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Financial Restructuring Primer

Learn the Core Concepts and Steps of the Financial Restructuring (RX) Process

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Financial Restructuring Primer

Key Learning Objectives
  • What are the common signs of financial distress and examples of catalysts?
  • What are the pros and cons of out-of-court restructuring vs. in-court Chapter 11?
  • How does the priority of claims in bankruptcies impact creditor recoveries?
  • When might a company opt to liquidate (Chapter 7) rather than restructure (Chapter 11)?

A lower debt-to-equity mix lessens the burden of debt financing, allowing the company to once again be a “going concern.”

The goal of a financial restructuring is to avoid a liquidation, which is when the company permanently goes out of business. Liquidations lead to significantly lower recoveries to creditors. Thus, it is not just the debtor that loses in a liquidation – everyone loses in a liquidation.

Catalysts of Financial Distress

At a high level, there are two primary drivers of financial distress:

Causes of Financial Distress

Unsustainable Capital Structure

For companies in distress, the amount of debt-related payments (and other payments related to contractual obligations like pensions and leases) is too high relative to the operating cash flows of the firm.

The issue stems from the company having a capital structure (debt to equity mix) that is misaligned with the current enterprise value of the business.

So how does a company get to a point where it needs to restructure?

While each distressed situation is unique, we can break down the common catalysts that decrease a business’ value and cash flows into three main types:

1. Macro / External Events
  • Recessions (e.g., 2008 Financial Crises, Greece IMF)
  • Global Pandemics (e.g., Coronavirus)
2. Secular Shifts & Trends Disrupting Industries
  • Changing Consumer Preferences (e.g., E-Commerce vs. Retail)
  • Technological Innovation (e.g., Ride-Sharing Mobile Apps vs. Taxis, Cloud vs. On-Premise Software)
  • Regulatory Changes (e.g., Flavored E-Cigarettes, Environmental Regulatory Compliance Laws)
3. Company-Specific Factors
  • Operating Inefficiency
  • Challenging Competitive Landscape (e.g., Commodification of Prices, Oversaturated Markets, New Entrants)
  • Fraudulent Behavior (e.g., Enron)

Any catalyst by itself could lead to distress and force a restructuring, however, the most vulnerable businesses are those that face challenges arising from more than one catalyst.

Financial Distress “Red Flags”traffic light, red, black

Companies can become distressed and face a growing risk of a cash (liquidity) shortfall for a multitude of reasons. Of course, the most common reason is an unanticipated deterioration in business performance. But a company under distress tends to also demonstrate common red flags such as:

When Does Financial Distress Trigger a Default on a Loan?

Financial distress does not instantaneously mean that the company is in default. As long as the company does not breach any covenants or miss due payments (e.g., supplier invoices, interest on debt, or principal repayments), it can continue operating even if it is losing cash, as long as it has sufficient reserves.

However, most lenders put protections in place that could still put a debtor into a technical default if certain “triggering” events occur. Examples include a credit rating downgrade, breach of a debt covenant, or failure to remain in compliance with other agreed-upon terms.

In each of the scenarios stated, the lender can pursue litigation against the company (i.e., foreclosure), which is why companies file for bankruptcy protection.

Out-of-Court Financial Restructuring

Out-of-court restructuring is usually best-suited for a company with a limited number of creditors. Debtors ordinarily prefer out-of-court restructuring, which attempts to come to an agreement with creditors without having to go to Court.

In contrast to a Chapter 11, an out-of-court restructuring is:

  1. Less Costly (Fewer Legal and Professional Fees)
  2. Often Resolved Faster
  3. Creates Less Business Disruption
  4. Reduces Negative Attention from Customers/Suppliers

Recoveries in Out-of-Court vs In-Court Restructuring

Since all the parties involved understand that Chapter 11 is the alternative to an out-of-court restructuring, creditors will only agree to an out-of-court plan if they believe they will be better off than by insisting on an in-court bankruptcy.

