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Restructuring Internal Stakeholder Dynamics: Claimholder Incentives Alignment

Restructuring Plans Necessitate Aligning the Incentives of the Key Internal Stakeholder Groups

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This article is part of a series on Restructuring.

Restructuring Internal Stakeholder Dynamics: Claimholder Incentives Alignment

Internal Stakeholders Disconnect: Lenders vs. Equity Holders

As an example, a lender will prioritize being repaid their interest and principal amount – thereby desire the company to be more risk-averse.

Hence, the usage of covenants as a method of protecting their interests by preventing reckless decision-making that could put their chances of being paid back in-full into question.

On the other hand, equity holders theoretically have unlimited upside, which oftentimes can lead to shareholders urging for more aggressive, growth plans and new initiatives to scale the company.

In the case that the company does indeed outperform expectations, the yield earned by lenders is capped, and at most, they could earn interest on-time and the principal amount back (i.e. the disconnect between lenders and equity holders).

Restructuring Stakeholder Dynamics: Alignment of Incentives

To accomplish a successful restructuring and implementation of a turnaround strategy, all stakeholders must be on the same page for the most part or at the very least be open to negotiation and working together to figure out a solution.

For negotiations to continue moving forward, the trade-off between ones’ self-interests and an objective understanding that certain sacrifices must be made for the greater good is necessary.

On that note, understanding the key internal stakeholders in a restructuring cannot be overstated for RX investment bankers, distressed debt investors, and other stakeholders in a potential restructuring to come to an agreement satisfactory to all parties.

While this certainly does not equate to complete agreement on every single point of discussion with no areas of conflict, the willingness to make compromises must be present for the stakeholders to come to terms for the best interests of the company, as well as for themselves.

Internal Stakeholders: Management Fiduciary Duty

Differences in Restructuring

For a non-distressed, financially healthy company, the fiduciary duty of the management team and its Board of Directors is to the equity shareholders (i.e. maximize the firm value for its shareholders).

However, in a restructuring scenario, there is a shift in the management’s fiduciary responsibility once a company appears insolvent (or as it nears that point).

More specifically, the management team’s fiduciary duties must transition from equity holders to creditors once the company enters the so-called “zone of insolvency,” as once a company becomes distressed.

The management and board now have an obligation to act in the best interests of all stakeholders across the capital structure, as opposed to prioritizing the equity shareholders.

Financial Restructuring: Identifying the Key Stakeholders

Restructuring Bankers (RX)

As mentioned in our article on the Financial Restructuring Product Group, one of their main objectives is to “right-size” the balance sheet when deemed necessary.

This would imply that either the financial obligations of a company exceeds the enterprise value or the free cash flows to the firm are unable to satisfy its Debt Service Requirements (DSCR).

The ability to facilitate successful negotiations stems from understanding what each specific stakeholder desires, as each has differing motivations.

In these types of scenarios, the restructuring investment bankers must identify the key stakeholders because the relationship amongst one another is a critical factor that determines how negotiations in crafting a feasible plan for the distressed company will turn out

For RX bankers, it is an absolute necessity that the plan of reorganization (POR) or the solution presented to the key stakeholders is viewed as an equitable solution by most (if not all) classes in order to get their buy-in.

Upon understanding and analyzing the key stakeholders and their incentives, it is also important for bankers to determine which options are available to the debtor at the same time. Neglecting the views of each stakeholder could lead to the common hold-up issue (e.g. a creditor may disapprove of certain fundraising avenues).

Besides raising additional capital, another example would be if the debtor desires to complete a distressed asset sale, which risk-averse stakeholders may disapprove of and attempt to block.

Distressed Debt Investors

For distressed debt investors, analyzing a restructuring is important in accurately assessing the value of a troubled business and the debt capacity (i.e. its perceived ability to service debt).

In addition, closely observing the key stakeholder dynamics in play can affect the value of distressed securities when putting together a well-thought-out investment decision.

While a subjective evaluation, the investor can try to estimate how the restructuring will pan out.

There are numerous types of investment strategies regarding distressed scenarios, but two of the most common strategies are:

  1. Identifying the Fulcrum Security: Locating and becoming the holder of the Fulcrum Security through trying to pinpoint the tranche in the capital structure at which the value break occurs is a strategic investment strategy (i.e. leverage from positioning)
  2. Debt-to-Control: In contrast, debt-to-control is more along the lines of purchasing the distressed company’s debt at steep discounts, and in effect, the investor will become a majority shareholder as a result of owning a sizeable share of the newly issued equity as part of the agreement post-emergence (i.e. influence from holding a large stake).

