Corporate

C t RRestructuring
t t i
in Financial Distress

Fi
Financial
i l Distress
Di t

• What Is Financial Distress? It’s All About Liquidity!

– Cash and other liquid assets are insufficient to meet current
debt obligations.
obligations

• Is the firm worth restructuring? Or should it be liquidated?

– Negotiations between different parties involved.
– Each party (investment banks, vulture investor, potential
acquirer shareholders
acquirer, shareholders, bondholders etc.)
etc ) will have its own
valuation (and its own agenda).
– Reaching a jointly beneficial agreement is often difficult.
– Bankruptcy laws help resolve conflicts if no agreement is
reached out of court.

2
 Valuation

V l ti
Valuation

• Do not use multiples because they are about companies that

are not in financial distress.

• DCF Valuation is the better tool:

– CCF is the right method to use.

• Liquidation Value is also computed as an alternative outcome.

4
 C it l Cash
Capital C h Flow
Fl Method
M th d

• Be careful about cash flows: consider scenarios and take into account
the indirect cost of financial distress.

• Because of high and changing leverage, there are lots of tax shields:
– Debt tax shield,
– Net operating losses
losses.

• Model explicitly the future debt structure and tax liability.

CCF = NI + Pre-tax int.+ Def. Tax + Dep. – CAPX – ΔWC + Other

• Discount rate: Unlevered cost of capital kA.

E
Example:
l CCF

Note: Assume that the firm uses all available net cash flows (= free cash flows
- after tax interest expense) to pay down debt each year through year 5,
then maintains debt at a constant level thereafter

Inputs

Initial Debt 300

Initial net operating loss carry forwards (NOLs) 140
Expected rate of return on debt (Rd) 8.0%
Expected rate of return on equity (Re), initial value 14.8%
Asset beta (Ba) 0.8
Long term US govt bond rate (Rf) 6.0%
Market risk premium (Rm-Rf) 7.5%
Expected rate of return on assets (Ra), where
Ra = Rf + Ba(Rm-Rf) 12.0%
12 0%
Long term annual growth rate (g) 3.0%
Marginal corporate tax rate (t) 34.0%

6
 Example
p (cont.)
( )
Year
1 2 3 4 5

Revenues 800.0 860.0 925.0 950.0 1020.0

Cost of sales (720.0) (774.0) (786.3) (807.5) (816.0)
Selling, general & administration expenses (48.0) (51.6) (50.9) (52.3) (40.8)
EBIT 32.0 34.4 87.8 90.2 163.2
Interest expense (24 0)
(24.0) (24 2)
(24.2) (24 9)
(24.9) (21 9)
(21.9) (19 0)
(19.0)
Profit before tax 8.0 10.2 62.9 68.3 144.2
Taxes (@ 34%) (after NOL utilization) 0.0 0.0 0.0 (3.2) (49.0)
Net income 8.0 10.2 62.9 65.1 95.2
+ Depreciation 90.0 93.0 98.0 105.0 112.0
- Capex (95.0) (96.0) (105.0) (115.0) (120.0)
- Investment in net working capital (16.0) (17.2) (18.5) (19.0) (20.4)
+ Excess cash 8.0 0.0 0.0 0.0 0.0
+ Proceeds from asset sales 3.0 1.0
Net cash flow ((2.0)) ((9.0)) 37.4 36.1 66.8

Beginning of year debt 300.0 302.0 311.0 273.5 237.4

End of year debt 302.0 311.0 273.5 237.4 170.7

Uses of net operating loss carry forwards (NOLs)

NOLs available 140.0 132.0 121.8 58.8 0.0
NOLs used 8.0 10.2 62.9 58.8 0.0
NOLs remaining 132.0 121.8 58.8 0.0 0.0

E
Example
l (cont.)
( t)

