converts, it is even easier to issue secured debt as converts are almost always unsecured and typically have no negative covenants (including negative pledge or other restrictions on borrowing).
- In case of issues with existing secured debt, looks for the ability to layer on more (1st, or 2nd lien)
Sale/Leaseback Financing: This is a hybrid of asset sale and secured financing, and can be advantageous as this could be structured as an off-B/S liability (vs. secured/mortgage financing). A typical example would be a company doing such a transaction on an unencumbered assets.
Sponsor Financing: Investors need to be worried about the sponsor structuring a capital infusion as a borrowing that is senior to the existing debt in question. In such cases, if any type of debt is due within an year or so (and thus, the company is at risk of going bankrupt soon), the sponsor’s lawyers will advise against such a 2nd lien financing to avoid the risk of equitable subordination.
Reducing Leverage by Buying Debt at Discount (Using Cash): In general there are three approaches: (a) open market repurchases, (b) direct purchase from holders, and (c) cash tender offers (includes deadline, maximum amount that will be purchased, and price or price-range if it’s a modified Dutch auction).
Exchange Offers: Usually these are coercive, as can be expected.
PROFITING FROM FINANCIAL DISTRESS: INVESTOR’S PERSPECTIVE
The first factor a distressed debt investor should analyze is the capital structure, and what it allows the investor to do (cap structure is the chessboard on which the game is played).
A key factor is the amount of bank debt in the company’s bank structure.
- If the bank doc has financial covenants with teeth, this will allow bank debt holders to extract concessions that are often to the detriment of the unsecured debt
- Even though automatic stay prevents banks from seizing collateral, they’re still protected by the powerful concept of adequate protection (used to demand post-petition interest, limits the type of asset sales, among other leverages on the shape of the POR)
PRACTICAL ASPECTS OF INVESTMENT PROCESS
Collateral Value: If bank debt is trading at 60, and unsecured debt is trading at 20, clearly the 40-pt premium is being driven primarily by the pledge of the collateral. Given this, some of the factors to consider are:
- What are the chances that, in event of bankruptcy, bank debt is considered underscored and thus not entitled to post-petition interest?
- Has the bank properly perfected its security interest? Do other pre-petition creditors have priority over bank’s security interest?
- Was the bank debt originally unsecured, but became secured as part of a transaction? If so, when did that happen, and what is the risk that this pledge could be challenged as a preferential transfer in case of an immediate bankruptcy?
- Liquidity implications of a distressed firm’s current tax status (how much cash tax does the co. need to pay / will it get a tax refund?)
- Potential value of NOLs:
- The basic rule under IRC §382 is that whenever ownership of >5% holders increase, in aggregate, their stake by >50% vs. any point in the last 3 years, a 50% Change of Ownership (COO) has occurred, and a limitation may be imposed (though there are many exceptions, in general, deduction of pre-COO NOLs is limited to what’s the called the §382 statutory tax rate x pre-COO equity per year over the next 20 years.
- In case the borrower open an unrelated business and there’s not “significant use” of pre-COO assets over the next 2 years, the carry forward deduction amount can be reduced to zero.
- Rules allow increase of the NOL carry forward for 5 years to offset any gain on assets sales (so as not to incentivize pre-COO tax-sheltered asset sale)
- One big exception to the COO rule is the “bankruptcy exception”, which looks at the shareholder and creditors as one big happy family. No limitation is applied if at least 50% of the stock is held by (a) pre-petition shareholders, (b) continuing trade claimants, and (c) creditors that held their debt claim at least 18 months (!!) prior to filing the petition. This “bankruptcy exception” is a reason to do Ch. 11 vs. a negotiated re-org.
- Priority status of tax claims in a Ch. 11 re-org
- Under BRC §507 pre-petition claims for taxes have a priority claim status and are senior to unsecured claims)
Legal Due Diligence:
- Voidable Preference: under BRC §547, if a creditor has received any payment within 90 days of a bankruptcy filing (one year, if the creditor is deemed to be an insider), the payment may be deemed as a voidable preference and would be required to be returned to the estate.
- Substantiative Consolidation: eliminates notion of structural priority.
- Structural Advantages: OpCo vs. HoldCo
- Equitable Subordination:
- the BRC §510(c) doctrine has evolved over the years and has been applied not only to classic insiders, but also senior creditors that exercise substantial influence and used it to inappropriately benefit their own interest
- this needs to be specially looked at if a capital infusion was made as debt (vs. equity)
- Special Considerations when investing in claims that are not Negotiable Instruments:
- A negotiable instrument contains the obligor’s unconditional promise to pay the obligation in accordance with its terms. Under state law (generally governed by the UCC), the payer on a negotiable instrument cannot assert defenses against a holder in due course to payment that would have been valid against the original payee on the instrument.
- Trade claims, however, do not qualify as negotiating instrument, and thus, purchasing them carries significantly more risk.
- Debtor may argue that it is not an allowable claim (because, say, the goods/services rendered were defective, never ordered etc.). This non-allowable risk can be managed by purchasing claims that have been allowed by the bankruptcy court, but by the time this happens, the prices may be closer to fair value.
- Notice of any transfer has to be submitted to the bankruptcy court (and in some cases, bankruptcy court may not approve the transfer, which would mean that the holder wouldn’t be have the right to vote the claim in the POR)
“Irrational selling” can come from –
- Downgrades etc. forcing banks to sell assets
- CLO managers being subjected to ORs (operating rules) that mandate certain company/industry/rating (or, a combination thereof) concentration etc.
- HY fund outflows
Types of Ch. 11 process –
- Pre-packages / pre-planned restructuring (a relative rarity)
- Pre-planned sale leading to liquidation/restructuring (this is different from Ch. 7 liquidation because in Ch. 7, management is removed and a liquidating trustee is appointed). Ch. 11 liquidation assumes that the units within the debtor can be sold as a “going-concern” units.
- Free-fall / contested bankruptcies