Understanding Financial Restructuring

Transcription

1 Understanding Financial Restructuring December 2018

2 What is Distress? At its core: a distressed business is simply one with unsustainable operations This can be defined as: the inability to generate consistent, positive cash flow over a period of time relative to the financial obligations of the business Usually, this is discovered by the firm s lender following a covenant breach, which can push a relatively healthy business into distress, because of the lender s ability to shut down liquidity and force a liquidation of the business Temporarily unsustainable operations can be restructured or funded via: Junior Capital (typically equity) Working capital run-down Excess revolver/term debt availability/capacity Capital restructuring So the definition of a distressed business becomes: a business with temporarily unsustainable operations, in combination with inadequate liquidity, relative to the working capital and debt service needs of the firm Page 2

3 Causes of Distress External Internal Changes in Market Demand Housing market Coal industry Competition New competition Change in relative competitive position Brick and mortar retail vs. online Change in Costs Adverse change in commodity prices Disconnect with customer contracts Poor Management Not necessarily incompetence but poor team dynamic Inadequate Financial Control Failure to identify declining performance and take action High Cost Structure Fixed costs may have increased as a result of an attempted growth push Loss of Talent Or mis-alignment of resources due to management changes Poor Marketing Lack of focus on selling and marketing efforts Big Projects / Acquisitions Poor integration Distraction from core competencies Drain on financial resources Capital Structure / Leverage Page 3 Copyright All Rights Reserved.

4 The Distress Decline Curve Course of a company crisis Fig. 2 Probability of continuance Stakeholder crisis Strategy crisis Success crisis At the beginning of a company crisis there is a stakeholder crisis, or strategically wrong decisions were taken. However, measures are only taken in case of a success or liquidity crisis. The probability of continuance decreases over the course of the time. Liquidity crisis Usually Where an advisory is brought in Insolvency maturity time Source: bdp-aktuell.de Page 4

5 Path of a Turnaround or Restructuring The transition to a Crisis can take weeks, months or years depending on many factors, such as: the industry the degree of indebtedness the availability of capital the nature of the causes of poor performance Sustainable Recovery Non-Crisis Crisis Turnaround strategies adopted Mere Survival Short-Term Survival Failed Turnaround Financial Position Time Insolvency Page 5

6 The Impact of Distress on Valuation Liquidation v. Enterprise Value Liquidation Value Partial Breakup Value Enterprise Value Asset Liquidation Value Cash Flow Value Asset Liquidation Value Partial Liquidation Value Partial Cash Flow Value Asset Liquidation Value Cash Flow Value The key is actual value versus expected value Page 6

7 Four Key Objectives of Turnaround Process Successful turnarounds are based on addressing both strategic and operational issues and by doing so, creating a new EBITDA engine. Only then can a new financial structure be put in place to match the new EBITDA engine. Four Key Objectives 1. Take Control of the Situation Crisis stabilization Leadership 2. Rebuild Stakeholder Support Stakeholder management 3. Fix the Business Strategic focus Organizational change Critical process improvements 4. Resolve Future Funding Financial restructuring Phases of the Turnaround Process Survival Phase Stability Phase Growth Phase Page 7

8 Seven Essential Ingredients of Turnaround Process Seven Key Ingredients Generic Turnaround Strategies Crisis Stabilization Take Control Cash Management Working Capital Reduction Asset Reduction Short-term Financing First-step cost reduction Leadership Critical Mass of New Thinking Potential Change of Senior Management Stakeholder Support Communications Strategic Focus Redefine Core Businesses Divestment and Asset Reduction Product-Market Refocusing Downsizing Outsourcing Investment Organizational Change Structural Changes Key People Changes Improved Communications Building Commitment and Capabilities New Terms and Conditions of Employment Critical Process Improvements Improved Information and Control Systems ( Management Accounting ) Improved Sales and Marketing Cost Reduction Quality Improvements Improved Responsiveness Financial Restructuring Refinancing Asset Reduction Page 8

9 Restructuring Framework Page 9

10 Tools of the Trade Situation Analysis What is the initial understanding of the problem? Capital Structure Analysis Who has the leverage? Liquidation Analysis Again, who has the leverage? Viability Analysis Is this a viable business? Strategic Alternatives Status quo, Amendment, Refinance, Restructure and Sell Debt Capacity Analysis How much new equity is needed? 13-Week Cash Flow Forecast Can the Company keep operating? Financial Assessment Projections Is there value in the business? Liquidity Analysis How do we get thru the next month? Covenant Analysis What are the limitations in the credit agreement? Business Plan Review Is there a valid recovery strategy? Operations Improvement Is more needed than a financial restructuring? Bankruptcy as Strategy Can we motivate creditors to cooperate? Restructuring Proposal What is the plan? Feasibility Analysis Will the plan work? Page 10