Year
1 2 3 4 5

Net income (after NOL utilization) 8.0 10.2 62.9 65.1 95.2
+ Depreciation 90.0 93.0 98.0 105.0 112.0
- Capex (95.0) (96.0) (105.0) (115.0) (120.0)
- Investment in net working capital (16.0) (17.2) (18.5) (19.0) (20.4)
+ Excess cash 8.0 0.0 0.0 0.0 0.0
+ Proceeds from asset sales 3.0 1.0 0.0 0.0 0.0
+ Interest expense 24.0 24.2 24.9 21.9 19.0
Capital cash flows 22.0 15.2 62.3 58.0 85.8
Terminal value (CCF5 * (1+g) / (Ra-g))
(Ra g)) 981 6
981.6
Present value of year 1-5 cash flows 161.6
Present value of terminal value 557.0
Total present value (discounted at Ra) 718.6

8
 V l i Equity
Valuing E it

• Notice that the CCF Valuation produces enterprise value (EV).

How is EV divided between Debt and Equity?

• Typically (in firms without financial distress), we take EV and

subtract the book value of debt
debt. However
However, for companies in
financial distress the book value of debt is very different from the
market value of debt.

What to do?
- If yyou have market value of debt,, use it.
- If not, adjust book value of debt for the probability of default:
DMarket = DBook * (1 - pD)

P b bilit off Default

Probability D f lt

• We expect that pD is a function of the credit ratings (the worse

the ratings, the higher pD).

EBIT Interest Estimated Cumulative prob of default

Coverage Bond Rating 1 year 5 years 10 years
> 8.50 AAA 0.00% 0.28% 0.67%
6.50 - 8.50 AA 0.02% 0.45% 1.08%
5.50 - 6.50 A+ 0.05% 0.61% 1.46%
4.25 - 5.50 A 0.07% 0.60% 1.73%
3.00 - 4.25 A– 0.07% 0.73% 2.12%
2.50 - 3.00 BBB 0.23% 1.95% 4.44%
2.00 - 2.50 BB 0.81% 8.38% 14.62%
1.75 - 2.00 B+ 2.53% 17.65% 26.11%
1.50 - 1.75 B 6.27% 23.84% 30.43%
1.25 - 1.50 B– 9.06% 29.44% 35.73%
0.20 - 1.25 CCC/C 25.59% 44.50% 49.76%
< 0.20 D 100.00% 100.00% 100.00%

10
 O ti Pricing
Option P i i Method
M th d
Equity is a call option with exercise price
F, equal to the face value of debt

EQUITY

DEBT

45°

VT
F

11

M t ’ Model
Merton’s M d l

• Let Et be the value of equity at date t, Dt the value of debt, Vt the

value of the firm, F the face value of the firm’s only zero-coupon
debt maturing at T, σ the volatility of the value of the firm, Pt(T)
the price at t of a zero-coupon bond that pays $1 at T, and N(d)
the Normal cumulative distribution function evaluated at d:

Et = Vt N (dt ) − Pt (T ) F N (dt − σ T − t )
ln(Vt ) − ln( Pt (T ) F )
where dt = + 0.5 σ T − t
σ T −t
and Dt = Vt − Et

12
 C
Comments
t

• This is simply and application of the Black-Scholes formula for

the pricing of a European call option.

• Assumptions:
– V, the value of the firm, follows a log-normal distribution with
a constant volatility σ: dV = μ*V*dt + σ*V*dz;
– Interest rate r is constant: Pt(T)=(exp(r*(T-t)))-1;
– Trading takes place continuously;
– Financial markets are perfect.

13

S l ti tto P
Solution Practical
ti l PProblems
bl

• How do you find Vt?

– DCF valuation (or liquidation value) of company.

• How do you find σ?

– Weighted average of debt and stock volatility: weights?
– Debt volatility? Bond price volatility.
– Historic volatility, where S = (stock or bond) price
ut = ln (St / St-1)

1
( )
2
∑ ut − u
n
v=
n − 1 t =1

14
 I Practice
In P ti …

• The amount of assumptions necessary to operationalize this

method makes it quite cumbersome and unrealistic.
• So in p
practice it is rarely
y used and can only
ypprovide a rough
g
guideline for the value of equity.

• The critical insight is however very general:

– In distress equity is worth more than the difference between
enterprise and book value of debt. This is because
shareholders have an option to default and therefore the
market value of debt is smaller than its book value.

