by Robert H. Barnett, Brian J. Grant
The credit crunch and economic downturn over the last two years have created a need for restructuring a large number of companies. Yet at the same time, the downturn created conditions that have made it very difficult for debtors to use the U.S. Bankruptcy Code as a tool to restructure. Although the number of bankruptcy filings hit a nearly 20-year high in 2009, second only to 2001 in terms of large corporate filings, the percentage of successful reorganizations is down significantly in this cycle.
Many companies that entered bankruptcy, including such high-profile debtors as Circuit City and Linens ‘N Things, failed to reorganize and ended up in liquidation. During that that time, a large number of companies simply liquidated out-of-court.
Unlike any other time in recent history, corporate restructurings are challenged by the systemic lack of financing, great uncertainty over asset values, and complex and often convoluted capital structures. As a result, Chapter 11 bankruptcy has become less effective in today’s environment, and the conditions of the credit crisis have created new and unique challenges to out-of-court restructurings.
The first and potentially most important and daunting hurdle for a debtor in Chapter 11 is access to financing. Companies must have ample liquidity to finance a restructuring through the bankruptcy process; liquidation is the default solution to insufficient liquidity to fund the process.
Unless a debtor is able to generate adequate cash flow from operations, debtor-in-possession (DIP) financing is generally required to continue operations. Yet DIP financing sources seized up at the onset of the credit crunch and banking crisis in 2008. Several large institutions in the third quarter of that year dramatically tightened new DIP lending; Lehman Brothers filed for bankruptcy in September of 2008, and Merrill Lynch and Wachovia, two other top players in the market, were sold in last-minute distressed deals to Bank of America and Wells Fargo, respectively.
As credit vanished throughout the financial system, other DIP lenders followed suit. According to industry sources, the number of active DIP lenders dropped from more than 30 at the beginning of 2008 to only five or six by the end of the year. Aside from some high-profile deals in which lenders pulled together to support large companies (such as Lyondell Chemical Co.’s $8 billion DIP loan, which came with a 13 percent interest rate and a 7 percent fee), DIP financing remained scarce in 2009, forcing companies either to restructure by other means or to move straight to liquidation.
Even though DIP lending has begun to normalize, the presence of lenders willing to invest into safe deals does not mean that all companies are able to tap DIP financing. In many cases, debtors’ ability to borrow is still limited by extraordinarily high leverage. Fueled by the credit boom that preceded the recession, many borrowed heavily, not only from senior lenders, but also from second- and even third-position lenders and funds.
As a result, many debtors today lack sufficient unencumbered assets required to attract financing from a DIP lender. Unless first lien lenders are willing to provide a carve-out for a new DIP lender, securing financing is almost impossible. Over the past two years carve-outs have been rare and in many cases were provided by existing lenders only to support short-term solutions, such as completing Section 363 sales.
Without available DIP financing, the utility of Chapter 11 bankruptcy protection is diminished, and bankruptcy is largely taken off the table as a viable option. In lieu of liquidation, restructuring out-of-court is often a company’s only remaining alternative.
However, without the benefit of the rules and structure of the Chapter 11 process, a company that likely would be liquidated or sold in a bankruptcy may not have the time and flexibility to survive out-of-court. Additionally, just as the credit crisis and economic downturn have impacted the usefulness of bankruptcy, they also have created new challenges to restructuring out-of-court that must be considered carefully.
Uncertain Asset Values. A year and a half after the credit crisis began in 2008, substantial confusion remains between buyers and sellers over the true market value of assets. The combination of tepid credit markets, a surge of assets for sale, and overall depressed economic conditions has created a challenging environment for restructurings.
The seizure of the credit markets was a pivotal issue. Without access to debt financing, equity funds and other buyers have been forced to invest greater amounts of equity into deals. Recent deals have required as much as 50 to 60 percent equity investments, and in the case of out-of-favor assets, such as real estate, some transactions have been financed without any debt whatsoever.
Without leverage, buyers needed to purchase assets at steep discounts to meet internal rate-of-return requirements. Once asset values began to fall, the crisis created a circular effect. When collateral values dipped below debt levels, lenders’ positions were compromised, which in turn triggered foreclosures, forced sales, and liquidations, flooding the market with additional assets and further driving down values.
The market for companies, real estate, and other physical assets remains inefficient. Buyers with available capital, or “dry powder,” have been selective and, for the most part, have yet to fully unleash their pent-up purchasing power. On the other hand, lenders have been slow to monetize collateral, either because they have unrealistic perceptions of asset values or because they are financially unable to recognize the true value of assets or loans on their books. For whatever reason—political and public relation dynamics are also at play—the bid-ask spread between buyers and sellers is still extremely wide, and this uncertainty is a major challenge to companies attempting to restructure.