Challenges of Out-of-Court Processes

Despite the benefits of an out of court process, there are some cases where an in-court process may still make more sense:

  • Unfavorable contracts: Unfavorable leases, as well as pension and collective bargaining (union) agreements can only be rejected in court
  • Holdouts: Since you can’t compel a creditor to accept a debt restructuring out of court, holdout problems exist in out-of-court restructurings – this problem increases in tandem with the number of impaired claim holders

Out-of-Court Restructuring: Potential Remedies

Negotiations at this stage are usually centered around restructuring debt obligations. The chart below lists the most common out-of-court solutions:

Financial Restructuring: Out-of-Court Remedies
Debt Refinancing
  • The refinancing of debt is an ideal option, as it involves revisions to the interest rates, repayment schedules, and pricing terms of an existing agreement
  • The concern is whether lender(s) would want to refinance the debt of a borrower at risk of default – hence, there may be unfavorable terms if approved
“Amend and Extend” Provision
  • An agreement to extend the maturity date of a debt instrument coming due
  • In exchange, the lender receives a higher yield on their extended loans (i.e., higher interest rate) and more protection through covenants
Interest Payment Schedule Adjustment
  • Similar to the extension of the maturity date, a lender could modify the due date of interest expense payments
  • For example, one solution could involve the deferral of an interest expense payment into the next period
Debt-for-Equity Swap
  • In a debt-for-equity swap, existing debt is exchanged for a pre-determined amount of equity in the debtor
  • The exchange normally coincides with the lender not wanting to force the debtor into bankruptcy – or the belief that the equity can hold value someday
Debt-for-Debt Swap
  • In a debt-for-debt exchange, the existing debt is exchanged for a new issuance with a longer tenor, and other terms of the debt are changed to favor the lender – all while reducing the near-term obligations
  • Or, the borrower can propose to unsecured debt holders an exchange of their debt with secured debt with a lien for a lower principal amount (i.e., certain debt holders move up the priority waterfall in return for a reduction in principal and interest)
Cash Interest to Payment-in-Kind (PIK)
  • To provide the debtor with more short-term liquidity, a creditor can agree to convert some (or all) of the cash interest terms to PIK, which causes the interest to accrue to the principal as opposed to requiring cash payments upfront
  • While the near-term cash outlay is reduced, the accruing interest expense increases the principal amount due at maturity
Equity Interests
  • Debt-for-equity swaps would fall into this category, however, there are also other types of equity interests that can be given to lenders in return for renegotiated terms
  • E.g., Warrants, Conversion Feature, Option to Co-Invest
“Standstill” Agreements (or Forbearance)
  • Once a debtor has missed a payment on its debt obligations or breached a covenant, the debtor may request to enter into a standstill agreement
  • These agreements usually lead to modifications to the existing debt – but for now, time is given to the debtor to sort out a proposal
  • In return, the lender agrees to not take any legal action against the borrower for a period of time after the debtor has defaulted (e.g., foreclosure/litigation)
Debt Issuance
  • The debtor can participate in a new round of debt financing to implement growth initiatives, but the terms are unlikely to be in their favor – and there is a low chance of there being much investor interest with the requisite risk appetite
  • The existing senior creditors would likely push back against putting another lien on the company, or a covenant breach may occur from raising more debt
Equity Injection
  • Equity issuances would likely receive less scrutiny from lenders (although there is a dilutive impact created for existing shareholders, the new capital may be in their interest as their chance of recovery is low)
  • But again, considering the risk of equity being at the bottom of the capital stack, it may be challenging to raise new equity
Distressed M&A
  • Selling non-core assets and using the proceeds to fund operations and meet debt obligations is a frequently used restructuring technique
  • However, given the “fire sale” nature of distressed M&A, the selling price may be a fraction of the asset’s fair market value (FMV)
  • In an out-of-court restructuring, any sale of assets will NOT be completely free and clear of all claims unless the debtor obtains all necessary creditor consents
Covenant Waivers (or “Relief”)
  • If the creditor sees this as a non-continuous breach, the breach of a covenant may be waived for the debtor (i.e., a one-time “pardon”)
  • The lender may agree to loosen the debt covenants until maturity – e.g., the calculation of EBITDA can become more lenient with more add-backs
  • Alternatively, as part of the waiving the breach, future covenants may be modified to be more restrictive to protect the lender(s)
Rights Offering
  • A rights offering would give creditors the right to purchase a pro-rata share of equity (calculated off their existing claim or interest) in the reorganized company
  • The purchase is at a discounted rate, with the norm being a ~20-25% discount
Debt Repurchase
  • If the debtor has enough cash, it can repurchase debt (i.e., a buyback) to avoid breaching a covenant or to lower its leverage ratios
  • Doing so enables the D/E ratio return to a normalized level, reduces the total leverage ratio, and decreases the interest payments – but some prepayments may come with a call premium

In-Court (Chapter 11) Financial Restructuring

An out-of-court restructuring may not work if there are too many creditors to gather sufficient consensus (i.e. “holdout problems”) or because there are particularly unfavorable contracts like leases and pension obligations that are better dealt with in-court. In these cases, a company in distress will go to Chapter 11.

