What are External Stakeholders in Restructuring?
While External Stakeholders might not hold a claim on the company in the sense that lenders do or by holding an ownership stake in the equity of the distressed company, it is nevertheless important to maintain relationships with such groups. In particular, External Stakeholders can be impactful in terms of allowing a distressed company to be able to implement its business plans to achieve a successful turnaround.
External Stakeholders Management: RX Investment Banking
Some examples of the key third party external stakeholders include:
- Suppliers & Vendors
- Customer Base
- New Capital Providers (Equity Injections & Debt Issuances)
- Governmental / Regulatory Bodies
To maneuver the restructuring process in a strategic manner that maximizes the chances of a plan turning out as intended, there are a number of influential external stakeholders that restructuring banks must pay close attention to.
One of the most important tasks of RX bankers is to carefully manage the relationships with all stakeholders and become cognizant of each of their specific goals to put their client(s) in a more advantageous position.
Suppliers/vendors and customers are the groups most within the control of the debtor, whereas the other external stakeholders are less reliable variables outside of their circle of influence (e.g. new investors, governmental/regulatory bodies, competitors).
Examples of External Stakeholders: Suppliers / Vendors
Suppliers and vendors are oftentimes open to helping out a long-term customer, but they have no obligation to extend credit if receiving payment is doubtful.
When external stakeholders become aware that a customer is near or currently in a distressed state, the response of suppliers/vendors and customers will depend on various factors.
Notably, some of the key factors taken into consideration are:
- The longevity of the history between the two (i.e. the time span in which the two have been in business together)
- The amount of goodwill existing in their relationship
- The reliance on the customer by the vendor/supplier, which can be estimated by the average historical percentage of total revenue that has come from this particular customer
Tesla Suppliers Example
An interesting anecdote of the customer and supplier relationship was seen in 2018 when Tesla (NASDAQ: TSLA) sent out a memo to approximately ten of its suppliers asking for money back related to projects that extended as far back as 2016.
This was done in an effort to improve Tesla’s profitability for the year, as the company was continually being criticized for burning cash and missing its target dates for turning a profit on a consistent basis.
While this was not a restructuring scenario, it was an unusual situation nonetheless (especially for a high-profile public company) that shows the amount of leverage a customer has over its supplier when there is a great amount of dependence.
In the memo, suppliers described the request as urgent for Tesla’s continued operations and the request was portrayed as an “investment” in the electric vehicle company to continue the long-term growth between BOTH Tesla and the supplier(s).
Message from Tesla Representatives (Source: Engadget)
In other words, helping Tesla now would let them reap the benefits in the future.
The number of suppliers that fulfilled Tesla’s refund request was never publicly disclosed, but it would not be that much of a surprise if a few suppliers actually did proceed with the request and/or at least negotiate contracts favorable to Tesla’s interests.
At the time that the news surrounding the memo was leaked, Tesla’s share price fell immediately as the pre-existing criticism regarding its liquidity risk and profitability was reignited. The memo was heavily scrutinized, as most equity analysts interpreted it as a sign that trouble lied ahead and the memo was an act of desperation.
Ignoring the questionable, often criticized accounting tactics utilized by Tesla (as that is not the point of bringing up this example), Tesla became profitable on a GAAP-basis for the first time in 2020 to the surprise of many and since then, has continued to set records in its revenue and number of deliveries, all while consistently exceeding profitability expectations each quarter.
From a broad perspective, the dynamics at play in Tesla’s refund request are comparable to when suppliers/vendors are requested to work with a distressed company that they know is undergoing financial difficulty.
To tie this back to the main point, the perception of a struggling company and its prospects by its suppliers, vendors, and customers can be influential in their willingness to be accommodating and continue working with the company.
From the perspective of the supplier or vendor, the decision to work with the company (or to avoid) is similar to making an investment decision in which the return/risk profile must be assessed to make an informed decision.
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Collection of Payments Considerations
If a supplier or vendor is owed payments for products/services already delivered, they can be categorized as a creditor. Basically, they are akin to debt collectors with unsecured claims.
While not as straightforward as creditors and equity shareholders, suppliers, and vendors that have been repaid held up their end of the bargain and are rightfully entitled to payment for the amount due.
But the problem is, their claims are unsecured and not prioritized – instead, suppliers and vendors owed payment(s) are near the bottom of the capital structure, above only preferred and common equity.
Instead, they would be classified as general unsecured claims (or “GUCs”), the largest stakeholder group on the creditor side (with a low chance of recovery).
