Common Distressed Company Transactions
Common Distressed Company Transactions
No Rest for the Weary
Both private equity-sponsored and non-sponsored companies that weathered the worst of the pandemic as well as the subsequent supply chain disruption, soaring energy costs, and challenges sourcing labor deserve a respite. Unfortunately, there is no rest for the weary. As the federal reserve continues with the fastest interest rate hiking cycle in history, levered companies can add to their concerns the impact of cash interest expense on liquidity and certain financial covenants. In concert with the aforementioned business challenges, the increased carrying cost of floating rate debt is pushing many companies against the wall. As a result, many will need to initiate difficult conversations with their lenders. An unfortunate few may be forced to consider Chapter 11 filings or other forms of distressed change of control transactions. This article will introduce several transactional alternatives stressed companies may consider.
One Size Does Not Fit All
There are multiple flavors of “distressed” transactions all driven by the level of financial pressures facing a borrower, the financial support offered by ownership / equity, the unique negotiating leverage that lender or borrower may have, and other non-economic considerations which could have an outsized impact on the determination of the appropriate distressed transaction alternative.
For example, consider the following:
- A company experiences dwindling liquidity brought on by transitory business disruption negatively impacting the income statement. Both the company and its lenders are confident that performance will soon return to historical levels of profitability and cash generation. The company has valuable assets not currently encumbered by liens.
- A company’s profitability erodes due to severe demand destruction brought on by the market entry of a new competitor or superior product offering. All the company’s valuable collateral is already subject to liens of the existing lender. Further, the company is the named defendant on a suit alleging failure to perform on a contract with significant damage claims arising as a result.
In scenario number one, it is highly plausible that the company will be able to find temporary covenant relief if needed and incremental liquidity. In scenario number two, the lack of unencumbered and valuable collateral mixed with unfavorable business prospects could force a more severe distressed transaction. The added variable of a potential damages claim that could dilute collateral value all but assures such an outcome.
Amendments, Waivers, and Forbearance
For certain borrowers, a negotiation with its lenders to seek a temporary waiver of financial covenants, a modification to covenant levels, or a forbearance is common. These agreements achieve different outcomes. A waiver simply waives the borrower’s obligation to comply with a stated financial covenant for a given period, while an amendment could re-set covenants to levels with which the borrower could comply, even in the period of its stress. However, a forbearance neither waives nor modifies financial covenants, but states a lender will in effect “look the other way” and ignore a covenant breach for a period of time. While lenders may prefer forbearances because they preserve greater control, borrowers will find greater comfort in waivers and amendments.
Refinancings To De-Risk Senior Capital
Often, a senior secured lender observes a borrower’s deteriorating profitability through the lens of leverage multiples. When the borrower’s leverage multiple rises beyond a lender’s comfort level, the lender may strongly encourage the borrower to seek new junior capital in a “de-risking recapitalization.” The proceeds of the junior capital would be used to pay down, or de-risk, the senior lender to a more comfortable leverage level. For example, if a borrower owes $100 to its bank and regularly produced $25 in annual EBITDA, the lender may feel comfortable at a leverage point of 4.0x (i.e., $100 / $25 = 4.0x). If the borrower’s EBITDA drops by 50% to $12.5, then leverage is now 8.0x ($100 / $12.5 = 8.0x). The lender may ask the borrower to raise enough junior capital to repay the senior loan to a level where the lender is more comfortable. In this example, the lender signals a willingness to accept deleveraging to 5.0x, in which case it would take $37.5 of new junior capital to reduce senior leverage to 5.0x leverage. It bears mentioning that junior lenders require higher rates to compensate for the risk profile of being junior in priority to the senior lender. Moreover, given these sorts of de-risking financings come during unfavorable economic performance of the borrower, new money financing will seek compensation for risk with increased rate (although often PIK) and sometimes equity conversion features.
Negotiated Debt Repurchases
Where a borrower may have tested the market’s appetite for senior capital and / or junior capital to de-risk an existing lender and found no lenders willing to provide new capital, the lender and owner / private equity sponsor may decide to negotiate for a discounted repurchase of the debt. This is a restructuring transaction whereby third-party debt is effectively retired at a discount by the company’s owners.
Rescue Financings & Bridge Capital
A rescue financing and “bridge” capital are frequently used interchangeably. Companies that require a rescue financing have typically experienced a long period of unprofitable financial performance, may have incurred a large non-operating cash obligation, have eroded their liquidity, and have few options to source incremental liquidity. Sometimes the borrower has experienced a sudden, unforeseeable cash need. Other times, the borrower simply waits too long to initiate a strategic conversation with its lenders about its challenging circumstances.
Regardless of what drove the business and balance sheet distress, any new lender will require that their new money not be a “bridge to nowhere.” Bridge capital is typically accompanied by a detailed plan that addresses the business challenges facing the borrower and is marked by a clear path to financial sustainability. Financial sustainability is a condition marked by a borrower’s ability to meet all financial obligations as they come due. For the distressed borrower, achieving financial sustainability may require reducing its debt burden and / or modifying its cash interest burden.
Out of Court Restructuring
Out of court (“OOC”) restructurings take a number of forms, but are typically marked by a material change in ownership and a right-sizing of the balance sheet to reflect future expectations of the business’ earnings power. Sometimes, new equity capital is invested as part of the restructuring plan. In any event, lenders and borrowers may prefer an OOC solution to avoid the publicity that comes with a public bankruptcy process and the burdensome cost of the process, which ultimately must be borne by the new owners of the business. For beleaguered lenders potentially facing an obligation to recapitalize the balance sheet with new money, those incremental costs can be a deterrent to Chapter 11.
In-Court Restructuring
Where OOC restructurings may potentially be more private, less expensive, and even speedier, in-court restructurings may be preferable in various scenarios. A Chapter 11 filing provides a forum for debtor-in-possession (“DIP”) financing that could expand the universe of capital available to the company. Moreover, debtors in Chapter 11 processes receive the benefit of a stay that forbids creditors from exercising their rights on collateral and which frequently provides a boost to liquidity by prohibiting the payment of prepetition claims, including regular way trade vendors (with some exceptions). A bankruptcy process also creates a venue for a company to renegotiate uneconomic contracts and leave behind burdensome liabilities in a manner that binds all stakeholders of the business with a level of finality that may not be achievable in an OOC restructuring.
Article 9 Sales
Article 9 of the Uniform Commercial Code (“UCC”) provides secured lenders with the right to exercise remedies to realize value on their collateral. Where a secured lender has provided a loan to a company that it cannot repay, the lender may initiate an Article 9 sale, usually in cooperation with the borrower. The sale process may vary by state, but generally involves (1) repossessing collateral, (2) giving public notice of a sale process (even if a buyer is identified already), (3) running a commercially reasonable sale process, and (4) distributing proceeds of the sale according to collateral priorities.
An Ounce of Prevention is Worth a Pound of Cure
Benjamin Franklin’s advice applies as well to stressed borrowers as it did in the 18th century to fire-plagued Philadelphians. When companies experience stress and the probability of needing incremental liquidity or being unable to refinance looming debt maturities rises, it is prudent to begin designing strategies to address those potential outcomes. The universe of alternatives will be widest and if the borrower elects to engage with its lenders to proactively and cooperatively fix balance sheet and business issues, those forward-thinking companies are more likely to find receptive audiences.