11 Analytical Framework For Cash Flow Evaluation Historical Reconstruction Forward Projections Opportunities Rationalization Adjustments Revenue Enhancement New customers existing products New products existing customers New channels New pricing New markets New product technology Change focus of sales & marketing Normalization Adjustments Cash Flow Evaluation Cost Reduction New products existing methods New methods existing products New process technology Change production Change sourcing Change distribution Change selling Change marketing Change administration Change scale of operations Separation Adjustments Capital Redeployment Reduce facilities Reduce receivables Reduce inventories Change payables Reduce other assets Change investment process Left Brain Right Brain Page 11

12 Rebuilding the Past Reconstruct historical financials to reflect left side adjustments. Cash Flow Value Value added Rationalization Adjustments Normalization Adjustments Value lost Separation Adjustments Change in value based on historical reconstruction Unadjusted Historical Adjustment Layers Observations: Rationalization adjustments almost always add to value and can be very significant Normalization adjustments usually add to value, but are often overestimated Separation adjustments almost always subtract from value and are often underestimated Page 12

13 Projecting the Future Build on reconstructed historical to include right side adjustments. Cash Flow Value Value added Cost Reduction Capital Redeployment Revenue Enhancements Change in value over reconstructed historical Reconstructed Historical Adjustment Layers Observations: Cost reduction opportunities almost always add real value, but are often overestimated Capital redeployment usually adds to value, but timing is usually underestimated Revenue enhancements almost always are overestimated Page 13

14 Crisis Stabilization Mechanics of a 13-Week Cash Flow Granular detail, Direct cash flow Not GAAP cash flow statement (Indirect) Not an Excel model but a comprehensive process that must be used over an extended period of time Must develop primary drivers of business and how to include in model Find historical data in accounting systems Why... Why... Why... Must be able to cost effectively pull actual results on a timely basis from books for use in weekly variance analysis Talk to management and staff not just at the top, but also middle levels and DOERS Page 14

15 Crisis Stabilization Example 13-Week Cash Flow Page 15

16 Crisis Stabilization Example 13-Week Cash Flow Page 16

17 Restructuring Alternatives Page 17

18 Considerations of Constituents Objectives of Selected Constituents - Understanding various constituents behavior and reactions to the Company s situation is critical to developing an effective alternative that achieves the Company s goals Constituency Company / Board Objectives Preserve financial liquidity and business value Maximize value for all stakeholders Minimize cost, management distraction, process duration, and execution risk Shareholders Create greatest likelihood for maximizing equity value Minimize dilution to equity Seek transaction with greatest market impact Secured Lenders Preserve liquidity Monitor collateral Seek compensation for facilitating liquidity and taking a greater risk Bondholders Gain influence over any restructuring process through coordination with other holders Maximize investment returns (short-term or long-term) Bondholders will otherwise seek to marginally improve and protect the value of their position, since most holders mark to market; this allows broad solicitations to be effective when there is not significant concentration among few holders Assess impact of subordination agreement on recoveries Customers/Suppliers/ Employees Minimize operational disruption to Company Avoid compromise of collective bargaining agreements or trade terms Often encourage de-levering transaction Page 18

19 Definition of Insolvency Bankruptcy Code Defines Insolvency as a Balance Sheet test: When the value of liabilities is greater than fair value of all of the assets (where Fair Value is undefined) Outside of bankruptcy, a Capital Adequacy test covers: The inability to pay obligations as they come due Both definitions are applicable and meaningful to distressed companies Either form of insolvency typically leads to liquidation, unless the company can be turned around, restructured or sold in a reasonable amount of time Page 19

20 Restructuring Threshold Questions Is the business worth saving? Is there a Core business to restructure around? Canthe business be saved? Is the management team capable? Is the capital structure willing and able? Who is the fulcrum security? What level of new capital will be required to sustain the business or finance a turnaround? Can a restructuring be accomplished out of bankruptcy court? Page 20

21 Claims and Absolute Priority Understanding the Rules A company s indentures and/or the bankruptcy code ranks a company s claims to determine the order in which claims or a class of claims will be paid, if there is not enough money to pay all claims in full (the absolute priority rule) Administrative claims Expenses for lawyers, bankers, accountants, etc. Priority claims Employee wages (earned but not paid for up to 180 days) up to $12,475 per employee Taxes owed to state or federal entities Secured claims Only to the extent of the value of the collateral Unsecured claims Trade claims Deficiency claims (unsecured lenders) Bondholders Contingent claims (lawsuits, lease damage claims, etc.) Equity interests Preferred stock Common stock This is Traditional Bank Debt Page 21

22 Negotiating With Creditors Understanding Creditors Motives Reduce loan exposure via reducing advance rates, commitments or establishing reserves Reduce downside versus enhance upside Push for additional collateral, especially when making accommodations, loan waivers Call a loan default and negotiate a forbearance agreement Require company to hire a turnaround consultant and develop & execute a turnaround plan Credibility is critical Page 22

