THE WORLD BANK
Corporate Restructuring: International Best Practices
Washington, D.C.
March 22 – 24, 2004
Workshop : Financial Restructuring - Techniques and Negotiating Dynamics
Alan D. Fragen
The purpose of this workshop is to identify and discuss the principal balance sheet
restructuring techniques employed to resolve financial distress. More specifically, we
will discuss debt-for-debt exchanges, debt-for-equity exchanges and debt-for-cash tender
offers at below par value. Each of these techniques is an important arrow in the quiver of
the financial restructuring banker; they all have their time and place. To understand
which is most appropriate, one must investigate the causes of the financial distress and
the extent of the distress. A restructuring advisor must also have an appreciation for the
goals of the parties holding claims against the distressed enterprise.
This workshop is structured as a series of examples of each of these techniques. For each
type of exchange, a hypothetical example that illustrates the mechanics of a particular
transaction will be presented first. This will be followed by a case study that walks
through the specifics of a market transaction that utilized the particular technique. The
case studies will also explore some of the fundamental economic analyses that underpin
the negotiating dynamics of a restructuring transaction.
To a restructuring practitioner, a business enterprise is often categorized as either a “good
or distressed” company with either a “good or problem” balance sheet. In this very
simplified view, a “good” company produces positive cash flow before debt service (i.e.,
a company with positive free cash flow margins); a distressed company consumes cash to
maintain its operations. A “good” balance sheet is one where a company’s debt service
obligations (a company’s scheduled payments of interest and principal on outstanding
funded debt obligations) can be met by the free cash flow (“FCF”) generated by the

Managing Director, Houlihan Lokey Howard & Zukin. Particular thanks to my colleague James Zukin
for his valuable perspectives and to Christopher Wilson, Alya Hidayatallah and Christian Digemose for
their material assistance in preparing this article.
Page 1
company.1 The greater the cushion, measured by the ratio of FCF to debt service, the
“better” the balance sheet.
The following diagram illustrates the simplified view of the restructuring practitioner.
Companies to the right of the Y-axis generate positive free cash flow from operations;
companies to the left consume cash to either build or maintain a business.
A
Good Balance Sheet
1.0x
Problem Balance Sheet
Good Company
Distressed Company
FCF / Debt Service
The Restructuring Practitioner’s
Evaluation of a Business Enterprise
B
(0,0)
30%
FCF Margin
C
In the diagram above, Sector A includes “good” companies with “good,” or appropriatesized, balance sheets. In general, these enterprises are not restructuring candidates. A
restructuring indicates some element of distress; it is a forced event created by the breach
of one or more incomplete financial contracts. Because companies in Sector A are free
cash flow positive after debt service, the owners of the company either have no need to
re-profile the company’s debt obligations or have some measure of flexibility (measured
as the time before the enterprise becomes liquidity constrained) to refinance the
company’s outstanding debt obligations without completely compromising their equity
ownership.
1
This analytical perspective uses a measure of cash flow from operations to assess the sustainability of
balance sheet leverage. In reality, a company also has some level of access to capital markets that has to be
considered. A more accurate assessment of balance sheet sustainability would compare free cash flow
from operations to interest expense, and would look at the separate issue of debt maturities in the context of
the prevailing conditions of the relevant capital markets.
Page 2
Sector B contains “good” companies with “problem” balance sheets. These enterprises
generate positive cash flow from operations, but simply cannot afford their debt service
obligations. If the situation persists, a Sector B company will be starved for capital and
enter what has been identified as a “cycle of distress.” In general, the cycle of distress is
caused by owners/managers that seek to avoid a default at nearly any cost. While
extreme, this behavior is entirely rational if the presumed cost of default is a complete
disenfranchisement of such ownership rights. The cycle begins with a period of servicing
debt with capital that should be invested internally to maintain the productive asset base.
Over time, the under-investment will be manifest. Margins will erode, suppliers will be
stretched and generally the reputation and performance of the enterprise will degrade.
If unchecked, this distress will drive an enterprise from Sector B into Sector C. As we
will see, Sector B contains “going concern” enterprises, with both tangible and intangible
value. Sector C contains marginal enterprises, where the “cost” of maintaining the “going
concern” value (i.e., funding the negative cash flow from operations) rapidly consumes
the underlying asset (or liquidation) value.2 The transition from Sector B to Sector C is
value-destroying (at a minimum, all intangible value is lost); restructuring regimes that
count preservation and maximization of economic value as a top priority would do well
to create incentives to avoid these situations.
Companies in Sector B are good restructuring candidates. By definition, these enterprises
are free cash flow positive; they employ fixed assets and human resources in a manner
that generates a positive return. Before considering the capital structure, these enterprises
“add value” to the overall economy. Preserving these “good” companies as going
concerns through either a stand-alone reorganization or a “going concern” sale should be
part of any national policy that seeks to maximize the general economic welfare. Even if
the reorganization creates foreign equity ownership, it would still maximize the
“resident” value by preserving a host of benefits including, among others, demand for
domestic jobs and services (e.g., facilities, communications, etc.).
A stand-alone reorganization is basically a re-construction of the “problem” balance sheet
of a “good” company. A balance sheet becomes a “problem” balance sheet when the
value-generating enterprise cannot meet its contractual payments of principal and
interest. In this circumstance, the balance sheet (the mix of debt and equity capital) needs
adjustment to reflect the firm’s ability to generate FCF. To re-construct the balance sheet
(i.e., to change the mix of debt and equity), a restructuring banker would employ a
technique generally known as an exchange offer. Generically, an exchange offer is an
offer to exchange an existing claim against a company for some other consideration. In a
debt-for-debt exchange, old claims against a company are settled for new debt securities.
In a debt-for-equity exchange, old claims against a company are settled for an ownership
2
This is an oversimplification. In fact, almost every business begins as a cash flow negative proposition.
In successful ventures, capital is raised and invested in an aggregation of resources that produces profits (a
return on the invested capital). If a company is in this start-up phase, it would also fall into Sector C. After
all, it is free cash flow negative. But the start-up phase is usually the province of equity investors. Of
course, in the late 1990’s, the telecom sector provided several notable exceptions to this investing “rule.”
Page 3
interest. And in a debt-for-cash exchange (really a “tender offer”), the company uses
cash (either existing cash or newly invested capital) to retire debt obligations at a
discount to their claim amount.
The following section explores each of these techniques, first through a hypothetical case
study and then through an analysis of a recent market transaction. The hypothetical will
begin with a section discussing the past and projected performance of the subject
company, and an analysis of its balance sheet liabilities. After identifying the reasons for
the contractual breach, we will discuss the proposed exchange-based solution. During this
analysis, we expect to identify several of the issues that shape the negotiating dynamic
between obligors, creditors and other parties-in-interest that drives these transactions.
The market example of each type of exchange transaction will also set background and
explore some of the issues that affected the negotiated outcome.
Debt-for-Debt Exchange
Any restructuring transaction must begin with an analysis of the subject company. For
our case study, we created OpCo, a company facing a significant debt repayment.
Situational Overview
OpCo is engaged in a reasonably asset-intensive manufacturing business that requires
regular re-investment in order to maintain its asset base. As the historic Income
Statement and Cash Flow Statement below indicate, OpCo has produced positive but
declining earnings and cash flows from operations. These results are not inconsistent
with a mid-sized manufacturing concern experiencing pricing pressure that may be the
result of any number of factors including, potentially, increased competition from larger
scale enterprises, a concentration or reduction in its customer base, increased raw
material costs, or, if OpCo is an exporter, foreign currency issues. The pressure on the
revenue line has caused under-absorption of fixed costs, and margins have eroded.
OpCo
Historic & Projected Income Statement
($ in millions)
Actual Results
2000A
2001A
2002A
Revenues
$
% Growth
Cost of Sales
Gross Profit
% Margin
SG&A
Operating Income
Interest Expense
Secured Term Loan
10.5% Senior Notes due 2003
New Senior Notes
Interest Income
Pre-tax Income
Less: Taxes
40.0%
NET INCOME
$
300.0
$
291.0
$
279.4
Fiscal Year Ended December 31,
Estimated
2003
2004
$
273.9
$
280.7
Projected Results
2005
2006
$
291.9
$
303.6
2007
$
315.8
5.0%
-3.0%
-4.0%
-2.0%
2.5%
4.0%
4.0%
4.0%
190.5
109.5
189.2
101.9
187.2
92.2
186.2
87.6
186.7
94.0
192.7
99.3
198.9
104.7
205.2
110.5
36.5%
35.0%
33.0%
32.0%
33.5%
34.0%
34.5%
35.0%
69.0
40.5
71.8
30.1
74.6
17.6
73.1
14.5
73.1
20.9
74.6
24.7
76.1
28.7
77.6
32.9
(3.4)
(10.5)
0.2
3.9
(1.6)
2.3
(2.9)
(10.5)
0.2
1.2
(0.5)
0.7
(4.1)
(10.5)
0.0
26.0
(10.4)
15.6 $
(3.7)
(10.5)
0.2
16.0
(6.4)
9.6 $
Page 4
$
$
(2.2)
(12.0)
0.1
6.7
(2.7)
4.0 $
(0.9)
(12.0)
(0.5)
11.2
(4.5)
6.7 $
(12.0)
(2.7)
13.9
(5.6)
8.3 $
(12.0)
(1.9)
19.0
(7.6)
11.4
OpCo’s projected results indicate a sustained period of slow growth and improving gross
profit margins. To re-build operating income, management made modest, but important,
cuts to S,G&A expenses during 2003, and intend to grow S,G&A costs at a rate less than
the rate of sales growth. All in all, OpCo’s operating projections are assumed to be
reasonable relative to the existing and expected operating environment, and are not
inconsistent with historic results.
OpCo
Historic & Projected Cash Flow Statement
($ in millions)
<
Cash from Operations:
Net Income
Actual Results
2000A
2001A
2002A
$
15.6
$
9.6
$
2.3
Fiscal Year Ended December 31,
>
Estimated
2003
2004
$
0.7
$
4.0
Projected Results
2005
2006
$
6.7
$
8.3
2007
$
11.4
Adjustments:
Depreciation & Amortization
Working Capital, net
Net Cash from Operations
14.6
(1.1)
29.1
14.7
0.7
25.0
14.8
0.9
18.0
14.9
0.4
16.0
14.8
(0.5)
18.4
14.8
(0.8)
20.7
14.7
(0.9)
22.2
14.7
(0.9)
25.2
Cash from Investing Activities:
Capital Expenditures
Net Cash from Investing Activities
15.8
15.8
15.9
15.9
16.0
16.0
14.3
14.3
14.2
14.2
14.2
14.2
14.1
14.1
14.1
14.1
After-tax Cash from Operations
13.3
9.1
2.0
1.8
4.1
6.5
8.1
11.1
Cash from Financing Activities:
Repayment of Secured Term Loan
Repayment of 10.5% Senior Notes due 2003
Proceeds from New Notes
Repayment of New Notes
Net Cash from Financing Activities
(4.9)
(4.9)
(4.9)
(4.9)
(6.5)
(6.5)
(8.1)
(100.0)
100.0
(8.1)
(13.0)
(13.0)
(27.6)
(27.6)
-
-
Increase in Cash
Cash at Beginning of Period
Cash at End of Period
8.5
2.0
10.5
4.2
10.5
14.7
(4.5)
14.7
10.2
(6.4)
10.2
3.8
$
$
$
$
$
(8.9)
3.8
(5.0) $
(21.1)
(5.0)
(26.2) $
8.1
(26.2)
(18.1) $
11.1
(18.1)
(7.0)
In each of the first two years, OpCo generated enough cash from its operations to meet
contractual interest and principal payments, and accumulated enough extra cash over the
time frame to meet its most recent secured debt principal payment. Importantly, OpCo
has continued to make the capital investments necessary to maintain the earnings power
of its business.
Page 5
OpCo
Historic & Projected Balance Sheet
($ in millions)
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
$
$
LIABILITIES & SHAREHOLDERS' EQUITY
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2003
New Notes
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
2.0
50.9
175.0
227.9
$
$
18.0
11.4
65.0
100.0
194.4
$
1.0
32.4
227.9
Fiscal Year Ended December 31,
Estimated
2003
2004
Actual Results
2000A
2001A
1999a
10.5
53.4
176.2
240.1
$
$
18.9
12.0
60.1
100.0
191.0
$
1.0
48.0
240.1
14.7
51.8
177.3
243.9
$
$
18.3
11.6
55.3
100.0
185.2
$
1.0
57.6
243.9
Projected Results
2005
2006
2002A
10.2
49.7
178.5
238.5
$
$
17.6
11.2
48.8
100.0
177.5
$
1.0
60.0
238.5
3.8
48.8
177.9
230.5
$
$
17.3
11.0
40.6
100.0
168.8
$
1.0
60.7
230.5
$
2007
(5.0) $
50.0
177.3
222.3 $
(26.2) $
52.0
176.7
202.6 $
(18.1) $
54.1
176.2
212.1 $
(7.0)
56.2
175.6
224.8
17.7
11.2
27.6
100.0
156.5
18.4
11.7
100.0
130.1
19.1
12.1
100.0
131.3
19.9
12.6
100.0
132.5
1.0
64.8
222.3
$
1.0
71.5
202.6
$
1.0
79.8
212.1
$
1.0
91.2
224.8
A close inspection of OpCo’s estimated balance sheet reveals the nature of its problems.
As indicated, OpCo has two types of debt outstanding: traditional secured bank debt (in
the form of a term loan) and a senior unsecured bond issue. As is common, the “banktype” debt is a senior secured obligation of OpCo that requires regular payments of both
interest and principal. It is likely to be secured by most, if not all, of OpCo’s assets. If
OpCo were domiciled in a sophisticated legal jurisdiction, it would also be common for
the bank debt contract to name all of OpCo’s primary operating subsidiaries as either coborrowers or guarantors.
OpCo also has outstanding a $100 million issue of 10.5% Senior Notes due 2003 (the
“2003 Notes”). These notes pay interest at a relatively high rate; in OpCo’s financial
results, the annual interest rate on the secured bank debt and on the 2003 notes is 6.5%
and 10.5%, respectively. Contrary to the bank debt that was structured with periodic (and
escalating) payments of principal, the 2003 Notes have a “bullet” maturity. In other
words, the entire contract comes due on a single date. Bullet maturity or other back-end
weighted amortization schedules are not uncommon. These contract structures implicitly
incorporate the assumption that, as long as a borrower maintains its creditworthiness,
market-priced capital will be available to refinance the maturing obligation.
OpCo was aware of the maturity and, as the estimated results indicate, expected to refinance the obligation with a new series of unsecured notes. Prior to year-end, OpCo
hired an investment banker to market and arrange the debt placement. Because of the
generally difficult capital market conditions, OpCo budgeted a significant increase in
financing costs. Unfortunately, despite offering a very attractive interest rate, the
investment banker was unable to arrange the new financing. On December 31, 2003,
OpCo did not have the cash to pay the maturing 2003 Notes and declared a payment
default. With no compelling reason to make the $5.3 million semi-annual interest
payment that was also due on the 2003 Notes, OpCo decided to retain the cash and
preserve its operating flexibility. As of today, January 1, 2004, OpCo is in payment
default on its 2003 Notes and has the following actual balance sheet:
Page 6
OpCo
Estimated vs. Actual Balance Sheet as of 12/31/03
($ in millions)
Estimated
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
$
LIABILITIES & SHAREHOLDERS' EQUITY
Accrued Interest
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2003
New Notes
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
3.8
48.8
177.9
230.5
$
0.0
17.3
11.0
40.6
0.0
100.0
168.8
$
1.0
60.7
230.5
Actual
$
$
9.1
48.8
177.9
235.8
$
5.3
17.3
11.0
40.6
100.0
0.0
174.1
$
1.0
60.7
235.8
As noted earlier, a restructuring is a forced event. It is caused when an obligor to a
contract cannot perform. In this case, OpCo is in breach of its bond indenture contract
because of a failure to pay the principal and interest when it became due on December
31, 2003. OpCo could not repay its maturing bond debt because the underlying capital
markets did not cooperate. Capital markets are fickle and as the old market adage goes liquidity is a funny thing, it’s never there when you really need it. It may be that credit
markets are especially tight (like in early 1990 and, more recently, in late 2001 through
2002). Or it may be that credit markets are open, but just not to more highly leveraged
companies. For whatever reason, the financing market is closed to OpCo, and the
situation requires a balance sheet restructuring (versus a refinancing).
After terminating the investment banker that promised the refinancing, OpCo hires a
restructuring banker, who walks in and, after a thorough analysis, declares, “OpCo is a
good company with a problem balance sheet.”
Situational Assessment
Actually, once engaged, a restructuring banker will first take stock of the situation.
Assuming that all debts other than the financial debt are being paid on a timely basis (i.e.,
assuming the first focus of the restructuring is NOT on obtaining the liquidity necessary
to fund the immediate operations), the restructuring banker will attempt to determine the
value of the company’s operations and the priority and amount of the various claims
against this value. While it is clear from the hypothetical that OpCo cannot pay its bills
as they become due, it is not clear that the value of its liabilities exceed the value of its
assets. OpCo may be liquidity constrained, but it is not clear that it is “balance sheet”
insolvent.
In our case, we will assume that the restructuring banker completes a preliminary
valuation analysis of OpCo using four techniques: a market-multiples approach, a
Page 7
transaction-multiples approach, a discounted cash flow approach and a liquidation
approach. Based on these analyses3, the professional determines that, on a going concern
basis, OpCo is likely worth between $160 million and $195 million.
OpCo
OpCo Valuation
($ in millions)
Total Enterprise Value
Market-Multiples Approach
$ 165.0
-- $ 209.0
Transaction-Multiples Approach
160.0
--
195.0
Discounted Cash Flow Analysis
180.0
--
220.0
Implied Total Enterprise Value of OpCo
(1)
$ 160.0 -- $ 195.0
(1) On a controlling interest basis.
Given that OpCo has about $136.8 million of outstanding funded debt obligations, net of
any cash it holds, the restructuring banker concludes that OpCo is likely “balance sheet”
solvent. Enough value exists to satisfy the debt obligations in full, and leave value left
over for equity. A cursory review of the liabilities of OpCo reveals the following claims:
OpCo
Analysis of Liabilities as of 12/31/03
($ in millions)
Funded Debt Obligations
Secured Term Loan
10.5% Senior Notes due 2003
Accrued Interest on 10.5% Senior Notes due 2003
Total Funded Debt Obligations
$
$
40.6
100.0
5.3
145.9
Working Capital Liabilities
Accounts Payable
Accrued Expenses
Total Working Capital Liabilities
$
17.3
11.0
28.2
TOTAL LIABILITIES
$
174.1
As indicated, OpCo has about $145.9 million of funded debt obligations and another
$28.2 million of working capital liabilities. As noted above, OpCo is not under-invested
in working capital. In the event OpCo restructures and continues as a going concern, all
of the existing working capital liabilities will be settled and renewed in the ordinary
3
See Appendix for an explanation of the valuation analysis.
Page 8
course of business. Consequently, a “going concern” restructuring plan only needs to
consider the funded debt claims and equity interests4.
After determining the overall value of the enterprise and the amount and priority of the
claims against the enterprise, the restructuring banker is left to determine how best to
satisfy the claims. Other than cash, which is not available in this situation (other than
surplus cash on the balance sheet), a company has two types of consideration to offer,
debt and equity. The restructuring banker will perform several analyses designed to
determine the debt capacity of the company, that is, the amount of par-value debt the
enterprise could reasonably support. This analysis will include, among other things, a
review of the appropriate cost of par-value debt securities (as reflected in the prices and
indicated yields of the publicly-traded debt securities of comparable companies) and a
survey to determine the “average” capital structure in the subject industry (i.e., the
average mix of debt and equity capital employed by industry participants). Generally, the
point of the debt capacity analysis is to determine both the “optimal” and the maximum
amount of par-value debt that an enterprise can support. The debt capacity analysis
informs the restructuring banker as to the quantity of debt, and therefore the quantity of
equity available as consideration to satisfy the firm’s obligations. As an aside, many of
the market-based components of the debt capacity analysis are a subset of the research
that informs the analysis of the subject firm’s weighted average cost of capital, a critical
input into the discounted cash flow valuation technique referred to above.
OpCo
Debt Capacity Analysis
($ in millions)
Debt Capacity Target Ratio 1.5x
Debt Capacity Target Ratio 1.7x
EBITDA less CapEx
less Investment in Working Capital
EBITDA less CapEx
less Investment in Working Capital
Average Pretax
Cost of Debt Capital
$ 15.0
$ 20.0
$ 25.0
$ 30.0
$ 15.0
$ 20.0
$ 25.0
$ 30.0
10.0%
11.0%
12.0%
13.0%
$ 100.0
90.9
83.3
76.9
$ 133.3
121.2
111.1
102.6
$ 166.7
151.5
138.9
128.2
$ 200.0
181.8
166.7
153.8
$
$ 117.6
107.0
98.0
90.5
$ 147.1
133.7
122.5
113.1
$ 176.5
160.4
147.1
135.7
88.2
80.2
73.5
67.9
The above analysis estimates debt capacity based on three important operating statistics,
EBITDA, the maintenance level of capital expenditures and the maintenance level of
4
As discussed in the valuation Appendix, a valuation of OpCo (or any company) is largely based on
observed public market trading and transaction multiples for companies deemed comparable to the subject
company. Generally, these comparable companies are “healthy” public companies with adequate
investment in working capital. The other prominent valuation technique, a discounted cash flow analysis,
also assumes adequate investment in working capital. The assessment of OpCo’s liabilities assumes that,
like the comparable public companies, OpCo has adequate working capital. If, for some reason, OpCo is
under-invested in working capital (if, for example, OpCo had stretched its payables to vendors), then
OpCo’s “funded” liabilities would have to be expanded to account for any investment necessary to
“normalize” its working capital position. In a restructuring, if certain suppliers are critical to ongoing
operations, “debt” owed to such suppliers is often afforded priority beyond its legal entitlement.
