Capital Structure: Financial Distress

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 How Do You Work Through Financial Distress?

Out-of-Court Restructuring
Bank Debt Restructuring
Bond Restructuring

Chapter 11 Reorganization

Chapter 7 Liquidation

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 Bank Debt Restructuring

Waivers of Default

Maturity Extension

Debt-Equity Swap
US banks are allowed to hold equity in financially distressed firms.
Banks have little incentive to swap debt into equity unless bondholders
do so, too.
Banks are more likely to take equity stakes if the distressed firms
growth opportunities are more attractive.

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 Public Debt Restructuring: Exchange Offers

Trust Indenture Act requires unanimous consent of bondholders to

any change in maturity, principal, or interest.

Hence, public debt is typically restructured via exchange offers.

Debt for Debt Swap
Debt for Equity Swap

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 Debt for Equity Swap Example

You are one of 1000 bondholders, each holding a principal of $1000.

Bondholders participating in the exchange offer share all of the firms

equity equally if the offer succeeds.

The exchange offer is executed only if at least 80% of bondholders

participate.

Firm value after restructuring: $0.5 million

Liquidation value: $0.1 million

Will you tender your bond?

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 Will You Tender?

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 The Free Rider Problem

When is it more likely to be a problem?

How do we solve it?

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 Recap on Out-of-Court Restructurings

Restructurings are more likely to succeed when:

the firm has more growth opportunities
there are fewer distinct classes of debt
there is a higher proportion of bank debt

But often firms remain highly levered, and later re-enter distress.

Creditors often become the largest group of equityholders in exchange

offers.

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 Chapter 11 Reorganizations

Automatic Stay

Management has exclusive right to propose reorganization plan for

120 days.

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 Debtor-In-Possession (DIP) Financing

In financial distress, underinvestment is likely: Debt overhang!

DIP financing alleviates this problem.

This debt is typically senior to all existing securities.

It is subject to court approval and limited in purpose.

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 Approval of a Reorganization Plan

All claimants have to approve:

For creditors, holders of the majority (in number) of claims and
two-thirds of the dollar amount of claims have to agree to the plan.
Objections delay the reorganization and create additional legal fees,
paid from the firms assets.
In practice, senior creditors accept less than full value in order to leave
value for junior classes and buy their votes.
Voting alleviates the free-rider problem.
Cram-down by the judge is possible but rare.

The court has to approve:

The plan must make a return to bankruptcy unlikely.

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 Is a Chapter 11 Reorganization Worse than an
Out-of-Court Restructuring?

A Chapter 11 reorganization may be worse because:

The direct costs of reorganizations are higher.

Lots of time and energy is spent on legal proceedings.

The courts involvement can hamper the firms performance.

The publicity of distress can permanently damage customer

relationships.

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 Is a Chapter 11 Reorganization Better?

A Chapter 11 reorganization may be better because:

Voting reduces free-rider problems among creditors.

It provides the firm with much needed DIP financing.

Creditors cannot collect because of the automatic stay injunction,

i.e., no bank run.

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 Pre-Packaged Bankruptcy

The firm negotiates with creditors outside of bankruptcy a Chapter 11

reorganization plan.

Then it files for Chapter 11 and files the reorganization plan

immediately or shortly thereafter.

The time in Chapter 11 very short: Its a few months, instead of a

year.

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 Chapter 11 Reorganization or Chapter 7 Liquidation?

Chapter 11 is criticized for allowing an excessive continuation of inefficient

firms:
Their post-bankruptcy performance is poor. And worse if
management stays.

Many firms emerge with still high leverage.

Up to one third become Chapter 22s within a few years.

Pre-packs are more likely to become Chapter 22s.

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 Asset Reallocation

Under Chapter 11, there is a substantial asset reallocation.

About two thirds of assets are sold on average (Gilson, 1997).

Under Chapter 7, assets are liquidated

All the firms assets are sold to one or several buyers.
The sales proceeds go to creditors in order of priority.
The liquidation may lead to fire sales below fair market value.
Firms in the same industry might be the highest potential bidders, but
they may also be in a similarly precarious financial situation and cannot
bid on the assets.

Indeed, they may also be selling similar assets.

Assets end up being bought by a non-specialist who value them less.

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 Whos First?
1 Secured Debt
2 Debtor-in-Possession Financing
3 Priority Claims
1 Legal Fees
2 Wages
3 Consumer Deposits
4 Alimony
5 Taxes

4 Unsecured Debt
5 Preferred Stock
6 Common Stock
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 Conflicts of Interest

Different claim holders have different preferences regarding the

resolution of financial distress:
Management tends to favor Chapter 11 reorganization.
Shareholders and junior creditors also tend to favor Chapter 11
reorganization.
However, senior (in particular secured) creditors tend to favor asset
sales or Chapter 7 liquidation.

The Bankruptcy Code frames the negotiations between stakeholders.

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 CEO Turnover Rates

For healthy firms, the annual rate of CEO turnover is about 16%.

For financially distressed firms, the rate is at least 50%.

For firms one year post-bankruptcy, the rate is about 70%.

Source: Evans et al. (2013), Kaplan and Minton (2008)

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 Vulture Funds

Some hedge funds, private equity funds, and units of investment

banks specialize in distressed securities, typically through buying
distressed debt.

They can make money by bondmailing, i.e., threatening to hold up

the reorganization unless given a higher distribution.

More often, they help turn around distressed firms and performance
typically improves subsequently.

The market reacts positively to block acquisitions by vulture funds.

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 Creditor Rights Around the World

Unlike the US, the UK is known to be pro-creditor

Creditor consent for reorganization
No automatic stay
Removal of management
Absolute priority rule

Chapter 15 added to the US Bankruptcy Code in 2005 to deal with

cross-border insolvencies.

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 Financial Distress Take-Aways

Bank debt restructurings are more likely to succeed if publicly-traded

debt is also restructured.

Exchange offers for public debt should involve more senior debt.

Chapter 11 provides automatic stay, DIP financing, and voting rules

(that alleviate free-rider problems).

Asset sales and acquisitions are very common.

Managers and shareholders are overly optimistic about the

continuation value while senior creditors are overly pessimistic.

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