Restructuring — more specifically, financial restructuring — generally refers to a series of financial transactions that results in existing equity being significantly diluted and/or wiped out. Think of the process as musical chairs on the liability side of the balance sheet with the odd man out predetermined: equity.
Operational restructuring, on the other hand, describes how a company goes about its business, consolidating plants, selling business units, and so forth. An operational restructuring can (and often does) occur simultaneously with a financial restructuring, but this newsletter is about the balance sheet shuffle.
A financial restructuring happens when three conditions exist:
#1. The enterprise value of the firm is less than the firm’s liabilities and equity.
Enterprise value refers to the value an investor might pay to buy an entire company.
#2. An event occurs that allows a liability owner, usually a lender of some type, to force a restructuring. Typically, the trigger is a company’s default and/or failure to cure loan/note covenants.
#3. Existing equity chooses not to cure the default by adding more equity and/or new equity can’t be found.
Notice I have yet to mention bankruptcy or Article 9 sales. That is because they are one of many legal processes to effectuate a restructuring. More on that in a bit, but first, let’s focus on what to restructure and how.
How to Go About a Financial Restructuring
There are different perspectives from which to view a restructuring, but for our purposes, let’s assume you are the debtor (i.e., the company and/or equity). Lenders, other debt holders, and outsiders wishing to play have different perspectives.
What are the steps involved?
Step 1: Assess the situation and get in front of it.
Are there pressing liquidity concerns, deadlines that must be met, etc.?
Determine the enterprise value of the company — what is it worth? This can be tricky but be as objective as possible. How upside-down is the company? Can operational actions be taken to right the ship? If so, will equity be back in the money and, if yes, consider injecting and raising equity to buy time. If equity won’t recover, which liability on the balance sheet will? Will they fund a turnaround plan so they are better off?
If the above analysis indicates that it makes no sense for equity or a liability stakeholder to fund a turnaround, then it is restructuring time.
Step 2: Get financial and legal help.
Your creditors have been here before, many times — that is a cost of doing business. Hopefully, though, you haven’t. Which means that while many advisory firms say they can do this, if they haven’t done it before in a situation such as yours, you will need a new set of financial advisors compared to whom your firm has used in the past.
Same thing goes on the legal side. If you already use a larger firm, you may be all set. If your counsel is small, though, you’ll probably need to look elsewhere. There are other legal obstacles to retaining good legal counsel, such as conflict checks.
Step 3: Identify the fulcrum creditor and negotiate.
The
fulcrum creditor is the liability on the company’s balance sheet that is partially, but not completely, in the money. In other words, given what you think the value of the company is today, if the company gets those funds and starts paying creditors, secured lender first, etc., then
the fulcrum creditor is the creditor that
doesn’t
get paid in full, but does get something.
Now it’s time to negotiate with the fulcrum creditor. Do they want to own the company or not? Be prepared: Often, fulcrum creditors are not ready to accept that they are in such a position. They may well think they are in the money — show them they are not. Your financial advisor should be able to do that.
If the fulcrum creditor wants to take control, find a way to let them (again, this is for your financial and legal team to figure out). If they do not, find a buyer.
Step 4: Structure a transaction.
If the fulcrum creditor is willing to take control, more or less as is, then this is a reorganization. That is, the business will continue to operate within its existing legal entity. Ownership of that entity changes, but nothing else does.
If not, the option is an asset sale, in which the assets of the business are transferred to a new entity and some of the liabilities are left behind.
Step 5. Figure out the legal mechanism, if any.
Often, this decision is driven by whomever the new value player is and the existing secured lender. The fulcrum creditor that will put in more for a reorganization, or the asset buyer for a sale and liquidation that will buy the assets may want legal protection from creditors. The secured lender must release its liens or accept the change in ownership and control and doesn’t want to risk its recovery.
The most common legal mechanism is not really a legal procedure at all; it is simply written agreements between the debtor and lenders. This is particularly true in a reorganization as opposed to an asset sale.
Legal protections are often used when trade creditors get stiffed. The purpose of these is to shield the “winning” liabilities from suits brought by these creditors, the most common of these protections being something called an Article 9 Sale.
Article 9 refers to a section of the Uniform Commercial Code that allows a secured party, with notice to other creditors, to sell the assets free and clear of any claims from unsecured creditors. (Since this protects an asset sale, it won’t work in a reorganization.)
Formal bankruptcy, while rarely used, does have some features. All litigation is halted, which is a benefit if the business has festered so long that creditors are suing. If the restructuring requires additional funding to get through the process, extra protections can be provided to that lender. Onerous
executory contracts can be terminated or modified, something that is particularly handy for real estate leases, as “bad leases” (e.g., onerous terms, no longer needed, losing money) can be terminated or sold. Similar options exist for all other “executory” contracts.
Whatever the specifics of the legal mechanisms, it often comes down to a negotiation between the senior lender and the source of new equity.
A Recent Example
I worked with a high-end party rental company whose debt had greatly exceeded the enterprise value of the company. A competitor wanted to buy the assets and wanted protection from creditors by doing so through bankruptcy. The lender was concerned the high cost of bankruptcy would lower its recovery and refused.
The buyer then proposed an Article 9 sale. Again, the lender said no as the situation had festered so long, the lender was concerned trade creditors would force the company into bankruptcy. Finally, the buyer agreed to pay most trade creditors and did not lower the price (the buyer needed to keep them happy so it could continue using them).
In the end, the legal means was simply an asset purchase agreement between the debtor and the buyer, with the lender agreeing to release the liens.
Conclusion
As you can see, there are many pathways, hurdles, and considerations when moving through a financial restructuring. Be careful, especially if this is your first time through.
Enlist the help of qualified and experienced financial and legal counsel who will guide you to the best possible outcome.
