Restructuring And Distressed M&A

Question 1

How much do you actually know about what you do in restructuring?

Answer 1

Restructuring bankers advise distressed companies and help them change their capital structure to get out of bankruptcy, avoid it in the first place, or assist with the sale of the company.

Question 2

What are the 2 different sides to a restructuring deal? Do you know which one we usually advise?

Answer 2

Bankers can advise the debtor (company itself) or the creditors (anyone that has lent the company) money. In one you’re trying to advise the company how to get out of the mess, the other you’re advising the lenders that are trying to take from the company what they can.

Creditors can be multiple parties. There are also operational advisors who help with the actual turnaround.

Research what each company does. Black stone and Lazard advise debtors, Houlihan Lokey advise creditors.

Question 3

Why are you interested in restructuring besides it being the hot area right now?

Answer 3

You gain a very specialized skill set and the work is actually more technical/interesting than M&A. You also get broader exposure because you get to see both the good and the bad.

Question 4

How are you going to use your experience in restructuring for your future career goals?

Answer 4

It provides you with specialized skills and more technical understanding, so even if you don’t want to stay in restructuring, you can move to another division and have great technical knowledge.

Question 5

How would a distressed company select its restructuring bankers?

Answer 5

Restructuring requires extremely specialized knowledge and relationships. There are only a few banks with good practices and they are selected on experience.

Question 6

Why would a company go bankrupt in the first place?

Answer 6

Common reasons:

• company cannot meet debt obligations/ interest payments
• creditors can accelerate debt payments and force company into bankruptcy.
• an acquisition has gone poorly or a company has just written down its assets steeply and needs extra capital
• there is a liquidity crunch and the company can not afford to pay its vendors or suppliers

Question 7

What options are available to a distressed company that can’t meet its obligations?

Answer 7

• refinance and obtain fresh debt/equity
• sell the company
• restructure its financial obligations to lower interest payments/ debt repayments, or issue debt with PIK interest to reduce the cash interest expense
• file for bankruptcy and use that opportunity to obtain additional financing, restructure its obligations, and be freed of onerous contracts.

Question 8

What are the advantages of each option to a distressed company that can’t meet its debt obligations?

Answer 8

• refinance- advantages: least disruptive and would help revive confidence; disadvantages: difficult to attract investors to a company on the verge of going bankrupt
• sale - advantages: shareholders get some value and creditors are less infuriated; disadvantages: unlikely to obtain a good valuation in a distressed sale.
• restructuring- advantages: could resolve problems quickly without 3rd party. Disadvantages: lenders often resistant to increase exposure to the company.
• bankruptcy- advantages: could be best way to negotiate with lenders, reduce obligations, and get more financing. Disadvantages: significant business disruptions and lack of confidence. Equity investors lose all their money.

Question 9

What strategies do creditors have available to recover their capital in a destressed situation?

Answer 9

• lend additional capital/ grant equity.
• conditional financing
• sale- force company to sell
• foreclosure - force a bankruptcy filing

Question 10

How are restructuring deals different from other types of transactions?

Answer 10

More complex, more parties involved, require more technical skills, and have to follow bankruptcy legal code, also multiple negotiations going on, not just two sides negotiating.

Question 11

What’s the difference between chapter 7 and chapter 11 bankruptcy?

Answer 11

Chapter 7 = liquidation bankruptcy, where the company is past the point of no return and must sell off its assets.

Chapter 11 = a reorganization, where changes are made to the terms of its debt and renegotiates its interest payments.

Question 12

What is debtor-in-possession (DIP) financing and how is it used with distressed companies?

Answer 12

It is money borrowed by a distressed company that has repayment priority over all others and therefore is considered safer. This theoretically should help the company emerge from bankruptcy.

Question 13

How would you adjust the 3 financial statements for a distressed company when you’re doing valuation or modeling work?

And would those adjustments differ between private and public companies?

Answer 13

Most common adjustments:

• adjust COGs for higher vendor costs
• add back non-recurring legal/ other fees associated with restructuring
• add back excess lease expenses and excess salaries to operating income
• working capital needs adjusted for receivables unlikely to turn into cash, overvalued inventory, and insufficient payables
• capex spending is often off

Most of the above stays the same except excess salaries for public companies

Question 14

If the market value of a distressed company’s debt is greater than its assets, what happens to its equity?

Answer 14

Shareholders equity goes negative.

A company’s equity market cap (shares outstanding*price) would remain positive though since it can never be negative.

Question 15

In a bankruptcy, what is the order of claims on a company’s assets?

Answer 15

1. DIP lenders
2. Secured creditors
3. Unsecured creditors
4. Subordinated debt investors
5. Mezzanine investors
6. Shareholders

Question 16

How do you measure the cost of debt for a company if it is too distressed to issue additional debt?

Answer 16

You’d look at the yields of bonds or spreads of credit default swaps of comparable companies.

Question 17

How would valuation change for a distressed company?