Analyzing Key Stakeholder Dynamics in a Restructuring

In order to make an informed prediction of how a restructuring plan could play out, restructuring investment bankers and distressed debt investors must have an understanding of the stakeholders involved in the process and the options available to each of them.

For a normal, non-distressed company, the most important stakeholder group is the equity holders, but this shifts to the creditors in restructuring.

While equity is typically one distinct class, there may be multiple layers of debt with differing priorities.

For example, a company may have secured bank debt that has a first lien on all of the assets of the firm as well as unsecured notes or bonds outstanding.

Both of these will rank ahead of the equity in terms of the capital structure priority or a liquidation.

The company management acts in the interests of the shareholders and creditors are satisfied as long as interest and debt repayments are timely (i.e. since their upside is fixed, assuming there are no additional features attached).

Creditor Dynamics in Restructuring

Fulcrum Security

Otherwise known as the fulcrum debt, the Fulcrum Security in the context of financial restructuring represents the cumulative part of the capital structure that lines up with the economic value of the firm.

The most important creditor class that the creditors, equity holders, and the distressed company must be mindful of is the fulcrum security.

When a company is in financial distress and restructuring is likely, the most relevant stakeholder becomes the creditors – namely, the fulcrum debt.

The fulcrum security effectively functions as the dividing line that determines the claim holders that get paid back in-full (or the reasonable, negotiated amount) and those that receive either no or partial recovery.

Fulcrum Security – Illustrative Example

A company that previously raised a large quantity of debt twelve months ago when Credit Markets were favorable to borrowers and business sentiment was positive.

Financials

  • The company generates $50mm of EBITDA
  • In terms of debt, the company has $100mm of senior secured bank debt, $100mm of senior unsecured notes, and $100mm in junior debt
  • The economy enters a recession and the company is having difficulties servicing its debt, and the market values comparable companies in the industry at 3.0x EBITDA
  • On that note, the implied value of this company comes out to be $150mm

Fulcrum Security Location

  • In theory, the economic value of the company is less than the cumulative face value of the debt ($100 + $100 + $100 = $300)
  • For current market conditions, the fulcrum security is the unsecured bonds as it is the point in the cumulative capital structure that lines up with the enterprise value of the firm (i.e. where the “value break” occurs”)

To calculate the fulcrum security, the following formula can be used:

  • $150mm [Enterprise Value] = $100mm [Senior Secured Bank Debt] + $50mm ÷ $100mm [Senior Unsecured Notes] + $0mm ÷ $100mm [Junior Debt]

As the enterprise value breaks in the senior unsecured bonds, in theory, the junior debt and common shareholders should be ascribed to no value.

Bank Lenders

For most capital structures, banks are the most senior debt and sit at the top of the priority chart.

Simply put, the business model of banks is conservative with their lending – meaning that banks prioritize the preservation of capital and focus on profiting through large volumes of loans and capturing relatively lower interest spreads.

When a company becomes distressed, banks that do not sell down their exposure will look to get their recoveries in the form of cash or have the debt rolled over (i.e. the reformulated or restructured company will still have debt owed to the banks).

In most cases, if the company simply has a leverage or liquidity issue and the operating business value is worth more than the bank debt outstanding – which is often given their priority in the capital structure and conservative lending values.

As a result, the banks are indifferent to any restructuring solutions so long as their capital is not at risk, but there are various actions the bank can take:

  • This could entail a sale of the company in its entirety to pay off the bank debt or a reduction in debt subordinate to the banks which makes it easier to service the bank debt.
  • To the extent a full payout or exiting their loan facility to the company is not possible in a restructuring solution, banks will look to roll over their debt as alluded to above.
  • In very dire situations, the banks may get rid of the loan at a loss – usually selling to opportunistic hedge funds or credit funds.

Bondholders and Bondholder Committees

Bondholders are usually the middle tranche in the capital structure, as bonds are typically junior to the bank debt but senior to subordinated debt and equity.

Bonds are often the fulcrum security or otherwise key stakeholders in a restructuring, short of the company being extremely impaired (where the bank will become the fulcrum security).

Other than the shares (equity) which have little or no value, bonds are the more liquid trading security relative to bank debt for opportunistic investors to enter. There are a limited number of investors in bank debt whereas bonds are widely traded.

