Comm 4720 - Valuation and Restructuring (Smith Capstone)

Steps to a Successful Restructuring

1) Buying time during bargaining 2) Valuation 3) Establish a restructuring (liquidation plan) 4) Execute plan

3) Establish a restructuring (liquidation) plan 3 components

1) How to turnaround and fix operations to maximize value going forward (goes with step 2.) 2) Divide value across claimant groups: Recovery rate = $ new value to claimant / $ size of original claims 3) How to "pay" each claimant: Cash, new equity, or new/reinstated debt?

Ch 11 Tools: Assume or reject executory contracts (under §365 of Code)

Includes leases, labor and employment contracts, compensation contracts, franchise agreements, etc. Rejected contracts take position as unsecured claimant Lessor can take repossess property

Credit Agreement - Commitment

Lenders are severally committed to provide funds on a pro-rata basis if conditions for lending are met

Common examples of financial covenants

Leverage ratios Coverage ratios Net worth EBITDA

Insolvency

Organization can't meet its financial obligations as debts become due. Insolvency is a state of financial distress. Book value of debt > Market value of assets

Factors affecting bargaining positions of claimants and interests

Rights and remedies under contract Priority of claim Size of claim Importance of claimant to going-concern value -Provider of additional capital? -Critical vendor? -Skilled manager?

Pros of Chapter 11 bankruptcy

Rules can help bargaining and cleaning up of balance sheet Automatic stay on all collection efforts Creditor voting procedures that give some weight to smaller investors, but prevents them from holding up the process Debtor-in-possession (DIP) financing Sale of assets free and clear of liens; assume or reject leases and other "executory" contacts

Lease assumptions or rejections - designation rights

a 3rd party pays for the right to make assumption/rejection decision for debtor - debtor has right to sell these rights Designee receives right to assume and assign leases to its own benefit (e.g., below market lease).

Second Lien Loan

a secured loan that entitles holder to remainder of proceeds from foreclosure after first lien claims have been satisfied Used by borrowers in lieu of unsecured high-yield bond or mezzanine financing

Grants of collateral: liens

an interest in property to secure payment of a debt or performance of an obligation To properly secure an asset, a lender must "attach" and "perfect" a lien against the asset. Attachment connects asset to lien via, among other things, a security/collateral agreement. Lien is perfected, once a UCC financing statement has been filed in the headquarters state

Term Loan B

fixed length of time (4-8 years), floating rate (generally higher than term loan A because it is junior), less of principal is amortized characterized by bullet maturities; typically held by institutional investors such as CLOs and hedge funds

Ch 11: Claimants Vote on POR If POR is rejected by at least one class:

judge can: Send Plan back to debtors "Suggesting" they get it right this time Lift exclusivity and allow competing plans Cram down a plan of his/her own

Collateral agent

processes collateral doc, monitors collateral

non-investment grade

rated BB+ and below

Investment-grade

rated BBB- or higher

Advantages and Disadvantages of Second Lien Loans for Borrower

Advantages: Better pricing than unsecured debt at the same level of priority Access to investors who invest in secured loans (e.g., CLOs, insurers) Possibly easier to renegotiate terms compared to HY bond debt Lower prepayment penalties than HY bond debt Disadvantages: May limit future ability to issue first lien, second lien or, unsecured debt

Intercreditor agreement

Agreement between two creditor groups that establishes that one group has priority in claims against borrower over the other creditor group. Common element when tranching secured debt into "1st lien" and "2nd lien" loans.

Ch 11 Tools: Assets sales (under §363 of Code)

Allows debtor to sell assets free and clear of all liens and encumbrances Sale conducted through an auction

Types of potentially fraudulent transfers

Asset sales outside of Chapter 11 -Key benefit of Section 363 Loan guarantees within corporate family -Upstream or downstream? Asset transfers within corporate family Leveraged buyouts

Ch 11: Pre-filing Preparation

Attempt consensual out-of-court restructuring Retain counsel, financial and turnaround advisors Communicate intentions to creditors and stakeholders Arrange debtor-in-possession (DIP) financing Prep Plan of Reorganization in advance and get as many creditors on board as possible If feasible, attempt to arrange for "pre-pack" or pre-arranged filing

1) Buying time during bargaining

Must be able to keep firm "alive" during negotiations. Slow or stop collection efforts Find a managing team that can function while bargaining Usually implies involvement of turnaround/crisis management team Liquidity -- Additional financing?

