(TMA International Headquarters)
Lenders and company shareholders have very different interests when a company encounters financial difficulty. The owners of the equity are known as a residual claimant — that is, when all other debts are paid off, they get the residual value. The bank, on the other hand, has written a call option on the company — that is, it gets value up to the amount of its debt. All value above that amount remains for the residual claimant.
Because of these different positions, debt and equity holders may have very dissimilar motivations when difficulties are encountered. A bank’s desire to preserve value may be at odds with shareholders’ aspirations to increase value beyond the amount of the bank’s debt.
For example, hypothetical Conservation Bank has $50 million in debt outstanding with a sporting goods manufacturer that specializes in hockey equipment, Hockey Stick Manufacturing. The company historically has generated $15 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) each year and may be valued at six times EBITDA, or roughly $90 million.
In such a case, there would be little cause for concern because the company would have about $40 million in equity value ($90 million in total value less the $50 million in debt) (Figure 1). If Hockey Stick Manufacturing continued to grow — for example, to $20 million in cash flow and $120 million in total value — all incremental value would accrue to the equity/shareholders. The debt holders still would have only their $50 million of value.
However, if the company’s cash flow declined to $10 million and Hockey Stick Manufacturing was trending downward, the company might be worth only five times EBITDA, or $50 million. Despite this turn of events, the bank is no worse off than when the company was worth $120 million — the bank’s $50 million of value is still available.
However, Conservation Bank knows that the residual claimants, or equity holders, have a strong incentive to make Hockey Stick Manufacturing worth more. Under normal circumstances this would benefit both parties. A bank may lend even more money to finance growth in the business, putting its debt further “in the money.”
But Hockey Stick Manufacturing’s deteriorating situation lends itself to excessive risk-taking by its equity holders — they have nothing to lose. Their equity value is now $0 because the company’s entire $50 million of value belongs to the bank. Rather than give Hockey Stick Manufacturing to Conservation Bank at the $50 million that it is worth and receive nothing for themselves, the equity holders would be inclined to make risky bets to increase the value of the company and therefore pump new value into their now worthless investment (e.g., entering new and unproven product lines, opening new geographies in unknown markets, significantly adding to the size of the sales force, etc.).
At the extreme, shareholders would be better off visiting a Las Vegas casino and placing $50 million on black at the roulette wheel. They would have no downside risk. If the ball bounced their way, they would have $100 million, from which they could repay the bank its $50 million and keep $50 million for themselves. If the ball landed on red, they would be no worse off than they were before — their equity would still be worth $0. The bank, though, would see its potential full recovery on its $50 million plummet to $0 very quickly and therefore would vigorously oppose such a strategy.
This extreme example highlights the different incentives and motivations of equity and debt holders as a company experiences financial distress. Faced with such a scenario, management often wants more capital to expand product lines, services, and geographies in a sincere attempt to build value. They are often dumbfounded that the bank isn’t receptive to their plans to build value.
Just as with Hockey Stick Manufacturing, shareholders no longer would bear any of the downside risk of their decisions — that risk would be borne solely by the bank. Conversely, if the strategy succeeded, all upside would go to the shareholders. For this reason, a company’s board of directors should be aware that its fiduciary duties may shift from acting in the best interest of shareholders to acting in the best interests of all constituents — including creditors — as the company enters the zone of insolvency or becomes insolvent.
Put simply, things can’t get better for the bank, only worse, and things can’t get worse for shareholders, only better. It should surprise no one that the bank would just as soon sell the company to recover the value of its debt and call it a day.
But it need not come to that. Here are steps a company can take to prevent falling into trouble with its bank:
1. Review Loan Documentation. Covenants are contractual restrictions placed on a company when it borrows cash from a bank. They are automatic alerts that allow banks to monitor loan performance. Their purpose is similar to that of a car’s check engine light — they warn of potential trouble.
Covenants establish minimum standards and, if they are violated, regulate a company’s activities. When a company violates a covenant, its bank may have several alternatives, including:
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Increasing the cost of debt by imposing higher interest rates and fees
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Accelerating the maturity of the loan
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Starting a negotiated restructuring
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Imposing additional operational mandates, such as requiring the company to hire a chief restructuring officer (CRO) or restricting the use of cash
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Forcing the company into bankruptcy
There are two types of covenants: affirmative and negative. An affirmative covenant requires a company to fulfill certain obligations, such as providing updated financial statements, paying taxes as they become due, and maintaining adequate insurance levels. Rarely do companies get into trouble over affirmative covenants.
Negative covenants, on the other hand, restrain a borrower from taking certain actions, such as spending cash on capital expenditures, increasing management salaries, or paying dividends. Other negative covenants are financial in nature and require a borrower to meet certain benchmarks. It is with regard to financial covenants that companies often first encounter trouble. Common debt covenants for which a company should be especially vigilant are:
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Minimum net worth. Has the company maintained its assets relative to liabilities?
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Earnings. Have the company’s earnings simply fallen below an agreed upon threshold?
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Debt-to-EBITDA ratio. Has EBITDA declined to a point that debt may be five, six, or more times annual EBITDA?
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Fixed charges coverage ratio. Will the company generate enough free cash to make its interest payments?
A covenant default may signal that a company is in serious trouble or may simply serve as a “canary in a coal mine” by warning of potential peril to come unless problems are addressed quickly. The course of action a bank chooses in response to a covenant violation depends largely on whether it believes the borrower is headed for disaster or has simply hit a bump in the road. A company can influence what the bank believes in such a situation.