23 Find the Fulcrum Security The fulcrum security is the highest-priority security in a capital structure to recover less than par value in a hypothetical restructuring Consequently, it is the one most likely to be converted into equity; and therefore, can be valued as an option on the equity of the restructured firm This is where loan-to-own investors look to invest in distressed companies Knowing the fulcrum security often allows leverage to be applied to other constituents to get to a successful restructuring Equity Unsec. Debt Liquidation Value of Assets 2 nd Lien 1 st Lien Debt Fulcrum Security Page 23

24 Potential Alternatives Distressed Middle Market Company Strategic Alternatives Invest Additional Capital Refinance with Current / New Lenders Pursue a Going Concern Sale Restructure / Continue as a Going Concern File Bankruptcy and Pursue a Restructuring Liquidate Low Interference with Daily Operations High Page 24

25 Potential Alternatives Illustrative Decision Process While enhancing financial liquidity is a key objective, it is also the means toward pursuing a more comprehensive solution. Having enough cash today does not preclude investigating alternatives such as those shown below, given the current situation and operating environment Borrow More Secured Debt Strategic Sale New Equity Issuance PIPE Investment Exchange Offer Rights Offering CH Sale Reorganize in CH. 11 Page 25

26 Bankruptcy Page 26

27 Bankruptcy Overview Companies customarily seek protection under Chapter 11 of the Bankruptcy Code for one or more of the following reasons Company faces a serious liquidity problem and requires breathing room to operate its business and reorganize its capital structure (considerations include unsecured and trade debt versus secured debt) Company has made a strategic determination to restructure its business and utilize benefits of various statutory provisions of Chapter 11 to implement its restructuring plan often through a prepackaged or pre-negotiated reorganization plan Company has recognized serious going-concern or stand-alone operational issues and will use the Chapter 11 process for business combination or divestiture purposes (including, in some instances, liquidation) A catastrophic event has occurred and is reasonably foreseeable (i.e., mass tort, fraud, serious environmental problems) and the Company must immediately seek protection from creditors Page 27

28 Chapter 11 Alternatives Pre-Packaged Pre-Negotiated "Free Fall" Company and creditors agree to a plan of reorganization to bankruptcy filing - Plan is both negotiated and solicited prior to filing - Allows company to enter Chapter 11 with a consensual plan that is not subject to further negotiation Plan of reorganization can be consummated on an expedited basis after filing Avoids operational/legal risks and administrative expenses of a long Chapter 11 case Low risk of rejection of plan by court Debtor negotiates with creditors prior to bankruptcy but does not solicit creditor approval until after filing Dissenting stakeholders in bankruptcy may delay confirmation or block plan Dissent may inhibit Company from implementing business plan Debtor follows normal Chapter 11 procedures Debtor has no agreement with its creditors filing and negotiates with creditors while in Chapter 11 - Plan filed during pendency of case Typically longer timetable and higher administrative costs than prepacks / prenegotiated filings Page 28

29 Bankruptcy Overview Characteristics of U.S. Chapter 11 Bankruptcies (frequently referred to as a reorganization bankruptcy) The U.S. Bankruptcy Code is pro-debtor in its approach Debtor remains in control of business under a Chapter 11 filing and operates as a going concern on a business as usual basis ( debtor in possession or DIP ). Differs significantly from receivership-style bankruptcies common in many European countries The U.S. bankruptcy code is designed to give the debtor the opportunity to reorganize in a manner that maximizes value to all stakeholders and preserves jobs Debtor benefits from a stay of all claims and litigation Debtor often receives post-petition DIP financing to ensure continued operations of business Debtor has 120 days from date of bankruptcy filing to file a plan of reorganization. If the debtor shows progress toward formulating a plan, this period is customarily extended by the court Code allows debtor to reject contracts and leases that have unfavorable economic terms. Liabilities arising from the rejection of leases are limited by the bankruptcy code Code allows for orderly asset sales. The court employs several procedures designed to stimulate a competitive bidding process Page 29

30 Bankruptcy Overview Despite the benefits afforded a debtor by the bankruptcy process, bankruptcy can be expensive, litigious, and lengthy Debtor pays for fees and expenses of all professionals subject to reasonableness standard Bankruptcy Code provides a forum for all stakeholders to be heard, resulting in potential for creditors to pursue litigation to extract hold-up value In contrast to a Chapter 11 reorganization Chapter 7 has as its primary end the liquidation of the estate Business is shut down (not sold as a going concern as in a Liquidating Chapter 11 ) Trustee is appointed to locate and collect the property of the estate, to convert/reduce such property to cash and to make distributions to claimants in a prescribed order Debtor allowed to retain only exempt property Unpaid amounts on dischargeable debts are discharged In some instances, the Trustee may receive court authorization to operate the debtor s business temporarily when doing so facilitates orderly liquidation Page 30