Page 9
investment in working capital, and on the aforementioned market analysis of the industry
average pre-tax cost of debt capital. To estimate debt capacity, the above analysis sets a
target ratio of [(EBITDA - maintenance capital expenditures - maintenance levels of
investment in working capital) / interest expense] and estimates debt capacity based on
assumptions for operating performance and the average pre-tax cost of debt capital. Once
the target ratio is set, the analysis is sensitized across a range for the pre-tax cost of debt
capital and is further sensitized to incorporate a somber view of operating performance
(estimating EBITDA at the bottom of the range and maintenance expenditure levels at the
high end of the range) and more optimistic views. The analysis above also investigates
the results of selecting different ratio targets. Based on the aforementioned analysis, the
restructuring banker determines that OpCo can support between $100 million and $140
million of par-value debt.
Please note that the above analysis is but one way to estimate the debt capacity of a firm.
However, most of these methods are similar in that they estimate debt capacity based on a
firm’s ability to generate cash flow (the numerator of our target ratio) to cover the current
cost of its debt (namely, the estimated interest expense, the denominator of our ratio).
Also note that the above analysis is highly subjective. To begin with, the analyst must
come to some conclusion about the appropriate range of earnings. Next, an assessment
must be made of annual maintenance expenditures. While the results of our subject
company are reasonably consistent, and thus susceptible to simple techniques such as
averaging over a several year period, in the real-world, restructuring companies usually
exhibit more variability. In practice, estimating the appropriate range of annual
maintenance expenditures is rarely a simple exercise. Now the analyst must choose the
“appropriate” range of target ratios. This will be informed by, among other things,
industry averages. Note that even the most conservative target ratio in the above debt
capacity analysis would not generate enough free cash flow from operations after interest
(not to mention cash taxes) to fully repay the implied level of debt in any reasonable time
frame.5 In other words, to fully repay the target level of debt when it is likely to become
due, the analyst is assuming that the firm has access to the capital markets for a
refinancing at or before the time it is required. The point here is that the debt capacity
analysis and the valuation analysis are both subjective applications of objective tools; the
quality of the analysis is generally a direct function of the quality and experience of the
analyst.
At this point in the hypothetical, the restructuring banker has completed a valuation
analysis, an analysis of existing liabilities, and a debt capacity analysis. Armed with this
information, the restructuring banker can now turn to the task of assembling an
appropriate capital structure, and allocating the elements of that capital structure to the
5
Assuming zero cash taxes and the application of 100% of free cash flow from operations after interest
expense to debt repayment, the formula for years to debt repayment, i.e., Debt divided by Free Cash Flow
from Operations After Interest, can be expressed in terms of 2 variables: r, the target ratio and i, the
estimated average pre-tax cost of debt capital. Once simplified, years to debt repayment equals [((1/r) / i) /
1 – (1/r))]. According to this formula, assuming a target ratio of 2.0 x and an average pre-tax cost of debt
capital of 10.0%, it would take a company 10 years to repay the maximum amount of par-value debt it
could support.
Page 10
various claimants and interest holders. In the case of OpCo, the total allocable value (i.e.,
the total value of the OpCo’s debt and equity securities) is between $160 million and
$195 million, plus any cash on hand. Of this amount, the restructuring banker estimates
that he can distribute between $100 million and $140 million in the form of par-value
debt securities. The residual amount, between $29.1 million and $104.1 million6
depending on the pro forma capital structure and one’s view of valuation, is the value of
OpCo’s restructured equity. As indicated in the analysis of existing liabilities, as of the
restructuring date, there are three relevant claims against or interests in OpCo: a $40.6
million secured debt claim, a $105.3 million unsecured debt claim (which includes $5.3
million of accrued interest), and 100% of the equity interest in OpCo. In the vernacular,
there are three “classes” of claims7 that need to be satisfied. The restructuring banker
now turns himself or herself to the task of allocating value based on legal entitlements.
The concept of legal entitlement, what a party should be due based on a contract claim
and the notion that some contract claims have priority over other claims by virtue of,
among other considerations, a security (or first priority) interest in a defined collateral
pool, contractual subordination, or legal structural priority, is a pre-requisite for the
development of any sort of capital markets. Consider a system where an owner cannot
enforce property rights to evict a non-performing tenant, or a lender is prevented from
seizing and selling collateral to repay a non-performing loan. In such a system,
possession counts for everything; derivative ownership interests, such as the deed to a
house or the mortgage that is secured by the deed are worthless. For our hypothetical, we
assume that legal entitlements are discernable and enforceable (a subject we will address
below). The secured debt has priority over the unsecured debt to the extent of its
collateral, and the unsecured debt has priority over the equity.
The Negotiating Dynamics
A restructuring negotiation is best thought of as a multi-party, zero-sum allocation of
value. The negotiation is a forced event (the obligor is in default or is very likely to
default in the immediate future), and assumes that if the parties cannot reach a consensual
arrangement, that a court-officiated process would commence. For our hypothetical, we
assume that the court process would lead, over time, to a rational result (i.e., the accurate
enforcement of valid legal entitlements). In this environment, the equity owners have the
most to lose, and therefore, the most to gain from a consensual resolution of events. We
will also add the real-world observation that companies in debt restructuring situations
seldom do “better” than they would outside of a restructuring. While certain
restructuring regimes give debtors the power to improve performance by, for example,
shedding burdensome contracts, over time, the “cloud of distress” will affect business
performance. Because of the uncertainty caused by a restructuring, customers will often
choose an alternative supplier or a firm’s most productive employees may look elsewhere
6
Includes $9.1 million of cash on hand.
7
Each of the three classes of claims discussed, secured debt claims, unsecured debt claims and equity
interests, has a “call on value”; the secured and unsecured claimants have a call on a fixed amount of value
and the equity holders have a call on all of the residual value. However, only the secured and unsecured
debt claims are fixed, liquidated claims. Because of its uncertain value, the equity “claim” is usually
referred to as an “interest”.
Page 11
for more job security. Whatever the manifestation, the uncertainty erodes value over
time relative to normal business operations. In a legal environment that recognizes and
enforces contractual legal entitlements, this propensity towards value erosion would
provide OpCo’s owners (i.e., the recipients of the residual value) with a strong incentive
to work quickly to preserve their remaining value. One of the principal roles of a valuemaximizing restructuring banker is to drive parties towards a conclusion and to minimize
value destruction.
As identified, the equity will be the beneficiary of any value left over after the
satisfaction of prior claims. Generally, to avoid ownership dilution, equity can do three
things to debt: it can repay (or refinance) the debt, it can cure past monetary defaults and
reinstate the debt, or it can replace it with a new debt instrument (effectively an “internal”
refinancing). With these non-dilutive options in mind8, the first claim to consider is the
$41 million of secured bank debt.
For our purposes, we will assume that the value of the underlying collateral exceeds the
amount of the outstanding obligation – the claim is “fully secured.” At this point, it is
important to remember that OpCo has been performing on its secured debt obligation;
this claim is only in default by virtue of the cross-default tied to the unsecured notes. In
theory, if OpCo’s equity owners and the unsecured creditors reach a consensual solution
to cure that default, then OpCo’s equity owners have the option of simply re-instating the
secured debt. On the other hand, the terms of the existing secured debt indicate
significant upcoming amortization payments. OpCo’s projections indicate that even if
the unsecured debt is resolved, and even if all excess cash flow is reserved for repaying
the secured debt, OpCo still will not accumulate enough cash to make the scheduled
amortization payments. In other words, reinstating the secured debt (and not seeking an
extension of maturity, for example) will cause OpCo to once again, rely on the external
capital markets to avoid default. Clearly though, the risk of not being able to refinance
the top third of the capital structure (with access to all of a firm’s collateral and priority
over unsecured debts) is much lower than the risk of not being able to refinance the junior
most debt capital.
After careful analysis, the equity owners inform the restructuring banker that they believe
that reinstating the secured debt is the optimal solution. Given the facts surrounding the
case, and based on the assumption that secured debt financing will be available in the
future to replace the maturing secured debt, the restructuring banker agrees with the
equity owners. The restructuring banker’s view is clearly supported by the debt capacity
and valuation analyses. And after all, why engage in a negotiation when one can be
avoided, or at least delayed. With this plan in mind for the secured creditors, the equity
owners and the restructuring banker now turn their attention to the unsecured creditors.
8
In the case of OpCo, the total allocable value, $160 million to $195 million of enterprise value plus cash
of approximately $9.1 million, exceeds the total secured and unsecured debt claims of $145.9 million. As a
result, both the secured and unsecured debt holders have an economic expectation of being paid in full, or
left unimpaired. Further, because the company has enough “debt capacity” to satisfy existing debt claims
in full with new debt claims, equity also expects to be left unimpaired (ie, equity does not expect to have
their ownership interest diluted).
Page 12
The negotiation with the unsecured creditors is a much more complicated affair. To fully
understand the negotiating dynamic, one must investigate the bankruptcy laws of the
relevant jurisdiction and assess the judicial process through which the laws are applied.
As noted by Stiglitz, among others, because bankruptcy law affects the likely outcome if a
dispute has to be resolved by the courts, bankruptcy law affects the outcome of the
bargaining process designed to avoid the uncertainty and delay of relying on courtmandated solutions.9 In general, jurisdictions that do not have the infrastructure or the
sophisticated and impartial judiciary necessary to administer a complicated set of
bankruptcy laws would do well to avoid the situation entirely and enact the simplest set
of laws possible.10
For this hypothetical, OpCo is assumed to be domiciled in a jurisdiction with laws that
recognize the rights of unsecured creditors to realize value ahead of equity holders.
However, the mechanism for attaining this result, a formal court proceeding, is an
uncertain process. Among other things, we will assume that the equity owners remain in
control of business decisions during the court proceeding unless and until the unsecured
creditor class can demonstrate that it is impaired on a value basis, but that the process for
establishing this state of affairs is time-consuming, expensive and, because valuation is
subjective, somewhat uncertain. Also, the filing of a court proceeding is assumed to limit
the claim of an unsecured creditor; after a bankruptcy petition is filed, unsecured claims
stop accruing interest. Recall also the economic proposition that, while this conflict is
playing out in court (and often in public), the overall value of the business is prone to
erosion. Based on the uncertain and costly court process and the attendant risks, the two
parties decide to attempt to negotiate a consensual solution to the default.
First, we will address the likely perspective of the equity owners in this negotiation. In
this type of negotiation, where equity is the junior claimant in a zero-sum allocation of
value, equity can best be thought of in terms of option theory. The equity owners have an
option of uncertain duration on 100% of the economic value of the enterprise above a
strike price. The strike price is equal to the level of debt; the duration is the time until the
date on which the equity owners become disenfranchised (i.e., after a lengthy court fight
and well after the actual date of payment default). As option theory indicates, equity
owners have every incentive to attempt to negotiate a reduction in the strike price and to
extend the duration of their option. Volatility, another important component of option
value, can also play a very important part in explaining the perspective and behavior of
the equity owner. To increase volatility, equity owners should dedicate scarce firm
resources to increasingly risky projects; the degree to which equity actually engages in
this type of behavior depends on whose value is at risk. For example, if the actual
enterprise value of the firm is at or near the value of the debt (i.e., the current value of the
option is approximately equal to the strike price and there is little “intrinsic” value to the
option) then equity is increasingly investing value that, in bankruptcy and on an “absolute
9
Stiglitz, Joseph E. 2001. “Bankruptcy Laws: Basic Economic Principles.”
10
For an example of such a simplified system, see Reforming Chapter 11: Building and International
Restructuring Model by Jeffrey I. Werbalowsky, Journal of Bankruptcy Law and Practice (vol. 8, no. 6).
Page 13
priority” basis, belongs to unsecured creditors. There is little incentive to avoid risk;
100% of the benefits of a successful bet will accrue to equity and the risk of loss lies
largely with unsecured creditors.
But in our current example, OpCo is balance sheet solvent. At the current valuation
range, there is thought to be between $23.2 million and $58.2 million of equity value. In
this situation, equity has a lot (of intrinsic value) to lose and will conduct itself
accordingly. In this situation, equity owners will judge that they have significant
duration to their option and that value-maximizing behavior lies in making investments
that enhance intrinsic value without jeopardizing duration (there will be far fewer “bet the
ranch”-type of investments). In fact, because equity has value to lose and because a
lengthy and contentious in-court restructuring process will tend to erode value, the equity
owners in our hypothetical have significant and quantifiable value to gain (or really,
avoid losing) by completing a successful out-of-court negotiation with the unsecured
creditors.
From the perspective of OpCo’s unsecured creditors, the world is largely unjust. They
have a legitimate legal call on value, but forcing the issue through a bankruptcy is likely
to cost them present value. If they negotiate today and receive full or near full value in
new, performing securities they avoid a protracted fight which, at best, yields them a full
recovery of their current claim sometime in the future. Because they do not accrue
interest in our hypothetical bankruptcy regime, the unsecured creditors also have positive
incentives to avoid a failed negotiation. As a further incentive, the unsecured creditors
are aware that the cushion they enjoy today (the current difference between OpCo’s total
enterprise value and the level of debt) will erode in a contentious proceeding and, at some
point in time, the erosion will jeopardize the full recovery of their claim.
To initiate the negotiation, the equity owners turn to the restructuring banker to design a
“fair” restructuring proposal. After meeting with all parties, the restructuring banker
designs an offer that meets the principal goal of equity (avoiding or minimizing
ownership dilution) and the principal goal of debt (recovering “full value”, preferably in
debt securities). Based on the prior debt capacity analysis, the restructuring banker
determines that the debt holders’ preference for a full recovery in debt securities can be
achieved without over-leveraging the enterprise.
After careful consideration, the restructuring banker suggests an offer to exchange each
$1000 of 2003 Notes for $1030 of new 11.5% Notes due 2010; accrued interest would be
paid in new notes. In the view of the restructuring banker and based on market
comparables, the increased interest rate should create a security with a market value at or
near par value. The slight (3.0%) premium to par is justified to the equity owners as the
“cost of the internal refinancing” and likely less than the value that would be lost to a
non-consensual process. Also, the increased duration of the proposed debt security
should give the equity owners plenty of time to re-finance this obligation. After internal
debate, the restructuring plan is approved by OpCo’s equity owners and the restructuring
banker is tasked with the assignment of “selling” equity’s preferred restructuring plan to
the holders of OpCo’s 2003 Notes.
Page 14
To begin with, the restructuring banker must organize and coordinate discussions with
the holders of the 2003 Notes. Often times, this organizational effort can be quite
difficult. Because of the sophistication and liquidity of today’s capital markets,
unsecured debt is no longer concentrated in the hands of a small number of insurance
companies, banks and other financial institutions. Rather, these institutions continue to
own unsecured debt, but holder diversity has expanded to include everyone from
structured vehicles (e.g., CDOs and CBOs) to mutual funds, from unregulated hedge
funds dedicated to distressed investing to the “mom and pop” retail holders who invested
in “safe bonds” to fund their retirements. The problem of holder dispersion and diversity
is significant; when holders of similarly situated claims have different goals, reaching
consensus can be very challenging. There are also the two inter-related questions of
“What exactly constitutes a consensus?” and “Assuming consensus is reached, how does
one treat a non-consenting holder?”
For our first hypothetical, we will set aside the complexities of inter-creditor dynamics
and assume that the entire $100 million issue of 2003 Notes was placed with a single
institution. With this simplified dynamic, the restructuring banker meets directly with the
institutional investor and presents him with a term sheet that describes the exchange
offer. The restructuring banker also reviews the prospects for the company, the value of
the proposed new debt security and the risks of a non-consensual process. The
institutional investor considers the offer, and considers the various options for a counterproposal.
Among other economic benefits, the institutional investor considers asking for: (1) a
percentage of the equity of OpCo, (2) more new notes for each old note, (3)
modifications to the proposed new note including a higher interest rate, a shorter
duration, a second security interest in the available collateral pool and a package of
operating covenants, and (4) accrued interest paid in cash versus new notes. The investor
also understands the acute sensitivity the owners have towards equity dilution and that
the local bankruptcy regime treats secured creditors very differently than unsecured
creditors, particularly with regards to the accrual of interest during a court proceeding.
The investor is keen to avoid the situation “the next time around, if there is a next time
around.” With this in mind, the institutional investor makes a counter-proposal to
exchange each $1000 of 2003 Notes for $1070 of Escalating Rate Secured Notes due
2008; the interest rate on the new notes would begin at 11.5%, and increase 50 basis
points every six months. The new notes would be secured by all of OpCo’s assets. To
refinance the bank debt and provide liquidity, the investor proposes a carve-out for a $55
million first priority interest in the collateral pool. The investor indicates that, even after
paying accrued interest in cash, this amount provides OpCo with an additional $15
million of available liquidity. At this point in time, the “Bid” and the “Ask” in the
negotiation are summarized as follows:
Page 15
OpCo
Key Terms of Proposals
Equity Holders' Proposal
Security
Amount
Noteholder's Proposal
Accrued Interest
Term
Collateral
> 11.5% Unsecured Notes due 2010
> $1,030 for each $1,000 principal of 10.5% Senior Notes due
2003
> Paid in 11.5% Unsecured Notes
> 7 years
> None
Interest
> 11.5%, fixed and payable in cash
Amortization
> Bullet at maturity
> Escalating Rate Secured Notes due 2008
> $1,070 for each $1,000 principal of 10.5% Senior Notes due
2003
> Paid in cash
> 5 years
> Second security interest in all of OpCo's assets
> Carve-out for a $55.0 million first priority collateral interest
> 11.5%, through June 30, 2004, payable in cash
> Increases by 50 bps every six months thereafter
> Bullet at maturity
After much back and forth, the parties compromise on the following terms of an
exchange: for each $1000 of 2003 Notes, the holder will receive $1050 of Escalating
Rate Secured Notes due 2008 (the “New Notes”); outstanding accrued but unpaid interest
would be paid in cash. The New Notes have a security interest in all of OpCo’s assets;
the security interest includes a carve-out for a $65 million, first priority security interest
in the collateral pool to facilitate the refinancing of the bank debt and provide OpCo with
approximately $25 million of visible liquidity. The parties agree on an initial interest
rate of 11.5%, an initial interest rate period of 18 months and a 50 basis point increase in
rate every six months thereafter. The table below summarizes the negotiation between
OpCo’s owners and the institutional investor.
OpCo
Key Terms of Negotiated Restructuring Proposal
Accrued Interest
Term
Collateral
Equity Holders' Proposal
> 11.5% Unsecured Notes due 2010
> $1,030 for each $1,000 principal
amount of 10.5% Senior Notes due 2003
> Paid in 11.5% Unsecured Notes
> 7 years
> None
Interest
> 11.5%, fixed and payable in cash
Amortization
> Bullet at maturity
Security
Amount
Negotiated Terms
> Escalating Rate Secured Notes due 2008
> $1,050 for each $1,000 principal amount of
10.5% Senior Notes due 2003
> Paid in cash
> 5 years
> Second security interest in all of OpCo's assets
> Carve-out for a $65.0 million first priority
collateral interest
> 11.5% through June 30, 2005, payable in cash
> Interest rate increases by 50 bps every six
months thereafter
> Bullet at maturity
Noteholder's Proposal
> Escalating Rate Secured Notes due 2008
> $1,070 for each $1,000 principal amount of
10.5% Senior Notes due 2003
> Paid in cash
> 5 years
> Second security interest in all of OpCo's assets
> Carve-out for a $55.0 million first priority
collateral interest
> 11.5% through June 30, 2004, payable in cash
> Interest rate increases by 50 bps every six
months thereafter
> Bullet at maturity
With an agreement in place, the parties move to document and implement the
restructuring transaction. In this particular circumstance, the old notes are being
exchanged for new notes – it is a simple debt-for-debt exchange that achieves the primary
goals of the equity (minimization of ownership dilution, improved maturity profile) and
the primary goals of the debt (full recovery of value, improved positioning for any future
default). Because only one party holds old notes, the exchange transaction is greatly
simplified. The following table indicates OpCo’s pre-restructuring balance sheet, the
accounting adjustments for the exchange transaction, and OpCo’s balance sheet pro
forma for the exchange.
Page 16
OpCo
Restructured Balance Sheet
($ in millions)
Pre-Restructuring
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
LIABILITIES & SHAREHOLDERS' EQUITY
Accrued Interest
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2003
New Notes
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
Adjustments
9.1
48.8
177.9
235.8
$
$
$
5.3
17.3
11.0
40.6
100.0
0.0
174.1
$
1.0
60.7
235.8
$
$
Post Restructuring
(5.3)
0.0
0.0
(5.3)
$
$
$
(5.3)
0.0
0.0
(100.0)
105.0
(0.3)
$
0.0
(5.0)
(5.3)
$
$
3.8
48.8
177.9
230.5
$
17.3
11.0
40.6
0.0
105.0
173.8
$
1.0
55.7
230.5
Market Example of Debt-for-Debt Exchange: Grupo TMM, S.A.
Grupo TMM S.A. (“TMM”) is one of Mexico’s largest multimodal transportation
companies. TMM offers an integrated regional network of rail and road transportation
services, port management, specialized maritime operations and logistics. TMM’s most
valuable asset is its railroad operations. TMM’s principal railroad operations are
conducted through Grupo Transportacion Ferroviaria Mexicana, S.A de C.V. (“TFM”),
an indirect subsidiary of TMM.11 TFM’s rail operations serve the strategic north/south
corridor between Laredo, through Monterrey, to Mexico City. The performance of this
asset is closely associated with the level of cross-border trade between Mexico and the
United States.