Bond investors can be further bifurcated into par holders and discount holders / event-driven investors who may have different objectives.

Par Holders Discount Holders
  • The par holders investors group refers to mutual funds and insurers or other holders that bought the bonds at healthy trading levels
  • In other words, purchased at par valuehence the name (i.e. 100 cents on the dollar)
  • On the other side, the discount holders investor group includes hedge funds / distressed investors that purchased their holdings well below par value
  • In restructuring processes, hedge funds can have a cost base of 10, 20, or 30 cents on the dollar of par value
  • Traditional par holders such as mutual funds and other institutional investors will have clearly defined investment mandates and will face mandatory actions to sell once bonds trade at distressed levels or are downgraded by credit rating agencies such as S&P and Moody’s
  • Despite being owed payment, accounts payable is classified as a general unsecured claim (“GUC”), which do not have priority claims
  • In most restructuring mandates, the largest group of creditors consists of GUCs
  • Par creditors that have not sold out of their positions are often similar to bank loan creditors in mindset
  • Instead, they will look to stay on as debtors in a restructuring or look for a solution where they are paid out as opposed to taking over the equity (in restructuring jargon, “handing over the keys”)
  • Discounted holders such as hedge funds and distressed debt private credit funds are looking to maximize returns instead
  • Alongside converting the debt to equity and outright owning the company, they may look for other avenues to improve their economics through equity kickers (e.g. equity options or warrants) or other arrangements that act as “sweeteners”
  • Par creditors are focused on retaining their position and do not want to take a write-down on their books or becoming an unnatural holder of equity as doing so is not in their business model
  • Creative solutions are welcomed – for example, an oil and gas company that undergoes a restructuring could offer contingent payments to the creditors should the oil price be above a certain threshold
  • Opportunistic “loan-to-own” investors are looking for a low valuation assigned to the company while holding the debt so that more junior creditors and equity are largely wiped out while they end up taking over the company cheaply by converting debt into equity

Bondholder Liability Management and Amendments

When the debtor company has a near-term liquidity issue where they cannot refinance (for example, debt capital markets and equity capital markets are closed and the company cannot issue new bonds or shares to take out the maturing bonds) but think that the firm can recover later, there are a number of solutions.

This may also sometimes be the course of action if bondholders have no better options and simply want to kick the can down the road and address the issue later.

In this case, some of the most frequently seen restructuring solutions include:

Restructuring Solutions
Extended Maturities
  • As implied by the name, this option entails pushing back the maturity date of the debt
  • For example, a bond maturing 2022 may see the maturity date extended to 2024 so that the company has time to address its cash flow issues
Deferred Amortization
  • If a debtor company previously had to pay principal as part of debt service along with interest before the final maturity, the principal payments are now deferred
  • As bonds are typically structured as bullet repayments (all of the principal is paid only at the end), this is more common for term loans
Payment-in-Kind (PIK)
  • Instead of paying cash interest on the principal, the debtor pays a coupon in-kind or in the form of additional debt
  • However, the principal amount compounds and end up growing the obligations in front of the equity or shareholders in priority
PIK Toggle
  • Similar to PIK, but the PIK toggle comes with the option of paying a cash coupon or a PIK coupon
  • This offers flexibility for the debtor, who will opt to pay cash when it generates sufficient cash flow but also gives debt relief during challenging periods with the option to pay PIK
  • As an extra incentive to pay cash, the PIK coupon is usually higher than the cash coupon by ~2%
Cash Sweeps
  • To facilitate a faster path to full repayment, all or a portion of the excess free cash flow generated during each reporting period may be mandatorily used to repay debt

Of course, in exchange for these concessions, bondholders will require to be compensated with deal sweeteners or amendments that improve their returns.