Financial covenants

Negative covenants that require the borrower to maintain a pre- specified level of financial performance. Usually maintenance-based. Measures often cash flow based (EBITDA)

Out-of-court vs. Ch. 11 Restructuring

No interference from court By far least expensive and intrusive Use out-of-court remedies: UCC Code for dispositions and foreclosures Purchase and sale agreements Voluntary debt-for-equity and debt-for-debt exchanges Capital infusions BUT Requires consent of all parties; no holdouts Hard to renegotiate leases, franchise agreements, compensation contracts, and other executory contracts Often hard to get additional financing

Ch 11 Tools: Debtor-in-possession (DIP) financing

DIP lenders receive administrative priority Can jump ahead (called 'priming') secured lenders in special cases DIP amount must be approved by the judge DIPs receive automatic administrative claims priority, immediately below secured debt and pari passu with other admin claims like professional fees (lawyers, advisors, etc.).

Grants of collateral

Debt can be secured against specific assets of the firm through the granting of collateral. Secured interest gives the debtholder right to seize or foreclose (sell) assets in case of default out of court. Foreclosure and bankruptcy rights give secured holders highest priority in capital structure. Unsecured creditors are due residual cash flows after secured holders are made whole.

Ch 11: Filing of Voluntary Petition

Debtor (bankrupt) firm can choose court in district that is: (1) Headquarters state, (2) State of incorporation, (3) Place of major business operations. Filing immediately stops all collection efforts through automatic stay Debtor counsel files first-day motions: -Approval of counsel and advisors -Approval to use bank accounts, pay employees, "keep lights on" -Interim approval for use of DIP financing and/or cash collateral Debtor has exclusive right (for 120 days) to propose Plan of Reorganization -But well-functioning debtor will be communicating and negotiating Plan with creditors

Lease assumptions or rejections - assuming lease

Debtor chooses to keep lease. Debtor cures any defaults and keeps current on rent. Lessor (landlord) obligated to continue lease.

Ch 11: File POR and DS

Debtor must submit formal POR, along with a Disclosure Statement (DS) for approval by court Disclosure Statement contains a thorough overview of company history, reasons for bankruptcy, summary of POR, and information on valuation for purposes of confirmation Once POR is approved by court, mailed out to all voting claimants, along with ballots to vote to accept or reject POR

Valuation for fraudulent transfers - test of reasonably equitable value

Did the debtor receive something of reasonably equivalent value in exchange for the transfer? often interpreted to imply fair market value, i.e., using standard valuation tools

Indirect costs of financial distress

Drains on value created by being in financial distress Estimated up to 20% of firm value Ex: Management time and focus Decreased sales, especially for durable goods Restricted trade credit, cancelled shipments Working capital constraints Reduced capital expenditures Loss of customer base Unable to retain key employees

Leveraged loan - prepayment fee/make whole

Due upon early payment of loan principal; more common in high-yield bond market, but becoming important for loans too.

Credit Agreement - Floating interest rate

Equal to base rate + margin (LIBOR + 25-200 bps)

Cons of Chapter 11 bankruptcy

Expensive Leads to additional laws, rules/regulations in court

Ch 11: Claimants Vote on POR A cramdown must be:

Fair and equitable to all classes -Must receive at least liquidation recovery -Work to treat constituents within a class equitably. Approved by at least one class

Credit agreements

Governs syndicated loans. Contains: definitions, amount and terms of loans, conditions precedent, representations and warranties, covenants, events of default, agents, miscellaneous. This is important to protect lenders Agreements typically contain a revolving line of credit and one or more term loan

Debt Priority - four factors that influence

Grants of collateral (security status) Contractual subordination Structural subordination - parent organizations Guarantees - 3rd party/entity guarantees they'll pay if borrower can't pay

Ch 11: Claimants Vote on POR Who is entitled to vote? Voting is by? Yes vote amount? Consensual/nonconsensual?

Not all creditors are entitled to vote: -Entitled to vote: Impaired creditors (those receiving less than 100% of face value under the POR) that are also receiving more than zero under the plan -Not entitled to vote: Unimpaired creditors and impaired creditors receiving zero under the POR Voting is by creditor class (roughly, claimants of same priority) Debtor must receive "yes" vote from ½ (by number) and 2/3 (by amount) from each voting class for POR to be accepted and confirmed by judge -Consensual if all parties agree, nonconsensual if any dissenting parties --> judge can impose cram down on dissenting classes

Subordination clause in indenture

One set of unsecured note/bondholders agrees to subordinate its cash flow claims to another set of investors.