During Spring 2003, TMM found itself without adequate liquidity to meet its debt
obligations. On March 31, 2003, the company had $39.3 million of cash on its balance
sheet; TMM faced a bullet-maturity payment of $176.9 million on its 9.5% Senior Notes
due May 2003 (“2003 Notes”), an $8.4 million interest payment on the 2003 Notes and a
$10.3 million interest payment on its 10.25% Senior Notes due 2006 (“2006 Notes”). In
the months preceding the May 15, 2003 maturity date of the 2003 Notes, TMM attempted
to restructure its debt through an out-of-court debt-for-debt exchange offer. TMM
initiated its first exchange offer on December 26, 2002 and, by May 15, 2003, the
company had modified and extended the proposed exchange no less than five times.
11
TMM holds its interest in TFM through a 100% owned subsidiary that, in turn, owns an approximate
96.6% interest in TMM Multimodal, S.A de C.V (”Multimodal”). Multimodal owns a 38.4% economic
interest (and a 51% voting interest) in Grupo TFM, a holding company that owns an 80% direct economic
interest in TFM. TMM’s commercial partner in the TFM investment, Kansas City Southern (NYSE:KSU),
owns a 36.9% economic interest (and a 51% voting interest) in a Grupo TFM.
Page 17
Despite the amendments and the extensions, TMM was not able to obtain the approvals
necessary to consummate the proposed exchange transaction. On May 12, 2003, the final
exchange offer expired with acceptances by holders owning 48% of the aggregate
outstanding 2003 Notes and the 2006 Notes, well below the 80% aggregate threshold the
company needed to consummate the transaction.
Meanwhile, as the consummation of the exchange offer became increasingly unlikely,
TMM sought to raise sufficient capital to meet the upcoming principal and interest
payments by orchestrating a search for buyers for its important assets. On April 22,
2003, the company announced an agreement, subject to shareholder and other approvals,
to sell its interest in Grupo TFM to its partner Kansas City Southern (“KCS”) for, among
other consideration, $200 million in cash and 18 million shares of KCS common stock
(worth approximately $250 million). For a variety of reasons, the transaction to sell the
railroad asset remained incomplete on May 15, 2003, the day the debt service payments
were due. Additionally, on May 14, 2003, the company announced a completed sale of
its 51 percent interest in the TMM Ports and Terminals division to its partner Stevedoring
Services of America (SSA) for net proceeds of approximately $114 million. After using
most of the proceeds from the sale of the ports to repay secured debt, outstanding
commercial paper and a debt owed to an affiliate, TMM did not have sufficient liquidity
to satisfy the other matured obligations.
In an early effort to gain protection from its creditors, TMM applied for and was granted
a stay against creditors by a court of local jurisdiction in Mexico. The initial legal ruling
gave the company protection from its creditors for one year, but not pursuant to the
jurisdictionally customary bankruptcy or reorganization laws. Because of its irregularity,
the initial ruling was appealed. Within two weeks, the case was transferred to a different
civil court, which vacated the initial ruling.12 When the initial court-sanctioned one-year
reprieve from creditors was nullified, TMM hired an investment banker to help
renegotiate its debt. TMM was also approached by a group of institutions that owned a
significant amount of the 2003 Notes and the 2006 Notes and had formed an ad hoc
group of holders (the “Committee”). The Committee notified TMM that it had selected
financial and legal restructuring advisors, and requested the advisors be put under
contract and be granted access to due diligence materials.
During the next 6 months, TMM and its financial and legal advisors worked with the
Committee and its advisors to negotiate acceptable terms for an exchange transaction.
During the negotiating period, the Company was clearly in default position and thus, was
at risk of having an “involuntary” bankruptcy petition filed against it.13 However, several
From a creditor’s perspective, this chain of legal events elevated the sense of “process risk.” While the
initial legal skirmish did end with the “correct” result, the convoluted and secretive nature of the civil court
did nothing to enhance the comfort of foreign creditors regarding the fair application of existing laws.
12
13
Any effective set of bankruptcy laws includes a mechanism that provides access for creditors. Usually
such access, referred to as an “involuntary” filing (because the company does not voluntarily submit to
court supervision), is available after some objective criteria are met. Such criteria could include, for
example, not paying debts as they become due. In most jurisdictions, an acceptable involuntary petition
also needs support from more than one aggrieved creditor.
Page 18
factors caused the Committee (and other note holders) to exercise restraint. To begin
with, TMM was domiciled in a jurisdiction with bankruptcy laws that indicated
unfavorable treatment for unsecured creditors14. Most importantly, if and when a petition
was filed, any unsecured claim would be converted to local currency at the prevailing
exchange rate and would stop accruing interest.15 Equally important to the Committee
was the risk they associated with a contentious and unplanned bankruptcy proceeding in a
jurisdiction that lacked judicial clarity and consistency.
From a valuation perspective, note holders believed there was sufficient going concern
value to provide a 100% recovery on their claims (equal to par, plus accrued interest). In
fact, this view was supported by TMM’s approximately $200 million public stock market
capitalization, and a significant bid for the main railroad asset. From the perspective of
the majority owners, the company was clearly being undervalued. The principal asset
earns money based on the level of economic activity between Mexico and the United
States and, because of general, world-wide economic conditions and the “war-time”
nature of the US economy over the past eighteen to twenty-four months, the company
had not performed to its full potential. In fact, despite the generally difficult operating
conditions, TFM managed modest revenue and earnings growth from 2000 – 2002 and
the majority owners felt strongly that the company (and hence, equity) was poised to take
advantage of any economic recovery.
In the resulting negotiation, the Committee had several priorities. To begin, they held a
strong view that sufficient value existed to obtain a full recovery on claim, and even to
provide an enhanced return. Next, Committee members were very concerned about
improving the legal status of their claim. As noted above, the LCR creates obvious
financial risks for unsecured creditors. In this case, the Committee was determined to
negotiate for a note secured by all of the available assets of the company. In TMM (and
most other cases), old equity was negotiating to extend the duration of their option (by
extending the maturity date and reducing the cash debt service due prior to maturity) and
minimize their dilution. Because they knew any consensual solution would extend the
time until a creditor could exercise their rights, the Committee recognized the importance
of improving their position (and the position of all holders of old notes) at the end of the
extended “option period.” In the event the company did not generate sufficient capital
from operations and assets sales to repay claims at the end of the extension period, the
Committee wanted to have access to the more certain remedies the LCR provides to
secured claims.
14
TMM is a Mexican sociedad anonima subject to the Ley de Concursos Mercantile (Law of Commercial
Reorganization or ”LCR”), or bankruptcy laws, of Mexico. The LCR provides for two different
proceedings: conciliation and bankruptcy/liquidation. The LCR was enacted in May 2000 and is largely
untested, especially for large, complex proceedings and in the context of a pre-packaged plan. In fact,
TMM is the first company attempting to confirm a pre-packaged reorganization under the LCR.
15
Note that in our hypothetical, a creditor was subject to time risk and process uncertainty. Because of the
mandated conversion of claims to the local currency, this real-world example has at least one other
important risk element for a creditor to consider.
Page 19
By December 2003, TMM had reached an agreement with the Committee as to the terms
of the restructuring transaction (the “Transaction”). TMM would issue approximately
$450.8 million in 10.5% Senior Secured Notes due 2007 (“New Notes”) in exchange for
the $176.9 million of 2003 Notes and the $200.0 million of 2006 Notes. In early January
2004, over 64% of the aggregate outstanding notes had accepted the proposed
transaction. As shown in the table below, the holders would receive (i) par recovery on
the principal amount of the notes; (ii) the full amount of the accrued and unpaid interest
due on May 15, 2003; (iii) accrued interest from May 15, 2003 through the closing date
of the Transaction; and, (iv) a 5.0% consent fee.
Grupo TMM, S.A.
Composition of New 10.5% Senior Secured Notes due 2006
($ in millions)
Face Value of 9.5% Senior Notes due 2003
Face Value of 10.25% Senior Notes due 2006
$
176.9
200.0
Contract Rate Accrued Interest (11/15/02 - 5/15/03)
Negotiated Rate Accrued Interest (5/16/03 - 2/29/04)
18.7
34.2
5% Consent Fee
21.1
Face Amount of New 10.5% Senior Notes due 2006
$
450.8
Note: Assumes a 2/29/04 transaction date.
The proposed Transaction offers concessions, such as accrued interest through the closing
date16 and, as an added incentive to participate in the Transaction17, a 5% consent fee.
To understand the “negotiating value” of offering accrued interest through closing, it is
important to note that, among other factors, the 2003 Notes indenture does not provide
explicitly for post-maturity interest. Also, the company agreed to calculate accrued
interest from the default date at a rate of 11.5%. Neither indenture contemplates a default
rate of interest, but the negotiated transaction contemplates paying a 200 and 125 basis
point premium to the contractual interest rates on the 2003 Notes and the 2006 Notes,
respectively.
If completed, the proposed Transaction also meets many of the goals of TMM’s equity
owners. First, the Transaction extends the maturity profile of TMM’s debt obligations by
three years and, because of non-cash interest payment options, gives the company
significant future flexibility regarding its interim liquidity. In addition, the terms of the
New Notes permit TMM to extend the maturity an additional year in return for a 4.0%
cash extension fee. As per the table below, the New Notes include a number of economic
and structural improvements over the 2003 Notes and the 2006 Notes:
16
The Transaction included accrued interest at the default rate through the settlement date of the
Transaction. The text and the analysis assume a February 29, 2004 settlement date.
17
In order to implement an out-of-court transaction, TMM must obtain the participation of 98.0% of the
2003 Notes and 95.0% of the 2006 Notes.
Page 20
Grupo TMM, S.A.
Terms of New Notes
Security
Amount
Term
Collateral
Existing Notes
2003 Notes
2006 Notes
> 9.5% Senior Notes due 2003
> 10.25% Senior Notes due 2006
> $176.9 million plus accrued interest
> $200.0 million plus accrued interest
> 0 years
> 3 years
> None
> None
Interest
> 9.5%, fixed and payable in cash
> 10.25%, fixed and payable in cash
Amortization
> Bullet at maturity
> Bullet at maturity
New Notes
> 10.5% Senior Notes due 2006
> $450.8 million
> 3 years, extendable to 4 at a cash extension fee of 4.0%
> First security interest in all of TMM's equity interest in
subsidiaries and all other current and future encumbered assets
> Cash Interest Option
- 10.5%, fixed and payable in cash
- 12.0%, fixed and payable in cash in year four
> Paid-in-Kind Interest Option
- Min. cash payment of 2.0%, remainder, incl. 1.5% premium
(2.5% in year 3) paid in the form of New Notes or discounted
TMM ADR shares
- 12.0%, fixed and payable in cash in year four
> Bullet at maturity
TMM structured the exchange transaction with minimum participation rates of 98% and
95% of the 2003 Notes and the 2006 Notes, respectively. If this level of participation is
not reached, TMM intends to implement the Transaction through a pre-packaged Chapter
11 filing, and/or a coincident pre-packaged or pre-arranged filing under the LCR.
Debt-for-Equity Exchange
To illustrate a debt-for-equity exchange, we will stay with OpCo, but modify certain
assumptions. The story behind this hypothetical began at the end of 1999, when OpCo
completed a leveraged re-capitalization of its balance sheet.
In 1999, the equity public markets valued companies similar to OpCo at between 7.0 and
8.0 times EBITDA for the latest twelve months (“LTM”). With approximately $49
million of LTM EBITDA, OpCo was thought to be worth between $343 million and $392
million. At the time, and based on these valuations, the debt capital markets were
offering to lend up to 4.5 times trailing EBITDA to borrowers like OpCo. Unable to
resist the opportunity, OpCo’s owners completed a leveraged re-capitalization
transaction. OpCo borrowed a combination of $210 million of bank and high yield debt
and funds were used to refinance any existing debt, pay a dividend to the owners and
provide the cash working capital. From the debt market’s perspective, this debt load was
sustainable for the following reasons: at the prevailing interest rates, OpCo’s EBITDA to
pro forma cash interest coverage ratio was about 2.5 times; at 4.3 times leverage, OpCo
was perceived to have an ample equity cushion (with loan to value (“LTV”) ratios of
between 54% and 61%); and, at the end of the transaction, OpCo still had $5 million of
available cash to address any unforeseen operating issues. The following chart details the
sources and uses of funds for the re-capitalization.
Page 21
OpCo
Recapitalization Transaction
($ in millions)
Adjustments
Pre-Restructuring
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
$
5.0
50.9
175.0
230.9
$
LIABILITIES & SHAREHOLDERS' EQUITY
Accounts Payable
Accrued Expenses
Old Secured Bank Debt
Secured Term Loan
10.5% Senior Notes due 2006
TOTAL LIABILITIES
$
Paid in Capital
Retained Earnings (1)
LIABILITIES & SHAREHOLDERS' EQUITY
$
Post Restructuring
-
$
5.0
50.9
175.0
230.9
$
18.0
11.4
105.0
134.4
(105.0)
60.0
150.0
105.0
1.0
95.4
230.9
(105.0)
-
$
18.0
11.4
60.0
150.0
239.4
1.0
(9.6)
230.9
$
(1) Approximately $5.0 million of fees and expenses charged to retained earnings.
Subsequent to the transaction, OpCo performed as described in the first hypothetical.
Business conditions caused revenue and margins to erode, though cash flow before debt
service remained reasonably strong. Despite the interest burden, OpCo continued to
invest in its fixed asset base. And even today, OpCo was current with its suppliers.
However, as indicated in the following financial statements, OpCo’s balance sheet has
finally caught up to it.
OpCo
Historic & Projected Income Statement
($ in millions)
<
Revenues
Actual Results
2000A
2001A
2002A
$
% Growth
Cost of Sales
Gross Profit
% Margin
SG&A
Operating Income
Interest Expense
Secured Term Loan
10.5% Senior Notes due 2006
New Notes
Interest Income
Pre-tax Income
Less: Taxes
40.0%
NET INCOME
$
300.0
$
291.0
$
279.4
Fiscal Year Ended December 31,
>
Estimated
2003
2004
$
273.9
$
280.7
Forecast Results
2005
2006
$
291.9
$
303.6
2007
$
315.8
5.0%
-3.0%
-4.0%
-2.0%
2.5%
4.0%
4.0%
4.0%
190.5
109.5
189.2
101.9
187.2
92.2
186.2
87.6
186.7
94.0
192.7
99.3
198.9
104.7
205.2
110.5
36.5%
35.0%
33.0%
32.0%
33.5%
34.0%
34.5%
35.0%
69.0
40.5
71.8
30.1
74.6
17.6
73.1
14.5
73.1
20.9
74.6
24.7
76.1
28.7
77.6
32.9
(3.2)
(15.8)
0.2
(1.2)
0.5
(0.7)
(2.8)
(15.8)
0.1
(4.0)
1.6
(2.4)
(3.8)
(15.8)
0.1
21.0
(8.4)
12.6 $
(3.6)
(15.8)
0.2
11.0
(4.4)
6.6 $
Page 22
$
$
(2.2)
(15.8)
(0.1)
2.8
(1.1)
1.7 $
(0.9)
(15.8)
(1.2)
6.8
(2.7)
4.1 $
(15.8)
(3.7)
9.2
(3.7)
5.5 $
(18.0)
(3.2)
11.7
(4.7)
7.0
OpCo
Historic & Projected Cash Flow Statement
($ in millions)
<
Cash from Operations:
Net Income
Actual Results
2000A
2001A
2002A
$
12.6
$
6.6
$
Fiscal Year Ended December 31,
>
Estimated
2003
2004
(0.7)
$
(2.4)
$
1.7
Forecast Results
2005
2006
$
4.1
$
5.5
2007
$
7.0
Adjustments:
Depreciation & Amortization
Working Capital, net
Net Cash from Operations
14.6
(1.1)
26.1
14.7
0.7
21.9
14.8
0.9
14.9
14.9
0.4
12.9
14.8
(0.5)
16.0
14.8
(0.8)
18.0
14.7
(0.9)
19.4
14.7
(0.9)
20.8
Cash from Investing Activities:
PP&E, net
Net Cash from Investing Activities
15.8
15.8
15.9
15.9
16.0
16.0
14.3
14.3
14.2
14.2
14.2
14.2
14.1
14.1
14.1
14.1
After-tax Cash from Operations
10.4
6.1
(1.0)
(1.4)
1.8
3.8
5.2
6.7
Cash from Financing Activities:
Repayment of Secured Term Loan
Repayment of 10.5% Senior Notes due 2006
Proceeds from New Notes
Repayment of New Notes
Net Cash from Financing Activities
(3.0)
(3.0)
(4.5)
(4.5)
(6.0)
(6.0)
(6.5)
(6.5)
(12.0)
(12.0)
(28.0)
(28.0)
Increase in Cash
Cash at Beginning of Period
Cash at End of Period
7.4
5.0
12.4
1.6
12.4
14.0
(7.0)
14.0
6.9
(7.9)
6.9
(0.9)
(10.2)
(0.9)
(11.2) $
(24.2)
(11.2)
(35.3) $
$
$
$
$
$
(150.0)
150.0
-
-
5.2
(35.3)
(30.1) $
6.7
(30.1)
(23.4)
OpCo
Historic & Projected Balance Sheet
($ in millions)
1999a
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
$
$
LIABILITIES & SHAREHOLDERS' EQUITY
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2006
New Notes
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
5.0
50.9
175.0
230.9
Fiscal Year Ended December 31,
Estimated
2002A
2003
2004
Actual Results
2000A
2001A
$
$
12.4
53.4
176.2
242.0
18.0
11.4
60.0
150.0
239.4
18.9
12.0
57.0
150.0
237.9
1.0
(9.6)
230.9 $
1.0
3.1
242.0
$
$
14.0
51.8
177.3
243.1
$
$
18.3
11.6
52.5
150.0
232.5
$
1.0
9.6
243.1
6.9
49.7
178.5
235.2
$
$
17.6
11.2
46.5
150.0
225.3
$
1.0
8.9
235.2
(0.9)
48.8
177.9
225.8
$
$
17.3
11.0
40.0
150.0
218.2
$
1.0
6.5
225.8
$
Forecast Results
2005
2006
2007
(11.2) $
50.0
177.3
216.2 $
(35.3) $
52.0
176.7
193.4 $
(30.1) $
54.1
176.2
200.1 $
(23.4)
56.2
175.6
208.4
17.7
11.2
28.0
150.0
206.9
18.4
11.7
150.0
180.1
19.1
12.1
150.0
181.3
19.9
12.6
150.0
182.5
1.0
8.2
216.2
$
1.0
12.3
193.4
$
1.0
17.9
200.1
$
1.0
24.9
208.4
On December 31, 2003 the company lacked the cash to make the $7.9 million semiannual interest payment on the outstanding 10.5% Notes due 2006 (the “2006 Notes”).
OpCo’s counsel reviews the indenture for the notes and determines that the contract
provides for a 30-day grace period for payment defaults. Because the payment default on
the notes triggers a cross-default on the bank credit agreement, counsel also reviews this
document and discovers a similar 30-day grace period. OpCo’s owners decide NOT to
make the interest payment (and retain cash and operating flexibility) and to use the 30-
Page 23
day grace period to evaluate their alternatives. The following balance sheet reflects
OpCo’s actual cash position as of January 1, 2004.
OpCo
Estimated vs. Actual Balance Sheet as of 12/31/03
($ in millions)
Estimated
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
$
LIABILITIES & SHAREHOLDERS' EQUITY
Accrued Interest
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2006
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
(0.9)
48.8
177.9
225.8
$
0.0
17.3
11.0
40.0
150.0
218.2
$
1.0
6.5
225.8
Actual
$
$
6.9
48.8
177.9
233.6
$
7.9
17.3
11.0
40.0
150.0
226.1
$
1.0
6.5
233.6
As a first step, OpCo’s owners hire a restructuring banker to evaluate and recommend
alternatives and to manage any negotiations with the lending groups. To gain a rapid
understanding of the situation, the restructuring banker reviews OpCo’s financial results
and projections and schedules interviews with OpCo’s managers. During the interviews,
the restructuring banker focuses on the assumptions that support the financial projections
and whether or not they are achievable. After speaking to the managers responsible for
sales and customer service, the restructuring banker discovers that important customers
have taken notice of the press reports about OpCo’s default and are beginning to call and
inquire about OpCo’s ability to perform in light of its highly leveraged balance sheet.
OpCo’s payables manager also reports similar inquiries from important suppliers. In fact,
suppliers are also talking about shortening the number of days of credit they extend to
OpCo. Generally, OpCo’s managers (who may or may not be significant equity owners)
are nervous about the situation. At this point in time, it seems the overall employee base
is surprised by events, but confident in management’s ability to resolve the situation.
After this and other due diligence, the restructuring banker (and his expert staff) produces
a preliminary valuation analysis and a preliminary debt capacity analysis. As in the first
hypothetical, the restructuring banker concludes that OpCo is currently worth between
$160 million and $195 million (before surplus cash), and that OpCo can support between
$100 million and $140 million of par-value debt securities. In the presentation to OpCo’s
Board of Directors18, the restructuring banker makes several important points.
18
In most jurisdictions, both privately and publicly held companies manage corporate governance through
some form of proxy methodology. In other words, the equity owners nominate and elect individuals to
serve on a council to represent their interests in matters of corporate strategy and governance. In our case,
we are calling this governing council a Board of Directors.
Page 24
First and foremost, the restructuring banker reports to the Board that the company is in a
precarious state. Because of the uncertainty surrounding OpCo and its financial situation,
OpCo is in jeopardy of spiraling into a cycle of distress. If the situation is not resolved
soon, customers may cancel orders and put the projections (and the valuation) at risk, and
that the company potentially faced a working capital squeeze19. The restructuring banker
also makes the point that the current financial debt of the company (about $190.9 million,
including accrued interest and net of cash on hand) is just less than his most optimistic
assessment of value; in the view of the restructuring banker, OpCo is very likely to be
balance sheet insolvent (i.e., the financial liabilities exceed the “mark-to-market” value of
OpCo’s tangible and intangible assets)20. The restructuring banker also notes several
areas that, in his view, are ripe for cost cutting and recommends the Board bring in an
operations consultant to review the cost-side of the projections.
