Distress and Restructuring: Corporates in the Emergency Room - April 2009

Are you aware of:

• current trends in distressed debt and corporate restructuring,
• the causes of distress,
• the legal framework for restructuring in the UK vs. the US,

If not then read on...

The current outlook: the message is clear

In 2008, 101 Moody's-rated corporate issuers worldwide defaulted on a total of $281.2 billion of debt In contrast, in 2007, only 18 companies defaulted on $6.7 billion of debt. The ongoing banking crisis and global economic downturn make it almost certain that default rates will continue to climb sharply during 2009. The only outstanding questions are: to what levels will they rise and how quickly?

The chart below shows that default volume in 2008 reached a record high, and that the number of defaulted issuers was the highest since 2002.

Source: Moody’s Investor Services

Forecasts show that defaults are expected to exceed the levels recorded in previous downturns:

Source: Moody’s Investor Services

What causes financial distress?

Debt instruments (such as loans and bonds) that are in high danger of not being repaid are typically called “distressed”. Seeing a high chance of bankruptcy, investors are only willing to pay a fraction of par-value for these instruments, pushing the yields up, to spreads that are often above 1000 basis points.

A company in distress cannot (or doesn’t intend to) service is debt. In most cases, the number one problem is that the company is running out of cash, which is typically due to either operational cash burn or to a fragile capital structure. In the current environment, capital structure issues are the recurring element in distress stories.

A typical example of a fragile capital structure is one which is exposed to refinancing risk. As debt approaches its repayment date, existing lenders become reluctant to roll over the debt at existing amounts or under current terms, and new lenders are even less compelled to lend. Therefore, existing lenders start analysing whether recovery would be better in a bankruptcy scenario. A distressed company is at risk of breaching terms and covenants (such as EBIT/interest expense coverage) in the debt agreement even ahead of debt maturity date. Breaching covenants give lenders legal recourse to call back the debt, effectively pushing the company into insolvency.

In addition to high leverage, other important factors are: management inefficiency and complacency, overambitious expansion strategies, poor cash management, relaxation of internal controls and reporting. Many of these are the result of the corporate slack developed during good times.

Options for firms in distress

When a company is unable to pay its debt, it is technically defined as “insolvent”. Companies close to insolvency typically have three options: 1) winding up the business, 2) a fire-sale (if they can find a buyer), and 3) debt restructuring. The latter option aims at modifying the original lending agreements, to allow the borrowing firm to survive whilst mitigating lenders’ potential loss.

Restructuring usually involves both operating changes (disposal of assets, change in management etc) and capital structure changes, including a combination of: new debt, some degree of debt forgiveness, debt repayment extension, debt-equity swap, and shareholders re-capitalisation. The new capital structure is based on the post-restructuring valuation of the company, the likely degree of debt the new company can support, and the negotiating clout of different stakeholders.

In or out of court?

”In-Court” restructuring is a formal legal process of reorganization aimed at managing the uncertainty and instability surrounding a company experiencing financial difficulties. Legally organised debt restructuring frameworks provide a mechanism to protect stakeholders’ interests when a company is insolvent, or close to insolvency, by creating a stable environment to enable stakeholders to re-contract with a company on the basis of a better understanding of its current situation and future prospects. Alternatively, they provide for an orderly realisation and distribution of assets to stakeholders in accordance with an agreed priority of claims

Many of the drawbacks of rescuing companies within a statutory framework can be avoided if a company’s stakeholders, and in particular its creditors can agree a financial restructuring without recourse to the courts. “Workouts”, which are essentially restructurings agreed in an out-of-court process, can therefore be an effective tool in a corporate rescue.

The legal framework varies greatly from country to country, so understanding regional differences is an essential task for the restructuring practitioner. As an example, we will contrast some aspects of the US and UK frameworks below.

US vs UK: some examples

• The UK and US legal systems both provide “in-court” restructuring frameworks designed to allow insolvent companies to carry on operating as ongoing concerns. A framework of this kind in the UK is called “administration”, and the US version is “Chapter 11 bankruptcy protection”. One striking difference between UK and US practice is the so-called “debtor in possession” financing. In the US, once the debtor has filed for Chapter 11 (i.e. in the “post-petition” stage), lending institutions offering credit lines can relatively easily obtain enforceable super priority over all other secured and unsecured creditors.
  
  In the UK on the other hand, if a creditor succeeds in obtaining adequate security while a company is under administration, there is no certainty whether the security can be enforced in the event of default during the administration. This makes post petition lending in UK almost impossible unless the administrator can provide personal liability as a form of security - and who would do that?
• In the UK directors bear personal responsibility to file for administration, if it can be proved that the company is failing its covenants. In the US, it is the director’s/creditor’s fiduciary duty (not a personal liability) to file for bankruptcy, but they are not obligated unless they have to protect the assets.
• In the US, the pre-petition management remains in charge of the day-to-day running of the company. In the UK, the administrator usually becomes the effective management and has the power to dismiss directors. In the US, all significant actions post petition need court approval, thus making the process very transparent. This is not the case in the UK administration.

The way forward

The Financial Times recently reported that “bankruptcy-related M&A has only just begun”1. According to Thomson Reuters, 34 such deals were announced in March 2009 alone. These numbers are expected to rise steadily in the coming months, probably to exceed the peak of 87 bankruptcy-related deals observed in July 2002. As such, developing an understanding of financial distress and debt restructuring has become a key requirement for companies and their advisors.

If you are interested in a thorough analysis of these topics, AMT offers a full range of training courses, including distressed debt analysis and trading, the dynamics of workouts, corporate restructuring and financial modelling of reorganizations. We also offer credit analysis courses focused on detecting signs of distress, such as credit for equity valuation and credit analysis for corporate finance.

1 “Bankruptcy-related M&A has ‘only just begun’”, published by the Financial Times on 12 April 2009 .