INSEAD Library

Includes bibliographical references and index

Digitized

TABLE OF CONTENTS Distressed Debt Analysis Distressed Debt Analysis ... Notes on Style ........................................................................................... xi11 Acknowledgments ........................................................................................xiv xv About the Author ........................................................................................ Web Added ValueTM .................................................................................. xvi ............................................................................... 1 .................................................. 2 What Is Distressed Debt? ................................................................................ 6 Investing in Distressed Debt ........................................................................... 8 An Example of a Distressed Debt Situation Chapter I . Introduction Chapter 2. The Distressed Debt Investment Opportunity ........................ 13 Financial Restructurings in the 2000-2003 Era ........................................ 14 Precursors to Default .................................................................................... 22 Economic Performance .............................................................................23 Relative Quantity of Low-Rated Bonds ..................................................25 Capital Markets Liquidity ......................................................................... 28 Market Conditions That Permit Superior Returns ....................................... 32 Equal Access to Information .................................................................... 33 Rational Behavior .................................................................................. 35 Low Transaction Costs ........................................................................ 39 Summary .........................................................................................................41 Chapter 3. Conceptual Overview of Financial Distress and the Restructuring Process ............................................................................43 A Simple Model of the Firm .....................................................................43 Extensions of the Basic Model ...................................................................... 45 A Conceptual View of Financial Distress ............................................... 49 How Restructurings Attempt to "Fix" the Distress ..................................... 52 Summary ......................................................................................................... 53 Chapter 4. Legal Overview of Distressed Debt Restructurings ................. 55 Out-of-Court Restructurings: The Preferred Option When Effective and Feasible ................................................................................................... 56 The Financial Effects of an Out-of-Court Restructuring ........................ 56 The Out-of-Court Restructuring Process ................................................. 59 Parties Involved .................................................................................... 59 Strategic Considerations in Participating on the Bondholder Committee ............................................................................................. 61 Beginning the Process .......................................................................... 64 Implementing the Restructuring ............................................................... 67 Feasibility: The Holdout Problem ......................................................... 68 Summary ...................................................................................................... 70 In-Court Restructurings: An Overview of the Bankruptcy Process ........... 71 Declaring Bankruptcy ................................................................................ 72 Jurisdiction of Filing ............................................................................ 73 Timing of Filing ................................................................................... 73 The Goal: The Plan of Reorganization .................................................... 76 The Role of Exclusivity and Prefiling Coordination ......................... 76 Content and Structure of the Plan ....................................................... 78 Operating Under Chapter I I .................................................................... 80 Stabilizing Operations ........................................................................... 80 Developing a Going-Forward Business Plan ...................................... 83 Determining the Assets and Liabilities ........................................ 84 Determining the Valuation and the New Capital Structure ............... 87 Voting on and Confirming a Plan of Reorganization ............................89 Summary .................................................................................................... 92 Chapter 5. Overview of the Valuation Process ........................................ 95 The Basics of Cash-Flow-Based Valuation ................................................. 96 Using EBITDA as a Measure of Cash Flow .......................................... 96 Understanding and Adjusting EBITDA ............................................... 97 Limitations of EBITDA ..................................................................... 102 Comparing Discounted Cash Flow and EBITDA Multiple Approaches .............................................................................................. 103 Comparable Company Analysis Based on Enterprise Value ............... 104 Calculating Enterprise Value .................................................................. 105 Determining the Correct Multiple ..................................................... 109 Using Comparable Company Analysis .............................................. 112 Alternatives to the EBITDA Multiple Approach ....................................... 1 14 Revenue-Based Valuations ...................................................................... 115 Asset-Based Valuations ........................................................................... 115 Customer-Based Valuations .................................................................... 116 Liquidation Valuations ............................................................................ 117 Summary ................................................................................................. 117 Chapter 6. Leverage and the Concepts of Credit Support and C a p a c i ~.............................................................................................. 119 The Interrelationship of Credit Risk and Credit Support ..........................119 Credit Risk .............................................................................................. 120 Credit Support ......................................................................................... 120 Credit Capacity ........................................................................................ 121 Credit Capacity as Measured by Debt Repayment Ability ....................... 123 Stable Cash Flow Scenarios ................................................................... 123 Volatile Cash Flow Scenarios ................................................................ 126 Debt Capacity Under Alternative Criteria .................................................. 129 Asset Coverage .................................................................................. 129 Ability to Refinance ........................................................................... 132 Interest Expense Coverage ...................................................................... 133 Capital Instruments Designed to "Avoid Credit Capacity Criteria ......... 134 Exchangeable Preferred Stock .............................................................. 135 Convertible Bonds ................................................................................... 135 Discount Notes and Payment-in-Kind Notes ......................................... 135 Summary ....................................................................................................... 136 Chapter 7. Capital Structures and the Allocation and Management of Credit Risk ................................................................................................... 139 Using Corporate and Capital Structures to Allocate Credit Risk ............. 141 Grants of Collateral ................................................................................. 142 Contractual Provisions ............................................................................ 