Because of the upcoming expiration of the grace period and the looming liquidity crisis,
the restructuring banker reviews three possible courses of action with the Board. The
first option is to maintain the status quo. OpCo needs to “find” about $1 million of
liquidity to fund the debt service payments; the company could start to “slow pay”
suppliers and possibly generate the liquidity from working capital. The company also has
one or two regularly scheduled plant maintenance projects that it can defer, but not
cancel. But even deferral puts operations at some risk and will certainly raise the
suspicions of employees. All-in-all, the restructuring banker describes an unappealing
scenario where long-term value could be enhanced by cost-cutting, but where the
company lives hand-to-mouth in the interim. Further, the restructuring banker notes with
some sense of irony that, during the time frame that the company is working to cut costs
and build value, the company is just as likely to experience significant value erosion as
customers look for product from a more financially sound partner. And as if that wasn’t
19
As news of their distress spreads to customers and suppliers, companies like OpCo often face a working
capital squeeze. In this situation, customers either elect to hold or delay payments until long after goods
are received, or even until the next order is shipped or received. The first action increases receivables; the
second does the same and causes over-investment in inventory. Further, as suppliers learn of the situation,
they are likely to reduce their “credit exposure” to OpCo by reducing the number of days they give OpCo
to pay for goods or services. The net result of these actions or combination of actions is to increase the
amount of working capital OpCo requires to run its operations, and increase OpCo’s near-term need for
cash.
20
If a company is (arguably) insolvent, a question of appropriate corporate governance arises. The goal of
good corporate governance (and the duty of a Board member) should be the maximization of the riskadjusted, or expected value of the firm. If a company is solvent, maximizing the expected value of the
equity and maximizing the expected value of the firm are congruent. If equity is out-of-the-money, it may
be rational to pursue higher-risk, higher-reward investments because (a high probability) failure costs
equity nothing while success brings a massive return on equity’s “investment” (near infinite returns
because the amount of equity’s investment, defined as how much they have at risk in the event of failure, is
zero or near zero). Because corporate governors are elected by equity at a time when the company is
solvent, they may be tempted to show a filial loyalty to their electors versus a showing fiduciary duty to the
company. Such behavior must be considered contrary to any acceptable concept of good corporate
governance.
Page 25
bad enough, “finding” the first $1 million by drawing it out of working capital was very
likely to cause a working capital squeeze and trigger an even bigger demand for liquidity.
To be fair, the restructuring banker explains why this course of action may appeal to
equity. By making the debt service payments, the equity would, in effect, hope to extend
the duration of their option by at least six months (the date of the next coupon payment)
and possibly longer, especially if the restructuring banker is correct about the possibility
for cost savings and prospects for enhanced cash flow from operations. As discussed
earlier, in this paper we evaluate equity as an option (on 100% of the residual value) – the
value of the option is increased either by raising the current value, lowering the strike
price, increasing the volatility or extending the duration. The status quo strategy would
seek to maximize the value of equity by extending the duration of the option and increase
value of the firm by investing scarce resources in cost savings. The downside to this
strategy is that it risks doing serious damage to OpCo’s business, reducing its future
earnings prospects and long-term value. The restructuring banker also points out that the
high likelihood of a subsequent working capital squeeze undermines the “durationextension” value of the status quo strategy. And if the squeeze does occur, the potential
loss of value from an eroding customer and employee base would dominate any valueaccretion from cost savings.
The restructuring banker also points out that equity bears very little of the risk of this
loss. As noted earlier, OpCo is or is very nearly insolvent. If the current value were
monetized (through a sale process, discussed below as the second option) and distributed,
the residual equity claim would likely get little or nothing after repaying debt (i.e., after
an “absolute priority” distribution of proceeds). Now consider the expected value of
equity’s recovery in the status quo scenario. If the company can manage the current
liquidity crisis, restore customer confidence, avoid a working capital squeeze and cut
costs, equity will likely enjoy 100% of the increase in value. For example, if the
aforementioned events occur (assume a 20% probability) and firm value increases by
20%, equity value would increase by about $35 million. However, in the event the
situation devolves, equity would recover nothing. The expected value of “investing” in
the status quo scenario is $7.0 million; it is the probability-weighted return of $7.0
million [($35 million * 20%) + ($0 million * 80%)], less the cost of the investment to
equity, which is close to zero.
The restructuring banker goes on to explain that the cost of failure is borne by two
parties, the holders of unsecured claims against the company (principally Note holders
and vendors) and the “stakeholders” in the company; stakeholders are individuals and
businesses that are invested in the company because they depend, in some measure, on
the company for their economic livelihood. Stakeholders would include employees,
suppliers and their employees, and communities that have a high concentration of
stakeholders. The creditors suffer because, by the time they disenfranchise equity
through a court proceeding and recover 100% of the available value, the failed status quo
strategy and the subsequent court fight will deplete the value of the firm. To summarize,
the status quo scenario has a low probability of success, and failure would significantly
lower the value of the business. Equity would accrue all or nearly all of the benefits of a
Page 26
success, while the cost to equity of failure is near zero. Basically, the status quo scenario
gives equity a short-term opportunity to gamble with value that more correctly belongs to
creditors and, possibly, stakeholders. This presents what the literature usually refers to as
a “moral dilemma,” and causes the restructuring banker to call on the restructuring
attorney to explain the concept of fiduciary duties, and the question as to whom does a
fiduciary owe a duty of care?
The attorney begins to explain that a fiduciary relationship is one in which a designee, the
fiduciary, acts as a trustee for another party. In layman’s terms, the designated party, or
fiduciary, is entrusted to act in a manner that is “in the best interests of” the designating
party. The attorney goes on to point out that the concept is relevant because, under the
laws of the OpCo’s jurisdiction of incorporation, the members of the Board are
fiduciaries. They have been designated by the “owners” of a business enterprise to act in
the economic best interests of the owners. “And now it gets complicated” says the
attorney. “The laws are such” the attorney says matter-of-factly, “that the term “owner”
is interpreted to mean “the residual beneficiary.” In other words, the fiduciaries (or, in
this case, Directors) are generally charged with maximizing the value of the firm, because
maximizing the value of the firm accrues to the benefit of the owner; the “owner” is the
party to whom the next dollar of benefit accrues. If a company is insolvent, its liabilities
exceed the value of its assets. Any increase (or decrease) in value would most directly
impact the holder of a claim, not a holder of a share of stock. Thus, under the laws of the
jurisdiction, the “owners” of an insolvent company are holders of claims against the
company, not equity holders. The attorney cautions the directors that if OpCo is, in fact,
insolvent, then they owe their allegiance to the company’s creditors and not the equity
owners.
With that background, the restructuring banker continues to discuss OpCo’s alternatives,
other than the status quo. The next option to consider is an immediate sale of the firm.
The restructuring banker indicates that, at this juncture, a sale of the company as a going
concern is a viable alternative. He indicates that current market conditions are unlikely to
yield value in excess of the debt but, in exchange for agreeing to initiate and execute the
sale process, current equity could negotiate with its creditors for some modest split of
proceeds. The restructuring banker tells the Board to assume that current equity could
get as much as 5% of the sale proceeds, after repaying the secured debt. When asked
why the unsecured creditors would agree to pay anything to equity if creditors were not
paid in full, the restructuring banker replies that unsecured creditors would view such a
payment as an “insurance policy” against future value erosion. From the perspective of
an unsecured creditor, there is a time lag between knowing a company is insolvent and
being able to assert control over the situation. In the interim, the only source for their
recovery, the company, is very likely to decrease in value. The restructuring banker
produces the following exhibit for the Board to demonstrate why the aforementioned
strategy is maximizes value for an unsecured creditor.
OpCo
Comparison of Consensual Sale to Contested Deal
($ in millions)
Page 27
Consensual Sale
Proceeds from Sale
Less: Fees and Expenses
Plus: Cash Balance (2)
Net Distributable Proceeds
$
(1)
$
Secured Term Loan Distribution
195.0
(5.9)
6.9
196.1
Contested Scenario
$
$
40.0
Proceeds Available for Distribution to Noteholders and Equityholders
$
% Distributed to Noteholders
156.1
160.0
(9.6)
6.9
157.3
40.0
$
95.0%
117.3
100.0%
Noteholder Recovery
Future Value of Distribution to Noteholders
% Recovery
Present Value of Distribution to Noteholders
% Recovery
$
(3)
148.3
$
117.3
$
102.3
93.9%
(4)
$
(3)
143.2
74.3%
90.7%
64.8%
Equityholder Recovery
Future Value of Distribution to Equityholders
Present Value of Distribution to Equityholders
(1)
(2)
(3)
(4)
(4)
$
7.8
$
-
$
7.5
$
-
Assumes fees and expenses of 3.0% and 6.0% in a consensual sale and a contested scenario, respectively.
Assumes OpCo is cash neutral until the closing date of either transaction.
Assumes note claims equal to $150.0 million of principal plus $7.9 million of accrued interest.
Assumes a discount rate of 15 percent and 20 percent for the consensual sale and contested scenario, respectively, equal to the interest rate on notes, plus a premium
for uncertainty. A contested scenario is more uncertain and warrants a higher risk premium. Assumes Consensual Sale closes in 3 months and Contested Scenario
closes in 9 months.
The restructuring banker also points out that under the immediate sale scenario, the
expected value to the equity is over $7 million (equity’s expected recovery in the status
quo scenario). The restructuring banker caveats the comparison by indicating that while
equity is indifferent (on an expected value basis) between an immediate sale and the
status quo, the other affected parties (unsecured creditors and stakeholders) are
substantially better off in the immediate sale scenario. The creditors are better off in
simple economic terms; the stakeholders are better off because the immediate sale
scenario shelters an assumed risk-averse constituent from delay and the attendant
uncertainty. And now the restructuring banker turns his attention to the third scenario, a
conversion of debt to equity.
The restructuring banker begins by re-emphasizing to the Board that, at present, OpCo’s
problems are balance sheet related; the basic operations of the business are sound. But
to protect against customer and vendor defection and business erosion, the company had
to complete a substantial de-leveraging of its balance sheet. The restructuring banker
also re-states his belief that the company could cut its selling, general and administrative
costs in the next year, and further improve cash flows and firm valuation. If the company
could achieve recurring cost reductions of between $7 million and $8 million (or 6% and
8% of total S,G&A, after adjusting for inflation), and assuming the prevailing market
multiples of 5.5 times to 6.5 times EBITDA, the company could build between $40
million and $50 million of value over the next twelve to eighteen months. The
restructuring banker sets out his re-cast projections for the Board, and indicates that, with
a sound balance sheet, OpCo is likely to achieve the re-forecasted results. For the
purposes of the forecast, the restructuring banker assumed that OpCo had $40 million of
bank debt with a revised amortization schedule (basically a re-financing of the existing
Page 28
bank debt) and no other debt. In other words, the reforecast assumes all of the existing
unsecured notes are exchanged for equity.
OpCo
Projected Income Statement
($ in millions)
<
Revenues
Actual Results
2000A
2001A
2002A
$
% Growth
Cost of Sales
Gross Profit
% Margin
SG&A
Operating Income
Interest Expense
Secured Term Loan
10.5% Senior Notes due 2006
New Notes
Interest Income
Pre-tax Income
Less: Taxes
NET INCOME
40.0%
$
300.0
$
291.0
$
Fiscal Year Ended December 31,
>
Estimated
2003
2004
279.4
$
273.9
$
280.7
Forecast Results
2005
2006
$
291.9
$
303.6
2007
$
315.8
5.0%
-3.0%
-4.0%
-2.0%
2.5%
4.0%
4.0%
4.0%
190.5
109.5
189.2
101.9
187.2
92.2
186.2
87.6
186.7
94.0
192.7
99.3
198.9
104.7
205.2
110.5
36.5%
35.0%
33.0%
32.0%
33.5%
34.0%
34.5%
35.0%
69.0
40.5
71.8
30.1
74.6
17.6
73.1
14.5
68.7
25.3
67.4
31.9
68.7
36.0
70.1
40.4
(3.2)
(15.8)
0.2
(1.2)
0.5
(0.7)
(2.8)
(15.8)
0.1
(4.0)
1.6
(2.4)
(3.8)
(15.8)
0.1
21.0
(8.4)
12.6 $
(3.6)
(15.8)
0.2
11.0
(4.4)
6.6 $
$
$
(2.3)
(0.1)
22.8
(9.1)
13.7 $
(1.8)
0.0
30.1
(12.0)
18.0 $
(1.3)
0.2
34.9
(14.0)
20.9 $
(0.8)
0.4
40.0
(16.0)
24.0
OpCo
Projected Cash Flow Statement
($ in millions)
<
Cash from Operations:
Net Income
Actual Results
2000A
2001A
2002A
$
12.6
$
6.6
$
(0.7)
Fiscal Year Ended December 31,
>
Estimated
2003
2004
$
(2.4)
$
13.7
Forecast Results
2005
2006
$
18.0
$
20.9
2007
$
24.0
Adjustments:
Depreciation & Amortization
Working Capital, net
Net Cash from Operations
14.6
(1.1)
26.1
14.7
0.7
21.9
14.8
0.9
14.9
14.9
0.4
12.9
14.8
(0.5)
28.0
15.1
(0.8)
32.3
15.0
(0.9)
35.1
15.0
(0.9)
38.1
Cash from Investing Activities:
Capital Expenditures
Net Cash from Investing Activities
15.8
15.8
15.9
15.9
16.0
16.0
14.3
14.3
17.8
17.8
14.5
14.5
14.4
14.4
14.4
14.4
After-tax Cash from Operations
10.4
6.1
(1.0)
(1.4)
10.2
17.8
20.7
23.7
Cash from Financing Activities:
Repayment of Secured Term Loan
Repayment of 10.5% Senior Notes due 2006
Proceeds from New Notes
Repayment of New Notes
Conversion of Debt to Equity
Cash Flows from Financing Activities
(3.0)
(3.0)
(4.5)
(4.5)
(6.0)
(6.0)
(6.5)
(150.0)
150.0
(6.5)
(8.0)
(8.0)
(8.0)
(8.0)
(8.0)
(8.0)
(8.0)
(8.0)
Increase in Cash
Cash at Beginning of Period
Cash at End of Period
7.4
5.0
12.4
1.6
12.4
14.0
(7.0)
14.0
6.9
(7.9)
6.9
(0.9)
2.2
(0.9)
1.3 $
9.8
1.3
11.1
12.7
11.1
23.8
15.7
23.8
39.4
$
$
$
$
OpCo
Projected Balance Sheet
Page 29
$
$
$
($ in millions)
1999a
ASSETS
Cash & Equivalents
Other Current Assets
PP&E, net
TOTAL ASSETS
LIABILITIES & SHAREHOLDERS' EQUITY
Accounts Payable
Accrued Expenses
Secured Term Loan
10.5% Senior Notes due 2006
New Notes
TOTAL LIABILITIES
Paid in Capital
Retained Earnings
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
$
$
$
Fiscal Year Ended December 31,
Estimated
2002A
2003
2004
Actual Results
2000A
2001A
5.0
50.9
175.0
230.9
$
12.4
53.4
176.2
242.0
$
18.0
11.4
60.0
150.0
239.4
$
18.9
12.0
57.0
150.0
237.9
$
1.0
(9.6)
230.9 $
1.0
3.1
242.0
$
$
$
14.0
51.8
177.3
243.1
$
18.3
11.6
52.5
150.0
232.5
$
1.0
9.6
243.1
$
$
6.9
49.7
178.5
235.2
$
17.6
11.2
46.5
150.0
225.3
$
1.0
8.9
235.2
$
$
(0.9)
48.8
177.9
225.8
$
17.3
11.0
40.0
68.2
$
1.0
156.5
225.8
$
$
Forecast Results
2005
2006
1.3
50.0
180.9
232.2
$
17.7
11.2
32.0
60.9
$
1.0
170.3
232.2
$
$
11.1
52.0
180.3
243.4
$
18.4
11.7
24.0
54.1
$
1.0
188.3
243.4
$
$
2007
23.8
54.1
179.7
257.5
$
19.1
12.1
16.0
47.3
$
1.0
209.2
257.5
$
$
39.4
56.2
179.1
274.8
19.9
12.6
8.0
40.5
1.0
233.2
274.8
As indicated to the Board, the re-cast projections include real cuts of S,G&A of about
10% by year 2 (2005), tempered for the effects of inflation. The increased capital budget
in year 1 (2004) reflects identified investments that support the increased cash flow (e.g.,
investment in improved billing systems with added functionality that, over time,
improves collection rates and reduces headcount). Based on the re-forecast, the
restructuring banker indicates to the Board that, if the company achieves the re-cast
projections, it would likely be worth $200 million and $245 million. The increase in
value reflects the capitalization of the incremental cash flow generated by the assumed
cost savings. But the assumed cost savings cannot be achieved with a leveraged balance
sheet. Based on conversations with OpCo’s major customers, the restructuring banker
believes that customer defections are likely without a substantial, and perhaps complete,
de-leveraging of the balance sheet.
Based on the potentially increased value of OpCo, the restructuring banker presents the
following absolute priority distribution analysis to the Board. The analysis reflects the
new valuation range, and adjusts for the cash on the balance sheet.
Page 30
OpCo
Absolute Priority Analysis
($ in millions)
Noteholders Convert 100.0%
of Claim to Equity
Low
High
Noteholders Convert 50.0% of
Claim to Equity
Low
High
Enterprise Value
Plus: Cash Balance
$200.0
6.9
$245.0
6.9
$200.0
6.9
$245.0
6.9
Distributable Value
$206.9
$251.9
$206.9
$251.9
40.0
0.0
40.0
0.0
40.0
75.0
40.0
75.0
$166.9
$211.9
$91.9
$136.9
157.9
157.9
82.9
82.9
94.6%
74.5%
90.1%
60.5%
$9.1
$54.1
$9.1
$54.1
5.4%
25.5%
9.9%
39.5%
Secured Term Loan
10.5% Senior Notes due 2006
Implied Equity Value
Distribution to Noteholders
(1)
% of Implied Equity
Distribution to Existing Equity
% of Implied Equity
(1) Includes $7.9 million of accrued interest.
As indicated, if 100% of the outstanding unsecured debt is converted into equity, the
existing equity would be entitled to between 5.4% and 25.5% of the pro forma equity. If
50% of the unsecured claim is converted into equity and the balance left in place, the
existing equity would be entitled to between 9.9% and 39.5% of the pro forma equity.
The restructuring professional highlights that if half the unsecured claim is converted into
equity, it would take an enterprise valuation of about $274 million before old equity
would be entitled to as much as half of the pro forma equity. The restructuring
professional concludes the discussion about the third scenario by indicating to the Board
that, in his experience, he believes that a negotiated settlement with the unsecured
creditor(s) that converted half of their claim into equity would likely leave old equity
with between 10% and 30% of the pro forma equity; if 100% of unsecured claims were
converted into equity, old equity could expect to retain between 5% and 20% of the pro
forma equity. The expected value of each of these scenarios is depicted below:
Page 31
OpCo
Absolute Priority Analysis
($ in millions)
Enterprise Value
Plus: Cash Balance
100% Conversion of Claim to Equity
Low
High
50% Conversion of Claim to Equity
Low
High
$
$
Distributable Value
Secured Term Loan
10.5% Senior Notes due 2006
Implied Equity Value
% to Old Equity
5%
10%
15%
20%
25%
30%
200.0
6.9
$
245.0
6.9
200.0
6.9
$
245.0
6.9
206.9
251.9
206.9
251.9
40.0
0.0
40.0
0.0
40.0
75.0
40.0
75.0
$
166.9
$
211.9
$
8.3
16.7
25.0
33.4
$
10.6
21.2
31.8
42.4
$
91.9
$
136.9
$
9.2
13.8
18.4
23.0
27.6
$
13.7
20.5
27.4
34.2
41.1
The restructuring professional notes for the Board that the expected value of either the
status quo scenario or the immediate sale scenario is less than $8 million while the
expected value of the debt-for-equity conversion scenario was between $8 million and
$40 million. For existing equity owners, the “upside” to the debt-for-equity scenario is
the potential to share in the increased valuation. The “downside” to the scenario was that
the ownership percentage of old equity would be substantially diluted; the unsecured
creditors would end up as the new majority owners. From the perspective of a fiduciary,
a consensual debt-for-equity exchange scenario maximizes the expected value of the firm
and has a much lower expected value of any negative externalities (caused by a status
quo scenario failure and the protracted in-court negotiation over any remaining value that
would follow).
Before breaking for deliberations, the Board asks to be informed of any risks and
potential liabilities they face or the old equity holders face on account of a nonconsensual insolvency proceeding. At this point, the restructuring attorney re-enters the
picture to discuss the concept of avoidable transfers, and the risk to the recipient of such a
transfer in the event of a formal insolvency proceeding. In particular, the attorney
discusses the concept of a “fraudulent conveyance” – a fraudulent conveyance is a
transfer of value by a party to a third party in a transaction whereby the transferring party
received less than reasonably equivalent value. If the transferring party was insolvent at
the time of the transfer, or was rendered insolvent on account of the transfer, the transfer
is avoidable.
For example, the restructuring attorney indicates that if a company sold a piece of real
estate at less than fair market value and was insolvent at the time of the sale and,
subsequently, the company files for protection from creditors, the creditors of such
Page 32
company could seek to avoid the transaction. If successful, the creditors could seek a
variety of remedies ranging from a rescission of the transaction to seeking a payment
from the purchaser equal to the difference (at the time of the transaction) between the sale
price and the market value. The attorney goes on to point out that, in OpCo’s jurisdiction
of incorporation, insolvent companies can pursue these “avoidance actions” for up to one
year after the transfer if the transferee was a true third party, and for up to five years if the
transferee was an “insider.” Doing the math, the Board realizes that if OpCo files for
insolvency, then the original re-capitalization transaction that occurred four years ago (in
which a substantial dividend was paid to equity for no consideration) is open to attack.
