Paradigm Shift: Observations on the Current Bankruptcy Cycle

The cycle also represents the first wave of restructurings based on the new provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Among other changes, BAPCPA shortened the debtor's exclusivity period to provide a plan of reorganization. Even so, a Section 363 sale typically closes faster and places less of a financial and operational burden on a debtor's resources, since the transaction does not require approval from creditors and other interested parties.

In general, in prior cycles debtors had less secured debt, and secured lenders had more collateral coverage. In the present cycle, debtors hold more secured debt and secured lenders have less collateral coverage. As a result, a secured creditor with less than 100% value cover may now find itself in the position formerly occupied by the unsecured creditor in prior cycles, but with a significant distinction: It has more rights as a secured creditor, including the ability to foreclose on collateral and take control of the company outside of Chapter 11. In addition to liquidity restraints and limited financing options, this reduces the leverage a company has in developing a stand-alone plan of reorganization on its own timetable, while also tightening its treatment of creditor constituencies in a plan of reorganization.

DIP Financing

The scarcity of traditional DIP financing has also shifted the dynamic in restructurings. In situations where companies have not appropriately evaluated their options and developed an ability to survive through a restructuring or bankruptcy process independently, existing senior lenders providing “defensive” DIP financing are extracting onerous terms and improving their positions vis-'-vis other claimants. They do so by using the provision of DIP financing to further shoe-horn themselves into the controlling position in restructurings ' to the detriment of recoveries to non-participating secured lenders, unsecured creditors and shareholders.

The Increasing Importance of 'Optionality'

The new bankruptcy paradigm and changes in the capital markets have a number of implications for companies and boards or directors navigating an increasingly complex insolvency landscape. At or near the zone of insolvency, the Bankruptcy Code overhangs all decisions ' even outside of Chapter 11 ' for all constituencies assessing the relative merits of their options to move forward; these “rules of the road” inform all strategies and tactics. More than ever, it is critical that companies develop and evaluate multiple financial and operating alternatives on a parallel track, creating “optionality” as early as possible. In doing so, a company can identify potential allies before creditors have a seat at the table. Given an early start, a company can manipulate the pieces of the financial chessboard more adroitly.

This is vital for a number of reasons, including: 1) maximizing value for all stakeholders; 2) providing boards and management with the assurance that they have vetted options sufficiently and are using sound business judgment in endorsing a particular course of action; and 3) creating and preserving options (including to access liquidity) to maintain a strong negotiating position with all parties and achieve a successful resolution.

While a company may be able to achieve a successful resolution with its creditors, it is crucial that it engages an investment bank that is: 1) highly skilled in developing creative offensive and defensive strategies to maximize recoveries to shareholders and other junior constituencies, whether consensual or otherwise; and 2) unafraid of recommending, where appropriate, aggressive (and defensible) positions vis-'-vis the other parties at the table.

It is important to realize that the constituent groups around the table (e.g., senior secured creditors, junior secured creditors, and various tranches of unsecured creditors) are not necessarily monolithic. Senior secured lending groups are now less homogenous than in prior cycles and usually include a disparate cast of characters (e.g., hedge funds, private equity firms, CLOs and traditional banks). This can complicate matters when attempting to arrive at a consensual solution. At the same time, crafting “carrot and stick” tactics that make use of divergent motivations and interests may give leverage to debtors and old equity constituents.

'Carrot and Stick'

As an example, one of our clients is the private equity sponsor of an undisclosed industrial company. Here, the senior secured lending group to the portfolio company includes traditional banks alongside CLO hedge funds, none of whom necessarily have the same goals and concerns. In general, old equity has three weapons in distressed situations: 1) temporary control; 2) option value; and
3) the ability to provide new money. Accordingly, Gordian multi-tracked several aggressive strategies to attempt to effect a write-down of debt.

Among these was a proposal for the sponsor to provide a cash consent fee to the first 51% of senior lenders that agreed to commit to a stalking horse bid pursuant to a Section 363 sale. This strategy sought to create a “prisoner's dilemma” among the senior lenders by taking advantage of the different motivations of the members of the bank group. For example, a CLO or hedge fund may be more interested in a cash offer (a “carrot”) vis-'-vis a traditional bank lender. The “stick” here was that the 51% of participating senior lenders who accepted the cash receiving a considerably greater recovery (through a combination of cash, reinstated debt, and equity) than the non-participating lenders (receiving a recovery in the form of debt and equity only). Such tactics can sometimes shift the dynamic to the benefit of those who are farther down in the capital structure.