Leveraged loan - administrative fee

Paid annually to administrative agent to monitor the loan, disburse payments, etc.

Leveraged loan - upfront fee

Paid at loan closing with largest share going to lead arranger; ranges from 0 to 400 bps for leveraged loans

2) Valuation

Parties must value assets of restructured firm. Two assessments: Enterprise value as a going concern Liquidation value

Ch 11: Bargaining Towards Plan (POR)

Plan acts as a guidebook on how the company will emerge from bankruptcy. Covers questions: How will firm restructure operations and capital structure (fix balance sheet) to exit as a healthier going concern. What is the estimated enterprise value of the going concern once it exits Ch. 11? How will enterprise value be divided across original claimants? How will claimants be paid (cash, new debt, new equity)?

Ch 11: File SOFA & Schedules Claims register?

SOFA is the debtor's Statement of Financial Affairs Schedules are the Schedules of Assets (Detailed accounting of real and personal properties, leases, etc.) and Schedules of Liabilities (Detailed accounting of secured and unsecured liabilities, include amounts owed and names and addresses of creditors) Claims register: Online format for creditors and other claimants to assert claims not covered in Schedules of Liabilities Throughout the case, debtor will continue to file Monthly Operating Reports (MORs) with financial statements and cash flow budgets.

Avoidable transfers

The bankruptcy code gives the trustee the power to avoid - i.e., reverse or "claw back" -- preferential and fraudulent transfers Mechanisms for bringing cash or other value back into bankruptcy estate. More value back in = Higher recoveries for creditors! Often only retrievable via litigation. Claimants and/or debtor trustee must sue to avoid transfers Good source of value for unsecured creditors who are otherwise looking at small recoveries from going-concern value.

Key Issues to be Resolved

Where does value "break" in capital structure? Valuation analysis: Who is in? Who is out? How to meet short-term liquidity needs? Need cash to meet ST obligations. Where to get it? How to "fix" balance sheet? Right-side only? Or left-side too? Short-term or long-term fix? How to divide or delegate control of restructuring? Who makes decisions? How to split value? Who gets what? How are they paid?

Representations and warranties

assure the bank that that the borrower has provided accurate information in its loan application

Lender protections - asset substitution

choosing risky +NPV projects over less risky projects with the same NPV

Administrative agent

collects payment and monitors loan; managers renegotiations

Conditions precedent

conditions that must be met to receive funds Important for revolvers

Syndicate

funding provided by a group of lenders Loans "originated" (issued) by lead arrangers and may include other banks as initial participants Following origination, pieces of loan are sold off in whole as "assignments" or as "participations" to other lenders. Administrative Agent bank - often the relationship bank - typically retains a piece of the loan.

Preferential transfer

gives preferential treatment one creditor over/at the expense of other creditors

Fraudulent transfer

harms all creditors may be avoided if: Actual intent - If the company made such transfer with "actual intent to hinder, delay, or defraud" creditors Constructively - If the company was insolvent - or rendered insolvent -- at the time of the transfer and received less than "reasonably equivalent value".

Goals of restructuring

increase liquidity, decrease leverage, ultimately improve value, minimize costs of financial distress!

Lender protections - overinvestment

investing in -NPV projects that increase the riskiness of the firm

Lender protections - claim dilution

issuing new debt, especially debt with equal or greater priority to existing debt

Guarantees

make the obligations of the borrower become obligations of the guarantor in the event of default can eliminate structural subordination by making (guaranteed) HoldCo debt pari passu with OpCo debt

Documentation agent

manages loan documentation, hires lawyers

Valuation for fraudulent transfers - 3 tests of solvency

measured as of the time of the transfer: Balance sheet. Does the market value of the assets, either under liquidation or as a going-concern, exceed the book value of assets? Did the transfer itself render the company insolvent? Debts as they come due. Was the debtor able to continue to meet debt obligations as they came due? Capitalization. Did the transfer leave the company with too small of a capital cushion?

Incurrence-based covenants

only checked upon an event (e.g., merger, new capital raising, etc).