Basically, the restructuring attorney has added an additional element of risk the old equity
must consider.
The restructuring attorney goes on to tell the Board that, from the perspective of a
fiduciary, most of the discrete risk is mitigated by (1) pursuing legitimate business
strategies that maximize the risk-adjusted expected value of the firm and (2) avoiding the
potential defrauding of future unsecured creditors by recognizing the moment at which
OpCo becomes insolvent (i.e., the moment at which OpCo incurs a debt that it knows it
cannot repay in full) and, at that moment, cease “trading” or pursue a court-supervised
reorganization. Because it is difficult to know the “precise moment” at which a firm’s
assets exceed its liabilities, the Board is informed that they should consider themselves at
risk of running afoul of point 2 above if the firm is “in the zone of insolvency.” For all
practical purposes, the attorney suggests that unless a firm has at least a 5% cushion
between overall value and the value of its liabilities, it should consider itself at risk of
being in the zone of insolvency. The attorney concludes by stating that, if a firm is
insolvent or in the “zone of insolvency,” then the “residual claimant” is the unsecured
creditor class and not the equity. And given the legal definition of “owner” outlined
above (the owner is the residual claimant) and the aforementioned legal conclusion that a
fiduciary owes an obligation to the “owner”, the Board should be aware that, if OpCo is
insolvent or in the “zone of insolvency”, they avoid risk by demonstrating a fiduciary
obligation to unsecured creditors and not old equity holders.
In effect, the restructuring attorney added two elements of risk to the equation. First, if
the company is insolvent, then old equity is at risk from an attack by creditors against the
original re-capitalization transaction. Next, if a company is either insolvent or “in the
zone of insolvency,” then its fiduciaries are at risk of, in effect, committing fraud.
With this additional information, the Board deliberates about the alternatives. As value
maximizing and risk-averse individuals, they determine that OpCo is best served by
pursuing a debt-for-equity exchange transaction. Because no reasonable valuation
scenario or pro forma balance sheet would leave the old equity with a majority of the pro
forma equity, the Board determines that a complete conversion of the outstanding Notes
is the preferred (though not necessarily the most tax-efficient) solution. Among other
things, the Board recognizes that the new owners (by proxy, through a re-constituted
Board elected by the pro forma equity owners) can choose to re-lever the balance sheet
after a complete conversion of the unsecured debt to equity. After deciding on the best
course of action (a consensually negotiated debt-for-equity conversion) the Board calls
Page 33
on the restructuring banker to organize and negotiate with the relevant creditor groups.
Based on guidance from the restructuring banker, the Board expects to retain between
10% and 20% of the fully de-levered company.
The Negotiating Dynamics
In the first hypothetical, we greatly simplified the negotiating dynamic (and the
implementation process) by assuming that a single institution held all of OpCo’s
outstanding unsecured notes. For this example, we are going to relax this assumption; in
this case, we assume OpCo’s outstanding unsecured notes are held in unequal amounts by
at least 30 institutions, and that the five largest holders each own between 10% and 15%
of the outstanding notes.
The first goal of the restructuring banker is to reduce the restructuring proposal to
writing, and present the written proposal to a group that represents, or speaks for, a
consensus amount of each affected class of claims (or interests). In this case, drafting the
restructuring proposal is easy; identifying and coordinating the creditor groups is the
difficult matter.
With regard to the bank group, we will maintain the simplifying assumption that a single
lending institution holds OpCo’s outstanding bank debt. The restructuring banker
identifies the appropriate individual (or group of individuals) at the bank, introduces
himself, sends the restructuring proposal and schedules a meeting to follow-up. In this
hypothetical, the bank debt is either being cured and reinstated (on top of a largely deleveraged capital structure) or refinanced and repaid. At the meeting, the restructuring
banker points out that, in reality, he is only asking the bank for enough time to negotiate
with the note holders and implement a Board-approved restructuring. The restructuring
banker points out that, in the event of a successful debt-for-equity exchange, OpCo would
be an attractive borrowing prospect for any bank. Despite the current default, OpCo’s
existing bank lender understands the value of keeping a performing (and fee paying) loan
in its portfolio, agrees that a successful restructuring would create an attractive borrowing
candidate and understands the costs to a non-consensual process21. Near the end of the
meeting, the bank principal expresses his relief that OpCo’s management is addressing
the balance sheet in a professional way, and wants to help by waiving the current default
for 60 days and “giving the company the time it needs to negotiate with note holders.” In
return for the 60-day waiver, the principal banker indicates the bank will charge a fee
equal to 0.50% of the outstanding balance, and would like a right to match any proposal
the company receives regarding a re-financing of the bank debt.
Given the fact that the bank debt is over-collateralized, in a formal restructuring the bank
debt would expect to recover its claim, including accrued interest through the effective
date of a restructuring. By asking for a waiver fee, the bank is seeking to increase its
Among other costs, a bank needs to consider the impact having one of its loans fall into the “nonperforming” category, and the attendant impact on its risk-adjusted capital adequacy ratios. As an
individual bank approaches the point of having inadequate risk-adjusted capital (and absent negative
ramifications that result from “ignoring the problem”), the owners of the bank have less of an incentive to
identify and categorize a loan as non-performing.
21
Page 34
claim, and hence its overall recovery. From the company’s perspective, the value of the
60-day waiver is illusive; absent an agreement with note holders (or at least a standstill
during negotiations) the company is still in a default position. Though the bank couldn’t
call a default until the waiver expired, nothing prevents the note holders from doing so.
However, in the event the company develops a coherent negotiation with note holders, a
bank standstill will have value insofar as it provides a negotiating environment that is
within the control of the negotiating parties; it takes the bank out of the immediate
negotiation. The restructuring banker takes the matter under advisement and indicates he
will go back to the Board with the bank’s request and the follow-up with the bank.
After explaining to the Board the potential benefits of a standstill, the restructuring
banker advises the Board that the approximately $200,000 waiver fee was worthwhile in
the event it promoted a successful negotiating environment. On the other hand, in the
view of the restructuring banker, the right of first refusal on a refinancing was
overbearing, and would inhibit OpCo’s ability to create a competitive process for a bank
refinancing. While the waiver was a one-time, relatively modest expense, a chilled
refinancing process risked costing the company at least 50 basis points in recurring
interest charges. The restructuring banker also reports to the Board that, in an effort to
realize the value of the standstill, he identified and initiated contact with the 5 largest note
holders. The restructuring banker also reports that, collectively, these institutions owned
65% of OpCo’s outstanding unsecured notes and that they wanted to organize themselves
into a negotiating committee (a “Committee”) and hire professional legal and financial
advisors.
Based on the foregoing, the restructuring banker advises the Board to propose a 90-day
standstill with the bank that commences on the day the 30-day grace period expires in
return for a 50 basis point fee (that is added to the loan balance) and, if absolutely
necessary, a right to participate in some material minority amount (e.g., 30% - 40%) of
any bank refinancing that is agreed to during the restructuring process.
With regard to the note holders, the restructuring banker recommends that the Board
approve the retention of professionals on behalf of the Committee, subject to certain
restrictions. To begin with, the restructuring banker explains that the role these
professionals play is similar to the role he and the restructuring attorney are playing for
the Board – they provide analysis and advice (to the Committee) regarding restructuring
options. If properly informed, the theory goes, the Committee was more likely to engage
in a rational (i.e., value maximizing) negotiation. In addition, the restructuring banker
recommends structuring the retention contracts to incorporate a financial incentive (a
transaction fee) that rewards a timely and consensual result22. While the transaction fee
should not motivate these professionals to achieve any particular result, and thus not
create any credibility-sapping conflict of interest, a properly structured transaction fee
will motivate the professionals to be pro-active and work to catalyze a consensus within
the group they are advising. As a pre-condition to hiring the outside professionals on
22
While the professionals work on behalf of the Committee, the engagement contract is an obligation of the
company.
Page 35
acceptable terms, the restructuring banker recommends that the Board require the 5 large
note holders agree to “get restricted” 23 and actively participate in a negotiating
committee. After active deliberations, the Board agrees to support the recommendations
of the restructuring banker and directs the restructuring banker to (1) negotiate acceptable
terms for a 90-day standstill with the bank and (2) organize the note holders into a
committee and (3) initiate a negotiation with such committee. The last task includes
negotiating acceptable (i.e., transaction motivating) terms for the retention of committee
professionals.
After another meeting between the bank principal and the restructuring banker, the two
sides agree on a waiver of defaults and a 90-day standstill commencing on the expiration
of the grace period in exchange for a 50 basis point fee, to be added to the loan balance
and payable at maturity. Ultimately, the bank did not insist on a participation in any
future lending agreement, but the restructuring banker did commit that the company
would review and respond within one week to any refinancing proposal the bank had to
offer. With this agreement in place, the restructuring banker turns his attention to the
matter of organizing a formal committee.
As noted above, we are assuming that the notes are held by a large number of institutions,
but that 65% of the notes are concentrated with 5 large holders. To understand the
significance of the ownership figures, we have to address the two inter-related questions
posed (but assumed away) in the first hypothetical. First, according to the bankruptcy
laws of the jurisdiction, what constitutes “consensus” for any particular class? And next,
according to the bankruptcy laws of the jurisdiction, what treatment is afforded to nonconsenting members of a consenting class? These questions are important because they
affect the methodology by which a company would hope to implement any negotiated
exchange –based solution.
In our first hypothetical, we had a single holder of the unsecured notes. Any negotiated
solution could be implemented by way of a bilateral exchange agreement. Because the
company was only dealing with a single counter-party, the company knew it would
achieve participation by 100% of the outstanding notes. If more than one party holds
notes, the company has no guarantee of full participation. Any settlement negotiated
between the company and the “bankruptcy consensus” majority is exposed to “holdout”
risk, or the risk that some holders of a “minority” amount of notes may elect not to
participate in the negotiated exchange offer. When debt issues are widely held, holdout
risk always exists. However, holdout risk is particularly acute when debt holders are
being impaired on a value basis and when debt securities, like the notes, are being
exchanged for more junior securities (e.g., an equity interest in a company).
23
In restructurings, it is common for some (or most) of the outstanding claims to be structured as publicly
traded securities. Depending on the jurisdiction, there are usually restrictions on buying and selling
securities when in possession of material, nonpublic information. By participating in a restructuring
negotiation, the security holder becomes privy to some level of material, non-public information (even if
the only additional information is the bid and the ask) and thus, is prevented from trading in the securities
of the company. In the context of a rapidly evolving and potentially, unstable restructuring environment,
this restriction is often an important concession for a security holder to make and is an expression of a
sincere desire to negotiate to a conclusion.
Page 36
In a situation where debt securities are being impaired on a value basis, holdout risk is
driven by economic considerations. For example, recall that in our second hypothetical,
OpCo has $40 million of bank debt and $150 million of notes, and the preliminary
valuation range, before credit for likely cost savings, is between $160 million and $195
million. Assuming that an average note holder uses the low-end of the range for the
exchange decision (not an unlikely assumption, in the experience of this practitioner), the
note holder might produce the following analysis.
OpCo
Holdout Analysis
($ in millions)
Enterprise Value
Plus: Cash
Distributable Value
$
Less: Secured Term Loan
Distributable Value to Noteholders
$
Claim
Holdout Noteholders (34.0% of Noteholders)
Participating Noteholders (66.0% of Noteholders)
Aggregate Noteholders
$
$
53.7
104.2
157.9
160.0
6.9
166.9
40.0
126.9
Distribution
$
$
53.7
73.3
126.9
% Recovery
100.0%
70.3%
80.4%
As indicated, if 100% of the notes participate in an exchange offer that converts all
participating notes into a ratable share of 100% the subject company’s post-exchange
equity, each note would recover 80.4% of its claim value. In the event that less than
100% of the outstanding notes participate, the holdout notes (enjoying priority in a newly
equitized capital structure) would retain their claim. If the holdout percentage is low
enough (in our case 34%), then un-exchanged claims would be valued at par (as they are
in the above analysis) and the post-exchange equity value would be reduced dollar-fordollar to account for the holdout claims. The participating notes would still get 100% of
the pro forma equity, and the equity would be spread over a smaller pool of claims (i.e.,
each participating claim would receive a higher percentage of the pro forma equity) but
the equity is now worth less than before and, as indicated, the expected recovery for
participating notes is reduced to 70.3% of claim value. The disparity in recovery, 100%
for a holdout versus 70.3% for an exchanging holder, is the principal driver of holdout
risk in a value impairment situation.
Even at the high-end of the valuation range, where note holders are arguably unimpaired
on a value basis, holdout risk is high. For one thing, being unimpaired versus “arguably
unimpaired” is not the same thing. Unless note holders are clearly receiving full value,
economic holdout risk is relevant. Next, institutions and individual holders that invest in
bonds are investing in fixed-income securities, either by choice or by charter. They either
do not want to own a different asset class or may be prohibited (or significantly
disincentivized) from owning other asset classes. For example, consider a high-end
valuation case, but where the note holder is a regulated financial institution that must
Page 37
meet risk-based capital adequacy ratios. These types of calculations cause the regulated
entity to follow proscribed rules for valuing its investment portfolio and, because the
value of an equity instrument is less certain and more volatile than the value of a debt
instrument of the same issuer, regulatory agencies often structure rules to encourage the
regulated institution to hold securities of more determinate and stable value. So, even if
the regulated financial institution is convinced of the high-end valuation and thus, is
economically indifferent between participation and holdout, it will likely not participate
in a voluntary exchange if participation causes the institution to have to increase its riskbased capital (relative to the value of the institution’s investment portfolio).
Other types of investors that tend to holdout when fixed income securities are exchanged
for equity include closed-end bond funds. Closed-end bond funds (e.g., Collateralized
Debt Obligations and Collateralized Loan Obligations) are a prominent form of leveraged
investment vehicle that raises a fixed amount of debt and equity capital and invests it in
participations in fixed-income securities. By their charter or indentures, they are unable
to hold equities and hence, a holdout risk. For this investor category, only cash (to
reinvest) or new fixed-income securities will suffice. To address this problem, many
debt-for-equity exchanges require the company take all reasonable steps to create a public
market for the new equity and hence, a way for these (and other) investors to monetize
consideration.
As indicated in the above analysis, the cost of holdouts to participating note holders can
be substantial. To eliminate this “free rider” problem, one generally has to look at the
bankruptcy laws of the relevant jurisdiction. In most jurisdictions, in the event a
consensus majority of a class of creditors approves a particular class treatment (and
assuming certain other conditions are met), the bankruptcy laws allow equal treatment to
be imposed on non-consenting creditors of the consenting class. In other words, most
bankruptcy laws allow a consensus majority of claimants of a particular class to bind the
minority, non-consenting claimants of that class to the treatment agreed to by the
consensus majority. Because of the ability to bind holdouts, a bankruptcy code can be a
powerful tool to drive negotiations to a consensual resolution (by freeing the negotiation
from the “tyranny of the minority”) and to implement transactions in a manner that
eliminates free rider inefficiencies without unfairly discriminating against any particular
class member. For our hypothetical, we will adopt the United States standard for
bankruptcy consensus, namely; that a class of claims accepts a plan treatment if such plan
treatment is accepted by creditors that hold at least two-thirds in amount and more than
one-half in number of the allowed claims of such class that vote to accept or reject such
plan treatment.24
With this in mind, the restructuring banker reviews his list of note holders. In this case,
nearly two-thirds of the claims are held by a limited number of institutions. Clearly an
agreement with this group would go a long way towards achieving a super-majority
consensus. To organize a dialog with this group, the restructuring banker speaks to
several of the large note holders and invites them to form an ad hoc negotiating group
that includes the five large note holders. The restructuring banker indicates that the
24
See 11 U.S.C. §1126 (6).
Page 38
company will pay for legal and financial advisors for the group, subject to reviewing and
approving the engagement contracts.
Once professionals are retained for the Committee, they execute confidentiality
agreements with the company and begin to review and analyze material and non-public
information about OpCo, its operations and contractual commitments.
These
professionals are also likely to spend time communicating with members of the
Committee to establish a schedule for a negotiating process, and to begin to assess the
views and goals of the individual holders regarding an optimal restructuring outcome. At
this point in time, committee professionals are researching and attempting to draw
conclusions to the same questions that faced the company’s professionals. What is the
company worth? How much debt can it support? What are the amount and priority of the
various classes of claims? And, what are the time, cost and expected value of achieving a
court-supervised, absolute priority distribution of value?
With less than a week to go in the 30-day grace period, the restructuring banker calls the
Committee banker and invites him and his clients to a meeting to present the background
and support for the Board’s preferred restructuring solution. At the meeting, the
restructuring banker and management present OpCo’s revised operating plan, and discuss
the risks to the plan. In particular, the presentation outlines risks that could immediately
reduce the going concern value of OpCo, such as the potential for customer defections
due to OpCo’s highly leveraged balance sheet.
The restructuring banker indicates that, to reduce to the risk to the business, the Board
has made the courageous decision to cede control of the company to note holders in
connection with a full conversion of the outstanding notes into equity. Specifically, the
restructuring banker presents the following analysis to the note holder group and their
advisors.
OpCo
Conversion of Debt to Equity
($ in millions)
Accrued Interest Paid in Equity
Enterprise Value
Plus: Cash
Distributable Value
$
Secured Term Loan
200.0
6.9
206.9
$
245.0
6.9
251.9
Accrued Interest Paid in Cash
$
200.0
6.9
206.9
$
245.0
6.9
251.9
40.0
40.0
40.0
40.0
Distributable Value After Secured Term Loan
Less: Cash Paid for Accrued Interest
166.9
0.0
211.9
0.0
166.9
7.9
211.9
7.9
Implied Equity Value
166.9
211.9
159.1
204.1
10.5% Senior Notes due 2006 Claim
$
% of Implied Equity
157.9
94.6%
$
157.9
74.5%
$
150.0
94.3%
$
150.0
73.5%
At this juncture, the restructuring banker makes the specific offer to convert all of the
outstanding notes into 80% of the post-restructuring equity. The banker goes on to
indicate that the company will agree to reconstitute OpCo’s Board of Directors to reflect
Page 39
the new ownership percentages. The restructuring banker explains that the Board
considered several other alternatives, including a sale of the company, which was rejected
because it didn’t take advantage in the expected, “highly likely” improved performance
and valuation, and alternative exchange consideration, including a combination of debt
and equity, but, for a variety of reasons, preferred a full equitization. First and foremost,
a de-leveraged balance sheet would help the company repair its reputation with customers
and suppliers, and would increase the probability of achieving forecasted results. And
next, if note holders insisted on retaining a substantial debt claim, then the trade-off was
control of the equity. Because the Directors believed that a de-leveraged balance sheet
gave OpCo its highest expected value, they were willing to concede control of the firm to
achieve this result.
With that, the restructuring banker and the company ended their presentation. The
Committee and its professionals thanked the company for the presentation and the
proposal, and retired to consider their alternatives and response.
To begin with, the financial and legal professionals make sure the Committee is clear on
the laws and process that would govern a non-consensual process. The Committee’s
banker also notes that a prolonged, non-consensual process would pose a very real risk to
enterprise value. Because the duration of a non-consensual process rests on valuation,
the Committee’s banker expresses his opinion that the company’s valuations may be
aggressive, especially in the “assumed cost savings” case, but, on balance, were
defensible. And the attorney reminded creditors that, if OpCo had to file for bankruptcy
protection, they would not accrue interest on their claim during the proceedings. In other
words, a non-consensual process was uncertain, and, most likely, would cost creditors
absolute economic value and time value. The Committee’s restructuring professionals
also noted that, in this particular circumstance, OpCo’s owners seemed particularly
enlightened; in an effort to maximize value for all parties, they were willing to cede
control of the equity (and hence, the company). The more traditional response would
have been to offer enough new debt so that old equity could retain control, and claim the
still leveraged balance sheet would not affect customer and vendor confidence. Both
professionals also note that the 30-day grace period on the interest payment default
expires in less than a week and, after expiring, the company was at risk of being forced
involuntarily into a bankruptcy proceeding. In summary, both professionals expressed a
view that time was of the essence, and that the Committee should take the opportunity to
negotiate aggressively to a consensual resolution.
After considering the advice of their professional advisors and seizing on the good
judgment of the Board, the five note holders agree to support a full equitization, but agree
that taking less than 90% of the equity is “a mistake.” The Committee’s professionals
work to get the five holders to agree to a counter-proposal that converted 100% of the
outstanding notes into 91% of the pro forma equity, and paid the outstanding accrued
interest in cash. With that, the Committee ends their deliberations and the Committee
professionals convey the counter-proposal to the restructuring banker.
Page 40
Over the next two days, the parties engage in spirited negotiations that result in an
agreement to convert 100% of the outstanding notes into 86% of the pro forma equity,
with accrued interest (through the closing of any transaction) paid in cash, on the closing
date. The agreement was contingent on the company obtaining a new bank facility that
provided enough liquidity to pay the accrued interest, and leave the company with a
minimum of $10 million of available liquidity. After all, if the note holders were about to
become equity, they wanted to create as much “duration” as possible. The parties agree
to attempt to complete the transaction through an exchange offer, but closing the
exchange offer was conditioned on achieving a 95% acceptance rate. In other words,
participating note holders were willing to tolerate a limited “free rider” tax from holdouts.
But what happens if less than 95% of the outstanding notes agree to exchange?