Challenges such as these mandate that a company should retain an investment bank that does not require “on-the-job” training in distressed investment banking. It is also imperative that a company engage an investment bank that is unbiased and conflict-free (i.e., without prior or existing relationships with bondholders). This becomes incredibly important when there may not be enough value for all of a company's constituencies.

Defensive and Offensive Strategies

Another notable distinction in the current cycle is the prominent role played by private equity firms and hedge funds in the reorganization process.

In our experience, many private equity firms initially resist ' for fear of potential damage to relationships with senior lenders and other parties ' the more creative and aggressive tactics that Gordian develops in order to maximize firms' recoveries. In this cycle, all constituents (including private equity firms) are seeking to maximize their recoveries. As fiduciaries, private equity firms and hedge funds are obligated to fight for every last dime of their limited partners' capital. Many of them are doing so. Private equity and hedge funds that are under-capitalized find themselves in defensive positions. While in previous cycles they may have walked away from portfolio companies facing bankruptcy, they are now focused on trying to maximize recoveries.

Many private equity firms have portfolio companies that are relatively more distressed in the current cycle (often purchased through buyout transactions funded with covenant-lite debt). Without having to face defaults or maturity dates to restructure, the underlying “zombie” companies are able to postpone the day of reckoning. In these situations, private equity firms want to preserve the status quo and keep existing, low-rate bank debt in place. They recognize that while their equity investment may be underwater, they have option value and control, and are prepared to wait for positive developments down the road.

The rub occurs when private equity firms find that their liquidity constrained portfolio companies require fresh capital. In this cycle, equity sponsors do not want to invest further below the “Mountain of Debt.” We have seen a slew of private equity firms seek expert investment banking guidance to right-size portfolio companies' balance sheets in such circumstances ' to the advantage of the sponsor. In distressed situations, private equity firms are best served by advisors with expertise in developing strategies to vault the sponsors “up the waterfall.”

There is no cookie-cutter set of solutions to benefit sponsors. Rather, each situation is unique, which permits creativity to have a huge impact. By either bringing new money to the table and/or utilizing creative and aggressive financial engineering tactics, private equity firms and hedge funds can enact strategies to buy significant amounts of equity, “encourage” others to move toward a consensual deal, and leapfrog more senior constituents to extract value.

For instance, Lyondell Chemical's controversial $8.0 billion “defensive” DIP exemplifies the degree of influence the DIP has on intercreditor and process issues. This $8.0 billion financing had two parts: a $6.5 billion term loan (which included $3.25 billion in new money and a $3.25 billion “roll-up” of certain of Lyondell's pre-petition debt to a number of hedge funds) and a $1.5 billion asset-based facility. Using this approach, certain existing constituents were able to roll-up their pre-petition exposure into a super-priority DIP, thereby vaulting over other creditors.

With credit remaining tight, well-capitalized private equity firms and hedge funds can buy positions in a company's capital structure below par and use bankruptcy as a venue to emerge with a controlling stake in the company. For example, Avenue Capital Group and DDJ Capital Management held 80% of Milacron, Inc.'s prepetition secured notes, and backstopped an $80 million DIP facility (which included $40 million in new money, and a roll-up of $40 million in pre-petition debt) to bridge to a Section 363 sale in which they used those securities to purchase the assets of the company. See http://www.shearman.com/Shearman–Sterling-Represents-Avenue-Capital-and-DDJ-Capital-Management-in-Acquisition-of-Milacron-Incs-Assets-08-31-2009/ (last accessed Nov. 11, 2009).

The Overhang of
GM & Chrysler

A commentary on the current bankruptcy cycle would be incomplete without addressing the landmark, unprecedented cases of GM and Chrysler. In these quick-sale bankruptcies, the often lengthy process of reorganization was circumvented due to governmental pressure, time concerns, the alleged potential risks to the broader economy, and the commitment of public financing for the debtors' operations. While selling the bulk of a company's assets is allowed under Section 363(f) of the Bankruptcy code, the Chrysler sale bypassed the conventional absolute priority rule by allowing the government to direct that unsecured creditors receive greater consideration than secured bondholders.