142 Maturity Structure ...................................................................................144 Corporate Structure .................................................................................146 How Capital Structures Manage Credit Risk .............................................149 Leverage ................................................................................................... 151 Priority .................................................................................................. 151 Restricted Payments ............................................................................ 151 Negative Pledge Clauses .................................................................. 156 Time ......................................................................................................... 157 Performance Covenants ......................................................................157 Put Rights ............................................................................................ 158 Forced Call in the Event of a Downgrade ....................................... 158 Performance-Linked Pricing Provisions ........................................... 159 Summary ....................................................................................................... 160 Chapter 8. Causes of Financial Distress and the Restructuring implications ............................................................................................. 163 Indicators of Financial Distress ..................................................................163 Debt Ratings ............................................................................................ 164 Predictive Models .................................................................................... 166 Market Prices ........................................................................................... 167 Causes of Financial Distress ......................................................................168 Performance Materially Below Expectation .......................................... 169 Economic Downturn ........................................................................... 169 Uncompetitive Product or Service .................................................... 170 Unrealistic Business Plan ...................................................................172 Poor Management ............................................................................... 174 Near-Tern Liquidity lssues ......................................................................... 177 Bank Debt Scenarios ........................................................................... 177 No Bank Debt Scenarios .......................................................................178 Unexpected Liabilities ................................................................................ 180 Tort Claims .............................................................................................. 180 Contract Liabilities ................................................................................ 181 Crisis of Confidence: Fraud and Other Events That Create Financial Uncertainty ................................................................................. 183 Reliability of Historical Financial Data and Valuation Issues ............. 184 Liquidity and the Likelihood of Bankruptcy ......................................... 185 Summary ......................................................................................................... 187 Chapter 9. Options for Alleviating Financial Distress: The Company's Perspective ........................................................................ 189 Properly Assessing the Distressed Firm's Likely Actions Is Key to Assessing the lnvestment Outcomes ...................................................... 190 Example 1: Playing the Waiting Game ................................................ 190 Example 2: Between a Rock and a Hard Place ................................... 194 Summary ............................................................................................. 198 Strategic Options to Resolve Financial Distress Outside Bankruptcy ...... 200 Raise Additional Capital ......................................................................... 200 Asset Sales .......................................................................................... 201 Secured Financings ............................................................................ 202 Salekeaseback Financings ................................................................ 204 Equity Sponsors ................................................................................. 204 Reducing Leverage .................................................................................. 207 Open Market Repurchases ................................................................. 207 Direct Purchases from Holders .......................................................... 207 208 Cash Tender Offers ............................................................................. Exchange Offers ................................................................................. 211 Coercive Exchange Offers ........................................................... 211 Noncoercive Exchange Offers ...................................................... 212 Constraints on the Range of Options ......................................................... 213 Liquidity ................................................................................................... 213 .......................................................................... Time-to-Liquidity Event 213 Magnitude of Problem ............................................................................ 214 Complexity of Capital Structure ............................................................ 214 Severability of Business Units ............................................................... 215 Cause(s) of Financial Distress ................................................................ 215 Strategies When Bankruptcy Appears Necessary ...................................... 215 Maintaining Liquidity .............................................................................. 215 Preplanned Filings ................................................................................... 216 ....................................................................................................... Summary 217 Chapter 10. Profiting from Financial Distress: The Investor's Perspective .......................................................................... 219 Defining the Investment Objectives ........................................................... 220 Tailoring a Strategy to the Investment Objectives .................................... 221 222 Non-Chapter 1 1 Situations ...................................................................... Passive Involvement ........................................................................... 222 Active Involvement ......................................................................... 224 Chapter 1 I Situations .............................................................................. 228 Feasibility Considerations ............................................................................ 238 238 Capital Structure ...................................................................................... Market Versus True Valuation ............................................................... 240 Market LiquidityIConcentration of Holdings ......................................... 241 Other Distressed Investors .................................................................. 241 Bank Debt .......................................................................................... 242 242 Large Block Holders of Public Debt ............................................... 242 Hedging and Capital Structure Arbitrage ................................................... Return Potential of Capital Structure Arbitrage .................................... 243 Common Capital Structure Arbitrage Trades ........................................ 249 Pari Passu Securities with Different Maturities ................................ 250 Senior Versus Junior Securities ....................................................... 252 254 Bonds Versus Equity .......................................................................... ......................................................................................................... Summary 256 Chapter I 1 . Practical Aspects of the Investment Process and Due Diligence ....................................................................................... 257 Practical Realities of the Investment Analysis Process ............................. 