31 Bankruptcy Overview Key Players in the Bankruptcy Process Bankruptcy Judge U.S. Trustee The Debtor (in possession) Management Board of Directors Advisors Secured Lenders (if any) and their advisors Unsecured Creditors Committee and its advisors Equity Committee (to the extent there is a reasonable chance of recovery to this class of creditor) Unions Other parties-in-interest (landlords, taxing authorities, plaintiffs in litigation, etc.) and their respective advisors Page 31

32 Bankruptcy Overview Plan of Reorganization Petition Automatic Stay Continued Control by Management Committees Form Creditors Meeting Plan of Reorganization Disclosure Statement Voting and Confirmation Discharge Paying Creditors Dispute Resolution Appeal Page 32

33 Overview of 363 Sales Process In addition to a plan of reorganization, Chapter 11 provides a forum for a company to sell some or all assets free and clear of all liens and encumbrances pursuant to a 363 sale process The filing of a 363 motion to sell assets places everyone on notice that the Company s assets are for sale and provides an opportunity for buyers to bid and creditors to object; both are highly visible and objections are usually resolved quickly To effect 363 sale, the Company only needs to substantiate a good business reason for sale (e.g., that the business is deteriorating or that a prompt sale is the best available means of preserving going concern value) In a sale of less than all assets, it is usually sufficient that the assets are non-core Page 33

34 Overview of 363 Sales Process Optimal vehicle to use when value of company is deteriorating rapidly Management can advance best interests of all stakeholders through the sale of the debtor s assets as a going concern The perception of the Debtor as having to sell assets may significantly depress price that might be obtained for the business A 363 sale of all or substantially all of the Debtors assets requires support of creditors whose money is at risk Makes it very difficult for those creditors who are out of the money to hold up the process In general the court requires that: The Debtor has demonstrated good faith and the assets have has been thoroughly shopped prior to filing Debtor s assets are wasting or there are other compelling business reasons for selling them Fair bidding process has occurred or is provided for in the proposed sale process Page 34

35 Overview of 363 Sales Process Illustrative Timeline for Middle-Market 363 Process Week 8 Week 11 Weeks 1-5 Weeks 6-7 Expedited Marketing Process (competitive, but fast) Select Stalking Horse (typical) Filing of Sale Motion Bid Procedure Competitive Bid Deadline Court Auction Weeks Closing (describes breakup fee, deposit requirements and overbid amounts) Page 35

36 Overview of 363 Sales Process Market Assets Marketing process is similar to that for non-distressed companies, though time pressure may be greater Limiting the initial buyer universe can accelerate the process, although fewer bidders may result in lower initial bids In some cases, there are relatively few easily identifiable potential purchasers Sales Process Select Stalking Horse Bidder Establish Bidding Procedures and Approve Breakup Fees Bids are solicited from parties showing the greatest interest and ability to move quickly Often, it is advantageous to sign up a "Stalking Horse" bid which represents the starting point for the auction process (required in most bankruptcy sales) Stalking Horse bidders often receive a break-up fee in the event their bid is topped Typically, Courts approve break-up fees of approximately 3%, plus the reimbursement of expenses After parties conduct due diligence, the most attractive bid is selected, and an Asset Purchase Agreement is negotiated and signed An Asset Purchase Agreement is subject to Court approval, which will typically not be granted in the face of a better offer The Stalking Horse bid and procedures for the auction are submitted to the Court The Stalking Horse bidder often influences the bidding procedure terms The procedures lay out deadlines and the rules for bidding (such as the minimum bid above the Stalking Horse bid and the bidding increments) They define what qualifies a bidder to participate in the auction process Often, a bidder is required to prove financial ability to execute a purchase by disclosing sources of funding and paying a deposit Conduct Auction The auction takes place according to the bidding procedures established by the Court Typically, the auction takes place after an initial round of bidding limits the participants Receive Court Approval During the auction, bids are evaluated and the best bid is determined An Asset Purchase Agreement is signed and submitted to the Court for approval Close Transaction Following Court approval and fulfillment of closing conditions, the transaction closes Page 36

37 Overview of 363 Sales Process Exclusivity periods No shop provisions (exclusivity) Termination provisions Bidding Procedures creditors may participate in approving such procedures Minimum overbids Qualification of bidders (expression of interest, ability to perform, etc.) Submission of initial bids (use of stalking horse s form of APA, deposit often required, bids irrevocable, firm offers) Possible to condition commitment to proceed on court approval of bid procedures Break-up or topping fees, expense reimbursement Accelerated auction process Credit bid of claims Quick court approval of sale Page 37