Chapter 24
Corporate and Distress
Restructuring
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Divestitures in General
• Involuntary divestiture usually is the result
of an antitrust ruling by the government
• Voluntary divestiture is a willful decision by
management to divest
• Include sell-offs, spin-offs and equity carveouts
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Reasons for Voluntary
Divestitures
• Efficiency gains and refocus
– Reverse synergy (4 - 2 = 3)
– Strategic change by the company
• Information it conveys to investors
• Wealth transfer from debt to stockholders
• Tax reasons
– Tax shield advantage
– Employee stock ownership plan (ESOP)
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Voluntary Liquidation and
Sell-Offs
• Liquidating the overall firm
• Partial sell-offs
• Empirical studies
– Indicate a large abnormal return(15%) to
stockholders of the liquidating company
– Partial sell-off studies indicate a modest
positive (2-3%) abnormal return to the seller’s
stock
– Stockholders of the buying company seem to
experience a positive abnormal return
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Spin-Offs
• Complete divestiture of a business unit to
existing shareholders
• Reasons
– Operating efficiencies
– May increase value and reduce information
asymmetry
– Obtain greater flexibility and improve
productivity
– May make financial markets more complete
– May have a scarcity value in the stock market and
be accorded a premium
• Empirical evidence suggests a significant and
positive stock price effect to a spin-off due to
the perception of greater efficiency
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Equity Carve-Outs
• Divest part of a business unit with an IPO
• Two-stage carve out/spin-off
• Motivations
– Managers may have more incentive to perform
well
– May reduce asymmetric information between
managers and investors
– Eliminate the cross-subsidization of business
units
– Favorable means for financing growth
– Favorable information effect for a parent
• Empirical testing document an average
excess return (2%) around the time of a
carve-out announcement
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Going Private
• Company ceases to exist as a publicly held
entity and the stockholders receive a
valuable consideration for their shares
• Stockholders must agree
• Motivations
– Avoid costs of being a publicly held company
– May improve resource allocation decisions and
thereby enhance value
– Realign and improve management incentives
• Greater the performance and profitability,
the greater the reward
• Offsetting arguments
– Transaction costs and lack of liquidity
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Leveraged Buyouts (LBO)
• Take a company private by buying out public
stockholders and taking on a large amount of
debt
• Debt is secured by the assets of the company
• Cash purchases
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Characteristics of Successful
LBOs
• Must be able to dedicate cash flow to debt
service, so competing needs for funds cannot be
large
• Subsidiary assets that can be sold without
adversely impacting the core business
• Stable, predictable operating cash flows
• Proven historical performance with an
established market position
• Experience and quality of senior management
• Absence of significant pre-existing leverage9
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Financing the LBO
• Debt service and equity commitment
– Determine likely cash throw-off
sufficient to service maximum debt
– Limited partnership for additional equity
• Debt financing
– Senior debt including revolving credit
– Junior subordinated debt
• Mezzanine-layer financing
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Empirical Evidence on LBOs
• Stockholders typically receive a sizable
premium for their stock when a company goes
private
– Gains shared between pre-buyout stockholders
and post-buyout owners
• Operating performance, productivity of
capital, and cash flows have been found to
improve after the buyout
• Efficiency gains
– Improved management incentives
– Tax benefits
– Small wealth transfers from pre-buyout
bondholders to post-buyout equity holders
– Reducing agency problems
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Observations on LBOs
• Permit going private with only moderate equity
• Assets used to secure a large amount of debt
• If the company can make its debt payments, the
interest burden declines over time as operating
profits improve
• Two kinds of risk
– Business risk where operations may not go according
to plan and the cash-flow to service debt may be
lower than forecasted
– Sizable increase in interest costs may cause the firm
to default
• If capital expenditures are cut, the company may
not be competitive once the debt is paid off 12
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Enterprise Value Placed on an
LBO
• Rule of thumb: no more than six to eight times
operating cash flow (EBITDA)
• If higher than eight, and if leverage is large, the
probability of default may be unreasonable
• Rule of thumb can be stretched if significant
growth is expected
• Only moderate growth for most LBOs is in the
offing and the rule holds
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Leveraged Recapitalizations
• Fund a large dividend to stockholders with debt,
usually causing book equity to turn negative
• The firm remains a public company with a
traded stock known as stub shares
• Management and other insiders do not
participate in the payout but take additional
shares instead
• Often occur in response to a hostile takeover
threat
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Valuation Implications
• May give management more incentive to
manage more efficiently and to reduce
wasteful expenditures
• Tax shield that accompanies the use of debt
• Event studies have found excess returns
somewhat in excess of 30 percent
• Internal organization changes may now be
possible that lead to improvements in
operating performance
• A number of levered recaps do not make it
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Voluntary Settlements and
Workouts
• Informal and occur outside the courts
• Extension involves creditors postponing the
maturity of their obligations
• Composition involves a pro rata settlement
of creditors’ claims in cash or in cash and
promissory notes
• Voluntary liquidation represents an orderly
private liquidation of a company
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Legal Proceedings
• Fall under bankruptcy law as carried out
through bankruptcy courts
• Chapter 7 deals with liquidation
• Chapter 11 deals with rehabilitation of an
organization through its reorganization
• Voluntary proceedings gives the debtor
immediate protection from creditors
• With involuntary bankruptcy, the
bankruptcy court must decide whether the
involuntary petition has merit
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Liquidation Under Chapter 7
• Trustee has responsibility for liquidating the
property of the company and distributing
liquidating dividends to creditors
• Priority of claims must be observed
• If anything is left, a liquidating dividends
can be paid to subordinated debt holders,
preferred stockholders, and, finally,
common stockholders
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Reorganization Under Chapter 11
• Effort to keep company alive by changing
its capital structure
• Should be viable when interest payments
are pared
• A high proportion of the companies that
reorganize later must be liquidated
• The idea is to reduce fixed charges by
substituting equity and limited-income
securities for fixed-income securities
• Gives postpetition creditors priority over
prepetition creditors known as debtor-inpossession (DIP) financing
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Procedures Followed
• Exclusivity period gives management the
sole right to propose a reorganization plan
within 120 days
• If a plan is not proposed, the trustee has the
responsibility
• Plans must be submitted to creditors and
stockholders for approval
• The plan should be fair, equitable, and
feasible
• Cram downs of reorganization plans by
judges seldom occur
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Reorganization Plan
• Total valuation of the reorganized company
must be determined
– Capitalization of prospective earnings
– Valuation may be adjusted upward if the assets
have substantial liquidating value
• Formulate a new capital structure
– Reduce fixed charges so that there will be an
adequate coverage margin
• The valuation of the old securities and their
exchange for new securities
– Total valuation figure arrived at sets an upper limit
on the amount of securities that can be issued
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Gaming With the Rule of
Absolute Priority
• The rule of absolute priority is often violated
• The delay card of management is a powerful
incentive for creditor concessions
• Vulture capitalists prey on the fallen and use
bullying tactics to extract value from other
parties, known as bondmail
– Break the log jam between various parties
– Add value and lower restructuring cost
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Prepackaged Bankruptcy
• Management has struck an agreement with
most creditors as to terms of the plan
• Quicker and more efficient, but difficult if
creditors are disperse
• Problems with creditors who hold out can
be reduced
• Permits more flexible use of net operating
loss carryforwards for tax purposes
• Efficiency gains of prepackaged bankruptcy
can be compelling to creditors
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