Lender protections - underinvestment

passing up +NPV projects where the benefit accrues to debtholders

Lender protections - distributions

paying out more than expected to equityholders through dividends or stock repurchases

Covenants

set of restrictions that borrow must adhere to in order to be in compliance under the contract (not be in default)

Lead arranger(s)

structure loan and credit agreement, take large initial positions/underwrite loan, solicit participants ("book runners")

Bonds/Notes

the instruments issued and traded in the high yield market Typically junior to loans Typically unsecured Contracts called indenture Interest usually fixed Penalties/premiums if paid early Weaker covenant protections Issued to disperse investors Difficult to renegotiate Public securities, easily traded

Credit facilities (loans)

the instruments issued and traded in the leveraged loan market Senior in capital structure Often secured Contract called credit agreement Interest usually floating Minimal pre-payments penalties Stronger covenant protections Often syndicated to "participant" investors Straightforward to renegotiate ("amend") Private agreements, pretty easily traded

Negative covenants

things a borrower must not do (restrictions on: raising more debt, acquisitions/divestitures, payments, cap ex)

Syndication agent

typically agent in name only; few responsibilities

Affirmative covenants

Things a borrower must do (disclosure, standard, other)

Early signs of distress: Covenant violations

A covenant violation is an event of default. More common with loans (credit agreements) than bonds or notes (indentures). Borrower typically has 15-30 days to remedy the violation. 10-15 days for financial covenant violations. Failure to "cure" or remedy default can lead to acceleration of loan, canceling of commitments, assertion of lender rights under contract. Financial covenants are set tight enough so that violations are common Initial violations do not lead to bankruptcy or exercise of "acceleration" rights -Lenders use opportunity to "kick the tires" of company and make sure all is OK; then "waive" violation. -Will often amend credit agreement to tighten contractual restrictions and monitor borrower more closely. -At the same time, may grant borrower longer-lasting relief in the form of maturity extensions, lighter financial covenants, etc.

Leveraged loan - commitment fee

Charged on undrawn balance of revolver; typically 25-75 bps for leveraged loans (10-50 for inv-grade).

Ch 11: Form Committees Official and ad hoc

Committees are formal "voices" of claimants and interests during Ch. 11 proceedings -Official committees get legal and advisory fees paid by debtor estate; includes unsecured creditors committee and, sometimes, equity committee -Ad-hoc committees formed by stakeholders wanting a voice outside official recognition (e.g., investor groups); Fees paid by committee members

Maintenance-based covenants

Compliance checked on scheduled periodic basis (e.g., quarterly).

Contractual Subordination

Contract or agreement in which one creditor group agrees to subordinate itself in priority to another creditor group. Two forms: Subordination clause in indenture Intercreditor agreement

Structural Subordination

In a complex organization with multiple separate entities, liabilities against a given entity are structurally senior to all claims against the entity created by other entities in the organization. Example: Loans to a subsidiary are senior to all claims, including secured claims, against the subsidiary by the parent. Idea that each wholly or partially owned subsidiary is a separate corporation with its own boundaries of "separateness." Organizational structure matters!

Financial distress

In danger of defaulting, or has defaulted on fixed obligation

Second lien rights

In many cases, second liens may have their rights restricted by first lien lenders through an intercreditor agreement -May be prohibited from foreclosing on collateral during "standstill" period of 90-120 days following default -May have to waive several rights in bankruptcy process, including approval of asset sales, new financing, etc. If so, the second lien holders are called "silent seconds" Often, however, second lien holders are anything but silent

Direct costs of financial distress

Lawyers, investment bankers, valuation experts, turnaround management, etc Estimated to be 1-2% of assets

Lease assumptions or rejections - assuming and assigning lease

Lease is assumed but rights to rent are sold ("assigned") to another renter, who takes over lease

Lease assumptions or rejections - rejecting lease

Lease is canceled. Debtor no longer obligated to pay rent. Lessor receives property back and asserts a "rejected lease" claim to cover damages for lost rent payments. Rejected lease claims are general unsecured claims. Claims are limited to rent from the greater of (a) one year, or (b) 15% of remaining term, not to exceed three years.

Mandatory prepayments

Lenders want to protect collateral and ensure that company funds are not used to benefit other parties at their expense Require prepayment when any of several events takes place: Asset sales sweep Debt issuance sweep Equity issuance sweep Change of control May also require that excess cash flow be used to pay down debt ("excess cash flow sweep")

Agents

Manage servicing and administration of the loan after syndication

Credit Agreement - Term/Tenor

Typically 3-8 years, revolvers typically have shorter maturities. Maturities can be 1 year or shorter for commercial paper backup lines and bridge loans

UCC Article 9

Unsecured creditors are due residual cash flows after secured holders are made whole.

Three types of guarantees

Upstream - Subsidiary guarantees debt that is issued by the holding company Downstream - Holding company guarantees debt that is issued by a subsidiary Cross-stream - Subsidiary guarantees debt that is issued by another subsidiary