15

C
Conclusion
l i on Valuation
V l ti

• Use DCF Valuation and Option Pricing together:

– The first one will help with the valuation of the Enterprise
Value.
– The second one will help you price Debt and Equity.

• In practice
practice, option pricing is not used because it is difficult to
implement and requires many assumptions.

• Remember that investing in FD is about realizing that there are

mutually-beneficial opportunities to restructure:
– Quick resolution of FD is beneficial to all parties.
p
– Agreeing on valuation is instrumental for this process to
happen faster.

16
 Execution

17

Once in Trouble:
What Can Be Done About It?
• Consider a firm that needs liquidity to survive (and survival is
efficient ).

• Infusions of new capital:

– New equity injection?
– New debt financing?
– Asset sales?
– Merger? ?

• Restructure the firm

firm’s
s liabilities:
– Private workout, i.e., out-of-court restructuring.
– Formal bankruptcy procedure.
18
 N
New E
Equity
it Injection
I j ti

• Existing shareholders may be willing to invest more money into

their company (rights issues).

• However, who is benefiting from the new money?

• Debt Overhang Problem:

– Shareholders incur the full investment cost and get only part
of the return (only if the firm does not later default).
– Existing creditors would incur none of the investment cost
and still receive part of the return (if firm’s survival is
efficient) .

Î Existing risky debt acts as a “tax on investment”.

19

XYZ’ Balance
XYZ’s B l Sheet
Sh t

• Assets:
– If good state next year (prob. 1/4): $100m.
– If medium state next year (prob
(prob. 1/2): $30m
$30m.
– If bad state next year (prob. 1/4): $5m.

• Liabilities: Face value $35m due next year.

• Discount rate: 0% throughout.

20
 St t Quo
Status Q Values
V l

• Valuation:
– Equity: 1/4 x 65 + 1/2 x 0 + 1/4 x 0 = $16.25m.
– Debt: 1/4 x 35 + 1/2 x 30 + 1/4 x 5 = $25m.
$25m

State Proba. Assets Creditors Shareholders

Good 1/4 100 35 65
Medium 1/2 30 30 0
Bad 1/4 5 5 0
Value 25 0
25.0 16 25
16.25

21

I
Investment
t t Opportunity
O t it

• XYZ has an investment project:

– Today: Investment outlay $15m.
– Next year: Safe return $20m.
$20m

• XYZ should invest:

NPV = -15 + 20 = $5m.

• However, no internal funds are available.

• Will XYZ’s shareholders inject new capital (or cut dividends)?

22
 Will Sh
Shareholders
h ld Inject
I j t New
N Funds?
F d ?
State Proba. Assets Creditors Shareholders
Good 1/4 120 35 85
Medium 1/2 50 35 15
Bad 1/4 25 25 0

Value (net of $15m) 13.75

Value
a ue u
under
de status quo 16.25
6 5

• XYZ’s equity is worth:

1/4 x 85 + 1/2 x 15 + 1/4 x 0 = $
$28.75m.

Î XYZ’s shareholders will not inject funds:

– They invest $15m.
$15m
– Equity value increases only by $28.75m – $16.25m = $12.5m.
– They lose the difference: $2.5m.

23

N
New E
Equity
it Injection
I j ti

• Would new shareholders help?

• New shareholders must break even:

– They may be providing new liquidity,
– but onlyy because theyy receive a fair return for it.

• This means that someone else is de facto incurring the cost: the
existing
i ti shareholders
h h ld via
i massive
i dildilution
ti off th
their
i stake!
t k !SSo,
they will refuse.

• Î Near financial distress, firms are often unable to raise

equity because most of benefits go to existing creditors.

24

 XYZ Equity
XYZ: E it Injection?
I j ti ?

• Suppose XYZ wants to fund the $15m with equity.

• How much equity does it need to issue?

