WCM Educational Recap #14: Intro to Restructuring

Recapped by Alyssa Choi

Week-In-Review: Virtual Real Estate to Top $1 Billion This Year

Virtual Real Estate is a non-fungible token with plots of land (pixels) on Metaverse platforms. Using the platform's currency, a form of cryptocurrency, users are able to purchase plots of land and build on them to make it interactive.

Growth of Virtual Real Estate Market

• With Facebook’s rebrand to Meta late last year, real estate sales on the “Big Four” metaverse platforms topped $500M last year, and sales in January topped $85M
• The virtual real estate market is expected to grow at a CAGR of 31% until 2028

Recent Large Purchases

• $4.3M USD — land purchased by Republic Realm for development of luxury islands in Sandbox
• $300,000 USD per luxury island that was developed by Republic Realm in Sandbox (95 islands purchased)
• $2.4M USD — land purchased by Tokens.com in Decentraland’s fashion district
• $450,000 USD — land purchased adjacent to Snoop Dogg’s mansion by an anonymous buyer in Sandbox

Overview of Restructuring

What is Financial Restructuring?

A restructuring (RX) is when a company seeks to make changes to its capital structure and operations in order to better meet its liabilities. A company in need of restructuring is a distressed, stressed, or bankrupt company.

• When a company is distressed and has difficulty meeting debt obligations, they will often hire advisors to advise the company on specific actions that the company can undertake to strengthen its balance sheet (Ex. M&A activity, Debt conversion to equity)

Credit advisory firms advise companies that are stressed, distressed, or bankrupt on how to restructure their capital structure. They advise creditors on the plan of reorganization.

• Example firms: Houlihan Lokey, Greenhill

Debt advisory firms also advise companies that are stressed, distressed, or bankrupt on how to restructure their capital structure, but they do so by advising management on how to strengthen their balance sheet.

What is Financial Distress?

Financial distress is a company’s inability to meet debt obligations.

• Insolvency: Total liabilities are greater than the fair value of assets
• Default: Borrower fails to honor a part of its agreement with creditors (Ex. principle repayment, interest payment)

What Causes Financial Distress?

There are several factors that could lead to financial distress, including poor management of debt obligations and cash flow, legal/political events, one-time expenses (fire, hurricanes), deteriorating company/industry (retail, coal), or leveraged buyouts went wrong.

How to Identify Underpriced Assets

“Fallen Angels” are companies that have been downgraded from investment-grade credit to junk status. Since equity holders are last in line to get paid, distressed companies often experience a drastic decrease in their share price. Some qualities of such companies are debt trading below par value, covenant defaults, declining cash flows, stretching working capital, limits to liquidity (credit facility re-determinations), and management announcements.

What is a Capital Structure?

The capital structure relates to the liabilities & equities side of the balance sheet. It is the order in which you are repaid:

1. Senior First-Lien Loan/Debt
2. Senior Second-Lien Loan/Debt
3. Unsecured Debt & Other Unsecured Obligations
4. Subordinate Debt / Bonds
5. Convertible Debt
6. Preferred Stock
7. Common Stock

The Absolute Priority Rule says that the most senior claim is paid out 100% prior to other claims receiving any redemptions. Senior claims are likely still impaired emerging from Chapter 11 despite junior claims receiving any distributions.

Methods to Pursue a Restructuring

The goal of a restructuring is to salvage value for creditors. There are several methods to pursue this.

1. In-Court Restructuring: Includes Chapter 7 (liquidation) and Chapter 11 (remain a going concern).
2. Out of Court Restructuring: 100% of stakeholders must approve the plan of reorganization (rare because of the holdout problem).
3. Distressed M&A: Distressed company seeks a strategic buyer or financial sponsor. A lot of money can be earned in this field (high risk, high reward).

Anatomy of a Restructuring: Holdout Problem

As a company in financial distress cannot pay back 100% of its credit obligations, every creditor must agree to less-than-ideal terms. The holdout problem occurs when select creditors hold out and wait to see if other parties will agree to a less-than-ideal arrangement and take a financial hit, thereby delaying the restructuring process.