Customer Concentration Consideration
If the distressed company has accounted for a relatively sizeable percentage of their total revenue over an extensive period, suppliers/vendors will generally be more receptive to putting in an effort to work out a resolution – albeit, the decision is theirs to make and they can opt to discontinue working with the debtor at any given moment.
For example, suppliers may decide to temporarily reduce their component or material prices to cater to the specific customer (i.e. helping them reduce their cash burn rate), which decreases the spread made on each sale and directly reduces the margin from each purchase made by the distressed company.
But the reason most suppliers or vendors would approve of this temporary discount for one individual customer is that if the company emerges from its current distressed state, the future sales from that customer would completely offset the temporary losses.
Thus, it could be in their best interests (and potentially be a risk worth taking) to help the company remain solvent and avoid liquidation to retain them as a customer for the long haul – assuming the distressed company has a well-put-together plan and a recovery seems plausible.
Chapter 11 Bankruptcy: Suppliers / Vendors Implications
Upon declaring Chapter 11, the Court requires the company to be able to function and continue operating in an effort to prevent any further degradation.
One major problem is the distractions from creditors and others that are owed payment from the distressed company, which the Court provides protection against.
“Automatic Stay” Provision
The automatic stay provision in Chapter 11 temporarily prohibits creditors (e.g. lenders, collection agencies, government entities) from attempting to collect claims such as interest payments from creditors through legal action.
If enacted, the distressed company is protected from foreclosure actions, lawsuits, etc. as this injunction halts the debt collectors’ ability to impact the company that has declared bankruptcy and is now protected under the provision.
In other words, it is meant to serve as a period for the company to try to identify and solve its problems, without outside pressure negatively impacting the management team’s judgment.
Note that an important distinction is that a supplier or vendor is restricted from requiring payment of pre-petition as a condition of providing services post-bankruptcy if the automatic stay provision is enacted.
However, there is one way for suppliers and vendors to be compensated for pre-petition claims with the automatic stay provision active.
“Critical Vendor” Motion
Under Chapter 11 Bankruptcy, a critical vendor motion is when vendors deemed “critical” are granted to receive their pre-petition claims to facilitate the continuation of their past alliance with the distressed company (i.e. the debtor).
But the one catch is that in exchange for being permitted to receive pre-petition payment, the vendor(s) are required to continue supplying the debtor on specified contractual terms, which is the purpose of the ruling in the first place.
The debtor can file a motion and approval will be based on the notion that not authorizing the company’s request would put its future in jeopardy.
With the best interests of all stakeholders in mind, such motions are usually approved.
Given the two provisions discussed above, the company is able to continue operating and focus on figuring out a viable plan to get out of the situation it is currently in.
One common issue, however, is that suppliers aware that a certain customer is facing financial difficulties may deny the customer credit sales and instead only accept all-cash upfront as the form of payment.
Thus, more financial stress is placed on the debtor that has limited options for financing and short on cash.
To try and alleviate these concerns, Chapter 11 provides a new source of funding for businesses in financial distress for this exact purpose of obtaining financing.
Debtor-in-Possession (“DIP”) Financing
One of the main benefits of Chapter 11 is that DIP financing becomes available – in fact, many distressed companies will specifically file for a Chapter 11 bankruptcy to gain access to DIP financing.
DIP financing helps offer assurance to suppliers and vendors that they will be compensated for post-petition deliveries, making the distressed company seem more reliable as a customer.
Moreover, these distressed companies do not have cash-on-hand to spend to make payments nor any negotiating power when it comes to dealing with suppliers.
In the ideal case, DIP financing helps facilitate access to working capital, secure the capital required to continue operating, and lessens the risk of working with the customer.
However, in the case that the plan of reorganization (“POR”) and turnaround strategy does not pan out as intended, the DIP lender may be a senior secured lender that is be entitled to be paid-in-full prior to any post-petition invoices are sent out.
This means that a company that has access to DIP loan financing can reduce the risk taken by suppliers and vendors, but it is not a guarantee of payment.
For this reason, a supplier/vendor still has the right to request payment upfront even with DIP financing available.
Once a distressed company has declared Chapter 11 bankruptcy, it can receive special court-approved financing that supersedes all existing debts (i.e. called a “super-priority” claim”).
In other words, the DIP financing loan “primes” the senior secured creditors (i.e. supersedes the most senior debt to have the highest placement in the capital structure), which would only be approved by the Court if the funding has been determined to not impair the secured holders and will bring enough positive benefits to warrant the additional debt.