In sophisticated jurisdictions, there is a useful trend towards using the bankruptcy laws to
implement negotiated settlements between a company (really, the equity owners) and
consensus group of creditors. The principal reason for relying on bankruptcy laws is the
embedded ability to bind holdouts to a transaction and eliminate free rider taxes. In such
jurisdictions, a company would seek to gain an agreement with the required “bankruptcy
consensus” and then either work to complete an out-of-court exchange with a very high
minimum acceptance rate or simply file for bankruptcy, with either a pre-negotiated or
pre-solicited plan of reorganization. In the case of a pre-solicited deal (in the United
States, known as a “pre-packaged” plan), the company solicits acceptances to an
exchange and acceptances to a plan of reorganization with the same ballot. If the
company reaches the minimum tender condition, it closes on the exchange offer; if the
exchange offer fails the minimum tender condition but achieves a “bankruptcy
consensus”, the company would seek bankruptcy court approval to implement its presolicited plan. In permitting jurisdictions, the bankruptcy court assumes that the out-ofcourt solicitation process (that was supervised by the relevant securities regulatory
authorities) was valid and waives the need for any in-court solicitation of a plan of
reorganization. While a pre-solicited transaction can save substantial time in court
(where costs grow and enterprise values shrink), it assumes that the company can
generate a solicitation document that is acceptable to the relevant securities regulatory
authorities. In the United States, it is often faster (and sometimes easier) to seek and gain
the approval of the bankruptcy court on the sufficiency of a solicitation document rather
than look to the Securities and Exchange Commission. In this circumstance, a company
would pre-negotiate a transaction with a consensus or near-consensus group of creditors,
prepare all relevant documentation, then file for bankruptcy. While in bankruptcy, the
court would review and comment on the solicitation document, then, if certain defined
criteria are met, approve the document and the solicitation process. After solicitation
(very similar, whether in-court or out-of-court) and achievement of a consensus vote, the
bankruptcy court would approve the plan of re-organization. This process is known as a
“pre-arranged” or “pre-negotiated” bankruptcy. In practice, the decision between a “prearranged” versus a “pre-packaged” process rests on the whether one expects an easier and
faster approval process for the solicitation document with the relevant securities
commission or the bankruptcy court.
Page 41
In our hypothetical, we’ll assume that OpCo executes voting agreements with the five
largest holders. The voting agreements contractually obligate the committed bondholder
to vote for the negotiated transaction. They also allow the signing holder to sell the
committed bonds to another investor, as long as the purchaser also agrees to support the
transaction. This sort of arrangement gives the company certainty regarding achievement
of a consensus and gives the holder more options for liquidity. With 65% of the notes
committed to support a transaction, the company only needs to gain the support of one
more significant holder to achieve a “value” consensus. Until the solicitation takes place,
the company can never really be certain about achieving a “numerosity” consensus.
At this juncture, the company will decide whether a pre-packaged plan or a pre-arranged
plan is more expeditious, and will make a public announcement about the terms of the
exchange transaction, the percent of note holders that support the transaction, and would
likely include any other material facts, including that the company will likely seek to
implement the transaction through a formal court proceeding. In practice, if a company
garners the support of an ad hoc committee that represents a significant amount of bonds
and includes sophisticated institutions, it is very likely to be able to “up-sell” the
transaction to a larger group of note holders. Usually, enough other holders (in this case,
the other 25 holders that own 35% of the notes) will respect an arms-length transaction
negotiated by adversarial parties as “fair” and either support the settlement or abstain
from voting. This market dynamic often gives a company confidence in its ability to
achieve a consensus despite negotiating with a committee that owns less than a threshold
amount of claims.
With 65% support in hand and a draft solicitation document at the ready, OpCo elects to
file for a pre-arranged bankruptcy. After receiving approval for the solicitation document
from the court (a 60 to 90 day process in the United States) and conducting a solicitation
(a 30 day process) where the company garnered the support of more than two-thirds of
the amount and at least 50% of the holders of the notes that actually voted to accept or
reject the plan, OpCo seeks to have its plan “confirmed” by the court. With no
significant objections, OpCo’s plan of reorganization is approved. After a 10-day appeal
period, OpCo’s plan “goes effective.” The old notes are cancelled and shares are issued
to holders of old notes. After emerging from bankruptcy (about 120 to 150 days after
filing a bankruptcy petition) OpCo is newly re-capitalized and has a new ownership
structure.
Market Example of Debt-for-Equity Exchange: Netia S.A.
Netia S.A. (“Netia” or the “Company”), formerly Netia Holdings S.A., is the largest
alternative fixed-line telecommunications operator in Poland. The Company operates
local and regional digital fiber-optic networks, targeting large to medium-sized business
customers. Netia offers switched fixed-line telephony for directly connected customers,
ISDN, Internet services, leased lines and voicemail. At the time of its restructuring, Netia
held 24 licenses to provide local voice telephony services in territories covering some 15
million people or approximately 40% of the Polish population.
Page 42
Incorporated in 1990, the company was founded by a group of Polish entrepreneurs to
take advantage of business opportunities created by the deregulation of the Polish
telecommunications market. Initial success led to several rounds of private equity
funding. Although still cash flow negative at the time, the Company raised $497 million
of debt financing in 1997 to fund construction of a nationwide network. Despite failure
to meet projections, the Company returned to the capital markets in 1999 to raise an
additional $309 million through two new high-yield issues and an initial public offering
of ADSs on the NASDAQ. By mid-2001, however, the Company’s cash reserves had
dropped to $173 million. With revenues of EUR 116 million, EBITDA of EUR 6 million
and interest expense of $119 million, the Company was rapidly approaching financial
collapse.
In light of these liquidity concerns, the Company retained financial advisors in the
summer of 2001 to seek a capital-markets based solution that would allow Netia to
address its balance sheet problems and avoid insolvency. In November 2001, Netia
announced a proposed Exchange Offer and Consent Solicitation of the Company’s
outstanding Notes. The objective of the offer was to purchase up to 85% of each class of
notes through a “modified Dutch auction” at 11% - 14% of face value, subject to a
minimum subscription of 65% in total and 50% for each individual bond issue. The
Tender Offer also contained provisions for an additional 1% of face value to be paid as a
consent payment for tendering note holders.
Netia S.A.
Summary of Exchange Offer
Summary
Summaryof
of Exchange
Exchange Offer
Offer
Se curity
Exchange Offer
Cash Paid Under
Note
Initial / Outstanding
Initial / Outstanding
Amount to
Principal Amount
P rincipal Amount (€m)
be redeemed
Exchange Offer (€m)
Exchange Offer
Low
High
Low
High
10.25% Senior Notes due 2007
11.25% Senior Discount Notes due 2007
$ 200.0 million
$ 193.6 million
€ 179.5 million
€ 173.8 million
85.0%
85.0%
11.0%
11.0%
14.0%
14.0%
16.8
16.3
21.4
20.7
11.0% Senior Discount Notes due 2007
DM 207.1 million
€ 105.9 million
85.0%
11.0%
14.0%
9.9
12.6
13.5% Senior Notes due 2009
€ 100.0 million
€ 100.0 million
85.0%
11.0%
14.0%
9.4
11.9
13.125% Senior Notes due 2009
$ 100.0 million
€ 89.8 million
85.0%
11.0%
14.0%
8.4
10.7
13.75% Senior Notes due 2010
€ 200 million
€ 200.0 million
85.0%
11.0%
14.0%
18.7
€
79.4
23.8
€
101.0
Note holder reaction was swift and unequivocal. Within days, a group of like-minded
investors formed an Ad Hoc Creditors’ Committee to act as a focus point for collective
action. Shortly thereafter, the Committee interviewed and retained financial and legal
advisors to assist them in negotiating with the Company. By the end of the first week of
the Tender Period, the Committee included well in excess of 50% of the notes – the
threshold for blocking both the Company’s proposal as well as any proposed
modifications to the indentures. Following a letter from the Committee indicating that
creditors had no interest in either the terms of the structure of the proposed deal, the
Company acknowledged defeat and allowed the Tender Offer to expire on its terms on
December 7, 2001.
Page 43
On December 15, 2001, Netia defaulted on several interest payments on two series of the
Company’s notes. Those defaults triggered cross-default provisions under the terms of
the indentures governing all the other series of notes. The Company also defaulted on
swap payments under certain swap agreements.
Following the failure of the Tender Offer and the defaults, the Committee initiated a
dialogue with the Company to discuss the terms of a comprehensive financial structure.
Given the Company’s need to re-invest all of its free cash flow in operations, it was
quickly determined that Netia required a comprehensive restructuring of the balance
sheet through a debt-for-equity exchange. To that end, the Committee prepared a term
sheet in line with international norms that would transfer nearly 100% of the equity to the
noteholders in exchange for a complete conversion of debt to equity.
Two problems became quickly apparent. First, Poland’s insolvency law was antiquated,
dating from 1934, and lacked the necessary provisions to enforce a debt for equity swap.
In particular, the insolvency laws did not override corporate statutes that required
shareholder approval for any issuance of shares. Second, the two largest shareholders,
who collectively owned 57.4% of the equity, had a dispute based on provisions of an
inter-shareholder agreement. In particular, any issuance of shares below a threshold
valuation (a certainty under a debt-for-equity exchange) would trigger a liability of up to
$50 million owed from one shareholder to the other. Despite intense negotiations, the
parties were at a standstill.
In combination with the outstanding defaults, the deadlock between the shareholders
forced the company to seek protection under Poland’s insolvency regime.25 Accordingly,
on February 20, 2002 Netia S.A. and its two operating subsidiaries, Netia Telekom S.A.,
and Netia South Sp. Z o.o., petitioned the court in Warsaw to open arrangement
proceedings.
Although the court proceedings called for the appointment of a court administrator that
would oversee operations and authorize cash disbursements, discussions regarding the
financial restructuring continued to be conducted by the Committee, the Company and
relevant shareholders. Management stayed in place and continued to direct the day-today operations of the business.
On March 31, 2002 and after difficult negotiations, the Company, the Committee and the
shareholders came to general terms regarding the debt-for-equity swap. Unsecured
creditors, including note holders and swap creditors, received 91% of the post-exchange
equity. Creditors also received a ratable share of EUR 50 million of new issue notes,
secured under Polish law. Existing equity holders were left with 9% of the pro forma
equity, and were granted warrants priced at a slight premium to market for up to 15% of
25
Under Polish Law, distressed companies may either file for bankruptcy (essentially a liquidation
proceeding) or petition for the opening of arrangement proceedings (a work-out process). Under
arrangement proceedings, the court can unilaterally reduce the amount of debt or change its terms subject to
certain limitations.
Page 44
the company’s post-restructuring share capital. The terms of the settlement between the
shareholders was not disclosed.
Despite agreement on the economic terms, the restructuring process took the better part
of nine months to implement, and incorporated legal proceedings in three jurisdictions:
Dutch moratorium proceedings, Polish arrangement proceedings and proceedings in the
United States of America under Section 304 of the U.S. Bankruptcy Code. The length of
the process was driven by a wide variety of novel legal challenges.
Despite the difficulties, the transaction closed on December 31, 2002. Since closing, the
new shareholders replaced the Board of Directors and a new management team was
installed. The company has used the fresh start and its strong balance sheet to build a
strong business. Netia has already repaid the notes issued to creditors, and has closed on
two important acquisitions. As a result of these steps, the Company has regained the
confidence of the market and has seen substantial share price improvement since the
restructuring (see table below). Given the alternative, a liquidation of a viable going
concern at a fire-sale price, the restructuring of Netia is a good example of how a
conversion of debt to equity can create value for all stakeholders.
Netia S.A.
Share Price Performance
7
8 Nov 2001
6
5 Mar 2002
5
Company and noteholder
ad-hoc committee, enter
into a restructuring
agreement on the
treatment of Netia’s debt
30 Jan 2003
Registration of series H ordinary shares completed,
giving creditors 91% of Netia’s share capital
16 May 2002
Completion of restructuring
4
3
14 Jun 2002
2
1
Company and the majority
of creditors enter into an
agreement on the terms of
the debt-for-equity swap
15 Dec 2001
6 Nov 2002
Defaulted on interest payments
causing cross defaults on all six
notes outstanding and defaulted on
swap payments to JPMorgan Chase
Bank
Dutch court rules existing claims
under notes and swap agreements in
Dutch subsidiaries are no longer
enforceable
0
2 -N
ov
2 -D 0 1
ec
- 01
2 -J
an
- 02
2 -F
eb
2 -M -0 2
ar 2 -A 0 2
p r2 -M 0 2
ay
-0
2
2 -J
un
-0
2 -J 2
u l2 -A 02
ug
- 02
2 -S
ep
-0 2
2 -O
ct 2 -N 02
ov
2 -D 0 2
ec
- 02
2 -J
an
- 03
2 -F
eb
2 -M -0 3
ar 2 -A 0 3
p r2 -M 0 3
ay
-0
3
2 -J
un
-0
2 -J 3
u l2 -A 03
ug
-0 3
2 -S
ep
-0 3
2 -O
ct2 -N 03
ov
2 -D 03
ec
-0
2 -J 3
an
- 04
2 -F
eb
2 -M -0 4
ar 04
Share price (Polish Zloty)
Announced a proposed Exchange Offer and consent solicitation
of the Company’s outstanding Notes
Page 45
Cash Tender Offer
To illustrate a cash tender offer we will stay with OpCo, post the leveraged recapitalization transaction, but add assumptions regarding the equity owner(s). In this
hypothetical, we are going to assume that a single owner holds 90% of the existing equity
and that this owner still has significant cash resources. Recall that the equity owners took
a $100 million debt-financed dividend from the company four years ago.
At present, OpCo finds itself in a familiar position. OpCo does not have enough
available cash to make the December 31, 2003 coupon payment on its outstanding $150
million of 10.5% Notes due 2006. The company retained its cash to maintain operating
flexibility, and hired our old friend, the restructuring banker. In short order, the company
had a standstill in place with its bank lender and was communicating with a coherent
group of note holders that owned more than two-thirds of the notes.
Once again, the restructuring banker (and his expert staff) undertake substantial due
diligence, including interviews with management. Next, the restructuring banker
produces a preliminary valuation analysis and a preliminary debt capacity analysis. As in
the previous hypothetical cases, the restructuring banker concludes that OpCo is currently
worth between $160 million and $195 million, and that OpCo can support between $100
million and $140 million of par-value debt securities.
After discussing the various options, including maintaining the status quo, an immediate
sale of the company and an internal restructuring that converts debt to a controlling
ownership interest, the banker asks if there are any questions. At this point, the
controlling equity owner (who is also on the Board of OpCo) indicates that, at a $160
million valuation, he was willing to invest in OpCo and let OpCo use the cash to retire
debt. To explain his idea, he produces the following analysis.
OpCo
Debt-for-Cash Offer Analysis
($ in millions)
Enterprise Value
Plus: Cash on Balance Sheet
Total Distributable Value
Secured Term Loan Distribution
Residual Value
$
$
160.0
6.9
166.9
$
40.0
126.9
% of Residual Value Distributed to Notes
100.0%
95.0%
90.0%
85.0%
(1)
Implied Equity Value
$
126.9
120.6
114.2
107.9
% Recovery
(1)
80.4%
76.4%
72.4%
68.3%
Assumes noteholders' claim is equal to $150.0 million of outstanding notes plus $7.9 million of accrued interest.
The controlling owner suggests that, if OpCo is worth $160 million, then wasn’t it correct
to say that any internal restructuring should bring note holders between $107.9 million
Page 46
and $120.6 million, depending on whether note holders negotiated for between 85% and
95% of the pro forma equity. And surely note holders would prefer cash to equity
securities. The controlling shareholder indicates that, at the high-end of this range, note
holders would recover just over 76% of their claim; he would like to invest cash in the
company and have it use the cash to retire debt. Based on a full conversion of the notes
to equity, a 95% / 5% split of the residual value (after allocating existing cash to note
holders), and a $100 million investment, the controlling shareholder indicated that, his
new investment would purchase about 83.3% of the pro forma equity. Note holders
would receive their ratable share of $106.9 million of cash (the new investment, plus cash
on the balance sheet) and about 11.7% of the equity; old equity would retain 5% of the
pro forma equity. The controlling shareholder uses the following chart to explain his
potential offer.
OpCo
Distribution of Potential Debt-for-Cash Offer
($ in millions)
Enterprise Value
Less: Secured Term Loan Distribution
Residual Value (1)
$
$
160.0
40.0
120.0
Noteholders
Residual Value Split Prior to New Investment
Residual Value
$
% of Residual Value
Residual Value Split After New Investment
Residual Value
Total Distribution to Noteholders
% Recovery
114.0
Old Equity
$
95.0%
$
% of Residual Value
Recovery to Noteholders
Cash from New Investment
Cash on Balance Sheet
11.7% of Pro Forma Equity
New Investor
14.0
11.7%
$
100.0
6.9
14.0
$
120.9
(2)
6.0
5.0%
$
100.0
83.3%
$
6.0
5.0%
76.6%
(1) Assumes cash on balance sheet is paid out to noteholders.
(2) Assumes noteholders' claim is equal to $150.0 million of outstanding notes plus $7.9 million of accrued interest.
When asked by other members of the Board about this course of action, the restructuring
banker indicates that the transaction is akin to a sale of the company to the controlling
shareholder. While it may be more customary to approach a wider buyer universe in
hopes of attracting a higher purchase price, there were several reasons to consider this
offer. First, time was of the essence. Without a coherent restructuring plan that gained
creditor support and restored market confidence, OpCo was in danger of spiraling into a
cycle of distress and value destruction. While the controlling owner’s proposal would
likely not gain note holder support without some sort of negotiation, it would go a long
way towards restoring customer and supplier confidence.
Page 47
Next, the restructuring banker pointed out that, by investing a small amount of money as
equity underneath the existing bonds (enough for OpCo to make the outstanding interest
payment), the controlling owner could effectively “extend duration.” This course of
action could put the company (and note holder recoveries) in significant jeopardy. As
noted earlier, because the company is so leveraged and because all (or nearly all) residual
value accrues to the benefit of equity, a modest investment that is likely to be lost but
which extends duration may be rational (expected value maximizing) to equity. But, as
also noted earlier, if this course of action fails, the loss of value can be devastating to
creditors and other stakeholders.
On balance, the restructuring banker indicates that the offer to invest is not unreasonable,
and with certain modifications, could be a fair transaction. In particular, if the controlling
shareholder allowed the company to “test the market” and solicit other potential buyers,
the company could be assured of maximizing value. In return for the opportunity to
expose a firm offer to the market, the controlling shareholder could expect certain
protections including, among others, a break-up fee (typically equal to between 2% and
5% of the value of the transaction), certain time limitations (for example, a 60-day
window to solicit other bids) and a minimum required over-bid. In the alternative, the
restructuring banker suggests that note holders could be offered a choice between (x) the
offer by the controlling shareholder (for each $1000 note, $713 of cash and its ratable
share of 11.7% of the pro forma, de-leveraged equity) and (y) a straightforward exchange
of the notes for approximately 90% of the pro forma equity (the debt-for-equity exchange
of the previous hypothetical). The controlling shareholder expresses a preference for
making an investment, but has no interest in seeing the potential transaction “shopped.”
He also expresses a strong preference for a more limited investment to fund the
outstanding interest payment, as opposed to ceding control of his company.
Now the restructuring banker faces a dilemma. The company hired the banker and, at the
moment, equity is in control of the company. Because of the likely state of insolvency or
near insolvency, equity (the residual claimant) is gaining a strong economic incentive to
invest a little of its own money (and a lot of value that, in an absolute priority
distribution, would belong to note holders) in the highly variable, low probability status
quo strategy. The restructuring banker knows that a de-leveraging transaction would
maximize the expected value of the firm, but the banker is facing the additional constraint
that the controlling shareholder seems unwilling to cede control. However, because the
controlling shareholder is willing to make a substantial equity investment in the company
to fund a repurchase of the debt, the banker believes the issue may simply be a question
of price (i.e., note holders would accept a re-purchase that reflects an enterprise value
greater than $160 million). With hope for a negotiated settlement, the restructuring
banker decides to bring the principal actors together for a direct negotiation.
The restructuring banker establishes a meeting between the controlling shareholder and
his personal attorney, and the ad hoc Committee of five large note holders and their
restructuring professionals. OpCo’s restructuring attorney and its senior operating
manager are also in attendance. The restructuring banker begins by presenting the
proposal by the controlling shareholder. He explains that, in effect, the proposal is an
Page 48
offer to undertake three simultaneous transactions: a conversion all of the notes into 95%
of the pro forma equity, the purchase of a 45.45% share of OpCo’s pro forma equity by
the controlling shareholder for $100 million, and the subsequent use of such proceeds by
the company to re-purchase a like amount of the post-conversion equity held by the note
holders at a price that reflects a $160 million enterprise value. In addition, the company
would pay all of the cash currently in OpCo’s possession over to the note holders. To
illustrate the transaction, the restructuring banker produces the following exhibit.
OpCo
Details of Stockholder Proposal
($ in millions)
Proceeds to Note Holders
Cash from New Investment
Cash from Balance Sheet
Total Fixed Recovery
Retained Equity of 11.7% @ $160.0 TEV
$
$
100.0
6.9
106.9
$
14.0
120.9
(1)
Buy-in Price Calculation
Investment
% of Equity Purchased
$
100.0
83.3%
Implied value of 100% Equity
Plus: Pro Forma Debt
$
120.0
40.0
Implied TEV
$
160.0
(1) Total Enterprise Value ("TEV") includes $40.0 million of remaining bank debt.
At this point, the leading note holder suggests that, perhaps the company should stop at
the first step and simply convert all of the notes into 95% of the pro forma equity. The
note holder suggests that, after the conversion, the new owners could decide what to do
with the company. The restructuring banker explains that this option is not available; the
controlling shareholder would rather invest enough capital to make the outstanding
interest payment and cure the default than cede control of the company. At this point, the
note holder Committee steps into a separate room to consider their options.