Benefits of Chapter 11 Bankruptcy

Listed below are the most notable benefits offered in Chapter 11 over an out-of-court restructuring:

In-Court Chapter 11 Benefits
“Automatic Stay” Provision
  • Upon the filing of the petition, the automatic stay provision goes into effect immediately and impedes collection efforts from pre-petition creditors
  • Unlike in the case of an out-of-court financial restructuring, creditors are legally prohibited from interfering with the debtor
Debtor in Possession Financing (DIP)
  • DIP financing provides much-needed access to capital to fund ongoing operations (and is incentivized through priority or super-priority)
  • Functions as a “lifeline” for the liquidity-constrained debtor to remain operating as it puts together its plan of reorganization
Cancellation of Executory Contracts
  • An executory contract is a contract whereby unperformed obligations remain on both parties as of the petition date
  • The debtor can reject burdensome executory contracts while retaining favorable contracts, but partial agreements are disallowed (i.e., “all or nothing” deal)
“Cram-Down” Provision
  • A cram-down means a confirmed POR can be applied to objecting creditors
  • The provision prevents the “hold-up” problem (i.e., when objecting creditors stall the process despite being the minority)
Section 363 Sale & “Stalking Horse” Bidder
  • Section 363 makes the debtor’s assets more marketable to potential acquirers by removing the “excess” that devalues the assets belonging to the debtor (e.g., liens, existing claims)
  • The stalking horse bidder puts the auction in motion while setting the minimum purchase price floor – removing the potential for the final bid to be priced too low

Free Fall, Pre-Pack & Pre-Arranged Bankruptcies

In general, there are three main types of approaches to filing for Chapter 11:

Plan of Reorganization Filing Types

Priority of Claims in Chapter 11

Perhaps the most important part of Chapter 11 is determining the priority of claims. Under the Bankruptcy Code, a strict structure is established to determine the order of payouts – thus, the priority of claims and inter-creditor dynamics play a critical role in creditor recoveries.

This hierarchy the distribution must abide by is set forth by the absolute priority rule (APR), which requires that senior claims must be paid in full before any subordinate claim is entitled to recovery – albeit, there are instances when senior claim holders give consent for exceptions.

At a high level, the pecking order is as follows:

  1. Super Priority & Administrative Claims: Legal & professional fees, post-petition claims, and claims by lenders that provide capital during bankruptcy (e.g., DIP loans) will typically receive “super priority” status above all claims generated pre-petition
  2. Secured Claims: Claims secured by collateral are entitled to receive value equal to the full value of their interest in the collateral before any value is given to unsecured claims
  3. Priority Unsecured Claims: Claims such as certain employee claims and government tax claims that are not secured by collateral can receive priority over other unsecured claims
  4. General Unsecured Claims (GUCs): Claims on the business that are not secured by collateral and receive no special priority, GUCs typically represents the largest claim holder group and includes suppliers, vendors, unsecured debt, etc.
  5. Equity: Last in line and at the bottom of the capital stack (and thus usually receive nothing)

Priority of Claims Waterfall

Treatment of Equity Claims

Pre-petition equity interests are typically wiped out in Chapter 11. However, equity holders can occasionally receive a “tip” for their cooperation to expedite the process.

Additionally, there are anomalies like the 2020/2021 bankruptcy of Hertz, in which equity owners fared famously well – serving as a rare exception to the typical recoveries of equity holders.

Pre-Petition vs. Post-Petition Claims

Chapter 11 typically starts when the debtor voluntarily files for bankruptcy. Technically, Chapter 11 can also be filed as an involuntary petition by creditors, but this is a rare occurrence as the debtor will preempt such a filing to avoid missing out on the benefits of being the one to file (e.g., selecting the jurisdiction).

The filing date creates an important red line between all claims created before and after the filing date. Specifically, “post-petition” claims (i.e., after filing date) generally receive priority treatment over “pre-petition” claims (i.e., before filing date) – excluding Court-approved exceptions.

Prepetition vs. Post-Petition Claims

First Day Motion Filings

First Day Motion Filings

Early on in the Chapter 11 process, the debtor can file first day motions, which are requests to obtain Court approval for certain tasks or access to resources.

For the most part, nearly all actions are overseen by the U.S. Trustee and require the authorization of the Court from this point onward – but in complex reorganizations, the benefits can outweigh the drawbacks of this tedious process (which are often menial in comparison).

As a side note, around this time creditors often form creditor committees to represent their collective interests, the most common example being the Official Committee of Unsecured Creditors (UCC).

