Proper Exit Financing Is Key to Chapter 11 Emergence
Challenges Abound for Debtors, Lenders Alike

(TMA International Headquarters)

As the effects from the economic downturn and negative trends in the travel, telecommunications, and high-tech sectors spread to suppliers and other companies, Chapter 11 filings were common during the early 2000s. For many, the path out of bankruptcy involved either conversion to a liquidating Chapter 11 or Chapter 7, or engaging in a 363 sale of selected assets or business units. As economic conditions continue to improve, however, reorganizing and emerging as a viable going concern may be more appealing.

Emerging from Chapter 11 with a fresh start can be a positive step, but CFOs and other top executives should be aware that a number of challenges could arise during the exit process. One significant concern involves securing exit financing during this critical time. For their part, lenders and advisors also need to understand the many issues that define successful participation in the exit financing market.

A successful recovery also involves regaining the market’s confidence. It requires that a troubled business acknowledge that there were problems and let suppliers and others know that these have been remedied.

The Bankruptcy Reform Act of 1978 restructured the U.S. bankruptcy court system and overhauled bankruptcy laws in an attempt to conform to modern commercial transactions. The revised bankruptcy process, along with more recent lower interest rates, has helped slash the time it typically takes to emerge from bankruptcy. From about 1979 through the 1990s, exiting bankruptcy took an average of 24 to 30 months. Now that period has shrunk to about 18 months.

Sense of Urgency

Structuring an exit financing package can be complicated. Debtors should begin to address the process as early as possible, perhaps even before the bankruptcy procedure formally begins. However, a debtor is not alone in making decisions — the bankruptcy court and all creditors must confirm proposed exit financing as part of a plan of reorganization. With many voices and agendas represented at the table, each plan is unique and often complex.

With few exceptions, companies want to confirm a plan and emerge from Chapter 11 as quickly as possible. One incentive for moving quickly is that the Bankruptcy Code gives a debtor the exclusive right to file a plan of reorganization for the first 120 days of its bankruptcy, after which other interested parties may file their own plans. Although a judge may grant an extension of this exclusivity period, such a delay may send the wrong message to creditors, vendors, and customers, resulting in a loss of confidence that can erode support for the plan.

Nonoperating costs associated with remaining in bankruptcy, such as professional fees and other administrative expenses, create further incentives for emerging from the process as quickly as possible. This sense of urgency carries over to lining up exit financing because its availability is often a condition of plan confirmation and emergence from Chapter 11.

Selecting an exit financing lender involves more than just weeding out unsuitable candidates. For a debtor, it can mean, among other efforts, gathering information about its particular circumstances and presenting a package for review by potential lenders. Such a package may include the following:

• At least three full years of historical financial statements
• Year-to-date financial statements for the most recent year and for the same period in the prior year
• Business plan and financial statement projections — including projected cash requirements, monthly liquidity forecast, and detail on all assumptions in the model — covering the anticipated term of the exit financing
• Draft plan of reorganization
• Detailed information on a company’s collateral for asset-based loans
• A business and industry overview

Speed is critical, making it incumbent on lenders to meet rigorous timing and other considerations. Depending on the size of their transactions, companies considering exit financing may be advised to get fully underwritten deals or at least to work with lenders that can carry large holds, which can take out some syndication risk.

Experience in managing potential surprises, such as creditors who launch a last-minute appeal against a plan of reorganization, should also be considered. Because the restructuring community can be tight-knit, selecting a lender who is well known to the debtor’s advisors may streamline the negotiations that are part of any deal.

Debtors should assess closely a lender’s commitment and staying power. Lender commitment can be driven by a need to protect existing exposure or a desire to forge new relationships with the debtor or its advisors.

Needs Assessment

Early on, a company seeking exit financing must determine its requisite level of funding. Often, debtors want only enough cash to address liquidity concerns without overloading their companies with debt. Concerned about getting paid, however, creditors may want the debtor to maximize its debt load. The key for a debtor is to forge an agreement that satisfies all parties and to identify a lender that has experience, resources, and flexibility to follow through on the accord.

A debtor’s needs assessment typically involves consideration of the most fundamental operating issues, such as its relationships with suppliers and customers. For example, a company needs to know whether supplier post-closing terms will be consistent with their pre-filing terms. Shorter terms imply that a debtor will spend more and need more cash earlier in the operating cycle.