However, in an out-of-court restructuring it is possible to use this uncertainty in the debtor’s favor, as supply-and-demand curves for companies and their assets can motivate lenders to avoid forced liquidation situations. In this context, lenders may be willing to entertain creative solutions that give them a reasonable chance of maximizing recovery. It is a turnaround professional’s job to articulate the situation and make sure that all parties have a mutual understanding of realistic asset values.
The liquidation analysis is the cornerstone of this process and potentially the most important tool available to a turnaround professional in addressing asset values. The analysis shows collateral values under several scenarios, typically a forced liquidation and orderly wind-down, which are then compared to the restructuring plan.
The analysis should be detailed, the assumptions should be logical and well-supported, and the conclusions should be as unimpeachable as possible. Overall, the key to developing a strong case for an out-of-court restructuring is the ability to demonstrate clearly both the current value of the collateral if it is forced on the market today and evidence that the value is not eroding by continued operations.
Capital Structure Challenges. Capital structures created during the credit boom of the last decade were often complex and present particular challenges in the out-of-court restructuring process. While in a Chapter 11, a bankruptcy judge can mediate issues such as asset values and the debtor may have the ability to cram down a plan on dissenting creditors, it often is possible for a single creditor to disrupt an out-of-court plan.
As a result, debtors and their advisors should be particularly cognizant of the divergent interests of a company’s creditors. During the boom, a variety of lenders, including hedge funds, CLOs, and even community banks, provided capital alongside or behind traditional commercial banks. Creditor motivations can be very different; while some lenders may cooperate, other creditors may have short-term investment horizons that make them less likely to do so. Still other creditors may have a loan-to-own strategy, in which their ultimate goal is to take control of a company’s equity through a reorganization process.
At the same time, commercial banks regularly syndicated loans during boom times, thus creating the potential for differing cost bases among lenders. As a result, debtors can find themselves negotiating not only with multiple tranches of lenders, but also with sub-groups within the individual creditor classes.
As the numbers and types of lenders increase, so does the difficulty in negotiating a resolution. Negotiating acceptable solutions to such complex capital structures is very difficult and much more challenging than the discussions with senior secured lenders in which many turnaround professionals and insolvency attorneys have engaged historically. Companies and their advisors must be aware of creditors’ different agendas, financial positions, cost bases, and levels of size and sophistication so that key bottlenecks can be identified and factored into the restructuring plan.
Importance of Liquidity. In the past, meeting additional liquidity requirements depended on convincing existing lenders that it was in their best interests to provide short-term financing for restructuring. However, due to the credit crisis, financial challenges facing lenders, and the diverse makeup of creditor groups, this is generally no longer a viable option in most situations. As such, it is more important than ever for companies to manage their cash flows, anticipate future cash requirements, and operate as close as possible to a neutral or positive cash position.
Given that lenders are keenly focused on their capital positions and are ultrasensitive to increasing loan exposure, creditors are much more likely to support a restructuring plan that doesn’t require funding support. In fact, running out of liquidity and requesting support can often precipitate adverse actions from creditors. Under these conditions, companies cut off from financial support are frequently destined for liquidation.
As such, debtors must put themselves into survival mode. Any excess or nonessential assets should be sold, disbursements and incurred expenses should be minimized, and all efforts to maintain positive liquidity and cash flow should be made. From the turnaround professional’s perspective, the use of a detailed 13-week cash flow report is especially critical in today’s climate. An accurate, detailed report not only provides a debtor with the ability to manage cash, but it also can generate confidence in both the current financial performance and any future projections.
Unfortunately, restructuring through a Chapter 11 bankruptcy is perhaps as difficult as it has ever been. DIP financing remains scarce, and many companies are so overleveraged that securing the DIP financing they would need to continue operating is very difficult.
However, there are new opportunities to successfully restructure out-of-court. Opportunistic investment funds and sources of debt and equity capital are willing to invest in restructured companies that are stable and on a clear and achievable upward path. Some of the most workable solutions involve a complete buyout of the entire capital structure. Existing lenders may also be willing to amend and extend loans if a plan is viable and the debtor can demonstrate that it makes sense.
Regardless of the structure, it is important to understand the new challenges facing both companies and lenders under current economic conditions. While it is unclear when these conditions will improve, companies should have a clear understanding and assessment of their financial position and their situations with creditors to identify potential financial tipping points and possible solutions.
Although some companies may be able to delay restructuring to allow market conditions to improve, many will require restructuring at some point. Delaying out-of-court restructuring until parties have a greater sense of urgency may allow conditions within a company to deteriorate, reducing flexibility, available options, and the overall potential for success. Thus, a restructuring plan should be prepared and pursued as early as possible while a company can still drive the process.