Answer 17

• you use the same methodologies most of the time
• except you look more at the lower range of multiples
• you also use lower projections for DCF and anything else needing projecting
• you should pay more attention to revenue multiples if the company is EBIT/EBITDA negative
• you look at a liquidation valuation under the assumption the assets will be sold off to pay obligations
• you sometimes also look at valuations on both an assets-only and current-liabilities assumes basis

Question 18

How would a DCF analysis be different in a distressed scenario?

Answer 18

Even more of the value would come from the terminal value since you normally assume a few years of cash flow negative turnaround.

Question 19

Let’s say a distressed company approaches you and wants to hire your bank to sell it in a distressed sale – how would the M&A process be different than it would for a healthy company?

Answer 19

1. Timing is often quick since the company needs to sell or else they’ll go bankrupt.
2. Sometimes you’ll produce fewer “upfront” marketing materials (Information
   Memoranda, Management Presentations, etc.) in the interest of speed.
3. Creditors often initiate the process rather than the company itself.
4. Unlike normal M&A deals, distressed sales can’t “fail” – they result in a sale, a
   bankruptcy or sometimes a restructuring.

Question 20

Normally in a sell-side M&A process, you always want to have multiple bidders to increase competition. Is there any reason they’d be especially important in a distressed sale?

Answer 20

Yes – in a distressed sale you have almost no negotiating leverage because you represent a company that’s about to die. The only real way to improve price for your client is to have multiple bidders.

Question 21

The 2 basic ways you can buy a company are through a stock purchase and an asset purchase. What’s the difference, and what would a buyer in a distressed sale prefer? What about the seller?

Answer 21

In a stock purchase, you acquire 100% of a company’s shares as well as all its assets and liabilities (on and off-balance sheet). In an asset purchase, you acquire only certain assets of a company and assume only certain liabilities – so you can pick and choose exactly what you’re getting.Companies typically use asset purchases for divestitures, distressed M&A, and smaller private companies; anything large, public, and healthy generally needs to be acquired via a stock purchase.
A buyer almost always prefers an asset purchase so it can avoid assumption of unknown liabilities (there are also tax advantages for the buyer).
A (distressed) seller almost always prefers a stock purchase so it can be rid of all its liabilities and because it gets taxed more heavily when selling assets vs. selling the entire business.

Question 22

Sometimes a distressed sale does not end in a conventional stock/asset purchase – what are some other possible outcomes?

Answer 22

Other possible outcomes:
• Foreclosure (either official or unofficial)
• General assignment (faster alternative to bankruptcy)
• Section 363 asset sale (a faster, less risky version of a normal asset sale)
• Chapter 11 bankruptcy
• Chapter 7 bankruptcy

Question 23

Normally M&A processes are kept confidential – is there any reason why a distressed company would want to announce the involvement of a banker in a sale process?

Answer 23

This happens even outside distressed sales – generally the company does it if they want more bids / want to increase competition and drive a higher purchase price.

Question 24

Are shareholders likely to receive any compensation in a distressed sale or bankruptcy?

Answer 24

Technically, the answer is “it depends” but practically speaking most of the time the answer is “no.”
If a company is truly distressed, the value of its debts and obligations most likely exceed the value of its assets – so equity investors rarely get much out of a bankruptcy or distressed sale, especially when it ends in liquidation.

Question 25

Let’s say a company wants to sell itself or simply restructure its obligations – why might it be forced into a Chapter 11 bankruptcy?

Answer 25

In a lot of cases, aggressive creditors force this to happen – if they won’t agree to the restructuring of its obligations or they can’t finalize a sale outside court, they might force a company into Chapter 11 by accelerating debt payments.

Question 26

Recently, there has been news of distressed companies like GM “buying back” their debt for 50 cents on the dollar. What’s the motivation for doing this and how does it work accounting-wise?

Answer 26

The motivation is simple: use excess balance sheet cash to buy back debt on-the-cheap and sharply reduce interest expense and obligations going forward. It works because the foregone interest on cash is lower than whatever interest rate they’re paying on debt – so they reduce their net interest expense no matter what. Many companies are faced with huge debt obligations that have declined significantly in value but which still have relatively high interest rates, so they’re using the opportunity to rid themselves of excess cash and cancel out their existing debt. Accounting-wise, it’s simple: Balance Sheet cash goes down and debt on the Liabilities & Equity side goes down by the same amount to make it balance.

Question 27

What kind of companies would most likely enact debt buy-backs?

Answer 27

Most likely over-levered companies – ones with too much debt – that were acquired by PE firms in leveraged buyouts during the boom years, and now face interest payments they have trouble meeting, along with excess cash.

Question 28

Why might a creditor might have to take a loss on the debt it loaned to a distressed company?

Answer 28

This happens to lower-priority creditors all the time. Remember, secured creditors always come first and get first claim to all the proceeds from a sale or series of asset sales; if a creditor is lower on the totem pole, they only get what’s left of the proceeds so they have to take a loss on their loans / obligations.

Question 29

What is the end goal of a given financial restructuring?

Answer 29

A restructuring does not change the amount of debt outstanding in and of itself – instead, it changes the terms of the debt, such as interest payments, monthly/quarterly principal repayment requirements, and the covenants.