These bondholder compensations can come in many forms but some of the most common examples include:

Bondholder Compensation
Coupon Step-Ups
  • After a certain amount of time, the interest rate on the bonds ratchets up
  • For example, the bonds may have a 7% coupon but after 2 years it jumps to 8% and after 3 years it is 9%
Additional Security, Collateral, or Guarantee
  • Although this does not improve the actual cash return, it improves the risk-adjusted return for the creditors
Equity Warrants
  • Equity warrants give the right but not the obligation to purchase stock in the company at certain exercise prices or strike prices
  • This includes penny warrants, which means that they are basically free shares and immediate ownership in the company
Convertible Options
  • A convertible option makes the bond a convertible bond, whereby the bond principal can be converted into a set amount of shares
  • One attractive element of a convertible bond in this context is that any conversion of the bond into equity results in deleveraging as well, making the company financially healthier
Ratcheting Take-Out Premium
  • Instead of a ramp-up in interest, the debt principal that needs to be repaid will increase the longer the bond remains outstanding
  • For instance, if repaid in 1 year, it is at par value (or 100% of the face value)
  • If repaid in 2 years it becomes 105% and in 3 years it becomes 110%)

In need of a quick refresher on debt terminology? Click on the link below:

Leveraged Finance & Debt Financing Primer

Bondholders generally want any amendments to be Net Present Value or NPV neutral or positive to justify making concessions.

This means that they are better off when discounting all future cash flows of the amended bonds (including the sweeteners) versus the existing bond maturing as scheduled.

When the company is severely distressed and noteholders have minimal negotiating leverage, they may have to take an NPV haircut impairing the debt.

An example of this is kicking out the maturities and reducing the bond coupon or interest at the same time – both negative events for creditors.

Equity / Financial Sponsors

When a company’s financials become stressed to the point where there is limited (or no) equity value, the public shareholders or private equity sponsor may have a limited role to play in a restructuring absent a willingness to inject new capital or money into the corporation.

However, for a public company with a fragmented shareholder base, valuation fights can occur with many shareholders not acquiescing to a new, dilutive equity raise.

For example, a distressed company can have $200mm in debt maturing and be unable to refinance while the shareholders disapprove of the idea of raising $200mm in equity as they purchased shares in the company at a much higher valuation.

Otherwise, their equity ownership that has close to zero value at this point would become further diluted, as well as their voting power.

For a financial sponsor (or any stakeholder) to supply the much-needed cash injection to the distressed company, the rewards must outweigh the risks.

In order to become an effective stakeholder group in a restructuring, a shareholder or a group of shareholders has to accumulate a large enough position to be controlling or at least influential in steering conversations with creditors and other stakeholders in a restructuring.

For private equity-backed companies, a capital injection may be more straightforward in saving a company if it is regarded as worthwhile.

Financial Maintenance Covenants: Restructuring Context

As a reminder, financial covenants are legal agreements that require the debtor to stay onside certain financial ratios or metrics.

Moreover, maintenance covenants are intended to protect the interests of the lenders by requiring the borrower to abide by a pre-specified rule, which is tested routinely for compliance (usually on a quarterly basis).

Maintenance Covenant Example – Financial Sponsor

An example of a maintenance covenant would be Debt / EBITDA being unable to exceed 3.0x at any time.

Furthermore, if the ratio exceeds 3.0x, the breach can cause the borrower to be forced into default and the creditors have the right to collect the collateral of the liquidated company.

Therefore, if a credit agreement stipulates that Debt / EBITDA cannot exceed 3x and Debt is $300mm while EBITDA is not quite $100mm, a private equity sponsor can inject $50mm into the company which counts as EBITDA and keeping the ratio below 3.0x.

For financial maintenance covenants, sometimes the private equity sponsor is allowed to contribute additional equity as an equity cure to hold off a covenant breach.

One caveat to this, however, is that there can be stipulations on the number of times they are allowed to do this in their credit agreement contracts with the lenders (usually the senior banks).

Continuing off the example in which there is a shortfall in meeting the required leverage multiple (Total Debt / EBITDA), private equity firms can also consider providing the contribution of new assets or collateral in order to satisfy creditors.

The decision of whether or not an additional injection of new cash into the business will be made is contingent upon the available capital of the sponsor as well as their belief in the company’s turnaround.

  • If the sponsor wants to buy back in at a lower valuation, it can argue that the industry and operating conditions have deteriorated and then purchase the company at a value where the debt is impaired
  • Conversely, if the sponsor thinks that the business can recover as a result of improving market conditions or an operating turnaround (or it just has no additional money and wants to play its option value as they can only lose up to their investment), it can argue for a higher valuation and for the existing debts to stay on the balance sheet

These types of decisions made by the financial sponsor (or any other shareholder and creditor) will ultimately determine its negotiating leverage in this aspect – and be very influential on the success or failure of the restructuring plan in the end.

This concludes our article on the internal stakeholder dynamics, click on the link below to view Part ll, where we will cover the key external stakeholders.

External Stakeholder Dynamics


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