Plan of Reorganization (POR)

The reorganization plan represents the proposed post-emergence turnaround roadmap – and includes details on the classification of claims and treatment of each class.  Once a debtor files for Chapter 11, the debtor holds the exclusive right to present a plan of reorganization to the Court within 120 days of filing – called the “exclusivity period”.

By the end of the Chapter 11 process, the objective of the debtor is to emerge with an approved POR and then shift to implement the outlined strategy. Extensions are often granted in 60 to 90-day increments after the initial period of exclusivity has passed – but up until around 18 months for proposal and 20 months for acceptance, if a POR has yet to be agreed upon, then any creditor is permitted to file a plan.

Disclosure Statement

The disclosure statement is a report that contains “adequate information” for the creditors to make an informed decision on the upcoming vote. Before the vote can proceed, the document must be submitted alongside the proposed POR. Collectively, the POR and disclosure statement must disclose all material facts pertinent to creditors participating in the vote.

Upon filing the required disclosure statement, the Court holds a hearing to assess whether the disclosure statement submitted by the debtor contains “adequate information”.

The depth of the documentation and supplementary data varies case-by-case, but one of the main purposes of the disclosure statement is the:

  • Classification of Claims by Priority
  • Proposed Treatment of Each Class of Claims

POR Voting Process: Approval Requirements

Once approved, the disclosure statement and POR will be distributed to the impaired claim holders deemed entitled to vote.

The acceptance of the proposed POR requires two conditions to be met:

Plan of Reorganization (POR) Acceptance Requirements

And to be confirmed by the Court, the following tests must be passed:

Minimum Standards of Fairness
“Best Interests” Test
  • The “fairness” of the POR is tested by confirming the anticipated recoveries by creditors under the POR exceeds the recoveries under a Chapter 7 liquidation
  • The liquidation value represents the minimum “floor” that must be bypassed
“Good Faith” Test
  • Under this subjective assessment, the proposed POR must be made in “good faith”
  • This means the POR must be made with the “best interests” of the creditors in mind, as well as the future of the debtor’s operations
“Feasibility” Test
  • The Court may reject the POR on the basis that the debtor might need to be liquidated or require restructuring in the foreseeable future
  • The cash flow test represents the debtor’s projected future solvency under the POR and must demonstrate that the new capital structure post-emergence will be sustainable

Chapter 11: Timeline Flow Chart

To summarize the Chapter 11 restructuring process, the chart below lists the main steps:

Chapter 11 Reorganization Timeline

Emergence from Chapter 11 requires payment of administrative claims in cash unless the terms are re-negotiated (e.g., DIP financing with admin status to exit financing conversion).

The debtor must also obtain “exit financing” – which represents how the debtor intends to fund the POR post-emergence from Chapter 11. In the final stage, assuming confirmation, the debtor distributes the agreed-upon consideration to each creditor class and emerges as a new entity discharged of all unpaid pre-petition claims.

Emergence from Chapter 11 ≠ Successful Turnaround

For a POR to be approved, it must pass the “feasibility test” which means the capital structure, among other things, is set up in such a way that there is “reasonable assurance” of long-term success. But “reasonable assurance” is not a guarantee.

In fact, some companies have found their way back to bankruptcy, which is informally called a “Chapter 22”. Or in other cases, the company will return to be liquidated after only a few years post-emergence.

The uncertainty of outcome is an unavoidable attribute of financial restructuring, but it is precisely the role of RX advisors, whether advising on a debtor’s or creditor’s mandate, to help their clients navigate through these complicated proceedings and negotiations.

Restructuring practitioners, when advising a debtor, have the central goal of contributing as much useful guidance to the debtor to put it back on the pathway of sustainable growth – whereas, on the creditor’s side, the RX bankers should strive to protect the client’s interests and ensure receipt of maximum recovery.

Chapter 7 Liquidation Process

Distribution of Proceeds

While a debtor undergoing Chapter 11 attempts to come up with a plan to emerge from bankruptcy, a Chapter 7 bankruptcy refers to the straightforward liquidation of a debtor’s assets. In a Chapter 7 proceeding, the debtor has deteriorated to the point that a reorganization is no longer a viable option.

Certain firms become distressed by poor decision-making (i.e., fixable mishap or short-lasting catalyst) and can change course despite the mistakes made.

But other times, there is seemingly little hope in even attempting a turn-around. These are the scenarios whereby undergoing liquidation would be ideal, as the source of difficulties stems from an ongoing structural change. A Chapter 7 Trustee is appointed to liquidate the assets of the debtor and then distribute the sale proceeds by the priority of each claim.

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