Chapter 24 Corporate and Distress Restructuring

1. Chapter 24Corporate and Distress Restructuring

2. Divestitures in General • Involuntary divestiture usually is the result of an antitrust ruling by the government • Voluntary divestiture is a willful decision by management to divest • Include sell-offs, spin-offs and equity carve-outs

3. Reasons for Voluntary Divestitures • Efficiency gains and refocus • Reverse synergy (4 - 2 = 3) • Strategic change by the company • Information it conveys to investors • Wealth transfer from debt to stockholders • Tax reasons • Tax shield advantage • Employee stock ownership plan (ESOP)

4. Voluntary Liquidation and Sell-Offs • Liquidating the overall firm • Partial sell-offs • Empirical studies • Indicate a large abnormal return(15%) to stockholders of the liquidating company • Partial sell-off studies indicate a modest positive (2-3%) abnormal return to the seller’s stock • Stockholders of the buying company seem to experience a positive abnormal return

5. Spin-Offs • Complete divestiture of a business unit to existing shareholders • Reasons • Operating efficiencies • May increase value and reduce information asymmetry • Obtain greater flexibility and improve productivity • May make financial markets more complete • May have a scarcity value in the stock market and be accorded a premium • Empirical evidence suggests a significant and positive stock price effect to a spin-off due to the perception of greater efficiency

6. Equity Carve-Outs • Divest part of a business unit with an IPO • Two-stage carve out/spin-off • Motivations • Managers may have more incentive to perform well • May reduce asymmetric information between managers and investors • Eliminate the cross-subsidization of business units • Favorable means for financing growth • Favorable information effect for a parent • Empirical testing document an average excess return (2%) around the time of a carve-out announcement

7. Going Private • Company ceases to exist as a publicly held entity and the stockholders receive a valuable consideration for their shares • Stockholders must agree • Motivations • Avoid costs of being a publicly held company • May improve resource allocation decisions and thereby enhance value • Realign and improve management incentives • Greater the performance and profitability, the greater the reward • Offsetting arguments • Transaction costs and lack of liquidity

8. Leveraged Buyouts (LBO) • Take a company private by buying out public stockholders and taking on a large amount of debt • Debt is secured by the assets of the company • Cash purchases

9. Characteristics of Successful LBOs • Must be able to dedicate cash flow to debt service, so competing needs for funds cannot be large • Subsidiary assets that can be sold without adversely impacting the core business • Stable, predictable operating cash flows • Proven historical performance with an established market position • Experience and quality of senior management • Absence of significant pre-existing leverage

10. Financing the LBO • Debt service and equity commitment • Determine likely cash throw-off sufficient to service maximum debt • Limited partnership for additional equity • Debt financing • Senior debt including revolving credit • Junior subordinated debt • Mezzanine-layer financing

11. Empirical Evidence on LBOs • Stockholders typically receive a sizable premium for their stock when a company goes private • Gains shared between pre-buyout stockholders and post-buyout owners • Operating performance, productivity of capital, and cash flows have been found to improve after the buyout • Efficiency gains • Improved management incentives • Tax benefits • Small wealth transfers from pre-buyout bondholders to post-buyout equity holders • Reducing agency problems

12. Observations on LBOs • Permit going private with only moderate equity • Assets used to secure a large amount of debt • If the company can make its debt payments, the interest burden declines over time as operating profits improve • Two kinds of risk • Business risk where operations may not go according to plan and the cash-flow to service debt may be lower than forecasted • Sizable increase in interest costs may cause the firm to default • If capital expenditures are cut, the company may not be competitive once the debt is paid off

13. Enterprise Value Placed on an LBO • Rule of thumb: no more than six to eight times operating cash flow (EBITDA) • If higher than eight, and if leverage is large, the probability of default may be unreasonable • Rule of thumb can be stretched if significant growth is expected • Only moderate growth for most LBOs is in the offing and the rule holds

14. Leveraged Recapitalizations • Fund a large dividend to stockholders with debt, usually causing book equity to turn negative • The firm remains a public company with a traded stock known as stub shares • Management and other insiders do not participate in the payout but take additional shares instead • Often occur in response to a hostile takeover threat

15. Valuation Implications • May give management more incentive to manage more efficiently and to reduce wasteful expenditures • Tax shield that accompanies the use of debt • Event studies have found excess returns somewhat in excess of 30 percent • Internal organization changes may now be possible that lead to improvements in operating performance • A number of levered recaps do not make it

16. Voluntary Settlements and Workouts • Informal and occur outside the courts • Extension involves creditors postponing the maturity of their obligations • Composition involves a pro rata settlement of creditors’ claims in cash or in cash and promissory notes • Voluntary liquidation represents an orderly private liquidation of a company

17. Legal Proceedings • Fall under bankruptcy law as carried out through bankruptcy courts • Chapter 7 deals with liquidation • Chapter 11 deals with rehabilitation of an organization through its reorganization • Voluntary proceedings gives the debtor immediate protection from creditors • With involuntary bankruptcy, the bankruptcy court must decide whether the involuntary petition has merit

18. Liquidation Under Chapter 7 • Trustee has responsibility for liquidating the property of the company and distributing liquidating dividends to creditors • Priority of claims must be observed • If anything is left, a liquidating dividends can be paid to subordinated debt holders, preferred stockholders, and, finally, common stockholders

19. Reorganization Under Chapter 11 • Effort to keep company alive by changing its capital structure • Should be viable when interest payments are pared • A high proportion of the companies that reorganize later must be liquidated • The idea is to reduce fixed charges by substituting equity and limited-income securities for fixed-income securities • Gives postpetition creditors priority over prepetition creditors known as debtor-in-possession (DIP) financing

20. Procedures Followed • Exclusivity period gives management the sole right to propose a reorganization plan within 120 days • If a plan is not proposed, the trustee has the responsibility • Plans must be submitted to creditors and stockholders for approval • The plan should be fair, equitable, and feasible • Cram downs of reorganization plans by judges seldom occur

21. Reorganization Plan • Total valuation of the reorganized company must be determined • Capitalization of prospective earnings • Valuation may be adjusted upward if the assets have substantial liquidating value • Formulate a new capital structure • Reduce fixed charges so that there will be an adequate coverage margin • The valuation of the old securities and their exchange for new securities • Total valuation figure arrived at sets an upper limit on the amount of securities that can be issued

22. Gaming With the Rule of Absolute Priority • The rule of absolute priority is often violated • The delay card of management is a powerful incentive for creditor concessions • Vulture capitalists prey on the fallen and use bullying tactics to extract value from other parties, known as bondmail • Break the log jam between various parties • Add value and lower restructuring cost

23. Prepackaged Bankruptcy • Management has struck an agreement with most creditors as to terms of the plan • Quicker and more efficient, but difficult if creditors are disperse • Problems with creditors who hold out can be reduced • Permits more flexible use of net operating loss carryforwards for tax purposes • Efficiency gains of prepackaged bankruptcy can be compelling to creditors