• After the investment, XYZ’s equity will be worth:

1/4 x 85 + 1/2 x 15 + 1/4 x 0 = $28.75m.
$

Î Issue
ssue equ
equity
ty equa
equal to 15/28.75
5/ 8 5 = 52.2%
5 %o of tthe
e post
post-issue
ssue equ
equity.
ty

• Note: Issue equity equal to 52.2%/(1-52.2%)= 109.1% of the

pre issue equity
pre-issue equity, ii.e.,
e starting with 10m shares
shares, they need to
issue 10.91m new shares.

25

New Old
State Proba. Assets Creditors Shareholders Shareholders
(52.2%) (47.8%)
Good 1/4 120 35 44.4 40.6
Medium 1/2 50 35 7.8 7.2
Bad 1/4 25 25 0.0 0.0

Value 32.5 15.0 13.75

Value under status quo 25 16.25

26
 N
New D
Debt
bt Financing
Fi i

• Issuing new debt junior to the existing debt will not work either:
The “tax” on investment is unchanged.

• New debtholders must break even:

– They may be paying the investment cost,
– but only because they receive a fair return for it.

• This means that the existing shareholders will pay the costs via
a reduction in the value of their stake! So, they will refuse.

27

N
New D
Debt
bt Financing
Fi i

• Issuing debt with same seniority as the existing debt will reduce
but generally not solve the problem: A (smaller) tax remains.

• Debt that is senior to existing debt avoids the tax on investment

because gets a large part of the return:
– either actual seniority
seniority,
– or shorter maturity (because it is de facto senior).

• But this may be prohibited by existing covenants.

28
 XYZ Junior
XYZ: J i Debt
D bt Financing?
Fi i ?

• Suppose XYZ wants to fund the $15m with new debt that is
junior to its existing debt.

• Its face value should be $30m.

Old New
State Proba. Assets Shareholders
Creditors Creditors
Good 1/4 120 35 30.0 55.0
Medium 1/2 50 35 15.0 0.0
Bad 1/4 25 25 0.0 0.0

Value 32.5 15.0 13.75

Value under status quo 25 16.25

29

XYZ Senior
XYZ: S i Debt
D bt Financing?
Fi i ?

• Suppose XYZ wants to fund the $15m with new debt that is
senior to its existing debt.

• Its face value should be $15m.

Old New
State Proba. Assets Shareholders
Creditors Creditors
Good 1/4 120 35.0 15.0 70.0
Medium 1/2 50 35.0 15.0 0.0
Bad 1/4 25 10.0 15.0 0.0

Value 28.75 15.0 17.5

Value under status quo 25 16.25

30
 N
New Fi
Financing
i

• Debt is easier than equity.

• Senior debt is easier than junior debt.
• Short term debt is easier than Long
Short-term Long-term
term debt
debt.

• Conversely, new financing is more difficult when existing debt is:

– Short term debt.
– Protected by covenants against new (senior) debt issues.

• Warning: Many firms in distress increase ST debt, delay actual

distress but eventually hit the wall with very high leverage
leverage.

31

A
Asset
tSSales
l

• Careful:
– Asset sale generates cash.
– But lose a source of cash flow
flow.
– Rule of thumb: Compare debt multiple and sale multiple.

• Example:
– Your company: Debt = 6 x EBITDA.
– Sell a non-core division.
– After-tax proceeds: 5 x EBITDA (of division).
– Your company: Debt/EBITDA has increased.
increased

32
 Merger

• Merging with another company can help but only if the acquirer
brings a better capitalization and more liquidity.

• However, unless the acquirer is planning some changes in

operations, this is like an equity injection.

• Indeed, the acquirer must assume the company’s liabilities.

Î If equity injection failed, why would merger succeed?

Î Need to combine this with other moves.

33

O t fC
Out-of-Court
tRRestructuring
t t i Pl
Plans

• In principle, out-of-court restructuring could avoid the

inefficiency associated with the debt overhang problem.

• Restructuring plans combine debt forgiveness or debt for equity

swaps (from senior creditors) with new equity infusion (from
shareholders).

• The first step is agreeing on valuation (and on whether

continuation is the appropriate course of action).

• The second step is agreeing on how to split the gains and the
costs.