As the note holders see it, they have two choices; they can either negotiate a deal with the
controlling shareholder, or they can attempt to force a default on the outstanding notes.
Further, the note holders recognize that forcing a default is of limited benefit; the default
can be cured by a minimal investment by the controlling shareholder. The only potential
leverage the note holders feel they have relates to the potential to bring a cause of action
seeking to avoid the original re-capitalization transaction and recoup the dividend
payment from those who received such payment, including the controlling shareholder.
However, their enthusiasm for this leverage point wanes when the Committee’s
restructuring attorney reminds them of a few key points. First, to pursue the avoidance
action, the company has to be in a formal insolvency proceeding. The company can
avoid this for at least six months with a minimal investment from the controlling
shareholder. Next, the attorney cautions that bringing a cause of action and winning a
Page 49
cause of action are two different things. To win such an avoidance action, a party must
demonstrate that OpCo was insolvent or made insolvent by the recapitalization
transaction. This would be no easy task, considering valuations at the time of the
transaction and the fact that the company stayed current on its new debt for over three
years. In the final analysis, the Committee’s attorney said such a suit, if it could ever be
brought, has a low likelihood of success. With this advice in mind, the Committee
decides a negotiation over financial terms proposed by the controlling shareholder was
the most expeditious course of action.
The Committee understands that the controlling shareholder will not support a transaction
that transfers control of the post-restructuring equity. Also, in light of the aggressive
posture that the controlling shareholder is taking, the note holders realize it is probably in
their best interest to take as much cash off the table as possible as quickly as possible.
Note holders realize they can only improve the current transaction by raising the price at
which the controlling shareholder reinvests in OpCo. This can be done either by (i)
reducing the ownership interest associated with the new money investment, or (ii)
allowing note holders to retain a modest amount of claim ahead of the new investment
(i.e., only convert 80% of the outstanding debt into 95% of the pre-investment equity,
then effectuate the investment/repurchase transaction). After a long deliberation, the note
holder Committee agrees on the following counter-proposal. The company would
convert 85% of the outstanding notes into 99% of the outstanding equity (after all, the
controlling shareholder was the direct beneficiary of any value left for old equity), then
the controlling shareholder would invest $100 million to purchase 79% (out of the 99%)
of the pro forma equity that note holders would own. In addition, note holders would
take all of the cash on the balance sheet. After significant back and forth, both parties
agree on a transaction that converts 90% of the outstanding notes into 99% of the
outstanding equity, then uses the $100 million investment by the controlling shareholder
to purchase 80% (out of the 99%) of the pro forma equity that note holders would own.
The chart below outlines the negotiation.
OpCo
Negotiation Dynamics
($ in millions)
Bid
Cash
Retained Debt
Fixed Value Recovery
$
$
Retained Equity
106.9
106.9
Settlement
$
$
11.7%
106.9
15.0
121.9
Ask
$
$
19.0%
106.9
22.5
129.4
20.0%
Re-investment Enterprise Valuation
$
160.0
$
180.0
$
189.1
EV for 100% Recovery
$
476.5
$
244.2
$
204.7
With consensus terms in hand, the company and its advisors quickly seek to document
and implement the transaction. As discussed above, by using a pre-arranged plan, the
Page 50
company saves some time and gains certainty over the process. The technique also
eliminates any free rider issues.
This concludes the hypothetical discussions exploring the various financial techniques
that professionals employ to resolve balance sheet distress. As demonstrated, even a
simplified hypothetical situation can generate difficult questions of entitlement, allocation
and appropriate incentives. In our hypothetical examples, the relevant bankruptcy rules
were exploited to, among other things, (1) create an assumed “baseline” in-court result to
provide a backdrop for rational out-of-court negotiations and, (2) provide a mechanism to
impose a consensus solution on non-consenting, minority holders of a class. To create a
proper environment for reorganizations, any bankruptcy code must also create a stay
period (to prevent a “run on the bank” mentality) and must create a superior class of
unsecured claim (for example, a post-petition claim) to create liquidity options for a
restructuring company.
Market Example of a Cash Tender Offer: Covad Communications, Inc.
In the hypothetical example of a cash tender offer, the subject company, OpCo, did not
have enough cash on its books to make a required interest payment. The resulting
contractual default catalyzed the company’s restructuring process. It was a forced event.
The market example of a cash tender offer presented in this section is different from the
hypothetical example; the restructuring process of the subject company, Covad
Communications, Inc. (“Covad”), was not initiated as a result of a technical default.
At the time Covad’s restructuring negotiations commenced, there was no outstanding
default or imminent triggering event. In fact, Covad had nearly $900 million of cash at
the time (remaining proceeds from debt and equity placements) and at least two years of
operations (at the current cash burn rate) before a default event was likely to occur.
Rather, restructuring negotiations were initiated by an ad hoc group of large
bondholders26 because these holders did not believe the company had a viable long-term
business plan. Bondholders believed Covad was likely to waste its remaining cash
resources pursuing this non-viable plan. But there was no default; Covad could walk
away from an unacceptable negotiation. This restructuring was not a forced event.
Because Covad entered into a negotiation prior to a default and while it still had
significant cash resources, Covad was in a strong negotiating position.
By the end of 2000, Covad was one of the leading national high-speed network and data
services companies with infrastructure in major metropolitan markets in the United
States. Although Covad had almost $900 million of cash on its balance sheet as of
December 31, 2000, the company’s February 2001 business plan projected a cumulative
funding gap of approximately $620 million.
During the first half of 2001, Covad bondholders became increasingly skeptical of the
business plan. Over the first six months of the year, Covad had consumed between $50
The group of holders owned approximately 45% of Covad’s outstanding unsecured bonds. After the
successful negotiation, Covad used a pre-negotiated Chapter 11 filing to bind 100% of the bondholders to
the agreed upon transaction.
26
Page 51
million and $75 million per month to fund its operating losses. Moreover, Covad’s
primary competitors, Northpoint Communications Group, Inc. and Rhythms
NetConnections Inc., both filed for bankruptcy and liquidated during the first half of
2001. In the Northpoint and Rhythms transactions, secured creditors were impaired and
unsecured creditors received little to no recovery (outside of litigation proceeds).
The following table shows the Company’s balance sheet for the two fiscal years ended
1999 and 2000 as well as the balance sheet as of June 30, 2001. The Pro Forma balance
sheet modifies the June 30, 2001 balance sheet based on the pre-negotiated transaction
discussed below.
Covad Communications, Inc.
Balance Sheet
($ in millions)
December 31,
1999A
ASSETS
Cash & Equivalents
Accounts Receivable
Inventories
Other Current Assets
PP&E, net
Other Long-term Assets
TOTAL ASSETS
LIABILITIES & SHAREHOLDERS' EQUITY
Accounts Payable
Accrued Expenses
Current Portion of Long-term Debt
Long-Term Debt
Capital Lease Obligations
Other Long-term Liabilities
TOTAL LIABILITIES
Preferred Stock
Shareholders' Equity
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY
$
$
$
$
794.5
15.4
8.5
12.7
186.1
130.5
1,147.6
$
19.5
57.8
374.7
5.2
457.3
$
690.3
1,147.6
June 30,
2001
2000A
$
$
897.6
26.9
14.2
19.5
338.4
214.9
1,511.5
$
72.9
163.2
43.7
1,324.7
3.7
85.9
1,694.1
$
(182.7)
1,511.5
$
$
June 30,
Pro Forma
552.4
31.1
10.6
24.7
294.3
184.6
1,097.8
$
31.8
151.8
1,338.4
130.5
1,652.5
$
(554.7)
1,097.8
$
$
269.1
31.1
10.6
24.7
294.3
184.6
814.5
31.8
151.8
130.5
314.1
100.0
400.4
814.5
As indicated, on December 31, 2000, Covad had liabilities of $1.7 billion and assets of
$1.5 billion. By at least one measure, Covad was likely to be insolvent. As discussed
earlier in the text, once a company enters the “zone” of insolvency, the fiduciary duties of
a Board member shift from shareholders to a company’s creditors. Based largely on
novel pre-emption theories regarding fiduciary duties, the bondholders approached Covad
regarding a potential restructuring transaction.
Initially, bondholders “demanded” that Covad liquidate its assets and distribute all cash
proceeds, including remaining cash on the balance sheet, to creditors. This initial
demand reflected the bondholders’ lack of confidence in Covad’s business plan. The
company, however, believed that the recent sector dynamics, including the bankruptcy
sales of NorthPoint Communications Group, Inc. and Rhythms NetConnections, would
allow it to continue to implement its business plan with even less competition, and
therefore more success. As a result, Covad was not interested in liquidating its assets to
repay bondholders. Instead, the company seized the opportunity to begin discussions
Page 52
with bondholders regarding a deleveraging transaction.27. Because the holders only
wanted cash (recall that they “did not believe in the business plan” and hence, thought
equity was “worthless”), the negotiation quickly distilled down to a question of the
magnitude of cash payment.
From Covad’s perspective, if they succeeded in tendering for 100% of the bonds, the
company would completely delever its balance sheet. By repurchasing the debt, the
company would eliminate approximately $9 million of cash interest per month for the
next 18 months and $12 million of cash interest per month thereafter. From an analytical
standpoint, the cash tender payment could actually be thought of as a “prepayment” of
the interest that the company would have had to pay the bondholders in the event no
tender transaction occurred.
The chart below illustrates how various levels of potential consideration paid to
bondholders in a restructuring otherwise equate to required interest payments.
Covad Communications, Inc.
Months of Prepaid Interest
$402.3
39
$335.3
33
$268.2
27
$201.2
22
$134.1
15
$0.10
$0.15
$0.20
$0.25
Months of Interest Saved
Tender Amount (in millions)
($ in millions)
$0.30
Consideration (Per $ of face value)
The negotiations between Covad and the bondholders began in early July 2001. As
expected, initial proposals varied according to how much cash and equity would be
offered to bondholders, with the bondholders requesting a cash payment at a significant
premium to the market price28 of the bonds and a significant equity stake in the
The bondholders’ argument that Covad had entered the zone of insolvency contained enough substance
to bring the company to the negotiating table.
27
28
As of July 15, 2001, bonds were trading at an average price of approximately 13 cents on the dollar.
Page 53
deleveraged company.29 The company conceded that, to obtain bondholder support for
any tender offer, it would have to offer a price in excess of the current market price of the
bonds. However, the company wanted to retain as much cash as possible; even without
future interest payments its business plan still required additional capital. Offering a cash
payment at a premium to market meant Covad and its equity holders would be taking a
substantial risk; if Covad could not raise additional capital within six to nine months, it
would completely deplete its (estimated post tender offer) cash balance. While the
company believed it would be able to raise $100 million to $200 million of additional
capital (and fully fund its business plan) once its balance sheet was deleveraged, it would
only have the six to nine month window to execute this financing.
After several weeks of negotiations, the bondholders and the company agreed to a
proposal in which the bondholders exchanged their securities for cash at approximately
21 cents on the dollar and approximately 15% of Covad’s fully diluted common stock30.
As the table below indicates, based on a July 15, 2001 announcement date, the
bondholders were receiving a cash payment that represented a 21% premium to the
market price. Including the retained equity interest, the bondholders received a total
payment of 28 cents on the dollar, representing at a 64% premium to market.
Covad Communications, Inc.
Proposed Cash Tender Offer
($ in millions)
Description
Issued
13.5% Senior Discount Notes
12.5% Senior Reserve Notes
12.0% Senior Notes
6.0% Convertible Notes
Total
3/11/1998
2/18/1999
1/28/2000
9/25/2000
Current Noteholder Offer (Cash Only)
Principal (1)
$
$
208.9
215.0
425.0
500.0
1,348.9
$
1,348.9
Interest
13.5%
12.5%
12.0%
6.0%
Last
Coupon
Next
Coupon
3/15/2001
2/15/2001
2/15/2001
3/15/2001
9/15/2001
8/15/2001
8/15/2001
9/15/2001
Current
Bid (2)
10.0
14.0
14.0
13.0
Total
Market Value
$
$
20.9
30.1
59.5
65.0
175.5
$
256.3
Accrued
Interest
$
21.1
9.9
Restricted
Cash (4)
Total
Accrued Value
$
26.3
-
$
$
26.3
$
10.0%
26.2%
19.0%
15.0%
17.3%
$
282.6
20.9%
Premium / (Discount) to Market
Current Noteholder Offer (Cash & Conv. Pref.)
Implied Recovery
of Principal
20.9
56.4
80.6
74.9
232.9
21.4%
(5)
$
1,348.9
$
Premium / (Discount) to Market
356.3
$
26.3
$
382.6
28.4%
64.3%
Note: Assumes a July 15, 2001 settlement date.
(1) Assumes that the 13.5% Senior Discount Notes are accrued to July 15, 2001.
(2) Based on bid levels on July 9, 2001 provided by the advisors to the Noteholders. Notes are trading with accrued interest.
(3) Before accrued interest and restricted cash.
(4) Noteholders assumed restricted cash of $27.7 million per the March 31, 2001 10-Q. However, restricted cash associated with the Notes is only $26.3 million.
(5) The current proposal offers bondholders convertible preferred stock ($100 million liquidation preference) which would mandatorily convert to common stock on a conversion event (i.e., raising $75 million of new capital) and would be convertible into
approximately 15% of Covad’s reorganized outstanding common stock on a pro forma basis and after adjustments to reflect certain outstanding options and warrants.
Based on the proposal above, Covad filed for bankruptcy on August 15, 2001 with a prenegotiated Plan of Reorganization. The Chapter 11 process was used for implementation
29
Though bondholders dismissed the business plan as non-viable, they still requested significant equity
compensation. In the event holders had misjudged and the company was successful, they wanted to
participate in the upside. And they wanted to avoid looking bad. Because of this last consideration, the
equity portion of a cash tender offer is often thought of as “stupid” insurance.
30
The proposal offered bondholders a package of cash and convertible preferred stock. The preferred stock
was obliged to convert into common stock upon a conversion event (ie, completion of a capital raise with
more than $75 million of proceeds). The underlying common stock represented approximately 15% of
Covad’s fully diluted pro forma outstanding common stock.
Page 54
to bind holdouts31. Covad anticipated emerging from bankruptcy by December 31, 2001
with approximately $90 million in cash and a funding gap of approximately $130 million.
The Company began its fundraising efforts shortly after the proposal was negotiated with
the bondholders.
Covad was able to successfully complete a cash tender offer for its bonds because (i) it
had the significant cash resources necessary to make a cash payment to bondholders at a
significant premium to market; (ii) it was willing to take the risk of having to raise an
additional $100 million to $200 million of capital within six to nine months following the
transaction; (iii) Covad was not in default, so it had the option of walking away from
negotiations if they did not proceed favorably; and, (iv) bondholders were interested in
accepting a cash payment (at a premium to market) because they did not believe in the
company’s business plan.
31
Note that equity holders were unwilling to execute this transaction without complete (or near complete)
participation by the existing notes. The company required new capital even after the deleveraging, and
leaving any outstanding debt would have materially impaired the company’s ability to raise this capital.
Page 55
Appendix – Valuation of OpCo32
As mentioned in the body of the text, once engaged, the restructuring banker performs
various analyses to determine the value of OpCo’s operations. These analyses often
include three techniques designed to estimate OpCo’s enterprise value: a market
approach, a transaction approach, and an income approach (e.g., discounted cash flow
approach). The analyses may also include a liquidation approach, which is an estimate of
proceeds available from the dismantling and selling of the company’s assets.
Market Approach
One valuation technique the restructuring banker may employ is the market approach.
This approach utilizes observed trading multiples of publicly traded comparable
companies (e.g., Total Enterprise Value (“TEV”) / Revenue, TEV / EBITDA) as a basis
for capitalizing “representative levels” of revenue and cash flow of the subject company
to derive a value estimate. One component of TEV (the numerator of trading multiples)
is the market value of equity, which is based upon observed public share prices. 33 Other
components include the market values of debt, minority interests, and surplus cash34.
The restructuring banker begins by identifying a universe of publicly traded companies
that ideally operate in the same or approximately the same industry as OpCo. For
example, an analyst may identify more than 50 publicly traded companies that
manufacture products similar to the widgets that OpCo manufactures. For the purposes
of the valuation analysis, the restructuring banker would narrow this group down to a
subset of companies that are most comparable to OpCo. To determine the degree of
comparability of a particular company, the restructuring banker could consider, among
other factors, the company’s size, level of integration, customer base, product mix,
jurisdiction of operations and past performance.
Once the comparable companies are selected, the restructuring banker reviews historical
financial information for each company (such as latest twelve month (“LTM”) results)
and looks for research reports that contain estimates of future performance (including
estimates for the next fiscal year (“NFY”)). Next, the banker calculates the TEV of each
of the comparable companies. The TEV equals the market value of the common and
preferred equity of the comparable company (number of shares times the share price),
plus the market value of the company’s interest-bearing debt, plus (or minus) minority
32
A complete dissertation in distressed company valuation is beyond the scope of this paper. However,
this appendix covers some of the highlights of the subject. The hypothetical valuation process outlined
herein is not intended to represent the only possible valuation conclusion for a company like OpCo. A
variety of factors may make the simplified, general guidance provided by this fictional valuation wholly
inapplicable to a seemingly similar deal. The ideas and strategies discussed herein do not represent the
institutional views of Houlihan Lokey Howard and Zukin.
33
It is important to consider that generally, a share of stock represents a liquid, minority interest in the
equity of a company. All other things being equal, the stock price usually does not include the so-called
“takeover premium” a buyer may (or may not) have to pay to own a controlling interest in the company.
34
Surplus cash is a reduction to TEV as surplus cash could be used to repay outstanding debt.
Page 56
interest(s), less cash. By deducting cash, the TEV calculation implicitly assumes that
such cash is truly “surplus” and could be used to repay debt. This assumption may not
always be appropriate; for example, a retail operation may require a minimum amount of
cash at the store locations or, if a company is distressed, one might assume that much of
the cash on the balance sheet is required to fund operations. In any event, the assumed
treatment of cash is one important factor to consider when calculating enterprise values35.
Once the financial research is completed, the restructuring banker must choose which
valuation parameters to consider. For example, if there is not enough research to
determine forward multiples (multiples of estimated future performance) for the
comparable companies, then the banker may emphasize multiples based on historical
revenues and cash flows. Similarly, if OpCo lacks a meaningful future forecast, then
emphasizing historical multiples may also be appropriate. However, if subject company
performance is expected to change markedly in the future, the analyst may emphasize
multiples based on estimates of future cash flow. To the degree that a valuation analysis
relies on future expected performance and such future performance is a significant
departure from recent history, the analyst should take great care building a “performance
bridge” that describes the factors that drive the improvements36. For OpCo, the projected
“upside” results are a significant departure from past performance and, though the
improvement (to SG&A in OpCo’s case) may be identified, it is far from certain.
35
As noted earlier, valuation is as much an art as a science. It is a subjective application of objective
principles. Often times it is appropriate to make adjustments to enterprise value to create true
comparability. The discussion of cash (and what constitutes surplus cash) is just one type of adjustment.
Other appropriate modifications could include, among other things, (i) debt that trades at significantly less
than or more than par value, (ii) any unconsolidated investments the subject company may have, (iii) any
minority interests in subsidiaries that are fully consolidated by the subject company, or (iv) any obvious
under-investment in working capital or the fixed asset base.
For a distressed company or a private company, the determination of historic “representative levels” of
earnings often includes adjustments to reflect non-recurring or unnecessary costs. For example, if a
company is implementing an operational restructuring, the analyst may exclude one-time charges for
severance, outside professionals, facilities closures and the like. Similarly, a private company may have
extraordinary compensation expenses or above-market contracts with related parties that should be
accounted for to produce a more accurate analysis.
36
Page 57
OpCo
Summary Financials
($ in millions)
LFY - 3
2000A
Revenue
$
% Growth
% Margin
Depreciation & Amortization
% Margin
300.0
$
5.0%
Operating Income (EBIT)
EBITDA
Actual Results
LFY - 2
LFY - 1
2001A
2002A
$
291.0
$
279.4
Estimated
LTM
2003
$
273.9
NFY
2004
$
280.7
Projected Results
NFY + 1
NFY + 2
2005
2006
NFY + 3
2007
$
$
291.9
$
303.6
-3.0%
-4.0%
-2.0%
2.5%
4.0%
4.0%
315.8
4.0%
40.5
30.1
17.6
14.5
20.9
24.7
28.7
32.9
13.5%
10.3%
6.3%
5.3%
7.4%
8.4%
9.4%
10.4%
14.6
14.7
14.8
14.9
14.8
14.8
14.7
14.7
55.1
18.4%
$
44.8
15.4%
$
32.3
$
11.6%
29.4
10.7%
$
35.7
12.7%
$
39.4
13.5%
$
43.4
14.3%
$
47.6
15.1%
In this case, where significant improvements in performance are forecast for the near
term, the restructuring banker considers the reasons for such improvements in assessing
the forecast. In this example, the restructuring banker decides to consider both LTM and
NFY multiples of TEV to Revenue, EBITDA and EBIT 37 when formulating the marketmultiple valuation of OpCo.
37
In certain industries, the valuation analyst may investigate multiples that utilize industry-specific
operating metrics. For example, in the wireless telecom and cable industries, a valuation might include
subscriber multiples. In a natural resource-related industry, one should likely investigate TEV multiples of
units of reserves and production.