The fact that the Court approved the DIP financing is also a signal to suppliers, customers, and other stakeholders that:
- The distressed company has a viable business plan to restructure and reorganize itself to return back to normalized, sustainable growth (i.e. the turnaround plan to emerge from bankruptcy is viable)
- The distressed company can continue to operate, at least in the near term, because it has the backing of the Court and the DIP financing (which is a vital lifeline to keep the business running as it reorganizes)
The main purpose of Chapter 11 is for the distressed company to restructure and reorganize to achieve a turnaround, as opposed to undergoing a forced liquidation.
To add, by declaring Chapter 11, the company is able to avoid further disruption from creditors pursuing legal action and other related distractions for the time being.
Not all suppliers and customers will be receptive to the state of the company (i.e. does not trust that the company is capable of pulling off a turnaround, even with DIP financing available) and have a positive outlook on its prospects.
But at the end of the day, the distressed company has access to capital to support its operations and an approved plan underway that was considered to be valid with the potential to lead to a turnaround in the foreseeable future by the Court.
Customer Base: Existing & New
Customers typically will not play a direct role in a restructuring process – however, it is important to understand the implications of customer actions on a distressed company.
For customer relationships where the certainty of delivery is necessary, such as a long-term agreement to receive five planes per year for the next 10 years, the customer will be reluctant to sign on with a bankrupt counterparty as it can disrupt their operations even if the price is attractive.
Customers may also demand price concessions and discounts if they have sufficient buying power.
From an initial glance, this may seem unethical, but the customers are essentially taking on a risk by partnering with a high-risk company (i.e. most commercial companies would be willing to pay a premium for long-term consistency and a reliable business partner).
Cash Conversion Cycle in Distressed Companies
To complete a quick concept check-up, answer the following two questions:
Q. “Once a company has become distressed, how would you expect accounts receivable (A/R Days), inventory (Inventory Days), and accounts payable (A/P Days) to differ?”
- Accounts Receivable (A/R): Oftentimes, the inability to collect A/R is one of the contributing factors for the diminished liquidity of a company. While there is no set rule, days sales outstanding (DSO) tend to increase as a company becomes distressed. One inefficiency that many companies suffer from is the inability to collect payments for services or products that have been delivered (and thus “earned” under GAAP)
- Inventory: In most cases, days inventory outstanding (DIO) will increase, as becoming distressed is generally associated with worsening working capital management and a decrease in customer demand (which leads to lower sales and inventory piling up)
- Accounts Payable (A/P): In most cases, days payable outstanding (DPO) can be expected to extend significantly due to the debtor being incapable of paying the suppliers in a timely manner as a result of liquidity issues. Usually, DPO extending is a positive sign that suggests buyer power over suppliers and vendors, but in the case of restructuring, it is a sign that the company is unable to make the due payments even if the management wanted to (and can be prevented from placing additional orders until the outstanding balance is paid off)
Now, moving on to a similar question:
Q. “For a company with a long-term contract-based business model, how would you expect deferred revenue to change if it became distressed?”
In most cases, deferred revenue tends to increase significantly for distressed companies. Such companies will often provide long-term offers of substantial discounts to their customers in order to compensate for the risk of signing a long-term contract with a company that may not exist in a few years.
In addition, the pricing reductions are usually done out of desperation to acquire new customers and to show creditors that there will be contractual revenue over the long run.
In short, the recurring theme is that the majority of the negotiating leverage is disproportionally on the side of the customer base, as the distressed company is at the mercy of its customers.
From the perspective of the customer (commercial customers in particular), they are doing what is in their best interests for themselves and their customers.
This includes ensuring there are no abrupt, unexpected events that could disrupt their day-to-day operations (i.e. minimize disruption risk).
Certain customers that are aware of the troubling situation might try to take advantage of this by intentionally delaying payments to the distressed company in case the company goes bankrupt.
But this type of unethical behavior would be part of the minority and is more prevalent in B2C, not B2B due to the potential reputational damage from the news that a business took advantage of a distressed company that was struggling to stay afloat (but certainly there are businesses out there that would be willing to take advantage of the situation).
Equity Injections and Debt Issuances
When a company is distressed, there are times when new cash must be injected into the business.
Capital in the form of a new equity injection or debt issuance from an outside investor or lender may be required. The newly raised capital would be used to invest in new capital expenditures in order to get the business back up on its feet or to take out stubborn creditors that were the cause of the hold-up problem.
In a restructuring, new capital is usually provided by existing lenders or shareholders that already have stakes in the company. For example, a private equity backer may inject more money into a company if necessary.
But the fact that internal existing shareholders are no longer willing to provide the needed capital can be perceived as a red flag, which can make debt financing challenging and costly with unfavorable terms.
