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A Return to Reason

A reader shares new research about corporate distressed restructurings and insolvencies, while another calls on CFOs to cast their vote on hedge accounting.
CFO Readers, CFO Europe Magazine
December 10, 2007

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Your article "Only the Strong Shall Thrive" (October 2007) made some interesting points about possible trends for corporate distressed restructurings and insolvencies in 2008 and chime with the results of a survey that Standard & Poor's conducted in the months preceding the recent turmoil in the credit markets, which polled members of turnaround associations in the UK and France and investors active in the European leveraged loan market. We believe the results should be of interest to CFOs across Europe, particularly any whose companies are currently highly leveraged or want to borrow over the next year.

Respondents to our survey predicted that defaults and restructuring activity would increase in 2008, with the car, manufacturing and retail sectors being the most vulnerable. However, while your article focused on excessive leverage as a cause of defaults, only 17% of our respondents cited this as the main driver. Competitive threats were the main cause identified for the car and manufacturing sectors, management and poor products in retail.

In terms of the most effective tools to use for restructuring over the next 12 months, a third of our respondents cited amending covenants and restructuring debt. However, when asked which tools would be the most effective if economic conditions were to deteriorate — as they now have — and the default rate were to increase significantly, respondents cited debt-for-equity swaps, new equity from investors and changes in operations and management.

Respondents also noted that the growth of credit default swaps (CDSs) would complicate future restructurings, largely because of unaligned interests between the various creditors involved and unpredictable behaviour among lenders that may be exacerbated by the ability to hedge exposure through CDSs.

We also asked respondents about how they felt investors would behave during a period of increased defaults and restructurings. What might influence investors in collateralised loan obligations (CLOs) to trade out of distressed loans, or stay invested through restructuring? Respondents reckoned the loan's price in the secondary market, the company's business prospects and its expected recovery rate would have the largest bearings — a response that highlights the importance of recovery ratings for fundamental credit analysis. (S&P's recovery ratings now directly determine the notching on secured bonds and loans.)

One group of investors your article failed to mention was hedge funds. We asked about their role in financial restructurings and 87% of respondents told us hedge funds were playing an "important" role. Why? Because they brought greater liquidity and a wide range of risk appetite to the table. What's more, because hedge funds are not relationship-based lenders, unlike banks, they can more easily push for management changes.

We agree that as long as macroeconomic conditions remain favourable, the year ahead promises "a return to reason rather than a restrictive market." However, for the leveraged finance market to open up fully again, issuers and investors will have to adjust to the new risk climate. And that will mean a return to covenants and more creditor-oriented documentation.

Paul Watters
Head of Leveraged Loans
Standard & Poor's

Last Chance

Time may be running out for those of you who want to hedge forecasted sales, floating rate debt, energy purchases or other cash flow hedges using options. In its September exposure draft, the IASB has proposed an amendment (Paragraph AG99E) to IAS 39, which would eliminate a favourable method for treating the time value of vanilla options. Currently some audit firms allow companies to defer all P&L volatility from vanilla options (including collars) until the underlying hedged transaction occurs.

Balanced hedging portfolios, which are critical for the creation of shareholder value, often include options. Under the proposed amendment, changes in the option time value would no longer be deferred in reserves, resulting in more P&L volatility. It is in the best interests of your stakeholders that the accounting treatment and economic substance of option hedges are aligned and don't suffer the consequences of a change to the accounting standards.

I urge you and your peers either to write a letter to the IASB or log on to and electronically sign a petition opposing the amendment. Comments must be received by January 11th 2008.

Jiro Okochi
CEO and Co-founder
New York