One of the first steps a company can take to ensure that it does not encounter a liquidity crisis is to read its loan documentation carefully, if possible with the help of counsel. Often, the first sign of trouble that an owner or CEO encounters is when the company has tripped a covenant. Blindsided by the default and unfamiliar with such scenarios, an owner may be slow to react and miss the opportunity to get the company back on course.
By becoming familiar with the terms of the credit facility, a company can anticipate when such violations may be about to occur. Knowing the covenants and proactively reaching out to the bank before one is tripped may enable a company to maintain a good relationship with its bank and mitigate interest rate increases, maturity acceleration, or other penalties.
If it is forewarned, a bank may decide that management has a good handle on the situation and will navigate through the crisis. If it doesn’t receive advance warning about a potential covenant violation, however, a bank may begin to distrust the management team, both in its ability to lead the company and in its desire to keep the bank informed about any risk to its investment.
Once loan documents have been reviewed and the covenants identified, they should be placed in a spreadsheet (Figure 2). Monitored weekly and/or monthly, this spreadsheet can reveal when a company may be about to encounter difficulties with its bank.
2. Communicate with the Lender. First, a company should put together a financial forecast reflecting how its performance will stack up against the debt covenants in the coming weeks, months, and years. Then it should constantly communicate updated information to the bank, along with high-level projections for sales, EBITDA, and working capital (accounts receivable, inventory, and accounts payable). This will reassure the bank that management isn’t harboring plans for a late night flight to Vegas.
If a competitor hires a CRO at its bank’s request, it is likely because management did not communicate well with the lender. The bank may maintain that the CRO was hired to improve profitability or help salvage the business. But a key reason for placing a CRO at a company is to ensure that a trustworthy and prudent individual is looking after the bank’s $50 million of value and that it isn’t being used to pursue risky options.
A company can serve much of this watchdog role itself, alleviating the need for a CRO, by providing its bank with thoughtful projections that lead the lender to believe that the management team has a handle on the situation and is proactively addressing potential concerns.
3. Refinance the Outstanding Debt. In past recessions, companies often could find other lenders willing to refinance their debt. Today, however, rare is the company that is able to refinance its debt, given the current credit crunch.
One alternative is to seek a debt and equity combination capital raise. Typically conducted with the help of an experienced investment banker, the strategy allows a company to seek both debt and equity to address its liquidity needs. Although this may entail current shareholders diluting their equity substantially, it is a better alternative than a distressed sale or bankruptcy down the road.
A company that is truly overlevered should ask its bankers if they are willing to swap a portion of their debt for equity. Although this is rarely the preferred route, a bank sometimes will agree to do so if it believes in the turnaround plan that management has set forth.
When the bank is an owner of equity as well as debt, some of the conflicts outlined in the Hockey Stick Manufacturing scenario are eliminated because the bank now shares in the upside potential as well as the downside. By the very nature of the conversion, the equity is worth little, so a company shouldn’t be surprised if its bank asks for a large portion of the equity. This is why bankruptcy may be imminent if there is little equity value and the bank prefers hard cash to paper shares.
4. Maximize Cash Flow. Through all of this, managers obviously should keep an eye on maximizing cash flow. An important distinction is that they must manage cash — not the paper profits and losses of an income statement. Turnaround practitioners are all too familiar with companies that, despite bright futures and a big sale just 30 days away, shut their doors and filed bankruptcy because they didn’t have enough cash to pay interest, principal amortization, and payroll (a more heartbreaking version of this scenario occurs when a big sale already has been made but the customer takes 90 days to pay, leaving the company without the cash it desperately needs).
A company must remember that it can’t use great upside potential to make interest payments and meet payroll. Instead, it should think critically about sources of cash it can tap into:
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Does the company own unencumbered real estate that could be sold quickly in a sale-leaseback transaction?
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Can the company more aggressively collect receivables from its customers?
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Can it succeed in coming weeks without paying vendors as customarily due? This strategy often works better if a CEO or president, as opposed to someone from the accounts payable department, telephones the vendor. It’s unpleasant but often successful.
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Can the company conduct a discounting program, warehouse sale, service line discount, or similar promotion to reduce inventory levels and generate needed cash, albeit at margins that are unsustainable over the long term?
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What nonessential personnel can be eliminated quickly to reduce payroll?
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Can the company divest any noncore assets or divisions without impairing the bank’s position?
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Will the bank allow for an extended principal repayment plan?
5. Seek Professional Advice. Often, shareholders are tempted to invest more of their own cash into a struggling business, and the bank may pressure them to do so. These shareholders should think carefully before doing this, however. If the value of the business has deteriorated to $30 million and the bank is owed $50 million, it may not be wise to invest new cash. The new money likely will be behind the bank’s $50 million and will only serve to reduce the bank’s outstanding position (assuming that there are no personal shareholder guarantees on the debt).
However, in a small number of cases, investing cash into a business may get the company through a difficult bind and back on the road to recovery. In this situation —and typically whenever a company is experiencing financial difficulties — it may be best to seek expert advice. By assembling a team of professionals — accountants, lawyers, turnaround professionals, and investment bankers who have been through similar situations many times before — a company is far more likely to endure its financial troubles and either get back on the road to recovery or maximize value for shareholders.
Preserving Future Value
A company in financial distress creates a tough situation for all involved, especially owners who have most of their net worth and life’s efforts invested in the business. Through all of this, a company should keep in mind that the bank is not, and has no interest in becoming, an operator of companies.
The general assumption used by banks is that the best team to lead a company through financial difficulty is the team that is in place. Taking actions outlined in this article demonstrates to the bank that this is, in fact, the case, preserving future value for the company’s shareholders.