Page 58
Having chosen the relevant valuation multiples, the restructuring banker calculates the
multiples for the comparable companies and examines the range, median and mean of
such multiples.38
OpCo
Market Multiples
($ in millions)
Share Price
Company
Company A
Company B
Company C
Company D
Company E
Company F
$
Shares
Outstanding
13.5
21.03
33.22
19.50
8.88
5.34
5.9
8.1
5.0
5.8
13.2
11.6
Market Value
of Equity
$
79.2
171.3
166.6
112.2
117.2
61.8
Market Value
of Debt
$
Enterprise
Value
Cash
16.2
215.2
252.2
37.3
94.0
105.1
$
8.3
16.2
27.3
6.4
10.3
4.4
$
87.1
370.3
391.5
143.1
200.9
162.5
Total Enterprise Value/
Company
Company A
Company B
Company C
Company D
Company E
Company F
Range
Minimum
Maximum
LTM Revenue
LTM EBITDA
LTM EBIT
$
20.3
63.3
52.5
26.7
32.4
50.0
$
8.1
27.1
21.5
16.5
14.9
22.4
0.44 x
0.77 x
0.86 x
0.58 x
0.71 x
0.40 x
4.3 x
5.8 x
7.5 x
5.4 x
6.2 x
3.2 x
10.8 x
13.7 x
18.2 x
8.7 x
13.4 x
7.3 x
$
197.2
483.2
$
20.3
63.3
$
8.1
27.1
0.40 x
0.86 x
3.2 x
7.5 x
7.3 x
18.2 x
19.0
18.4
0.65 x
0.63 x
5.6 x
5.4 x
12.1 x
12.0 x
NFY Revenue
Company
Median
Mean
LTM EBITDA
197.2
483.2
456.8
246.8
281.9
406.8
344.4
345.5
Range
Minimum
Maximum
LTM Revenue
$
Median
Mean
Company A
Company B
Company C
Company D
Company E
Company F
LTM EBIT
41.2
40.9
NFY EBITDA
NFY EBIT
NFY Revenue
Total Enterprise Value/
NFY EBITDA
NFY EBIT
$
220.1
522.3
517.6
281.8
316.9
439.8
$
23.1
69.5
61.1
31.3
36.8
51.5
$
10.9
33.2
30.0
21.2
19.3
23.8
0.40 x
0.71 x
0.76 x
0.51 x
0.63 x
0.37 x
3.8 x
5.3 x
6.4 x
4.6 x
5.5 x
3.2 x
8.0 x
11.1 x
13.0 x
6.8 x
10.4 x
6.8 x
$
220.1
522.3
$
23.1
69.5
$
10.9
33.2
0.37 x
0.76 x
3.2 x
6.4 x
6.8 x
13.0 x
22.5
23.1
0.57 x
0.56 x
5.0 x
4.8 x
9.2 x
9.4 x
378.3
383.1
44.1
45.5
Based on an analysis of OpCo and the comparable companies, the restructuring banker
selects the market-multiples shown below, and comes up with a preliminary TEV
indication of approximately $165 - $209 million (prior to any working capital or other
38
The mean and median multiples of the comparable companies are useful benchmarks in selecting a
multiple to apply to the subject company. However, the analyst must review the level of similarity between
the comparable companies and the subject company and, if warranted, apply a discount or premium to the
mean or median multiples to create a more meaningful valuation.
Page 59
adjustments). As indicated in the chart, the market multiple approach recognizes that the
share price reflects the price for a marketable minority interest in a company. To assess
TEV, the valuation is adjusted to include a control premium that reflects the additional
consideration an investor would pay in order to control a company.
OpCo
Valuation - Market Multiple Approach
($ in millions)
Rep. Level
LTM Revenue
LTM EBITDA
LTM EBIT
$
NFY Revenue
NFY EBITDA
NFY EBIT
0.55 x -5.0 x -11.5 x --
0.70 x
6.0 x
12.5 x
$ 150.6
146.9
166.7
280.7
35.7
20.9
0.50 x -4.4 x -8.6 x --
0.65 x
5.4 x
9.6 x
140.4
157.2
179.7
Selected Enterprise Value Range on a Minority Interest Basis
-- $ 191.7
-176.2
-181.2
----
-- $ 187.5
-- $ 187.1
$ 150.0
-- $ 190.0
(75.0)
$
(2)
Aggregate Equity Value on a Controlling Interest Basis
$
Add: Total Interest Bearing Debt
Enterprise Value Range on a Controlling Interest Basis
182.5
192.9
200.6
$ 156.9
$ 153.9
(1)
Aggregate Equity Value on a Minority Interest Basis
Add: Control Premium @ 20%
Indicated Enterprise Value
273.9
29.4
14.5
Mean
Median
Less: Estimated Debt Capitalization
Selected Multiple Range
75.0
(95.0)
-- $
95.0
15.0
19.0
90.0
-- $ 114.0
75.0
95.0
$ 165.0
-- $ 209.0
(1) Assumes an industry average capital structure of 50 percent equity and 50 percent debt.
(2) Control premiums typically vary by industry. For example, median trailing twelve month control premiums were 41.1% in the
communications industry, 33.8% in the mining industry, and 43.1% in the manufacturing industry as of 3Q03. Source: Mergerstat Control
Premium Study Third Quarter 2003.
Transaction Approach
The restructuring banker also considers transaction multiples under the comparable
transaction approach. Like the market approach, the transaction approach is also based
on public market information. This approach utilizes implied purchase price multiples
paid by acquirers in transactions for control of companies. Like the market approach, the
analyst uses observed multiples (e.g., TEV/Revenue and TEV/EBITDA) to capitalize
“representative levels” of subject company revenues and cash flows. The comparable
transaction approach provides a controlling-interest indication of value. Because of the
premium investors usually pay to acquire control of a company’s assets, transaction
multiples are usually higher than market multiples at any particular point in time.
Similar to the market approach, the restructuring banker searches for transactions
involving companies that are “comparable” to the subject company (i.e., the target also
manufactures widgets or something like a widget). The initial search returns nearly 200
transactions from the past five years, including many relevant transactions from the past
two years. In this example, the banker focuses on the more recent transactions. To
Page 60
narrow down the comparable transactions list, the restructuring banker begins by setting
aside transactions that occurred prior to 2001. In addition, transactions that do not have
sufficient public data (e.g., undisclosed total purchase price, undisclosed target earnings)
are eliminated. With about 30 remaining transactions, the banker reviews and selects the
most comparable remaining transactions. Final selections include the transactions in the
following table:
OpCo
Valuation – Comparable Transaction Approach
($ in millions)
Date
12/25/03
Target
Company G
10/30/03
Company I
8/19/03
Company K
8/13/03
Company M
1/1/03
Company O
9/27/02
Company Q
4/22/02
Company S
4/14/02
Company U
7/8/01
Company W
4/10/01
Company Y
Target Business Description
Manufactures steel widgets for the automotive
industry.
Produces light weight widgets, primarily for the
windmill and other natural energy markets.
Designs and manufactures plastic widgets for
wholesalers in the perishable foods packaging
industries.
Makes widgets for the computer peripherals
industry.
Manufactures concrete widgets for government
contractors in the transportation industry.
Produces environmentally-friendly widgets from
recycled rubber.
Fabricates assembled wooden widgets, primarily
to wholesalers in the consumer furniture market.
Contructs heavy-duty widgets for aircraft
manufacturers and government defense industries.
Acts as an OEM of widgets for high-end electrical
appliance manufacturers.
Engages in the production of customized widgets
for the North American hospitality industry.
Buyer
Company H
EV
$ 199.2
Target
LTM
LTM
Revenue
EBITDA
$
463.3
$
37.0
Enterprise Value/
LTM
EBIT
$
18.2
Revenue
0.43 x
EBITDA
5.4 x
EBIT
10.9 x
Company J
208.3
344.2
37.1
16.8
0.61 x
5.6 x
12.4 x
Company L
321.8
330.3
46.5
24.1
0.97 x
6.9 x
13.4 x
Company N
100.3
167.2
16.7
8.0
0.60 x
6.0 x
12.5 x
Company P
155.8
286.8
27.6
13.1
0.54 x
5.6 x
11.9 x
Company R
246.5
437.9
44.1
20.5
0.56 x
5.6 x
12.0 x
Company T
67.2
95.0
11.2
5.3
0.71 x
6.0 x
12.6 x
Company V
260.1
307.8
39.2
19.9
0.85 x
6.6 x
13.1 x
Company X
620.4
519.5
83.4
45.9
1.19 x
7.4 x
13.5 x
Company Z
310.2
428.2
51.0
24.5
0.72 x
6.1 x
12.7 x
Range
Minimum
Maximum
0.43 x
1.19 x
5.4 x
7.4 x
10.9 x
13.5 x
Median
Mean
0.66 x
0.72 x
6.0 x
6.1 x
12.5 x
12.5 x
The following table indicates the valuation conclusions drawn based on the transaction
approach:
OpCo
Valuation – Comparable Transaction Approach
($ in millions)
Rep. Level
LTM Revenue
LTM EBITDA
LTM EBIT
$
273.9
29.4
14.5
Mean
Median
Selected Enterprise Value on a Controlling Interest Basis
Income Approach
Page 61
Selected
Multiple Range
0.60 x -- 0.75 x
5.5 x -- 6.5 x
12.0 x -- 13.0 x
Indicated
Enterprise Value
$ 164.3
161.6
174.0
----
$ 205.4
190.9
188.5
166.6
164.3
---
194.9
190.9
$ 160.0
--
$ 195.0
A third approach used to estimate going concern value is an income approach, such as the
discounted cash flow approach (“DCF”). This technique calculates the value of a
company as the present value of its future cash flows. Often, debt-free cash flows (i.e.,
after-tax cash flow generated before any debt payments are made39) are used in the
present value calculations.
The banker begins the DCF analysis by reviewing OpCo’s projections. The banker hopes
to see a revenue forecast that appears reasonable in the context of the current and
expected industry environment (management predicts slow, sustained growth). The
banker also reviews any projected cost savings, paying particular attention to whether the
indicated savings come from external sources (e.g., cuts in raw material pricing) or from
internal sources (e.g., cuts in S,G&A expenses). Once satisfied with OpCo’s projections,
the restructuring banker calculates OpCo’s projected debt-free cash flows as shown
below:
OpCo
Debt-Free Cash Flows
($ in millions)
Actual Results
2001
2000
Revenues
$
Growth %
300.0
$
5.0%
291.0
Fiscal Year Ended December 31,
Estimated
2003
2004
2002
$
-3.0%
279.4
$
-4.0%
273.9
$
-2.0%
280.7
Projected Results
2005
2006
$
2.5%
291.9
$
4.0%
2007
303.6
$
4.0%
315.8
4.0%
EBITDA
55.1
44.8
32.3
29.4
35.7
39.4
43.4
47.6
Margin %
18.4%
15.4%
11.6%
10.7%
12.7%
13.5%
14.3%
15.1%
Depreciation & Amortization
14.6
14.7
14.8
14.9
14.8
14.8
14.7
14.7
Operating Income (EBIT)
40.5
30.1
17.6
14.5
20.9
24.7
28.7
32.9
Income Tax @ 40%
Unlevered Earnings
Plus: Depreciation & Amortization
Less: CAPEX
Plus: Change in working capital
Unlevered Free Cash Flow
16.2
$
$
24.3
12.0
$
14.6
(15.8)
(1.1)
22.1 $
18.1
7.0
$
14.7
(15.9)
0.7
17.6 $
10.5
14.8
(16.0)
0.9
10.2
5.8
$
8.7
$
14.9
(14.3)
0.4
9.7
8.4
$
$
12.5
9.9
$
14.8
(14.2)
(0.5)
12.6 $
14.8
11.5
$
14.8
(14.2)
(0.8)
14.5 $
17.2
13.2
$
14.7
(14.1)
(0.9)
16.9 $
19.7
14.7
(14.1)
(0.9)
19.4
To determine the present value of the projected cash flows for OpCo, the restructuring
banker must choose an appropriate discount rate. To do this, he estimates OpCo’s
weighted average cost of capital (“WACC”). This estimate is, in part, based upon the
WACC components for the comparable companies.
39
To avoid the distortions caused by a leveraged capital structure, the DCF analysis relies on debt-free
cash flow. In theory, estimating value with cash flows that are not affected by the capital structure will
produce a consistent estimate of value. The weighted average cost of capital (“WACC”) calculation (a
crucial element of any DCF analysis) incorporates the effects of a positive cash tax jurisdiction that allows
interest payments to be deducted from pre-tax income.
Page 62
OpCo
WACC Calculation
($ in millions)
Preferred
Stock
Debt
Market Value
of Equity
Total
Capitalization
Debt to
Equity
Debt to Total
Capitalization
Preferred to Total
Capitalization
Equity to Total
Capitalization
Company A
Company B
Company C
Company D
Company E
Company F
$
16.2
215.2
252.2
37.3
94.0
105.1
$
-
$
79.2
171.3
166.6
112.2
117.2
61.8
$
95.4
386.5
418.8
149.5
211.2
166.9
20.5%
125.7%
151.3%
33.3%
80.2%
170.0%
17.0%
55.7%
60.2%
25.0%
44.5%
63.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
83.0%
44.3%
39.8%
75.0%
55.5%
37.0%
Median
Mean
$
$
99.5
120.0
$
$
-
$
$
114.7
118.0
$
$
189.1
238.1
102.9%
96.8%
50.1%
44.2%
0.0%
0.0%
49.9%
55.8%
Levered
Beta
Unlevered
Beta
Decile
Based Beta
Adjusted
Unlevered Beta
Equity Risk
Premium (1)
Company A
Company B
Company C
Company D
Company E
Company F
1.38
2.06
2.14
1.45
1.57
1.49
1.23
1.17
1.12
1.21
1.06
0.74
1.41
1.34
1.34
1.41
1.41
1.41
1.23
1.24
1.18
1.21
1.06
0.74
Median
Mean
1.53
1.68
1.15
1.09
1.41
1.39
1.19
1.11
Size Risk
Premium (1)
7.0%
7.0%
7.0%
7.0%
7.0%
7.0%
Cost of
Equity
5.67%
2.56%
2.56%
5.67%
5.67%
5.67%
Cost of
Debt
Cost of
Preferred
WACC
20.4%
22.1%
22.7%
20.9%
21.8%
21.2%
6.3%
9.4%
10.3%
7.5%
8.6%
8.3%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
17.6%
12.9%
12.7%
16.8%
14.4%
11.0%
21.5%
21.5%
8.4%
8.4%
0.0%
0.0%
13.7%
14.2%
#
#
#
#
#
#
Notes:
Weighted Average Cost of Capital (WACC) = (Cost of Debt * (1-Tax Rate) * Debt to Enterprise Value) + (Cost of Equity * Equity to Enterprise Value) + (Cost of Preferred * Preferred to Enterprise Value).
Cost of Equity = Risk Free Rate + (Levered Beta * Equity Risk Premium) + Size Risk Premium.
Risk-free rate as of December 31, 2003.
(1) Ibbotson Associates, Stocks Bonds Bills and Inflation 2003 Yearbook, pp. 134, 136, and 177.
Based on the comparable companies, it appears that the WACC for companies in the
widget manufacturing industry ranges from approximately 10% to 20%, and averages
around 14.2%. The analyst estimates OpCo’s WACC after giving consideration to the
industry average WACC, typical industry capital structure, and company specific factors,
and other things.
OpCo
OpCo Specific WACC
($ in millions)
Market Assumptions
20-Year Treasury Bond Yield 5.1%
Equity Risk Premium (1)
7.00%
Size Risk Premium (1)
5.67%
Company Specific Risk Premium
2.00%
Tax Rate
40.0%
Concluded Weighted Average Cost of Capital
Beta Assumptions
Company Specific Decile Beta
Selected Adjusted Unlevered Beta
Levered Beta
Capital Structure Assumptions
1.41
1.11
1.77
Preferred to Enterprise Value
Debt to Enterprise Value
Equity to Enterprise Value
Cost of Debt
Cost of Preferred
Cost of Equity
0.0%
50.0%
50.0%
9.3%
0.0%
25.2%
15.4%
Instead of relying on one specific discount rate, the restructuring banker decides to value
OpCo using a range of discount rates that uses a mid-point approximately equal to
OpCo’s estimated WACC of 15.4%. The restructuring banker then applies the range of
discount rates to the projected cash flows for OpCo from years 2004 through 2007. The
present value of these cash flows is shown below:
Page 63
OpCo
Present Value of Cash Flows for 2004-2007
($ in millions)
13.5%
14.5%
15.5%
16.5%
17.5%
2004
11.8
11.8
11.7
11.7
11.6
$
$
2005
12.0
11.9
11.7
11.6
11.4
$
2006
12.3
12.0
11.8
11.5
11.3
$
2007
12.5
12.1
11.7
11.4
11.0
$
Total
48.7
47.8
47.0
46.2
45.4
The last step of the discounted cash flow valuation approach, determining a terminal
value (i.e., the value at the last year of the forecasts) for OpCo, is perhaps the most
important. Given that OpCo has only provided the restructuring banker with four years
of projections, the terminal value estimated by the banker will be the driving factor in the
DCF valuation (in this case, it accounts for about two-thirds of the estimated value). The
restructuring banker generally uses one or two methods to calculate OpCo’s terminal
value: (i) he can select an EBITDA exit multiple (or other appropriate multiple) and
apply that multiple to the 2007 level of EBITDA, or (ii) he can use the Gordon Growth
Method40, which assumes that the terminal year’s cash flow will grow at a specified rate
into perpetuity. The banker decides to use the exit multiple approach.
The table below shows the present value of the terminal value of OpCo over a range of
discount rates and exit multiples. The calculation assumes the investment (OpCo) is sold
in a change of control transaction at the end of 2007.
OpCo
Terminal Value of OpCo Exit Multiple Approach
($ in millions)
13.5%
14.5%
15.5%
16.5%
17.5%
$
4.50x
129.0
124.6
120.3
116.2
112.3
$
5.00x
143.4
138.4
133.7
129.1
124.8
$
5.50x
157.7
152.2
147.0
142.1
137.3
$
6.00x
172.0
166.1
160.4
155.0
149.8
$
6.50x
186.4
179.9
173.8
167.9
162.2
Summing the present value of the cash flows for 2004 through 2007 and the terminal
values calculated above, the restructuring banker reviews the range of aggregate values
and concludes that the discounted cash flow valuation of OpCo ranges from $180 million
to $220 million.
40
For a description of the discounted cash flow approach, including the use of the Gordon Growth Method,
please see Chapter 9 of Valuing a Business by Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs.
Page 64
OpCo
Valuation of OpCo – DCF Approach
($ in millions)
13.5%
14.5%
15.5%
16.5%
17.5%
$
4.50x
177.7
172.4
167.3
162.4
157.7
$
5.00x
192.0
186.2
180.6
175.3
170.2
$
5.50x
206.3
200.0
194.0
188.2
182.7
$
6.00x
220.7
213.9
207.4
201.1
195.2
$
6.50x
235.0
227.7
220.7
214.1
207.6
Liquidation Approach
Finally, the restructuring banker performs a liquidation analysis to determine whether the
liquidation value of the assets of the company exceeds the present value of the cash flows
the company can generate. The liquidation approach values a company based on current
sale or recovery value of such company’s assets in either an “orderly” or “fire sale”
liquidation41.
The restructuring banker begins by examining OpCo’s current balance sheet as of
December 31, 2003, and determining the value of OpCo’s assets. In general, more liquid
assets, such as accounts receivable, are assumed to have a higher rate of recovery than
less liquid assets, such as plant, property and equipment. Realizations on fixed assets may
be affected by, among other things, costs for removal.
41
Pursuant to §1129(a) of the U.S. Bankruptcy Code, a Plan of Reorganization is not confirmable unless,
among other requirements, each impaired class of claims or interests…will receive…value…that is not less
than the amount that such holder would so receive or retain if the debtor were liquidated. Because of this
test, a liquidation analysis becomes a required part of any Plan of Reorganization in the United States of
America.
Page 65
OpCo
Liquidation Analysis
($ in millions)
Assets as of
12/31/2003
ASSETS:
Cash & Equivalents
Accounts Receivable
Inventories
Property, Plant and Equipment
TOTAL ASSETS / Liquidation Proceeds
$
9.1
26.3
22.5
177.9
$
235.8
Liquidation
Factor
100.0%
70.0%
50.0%
30.0%
Distributable
Proceeds
$
9.1
18.4
11.3
53.4
$
92.1
Plus: Residual Cash Flow during Liquidation
Less: Administrative and Priority Claims
Less: Liquidation Costs (1)
Less: Employee Severance Claims (2)
$0.0
(5.0)
(2.8)
(15.0)
Net Liquidation Proceeds
$
Total Secured Obligations
$
% Recovery on Secured Obligations Assuming Absolute Priority
40.6
100%
Amount Available for Unsecured Claims
Total Unsecured Claims
69.4
28.7
(3)
$
% Recovery on Unsecured Claims Assuming Absolute Priority
133.5
21.5%
(1) Liquidation costs assumed to be 3 percent of gross distributable proceeds from the sale of assets..
(2) Assumes a priority claim for some level of severance.
(3) Includes 10.5% Senior Notes ($100.0 million), Accrued Interest ($5.3 million), Accounts Payable ($17.3 million), and Accrued Expenses ($11.0 million).
As shown in the table above, the restructuring banker is careful to consider any additional
expenses related to liquidating OpCo, e.g., employee severance costs, other wind-down
costs and liquidation fees. It should also be noted that liquidations generally result in an
increase in unsecured claims (e.g., pension liabilities, leases, etc.), which may further
dilute recoveries to unsecured creditors and equity holders.
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Having completed the final valuation approach, the restructuring banker considers the
valuation results generated by the various approaches used and arrives at a preliminary
valuation range of $160 million to $195 million for OpCo.
OpCo
Valuation of OpCo
($ in millions)
Total Enterprise Value
Market-Multiples Approach
$ 165.0
-- $ 209.0
Transaction-Multiples Approach
160.0
--
195.0
Discounted Cash Flow Analysis
180.0
--
220.0
Implied Total Enterprise Value of OpCo
(1)
$ 160.0
(1) On a controlling interest basis.
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-- $ 195.0