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Financial Distress

Step-by-Step Guide to Understanding Financial Distress (Insolvency)

Last Updated September 16, 2022

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Financial Distress

Financial Distress in Corporate Restructuring

Types of Financial Distress

For a non-distressed company, total assets equal the sum of all liabilities and equity – the same formula you learned in accounting class. In theory, the value of those assets, or the enterprise value of the firm, is its future economic value.

For healthy companies, the unlevered cash flows they generate are sufficient to meet debt service (interest and amortization) with a comfortable buffer for other uses.

However, if new assumptions indicate that the enterprise value of the firm as a “going concern” is actually lower than the value of its obligations (or if its obligations meaningfully exceed a realistic debt capacity), financial restructuring may be necessary.

Catalyst Events of Financial Distress

Financial restructuring is necessary when the amount of debt and obligations on the balance sheet are no longer appropriate for the enterprise value of the firm.

When this happens, a solution is required to “right-size” the balance sheet so the company can resume operations as a going concern.

Another cause of financial distress that may lead to financial restructuring is when a company runs into a liquidity issue with no near-term solutions.

If there are restrictive covenants on the company’s debt, or the capital markets are temporarily closed, the options to solve the liquidity issue may be limited.

Credit Cycle Contraction (Market Conditions)

There are many causes of financial distress which make it difficult for companies to service their debt or other obligations.

Often, it is purely a financial issue stemming from taking on too much debt because of loose capital markets when management’s expectations are bullish. In other words, market participants are willing to purchase debt despite higher leverage and greater operational risk.

When it becomes apparent that the company cannot grow into its expanded balance sheet, problems arise as debt arrangements near maturity (the “maturity wall”).

Capital Structure and Cyclicality

Cyclicality coupled with an improper capital structure is another cause of financial distress.

Many debt investors evaluate new issues based on current leverage (e.g., Debt/EBITDA). However, a broad economic downturn or change in underlying operational drivers (e.g., decline in the price of the company’s product), the financial obligations of the firm may exceed its debt capacity.

A large debt stack may also be a cause of financial distress and necessitate a restructuring if the company is poorly managed and operational issues cause costs to be unsustainably high. This may result from cost overruns on planned project spending, loss of a major customer, or a poorly executed expansion plan.

These potential turnaround situations are more complicated than restructurings caused by financial issues alone but may be more lucrative for the company’s new equity holders. If the restructured company can improve EBITDA margins and bring its operational performance in line with industry peers, the investors can walk away with outsized returns.

Structural Disruption

In some cases, underlying issues can’t be solved by simply fixing the balance sheet. The economy and business landscape are constantly developing. If a company fails to adapt to an industry disruption or faces secular headwinds, that can serve as another cause of financial distress.

For this reason, management must always be cognizant of how their industries may be disrupted.

Management must always be cognizant of how their industries may be disrupted.

Structural changes within an industry can often render a company’s products or services obsolete.

Some recent examples include the following:

  • Yellow Pages’ disruption by online listings
  • Blockbuster’s disruption by streaming services like Netflix
  • Yellow cab companies displaced by Uber and Lyft

Industries that are currently undergoing a secular decline include:

  • Wireline phone companies
  • Print magazines/newspapers
  • Brick and mortar retailers
  • Cable TV providers

Unforeseeable Events

Well-managed companies with strong secular tailwinds can still encounter financial distress and a need for financial restructuring. For example, if a company with a clean balance sheet experiences tort issues stemming from litigation, unexpected liabilities can arise from fraud or negligence.

There may also be off-balance-sheet obligations that blow up, such as pension liabilities.

Financial Distress Catalyst Event Examples

For a company to require financial restructuring, there is typically a specific catalyst – most often a crisis related to liquidity. Potential catalysts include:

  • Upcoming interest payments or required debt amortizations that cannot be met
  • Rapidly declining cash balances
  • Violation of a debt covenant (e.g., recent credit rating downgrade; interest coverage ratio no longer meets the minimum requirement)

If the next debt maturity is not for a few years and the company still has ample cash or runway via its credit facilities, management can elect to kick the can down the road rather than proactively come to the table with other stakeholders.

Corporate Restructuring Remedies

How Can Financial Distress Be Resolved?

Just as there are many causes of financial distress, there are many potential solutions for financial restructurings.

Restructuring bankers work with distressed companies to develop a holistic solution via corporate restructuring. If all goes well, the distressed company will restructure its balance sheet to reduce its debt obligation, resulting in:

  • Manageable debt balance
  • Smaller interest payments
  • New equity value

As a result, the majority of the old equity is wiped out, and the previous senior creditors and new investors become the new common shareholders.

The more complex the capital structure, the harder it is to come up with an out-of-court restructuring solution.

No two restructuring mandates are the same, and the options available are a function of the cause of financial distress, how distressed the company is, its future prospects, its industry, and the availability of new capital.

The two primary restructuring solutions are in-court solutions and out-of-court solutions.

If the capital structure of the debtor is relatively simple and the distressed situation is manageable, all parties usually favor an out-of-court settlement with creditors. That said, the more complex the capital structure, the harder it is to come up with an out-of-court solution.

When highly distressed companies require funding or new debt just to continue their operations, an in-court solution is often necessary.

Examples include Chapter 7, Chapter 11, and Chapter 15 bankruptcies, and Section 363 asset sales. After an in-court solution is reached, creditors typically take control of the company via a debt-for-equity exchange or with a large influx of new money capital.

Oftentimes, the least intrusive solution for an anticipated breach is a covenant waiver whereby creditors agree to waive a default for the quarter or period in question. This is usually feasible for companies that have a viable business but run into temporary operating issues, overextend on capital programs, or happen to be overleveraged relative to covenant levels.

If the issue is truly minor, a one-time covenant waiver is usually sufficient.

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