Question 30

What’s the difference between a Distressed M&A deal and a Restructuring deal?

Answer 30

“Restructuring” is one possible outcome of a Distressed M&A deal. A company can be “distressed” for many reasons, but the solution is not always to restructure its debt obligations – it might declare bankruptcy, it might liquidate and sell off its assets, or it might sell 100% of itself to another company. “Restructuring” just refers to what happens when the distressed company in question decides it wants to change around its debt obligations so that it can better repay them in the future.

Question 31

What’s the difference between acquiring just the assets of a company and acquiring it on a “current liabilities assumed” basis?

Answer 31

When you acquire the assets of a distressed company, you get literally just the assets. But when you acquire the current liabilities as well, you need to make adjustments to account for the fact that a distressed company’s working capital can be extremely skewed. Specifically, “owed expense” line items like Accounts Payable and Accrued Expenses are often much higher than they would be for a healthy company, so you need to subtract the difference if you’re assuming the current liabilities. This results in a deduction to your valuation – so in most cases the valuation is lower if you’re assuming current liabilities.

Question 32

How could a decline in a company’s share price cause it to go bankrupt?

Answer 32

Trick question. Remember, MARKET CAP DOES NOT EQUAL SHAREHOLDERS’ EQUITY. You might be tempted to say something like, “Shareholders’ equity falls!” but the share price of the company does not affect shareholders’ equity, which is a book value. What actually happens: as a result of the share price drop, customers, vendors, suppliers, and lenders would be more reluctant to do business with the distressed company – so its revenue might fall and its Accounts Payable and Accrued Expenses line items might climb to unhealthy levels. All of that might cause the company to fail or require more capital, but the share price decline itself does not lead to bankruptcy. In the case of Bear Stearns in 2008, overnight lenders lost confidence as a result of the sudden share price declines and it completely ran out of liquidity as a result – which is a big problem when your entire business depends on overnight lending.

Question 33

What happens to Accounts Payable Days with a distressed company?

Answer 33

They rise and the average AP Days might go well beyond what’s “normal” for the industry – this is because a distressed company has trouble paying its vendors and suppliers.

Question 34

Let’s say a distressed company wants to raise debt or equity to fix its financial problems rather than selling or declaring bankruptcy. Why might it not be able to do this?

Answer 34

• Debt: Sometimes if the company is too small or if investors don’t believe it has a credible turnaround plan, they will simply refuse to lend it any sort of capital. • Equity: Same as above, but worse – since equity investors have lower priority than debt investors. Plus, for a distressed company getting “enough” equity can mean selling 100% or near 100% of the company due to its depressed market cap.

Question 35

Will the adjusted EBITDA of a distressed company be higher or lower than the value you would get from its financial statements?

Answer 35

In most cases it will be higher because you’re adjusting for higher-than-normal salaries, one-time legal and restructuring charges, and more.

Question 36

Would you use Levered Cash Flow for a distressed company in a DCF since it might be encumbered with debt?

Answer 36

No. In fact, with distressed companies it’s really important to analyze cash flows on a debt-free basis precisely because they might have higher-than-normal debt expenses.

Question 37

Let’s say we’re doing a Liquidation Valuation for a distressed company. Why can’t we just use the Shareholders’ Equity number for its value? Isn’t that equal to Assets minus Liabilities?

Answer 37

In a Liquidation Valuation you need to adjust the values of the assets to reflect how much you could get if you sold them off separately. You might assume, for example, that you can only recover 50% of the book value of a company’s inventory if you tried to sell it off separately. Shareholders’ Equity is equal to Assets minus Liabilities, but in a Liquidation Valuation we change the values of all the Assets so we can’t just use the Shareholders’ Equity number.

Question 38

What kind of recovery can you expect for different assets in a Liquidation Valuation?

Answer 38

This varies A LOT by industry, company and the specific assets, but some rough guidelines: • Cash: Probably close to 100% because it’s the most liquid asset. • Investments: Varies a lot by what they are and how liquid they are – you might get close to 100% for the ones closest to cash, but significantly less than that for equity investments in other companies. • Accounts Receivable: Less than what you’d get for cash because many customers might just not “pay” a distressed company. • Inventory: Less than Cash or AR because inventory is of little use to a different company. • PP&E: Similar to cash for land and buildings, and less than that for equipment. • Intangible Assets: 0%. No one will pay you anything for Goodwill or the value of a brand name – or if they will, it’s near-impossible to quantify.

Question 39

How would an LBO model for a distressed company be different?

Answer 39

The purpose of an LBO model here is not to determine the private equity firm’s IRR, but rather to figure out how quickly the company can pay off its debt obligations as well as what kind of IRR any new debt/equity investors can expect. Other than that, it’s not much different from the “standard” LBO model – the mechanics are the same, but you have different kinds of debt (e.g. Debtor-in-Possession), possibly more tranches, and the returns will probably be lower because it’s a distressed company, though occasionally “bargain” deals can turn out to be very profitable. One structural difference is that a distressed company LBO is more likely to take the form of an asset purchase rather than a stock purchase.