In some instances, capital from within can be tapped out and a distressed company (and the advisory shop hired to help raise financing) must look elsewhere for new funds to keep things going.
New money providers in restructuring are niche and sophisticated investors looking for high returns to compensate them for the elevated risk of their opportunistic investing.
New Equity for Oil & Gas Assets
Company A is an oil and gas company that enjoyed strong profits during a previous time with high oil and gas prices but ended up taking on too much debt to fund its expansion plans.
Despite the declining oil production, there is a large resource base with plenty of oil in the ground and a high confidence level that it can be extracted at a reasonable cost.
- Currently, Company A has a debt balance of $300mm and cash flows of $50mm
- The total debt is comprised of $100mm of senior secured bank debt and $200mm of unsecured bonds
- The bond debt is coming due next year and debt capital markets investment bankers have informed the company that refinancing is not possible as the interest payments are too high
- Debt investors are also cautious about the company as the oil wells are getting depleted, which means that the $50mm of cash flow is expected to decline
Restructuring Plan (Source of Funding)
- Conservative estimates suggest that an additional $50mm would be required to boost cash flow to $100mm by drilling new wells and exploiting the resource
- After many negotiations, an energy-focused investor agrees to invest $250mm into the company
- The $250mm will be used to pay off the bank debt and half of the bonds, with $50mm of the residual money used to fund the capital expenditures above
- Under the proposed plan, the bank lenders are satisfied because their loans are not at risk of being left unpaid
- The bank lenders agree to provide a new credit facility for the reformulated company where none of the loans are drawn on day one
- The new credit facility again ranks senior secured, with priority to all other capital
- The bonds were trading at 20 cents on the dollar in the public markets and bondholders are pleased to take a payment of $100mm versus $200mm of face value (50 cents on the dollar)
- Additionally, the new investors offer the bondholders 5% of the reformulated company’s equity
- In order to purchase their compliance, the equity holders (who would otherwise be wiped out in liquidation) are offered 5% of the reformulated company’s equity
In the example above, the new money chooses to invest as equity with no new debt for the restructured company.
However, distressed investors can invest at any level of the capital structure – anywhere from the most senior to the most junior – as long as returns on their investment are commensurate with the risk.
When investing in very distressed companies, new money is often associated with investing senior or super senior in the capital stack ahead of all the other existing debt – often earning far superior lending returns versus being senior debt in a non-distressed setting.
When investing in more junior debt, new money providers may look to structure the debt so that outcomes are either them receiving their required returns or end up converting to equity and owning or controlling the company.
Convertible Preferred Shares: Funding Capital Expenditures
Company B, a petrochemical business with a few chemical plants, is currently receiving pressure from lenders to de-risk.
The problem is that the company needs to raise additional capital somehow to fund its growth capex related to building out a new plant.
- Company B is currently generating an EBITDA of $50mm
- On its balance sheet, the total debt balance is $300mm (but without any near-term maturities)
- However, Company B is being pressured by its bank lenders given the high leverage
- Company B is finding it difficult to meet interest payments comfortably
Restructuring Plan (Source of Funding)
- Company B requires additional capital to build a new, state-of-the-art petrochemical plant which will provide $50mm of EBITDA going forward
- Cost of the new plant is $100mm but the company has no cash
- The hired investment bankers were able to find a private credit fund that is willing to provide capital in the form of a convertible preferred equity instrument
- As a reminder: Preferred Equity ranks ahead of the common shareholders in terms of seniority – and at the preferred equity holder’s option, it is convertible into a predetermined amount of common shares (i.e. equity or ownership in the company)
- The private credit fund has agreed to provide $200mm in convertible preferred equity
- The use of the proceeds will be to use $100mm to pay down bank debt and $100mm to fund the new petrochemical plant
- From a high-level view, the financing plan appears to be a good resolution for all stakeholders
- The convertible preferred shares, in order to alleviate the debt burden on the company, has payment-in-kind (“PIK”) interest for the first two years (i.e. accrues to principal)
- The banks are satisfied as their money at-risk (the loan) is reduced while the creditworthiness of the company is improved from the lower debt and higher cash flow once the new project comes on-line
- Company B is able to expand and take on an attractive new project that could improve its cash flow profile
- Preferred equity is structured so that it gets an acceptable return on its investment and also has protection by being able to essentially take over the company if cash flows do not improve as expected
External Stakeholders: Other Groups in Restructuring Process
There are also a number of key external stakeholders to a restructuring (not debt or equity investors) that can influence the outcome.