Restructuring Case Study

Barren Wuffett Limited: A Story of Distress

Situation: Barren Wuffett Limited makes $100 a year in EBITDA; it takes out $500 in loans with 10% interest and thinks it can double EBITDA next year. Due to poor leadership under CEO Barren Wuffett, EBITDA actually drops to $70. $50 also goes to service interest and the company strains for cash flow. The lenders are concerned because the leverage ratio is now at over 7 times EBITDA, a restructuring ensues…

Solution:

Barren Wuffett Limited hires Sommers & Co. to advise the company on restructuring the company’s bloated capital structure.

As the company can still generate positive EBITDA, Sommers & Co. advises the company to remain as a going concern and pursue a Chapter 11 bankruptcy.

Sommers & Co. advises Barren Wuffett Limited to propose the following restructuring plan to creditors:

• Extend maturities — 10% notes due in 2021 become 10% notes due in 2024 = no immediate principle repayment due
• Modify interest rates — 10% notes become 12% PIK notes and the company does not have to pay interest for the first year
• Cut principal value — $500 in notes becomes $300 in notes
• Amend the management compensation plan to align interests

For accepting the plan of reorganization, the creditors receive some compensation

• Creditors get equity in exchange for decreasing the principal value of their debt from $500 to $300, creditors also get 100% of the post-petition equity in Barren Wuffett Limited
• Current equity holders receive nothing and experience a complete loss
• Creditor gets Barren Wuffett Limited to agree to more stringent covenants
• Company agrees to not raise any more debt in the future (incurrence covenant)

Conclusion: Barren Wuffett Limited was able to restructure its balance sheet, enabling the company to meet debt obligations going forward.

Other Restructuring Terms & Resources

Incurrence vs Maintenance Covenants:

• Covenants are controls placed in the lending agreement that define what the borrower is allowed & not allowed to do with their debt
• Incurrence — takes effect if the borrower is taking a specified action. They prevent the borrower from pursuing certain actions (ie. No new debt can be taken on unless total debt / EBITDA remains below 5.0x)
• Maintenance — the borrower must maintain a certain level of performance (ie. Interest coverage ratio of at least 3.0x) or risk defaulting
• Forbearance Agreement — Creditors can waive covenants for a period of time (usually 30 days). If the debtor is able to meet covenants by the end of the period then the debtor does not default on its debt obligations

Seniority:

• The order to which a lender gets paid — a lender subordinated to another lender must wait until the senior lender get fully paid before they can get a single penny
• Contractual Subordination — “I am senior to you because you agreed to it in the agreement”
• Structural Subordination — “I am automatically senior to you because of the way the company is set up”

Distressed Opportunities

How investment opportunities arise amid a restructuring:

Lack of Disclosed Information

• Even public companies do not have to disclose details on their lender negotiations, restructuring plans, etc… No one except their current lenders and investment bankers knows what’s really going on in this business
• Prospective investors are entering with a lot of uncertainty

Bank / Fund Regulations

• Many funds/banks do not have the ability to hold securities of a bankrupt company
• This may force the fund/bank to sell the security at a price below the security’s intrinsic value

Investors Create Value

• Your returns are tightly linked with the actions you plan to take and the expertise you possess in these complex situations
• Many distressed funds invest in distressed debt with the intention of converting the debt to equity in the reorganized entity and turning the company into a profitable company

*Although preferred, distressed debt investors do not need to achieve a 100% recovery on their debt securities to realize large returns. An investor that purchases debt for 30 cents on the dollar and receives only 60 cents on the dollar still doubles their money!

Careers in Restructuring

There are many different careers that concern distressed companies.

1. Restructuring Investment Banking: Advising & structuring financing and acquisition deals with distressed companies & investors
2. Distressed Private Equity: Investing in distressed situations with the intent of operating the business after bankruptcy
3. Distressed Hedge Funds: Investing in distressed situations by taking advantage of price dislocations
4. Restructuring Consulting: Helping distressed companies turn around their operations

Restructuring Resources

• Books: Houlihan Lokey’s Case Study (The Troubled Company), The Vulture Investors — Hilary Rosenberg, Distressed Debt Analysis — Stephen G. Moyer, Distress Investing — Fernando Diz and Martin J. Whitman
• Newsletter: PETITION — Curated Restructuring News
• Other News Sources: Reorg, Debtwire