258 Screening Situations to Prioritize Opportunities ................................... 258 Reacting to Volatile Situations ............................................................... 260 A Time-Efficient Valuation Methodology ............................................. 260 Performing Due Diligence ........................................................................... 262 Diligence Cost-Benefit Analysis ........................................................ 262 Prioritizing the Diligence Issues ............................................................ 263 Financial Due Diligence .............................................................................. 267 Basic Goals of Financial Due Diligence .................... ................... 267 Obtaining Publicly Available Financial lnformation ............................ 268 Accessing Management ........................................................................... 270 Special Valuation Considerations in Financially Distressed Contexts .................................................................................................272 Business Deterioration During a Reorganization .............................. 272 Reorganization Costs ............................................................................ 273 Critical Vendor Payments .................................................................. 273 Cash Accumulation During the Reorganization .................................... 275 Tax Issues ................................................................................................ 276 Liquidity Implications of a Distressed Firm's Current Tax Status ........................................................................................... 277 Potential Value from Carryforward of Net Operating Losses ......... 279 Priority Status of Tax Claims ......................................................... 284 Legal Due Diligence ..................................................................................... 284 Obtaining the Relevant Documents ....................................................... 285 Checklist of Legal and Bankruptcy-Related Issues to Consider .......... 286 Voidable Preferences ..........................................................................287 Substantive Consolidation .................................................................. 287 Structural Advantages ......................................................................... 288 Equitable Subordination .....................................................................289 Zone of Insolvency ............................................................................ 292 Special Considerations When Investing in Claims That Are Not Negotiable Lnstruments ............................................................ 292 Recent Developments Under the Sarbanes-Oxley Act of 2002 ........... 295 Mechanics of Accumulating the Investment ................... ...................... 296 Investment Strategy and Market Environment Drive Accumulation Approach .......................................................................... 297 Consummating the Trade ........................................................................ 300 Firm Market ........................................................................................ 302 No Market or Above-Market Offering .............................................. 303 . . . . Settling the Trade ............................................................................... 304 Bank Debt ................................................................................................ 305 Holder Identity ....................................................................................305 Settlement ........................................................................................... 305 Special Considerations for Revolving Loans .................................... 306 Summary ....................................................................................................... 307 Chapter 12 . Dynamics of the Workout Process: The Endgame ............... 309 The Parties ...................................................................................................310 The Debtor ............................................................................................. 310 Debtor's Bankruptcy Counsel ................................................................. 311 Debtor's Financial Advisor ..................................................................... 311 The Committee ................................................................................... 311 Committee Legal Counsel .................................................................... 313 Committee Financial Advisor .................................................................314 The Secured Creditors ............................................................................ 314 The Bankruptcy Judge ............................................................................ 315 Types of Chapter 1 1 Cases ......................................................................... 316 Preplanned Restructuring ...................................................................... 318 Full Prepack ....................................................................................... 318 Prenegotiated Filings .......................................................................... 320 Asset Sales ................................................................................................. 321 Sales Intended to Enhance Recoveries by Maximizing Estate Value ........................................................................................ 322 Sales Designed to Maximize Creditor Recoveries ...........................326 Free-Fall and Contested Chapter 11 Reorganizations ........................... 326 Sources of Leverage in the Chapter 11 Process ................................... 327 Delay .................................................................................................... 328 Management and the Right of Exclusivity ................................... 329 Creditors and the Threat of Litigation ........................................ 331 Priority ................................................................................................. 332 Secured Creditors ...........................................................................335 Valuation ............................................................................................. 336 Voting and Confirmation ............................................................................. 339 Voting ..................................................................................................... 339 Confirmation ............................................................................................ 341 Summary ................................................................................................... 346 Chapter 13. Postreorganization Considerations ........................................ 349 Postreorganization Equities ......................................................................... 350 Size of Expected or Probable Market Capitalization ............................ 350 Postreorganization Trading Float ............................................................ 352 Forced Sellers .......................................................................................... 353 Company Profile ...................................................................................... 354 Postconfirmation Lockups ....................................................................... 355 Tax-Based Trading Restrictions ............................................................. 356 Warrants ................................................................................................. 356 Trading Performance of Back-End Equities .......................................... 356 Postreorganization Debt Securities ............................................................. 359 Liquidating Trusts ...................................................................................... 360 365 Summary ....................................................................................................... Endnotes ....................................................................................................... 367 Literature Survey and Selected References ................................................ 405 ......................................... 433 . 435 437 Appendix: Chess Notation and Game Moves Disclosure of Possible Conflicts of Interest Index ............................................... ..........................................................................................................