Restructuring investment bankers and distressed debt analysts should be aware and understand the motives of the government, suppliers, and customers.
U.S Bankruptcy System Role in Restructuring
In the US, where longstanding legal frameworks and systems for bankruptcy and restructuring exist, investment bankers, restructuring and bankruptcy lawyers, and distressed debt investors will have more clarity in terms of how restructuring could play out.
Chapter 11 and Chapter 7 are globally well-known bankruptcy concepts and even foreign debtors will look to working out restructurings in the US court system.
The US is a debtor-friendly jurisdiction and works towards a company continuing to operate if possible as this may be the most efficient outcome. However, not every restructuring is done in the US.
International Bankruptcy System
Countries such as the UK and Canada will have bankruptcy proceedings that follow similar patterns in order to push through a restructuring effectively but legal professionals and restructuring bankers are needed to offer advice as to the differences and how this may affect how the proceeds are split.
Jurisdictions may be different in their social and political objectives. For example, a country such as China may take on a “society-first” approach.
Distressed debt investors may need to be aware that even though in theory they should be able to take over the company and fire inefficient workers, the Courts may take a view that such a plan would not be an acceptable solution due to the job losses and perceived instability that may occur.
Bankers and analysts also have to be cautious when dealing with restructurings in countries will less developed legal systems or with a high prevalence of corruption.
Although the creditors may in theory have recourse to the assets of the bankruptcy company, they may find that they have limited legal protections when looking to enforce them.
Another external factor to consider are bailouts by the government.
For example, following the latest financial recession, two of the leading automobile manufacturers in the US, General Motors (NYSE: GM) and Chrysler (NYSE: FCAU), both filed for bankruptcy in 2009 until being bailed out by the federal government.
Auto Bailout Announcement (Source: POLITICO)
A more recent example would be the $50+ billion bailouts of US airlines as part of the CARES Act passed in March 2020. The bailout consisted of $25bn in loans and loan guarantees from the federal government and $25bn in grants, with additional funds expected to prevent furloughs and laid-off employees.
Competitors in Restructuring
If a competitor is undergoing restructuring, realistically, it should come as no surprise that there certainly are companies out there that view the competitive landscape as a zero-sum game and are willing to implement ill-intentioned strategies (e.g. predatory pricing) to reduce the competition.
But if these acts were to be done, they would be implemented discreetly due to the stringent regulations surrounding anti-trust laws and the reputational risks.
On a more positive note, there are cases of when rival companies have actually helped one another as seen in the case of Microsoft (NASDAQ: MSFT) and Apple (NASDAQ: AAPL).
“Apple was in very serious trouble,” said Steve Jobs. “And what was really clear was that if the game was a zero-sum game where for Apple to win, Microsoft had to lose, then Apple was going to lose.”
Looking back, the $150mm investment made by Bill Gates’ Microsoft into Apple was the lifeline that saved Apple from going under.
Since then, Apple has grown to become one of the most prominent global technology companies and the first company to reach a $2tn market capitalization.
This is not to suggest that competitors will help each other out, nor will they necessarily attempt to contribute towards another’s downfall – but rather, to bring attention to the randomness in the unpredictable events that can completely change the trajectory of individual companies.
Distressed M&A in Restructuring
In addition, another key stakeholder group to consider is acquirers in Distressed M&A. The categorization most notably includes purchases of distressed companies and acquiring divestitures of underperforming assets.
Contrary to what many predicted following the initial breakout of COVID-19, the volume of distressed M&A has yet to see a significant increase.
Typically, the deal count tends to spike during recessionary periods, but this has yet to be seen, which is likely attributable to all the fiscal policy measures taken by the Fed.
No Spike in Distressed Acquisitions (Source: Bloomberg)
Distressed M&A is a very high-risk area, but many of the transactions that fall under this category have allowed near-liquidated companies to survive.
For example, American Airlines filed for bankruptcy in 2011 but merged with US Airways in 2013 to become American Airlines Group (NASDAQ: AAL).
US Airways had its fair share of troubles as well and had previously declared bankruptcy before undergoing a mega-merger with America West Airlines, which had also undergone bankruptcy.
Despite forming the largest airline company in one of the largest airline deals that received regulatory scrutiny, it involved companies that came close to succumbing to liquidation.
In the present day, American Airlines has been surpassed by Delta Airlines and is not the market leader; hence, many consider the merger to have been a failure given the amount of attention received from regulatory bodies.
But nevertheless, all the airlines involved in the merger managed to find a way to survive – which is often the central objective prioritized above all else in restructuring.