It is too soon to tell whether these cases will serve as precedent. Nonetheless, they could affect how investors think about financing companies where there are either large unions and/or a potential governmental interest. See www.jonesday.com/pubs/pubs_detail.aspx?pubID=S4313. Cases that push the envelope of settled bankruptcy law will be kept top of mind by advisors to private equity and/or other out-of-the-money constituencies to develop strategies that may enable their clients to leapfrog more senior stakeholders and extract value when there is not enough to go around.

What's Next

Looking ahead, there tends to be a period when defaults continue well after the economy nominally turns up. In particular, health care and commercial real estate will take several years to play out. Many players, including regional banks and other institutions that made significant loans to the commercial real estate market, will likely disappear.

As the capital markets open up, there will be greater liquidity and access to capital to help fund restructurings rather than liquidations. As more external sources of financing become available, whether for DIP funding, exit refinancing or acquisition, companies will have a greater ability to develop “optionality” to maintain control of the bankruptcy process and execute strategies to maximize recoveries for all stakeholders.

Peter S. Kaufman is the President and Head of Restructuring and Distressed M&A at the independent investment bank Gordian Group. Henry F. Owsley is the CEO of Gordian Group, which he founded in 1988. He has extensive experience in a variety of financing, advisory and merger transactions, as well as in expert witness engagements. Kaufman and Owsley are co-authors of Distressed Investment Banking: To the Abyss and Back.

The current bankruptcy cycle is unprecedented in a number of ways: The old playbook is stale and creative new strategies are the order of the day. It stems in large part from a glut of easy credit available from 2001 through early 2008. It breaks new ground due to seminal cases like Lehman, GM, and Chrysler, the presence of government bailout funding, the severity of the credit crisis, and the retrenchment of the traditional model of standalone reorganization through Chapter 11.

The Current Cycle

In the current cycle, the typical Chapter 11 stand-alone reorganization model has taken a back seat as the diminution of collateral value, increasingly complex and layered capital structures, the inability of companies to refinance debt or obtain debtor-in-possession (DIP) financing, constrained liquidity (and fewer acquirers able to access financing) are all having an impact on restructuring dynamics. These factors have given rise to increasing numbers of liquidations, pre-negotiated bankruptcies, and quick-cycle Section 363 sales.

The cycle also represents the first wave of restructurings based on the new provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Among other changes, BAPCPA shortened the debtor's exclusivity period to provide a plan of reorganization. Even so, a Section 363 sale typically closes faster and places less of a financial and operational burden on a debtor's resources, since the transaction does not require approval from creditors and other interested parties.

In general, in prior cycles debtors had less secured debt, and secured lenders had more collateral coverage. In the present cycle, debtors hold more secured debt and secured lenders have less collateral coverage. As a result, a secured creditor with less than 100% value cover may now find itself in the position formerly occupied by the unsecured creditor in prior cycles, but with a significant distinction: It has more rights as a secured creditor, including the ability to foreclose on collateral and take control of the company outside of Chapter 11. In addition to liquidity restraints and limited financing options, this reduces the leverage a company has in developing a stand-alone plan of reorganization on its own timetable, while also tightening its treatment of creditor constituencies in a plan of reorganization.

DIP Financing

The scarcity of traditional DIP financing has also shifted the dynamic in restructurings. In situations where companies have not appropriately evaluated their options and developed an ability to survive through a restructuring or bankruptcy process independently, existing senior lenders providing “defensive” DIP financing are extracting onerous terms and improving their positions vis-'-vis other claimants. They do so by using the provision of DIP financing to further shoe-horn themselves into the controlling position in restructurings ' to the detriment of recoveries to non-participating secured lenders, unsecured creditors and shareholders.