34
 XYZ Restructuring
XYZ: R t t i Plan
Pl A

• Suppose a negotiator proposes the following deal:

– The firm issues new equity to fund the project.
project
– Creditors write down 20% of face value to $28m, i.e., face
value reduced by 20% x 35 =$7m.

• Will shareholders agree?

• Will creditors agree?

35

R t
Restructuring
t i Pl Plan A ((cont.)
t)
State Proba. Assets Creditors Shareholders
Good 1/4 120 28 92
Medium 1/2 50 28 22
Bad 1/4 25 25 0

• Shareholders will agree:

– Total equity value: 1/4x92 + 1/2x22 +1/4x0 = $34m
– New equity must be worth: $15m
– Old equity is worth: $34 - $15 = $19m
– This exceeds the status quo value: $16.25m

• Creditors will agree:

– Debt value: 1/4x28 + 1/2x28 +1/4x25 = $27.25m
– This exceeds the status quo: $25m

36
• For the proposed debt write-down to be “acceptable” it must be:
– at least: 35 – 31.67 = $3.33m
– no more than:
th 35 - 25 = $10
$10m

State Proba. Assets Creditors Shareholders

Good 1/4 120 25 95
Medium 1/2 50 25 25
Bad 1/4 25 25 0

Value (net of $15m) 25.0 21.25

Value under status quo 25 16.25

State Proba.
Proba Assets Creditors Shareholders
Good 1/4 120 31.67 88.33
Medium 1/2 50 31.67 18.33
Bad 1/4 25 25 0

Value (net of $15m) 30.00 16.25

Value under status quo 25 16.25

37

XYZ Restructuring
XYZ: R t t i Plan
Pl B

• Suppose a negotiator proposes the following deal:

– The firm issues new equity to fund the project.
– Creditors swap their debt against 42% of the equity
equity.

• After the investment, XYZ’s equity will be worth:

1/4 x 120 + 1/2 x 50 + 1/4 x 25 = $61.25m.
$

• XYZ must
ust issue
ssue new
e equ
equity
ty equa
equal to 15/61.25
5/6 5 = 24.5%
5% o
of tthe
e
post-issue equity.

• For the swap to be “acceptable”:

acceptable :
– Creditors must receive at least: 25/61.25 = 40.8%.
– But no more than: 100% - 24.5% - 16.25/61.25 = 49.0%
38
 U i Thi
Using This Sensibly
S ibl

• When evaluating costs of financial distress, account for the

possibility of (mutually beneficial) financial restructuring.

• Perfect restructuring does not exist in practice.

• But you should ask:

– What are the impediments to restructuring?
– Are they likely to be important?
– Can we alleviate them?

 39

U i Thi
Using This Sensibly
S ibl (cont.)
( t)

• Proliferation of interests.

• trading. Î In constant flux

Creditors’ committee: Continuous trading flux.

• In general, there might be less restructuring problems with:

– Banks and private debt vs. bonds.
– Few vs. many banks.
– Bank relationship vs. arm’s length finance.
– Simple vs. complex debt structure (e.g., number of classes
with different seniority,
seniority maturity,
maturity security
security, ….).
)

40
 P bli Debt
Public D bt Restructuring
R t t i
• The p
problem is much greater
g with (diffused)
( ) public
p debt.
– Why? There are many more creditors!

• Moreover changing the principal

principal, interest or maturity of a public
debt issue requires the approval of all bondholders (in the US) or
a qualified majority (in UK).

• Response:
– Tender Offers: Offer to buyy existing
g debt at a premium.
– Exchange Offers: Exchange debt against new debt, equity
and/or cash.

– Non-tendering bondholders maintain their claims.

Î The Act is not violated.

41

B k
Bankruptcy
t

• An orderly, non-violent and somewhat predictable way of

dealing with failure to pay debts.

• Creditor rights (to seize and liquidate the assets of a firm that
has defaulted on its debt obligations) are weighed against
– the desires of the distressed firm’s employees and
shareholders to continue operating, and
– society
society’ss interest in keeping the firm in operation in order to
minimize losses to employees, customers, suppliers, …

42