Debtors also must take a realistic look at where their customers might be in a “switching” cycle. They must recognize that some customers might have started changing over to new suppliers early in the bankruptcy process. Others may not have completed a switch, and a debtor must determine whether those customer relationships will still be in place when it emerges from bankruptcy. Contractual relationships with customers can help clarify this dynamic.

Even more fundamentally, a debtor must keep in mind the cyclicity or seasonality of its business and its associated liquidity and capital availability needs at various periods, all of which help define its financing needs.

An emerging company also must assess its current status and business plan realistically and then consider its position from an exit lender’s point of view. Some considerations for debtors include the possible need to fund operating losses going forward. Debtors might need to weigh the potential role of consultants and advisors against the need to rebuild the management team, with its associated costs for recruitment, hiring, and guiding new executives through the learning curve. Debtors also need to anticipate whether the required management team will be in place at all when the company emerges from bankruptcy, which also can impact types of available financing.

Ultimately, a debtor must ensure that the loan structure provides ready availability in line with its operating circumstances and needs. Debtors should seek as much flexibility as possible with the future loan agreement, with, for example, as little debt service as possible in the initial emergence period, when uncertainty about the business is typically high. For an asset-based loan tied to advance rates against collateral, a debtor must project collateral levels. For a cash-flow loan tied to performance, a debtor must generate reliable and appropriate performance projections. In both scenarios, accurately projecting liquidity is critical to a lender’s financing decision.

Debtors should keep in mind that lenders are always most concerned about the outlook of the appropriate exit scenario and having the requisite cushion. In the case of an asset-based loan, that means audits and appraisals to determine collateral value and coverage are key. For a cash-flow loan, lenders assess loan-to-value ratios after extrapolating market multiples of comparable businesses and calculating an enterprise value for the debtor. Either way, lenders evaluate the projections for adequate debt service coverage to assess the risk in the new capital structure.

Liquidity and valuation will be key drivers of the lender’s flexibility regarding the debtor’s intentions and ultimate goals as the company moves toward and into its emergence phase.

Competing and even conflicting issues can emerge during the company’s in-depth examination of its needs and circumstances. Consider, for example, the possible range of shareholder types post-emergence. New money will probably have a long-term horizon. Alternatively, pre-petition creditors who have been reinstated with debt and equity will tend to have a short-term horizon and a desire to exit quickly — creating the need for flexibility in change-of-control provisions in the loan agreements.

The interests of reinstated pre-petition debt, new money exit financing, and shareholders typically diverge. For example, pre-petition lenders who were not paid in full and are contractually subordinated and new senior-secured lenders both are eager to claim excess cash flow. Shareholders, on the other hand, want the flexibility to use the cash for capital expenditures, acquisitions, dividends, or other purposes.

For their part, vendors who have lost money as a result of a filing and are unwilling to extend terms also can represent a point of conflict with management, which needs liquidity based on terms to help fund the business.

Market’s Appeal

Because net new borrowing has decreased, many lenders see exit financings as an appealing vehicle for broadening their lending activities. For a debtor and lender alike, an even more fundamental appeal of exit financing is to remove litigation and liability issues and restore to health the balance sheet of what in many situations is a fundamentally strong company. Company strength is enhanced, particularly if its business model remains essentially viable and customer relationships were not irreparably damaged during the bankruptcy process. For lenders already involved with the company, exit financing also can provide a better longer-term return than a liquidation or sale.

Overall, exit financing is a cyclical market that has expanded in recent years. For many debtors, it provides a viable and highly appealing alternative to liquidation or asset sales. For lenders, it provides opportunities to tap into a financing market with attractive economics and strong relationship potential.

But making the most of the opportunity requires that a debtor have a thorough and realistic understanding of its needs, circumstances, and prospects. For a lender, the challenge is to bring to the process the experience, flexibility, creativity, and commitment that these complex transactions demand to achieve the most successful resolution.

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Author’s Disclaimer: This article is intended to outline general concepts and principles associated with the exit financing market. Debtors and lenders should consult with their respective attorneys, accountants, and other professional representatives prior to entering into any bankruptcy or exit financing plan.