The Increasing Importance of 'Optionality'

The new bankruptcy paradigm and changes in the capital markets have a number of implications for companies and boards or directors navigating an increasingly complex insolvency landscape. At or near the zone of insolvency, the Bankruptcy Code overhangs all decisions ' even outside of Chapter 11 ' for all constituencies assessing the relative merits of their options to move forward; these “rules of the road” inform all strategies and tactics. More than ever, it is critical that companies develop and evaluate multiple financial and operating alternatives on a parallel track, creating “optionality” as early as possible. In doing so, a company can identify potential allies before creditors have a seat at the table. Given an early start, a company can manipulate the pieces of the financial chessboard more adroitly.

This is vital for a number of reasons, including: 1) maximizing value for all stakeholders; 2) providing boards and management with the assurance that they have vetted options sufficiently and are using sound business judgment in endorsing a particular course of action; and 3) creating and preserving options (including to access liquidity) to maintain a strong negotiating position with all parties and achieve a successful resolution.

While a company may be able to achieve a successful resolution with its creditors, it is crucial that it engages an investment bank that is: 1) highly skilled in developing creative offensive and defensive strategies to maximize recoveries to shareholders and other junior constituencies, whether consensual or otherwise; and 2) unafraid of recommending, where appropriate, aggressive (and defensible) positions vis-'-vis the other parties at the table.

It is important to realize that the constituent groups around the table (e.g., senior secured creditors, junior secured creditors, and various tranches of unsecured creditors) are not necessarily monolithic. Senior secured lending groups are now less homogenous than in prior cycles and usually include a disparate cast of characters (e.g., hedge funds, private equity firms, CLOs and traditional banks). This can complicate matters when attempting to arrive at a consensual solution. At the same time, crafting “carrot and stick” tactics that make use of divergent motivations and interests may give leverage to debtors and old equity constituents.

'Carrot and Stick'

As an example, one of our clients is the private equity sponsor of an undisclosed industrial company. Here, the senior secured lending group to the portfolio company includes traditional banks alongside CLO hedge funds, none of whom necessarily have the same goals and concerns. In general, old equity has three weapons in distressed situations: 1) temporary control; 2) option value; and
3) the ability to provide new money. Accordingly, Gordian multi-tracked several aggressive strategies to attempt to effect a write-down of debt.

Among these was a proposal for the sponsor to provide a cash consent fee to the first 51% of senior lenders that agreed to commit to a stalking horse bid pursuant to a Section 363 sale. This strategy sought to create a “prisoner's dilemma” among the senior lenders by taking advantage of the different motivations of the members of the bank group. For example, a CLO or hedge fund may be more interested in a cash offer (a “carrot”) vis-'-vis a traditional bank lender. The “stick” here was that the 51% of participating senior lenders who accepted the cash receiving a considerably greater recovery (through a combination of cash, reinstated debt, and equity) than the non-participating lenders (receiving a recovery in the form of debt and equity only). Such tactics can sometimes shift the dynamic to the benefit of those who are farther down in the capital structure.

Challenges such as these mandate that a company should retain an investment bank that does not require “on-the-job” training in distressed investment banking. It is also imperative that a company engage an investment bank that is unbiased and conflict-free (i.e., without prior or existing relationships with bondholders). This becomes incredibly important when there may not be enough value for all of a company's constituencies.

Defensive and Offensive Strategies

Another notable distinction in the current cycle is the prominent role played by private equity firms and hedge funds in the reorganization process.

In our experience, many private equity firms initially resist ' for fear of potential damage to relationships with senior lenders and other parties ' the more creative and aggressive tactics that Gordian develops in order to maximize firms' recoveries. In this cycle, all constituents (including private equity firms) are seeking to maximize their recoveries. As fiduciaries, private equity firms and hedge funds are obligated to fight for every last dime of their limited partners' capital. Many of them are doing so. Private equity and hedge funds that are under-capitalized find themselves in defensive positions. While in previous cycles they may have walked away from portfolio companies facing bankruptcy, they are now focused on trying to maximize recoveries.

Many private equity firms have portfolio companies that are relatively more distressed in the current cycle (often purchased through buyout transactions funded with covenant-lite debt). Without having to face defaults or maturity dates to restructure, the underlying “zombie” companies are able to postpone the day of reckoning. In these situations, private equity firms want to preserve the status quo and keep existing, low-rate bank debt in place. They recognize that while their equity investment may be underwater, they have option value and control, and are prepared to wait for positive developments down the road.

The rub occurs when private equity firms find that their liquidity constrained portfolio companies require fresh capital. In this cycle, equity sponsors do not want to invest further below the “Mountain of Debt.” We have seen a slew of private equity firms seek expert investment banking guidance to right-size portfolio companies' balance sheets in such circumstances ' to the advantage of the sponsor. In distressed situations, private equity firms are best served by advisors with expertise in developing strategies to vault the sponsors “up the waterfall.”

There is no cookie-cutter set of solutions to benefit sponsors. Rather, each situation is unique, which permits creativity to have a huge impact. By either bringing new money to the table and/or utilizing creative and aggressive financial engineering tactics, private equity firms and hedge funds can enact strategies to buy significant amounts of equity, “encourage” others to move toward a consensual deal, and leapfrog more senior constituents to extract value.

For instance, Lyondell Chemical's controversial $8.0 billion “defensive” DIP exemplifies the degree of influence the DIP has on intercreditor and process issues. This $8.0 billion financing had two parts: a $6.5 billion term loan (which included $3.25 billion in new money and a $3.25 billion “roll-up” of certain of Lyondell's pre-petition debt to a number of hedge funds) and a $1.5 billion asset-based facility. Using this approach, certain existing constituents were able to roll-up their pre-petition exposure into a super-priority DIP, thereby vaulting over other creditors.

With credit remaining tight, well-capitalized private equity firms and hedge funds can buy positions in a company's capital structure below par and use bankruptcy as a venue to emerge with a controlling stake in the company. For example, Avenue Capital Group and DDJ Capital Management held 80% of Milacron, Inc.'s prepetition secured notes, and backstopped an $80 million DIP facility (which included $40 million in new money, and a roll-up of $40 million in pre-petition debt) to bridge to a Section 363 sale in which they used those securities to purchase the assets of the company. See http://www.shearman.com/Shearman–Sterling-Represents-Avenue-Capital-and-DDJ-Capital-Management-in-Acquisition-of-Milacron-Incs-Assets-08-31-2009/ (last accessed Nov. 11, 2009).

The Overhang of
GM & Chrysler

A commentary on the current bankruptcy cycle would be incomplete without addressing the landmark, unprecedented cases of GM and Chrysler. In these quick-sale bankruptcies, the often lengthy process of reorganization was circumvented due to governmental pressure, time concerns, the alleged potential risks to the broader economy, and the commitment of public financing for the debtors' operations. While selling the bulk of a company's assets is allowed under Section 363(f) of the Bankruptcy code, the Chrysler sale bypassed the conventional absolute priority rule by allowing the government to direct that unsecured creditors receive greater consideration than secured bondholders.

It is too soon to tell whether these cases will serve as precedent. Nonetheless, they could affect how investors think about financing companies where there are either large unions and/or a potential governmental interest. See www.jonesday.com/pubs/pubs_detail.aspx?pubID=S4313. Cases that push the envelope of settled bankruptcy law will be kept top of mind by advisors to private equity and/or other out-of-the-money constituencies to develop strategies that may enable their clients to leapfrog more senior stakeholders and extract value when there is not enough to go around.

What's Next

Looking ahead, there tends to be a period when defaults continue well after the economy nominally turns up. In particular, health care and commercial real estate will take several years to play out. Many players, including regional banks and other institutions that made significant loans to the commercial real estate market, will likely disappear.

As the capital markets open up, there will be greater liquidity and access to capital to help fund restructurings rather than liquidations. As more external sources of financing become available, whether for DIP funding, exit refinancing or acquisition, companies will have a greater ability to develop “optionality” to maintain control of the bankruptcy process and execute strategies to maximize recoveries for all stakeholders.

Peter S. Kaufman is the President and Head of Restructuring and Distressed M&A at the independent investment bank Gordian Group. Henry F. Owsley is the CEO of Gordian Group, which he founded in 1988. He has extensive experience in a variety of financing, advisory and merger transactions, as well as in expert witness engagements. Kaufman and Owsley are co-authors of Distressed Investment Banking: To the Abyss and Back.