Restructuring Redux?

Thanks to the availability of cash, the options for bankrupt companies — and their advisers — abound.
Russ BanhamMarch 1, 2007

Larry Hyatt is no stranger to restructuring. In 2001, Hyatt, then-CFO of pioneering Internet service provider PSINet, navigated the company through its 13-month bankruptcy and a subsequent restructuring that included the sale of parts of its several business lines. Cash-flow positive a year later, PSINet emerged from bankruptcy and was sold to Cogent Communications.

If Hyatt were to attempt the same restructuring work today, he says, he would face a very different challenge. “Companies like PSINet that went into bankruptcy in 2001 were burning cash,” says Hyatt, now CFO of O’Charley’s Inc., a Nashville-based $1 billion (in revenues) restaurant company. Most were publicly held. “This time around, suspect companies are likely to be held by private equity. They are generating, not burning, cash. Their underlying business is likely to be profitable.”

The upshot? “In the telecom arena, the business has become more globalized,” Hyatt says. “Consequently, the U.S. and international pieces of a company like PSINet might be more valuable if they were part of the same company and sold as a unit. Restructuring is sensitive to a particular era.”

Unlike 2001, this particular era has been characterized by the availability of cash: more buyers with deep pockets mean more bankruptcy and restructuring options for troubled companies. “If the business model of a company in bankruptcy is fundamentally sound, it will have ample sources of financing available,” says Dennis Hernreich, CFO and chief operating officer of Casual Male Retail Group Inc., who was part of an investor group that purchased the clothing retailer in 2002 following its 2001 bankruptcy. In fact, companies that might have been in a turnaround situation 18 months ago have managed to stay afloat thanks to an influx of cash to sustain operations, adds Linda Delgadillo, executive director of the Turnaround Management Association.

Inevitably, however, the gravy train will stop. And 70 percent of 90 restructuring professionals surveyed last year by the American Bankruptcy Institute (ABI) and Daily Bankruptcy Review, for example, believe we will see an increase in U.S. corporate restructurings, starting this year. Global Insight, a financial forecasting firm, expects the 20 percent decrease seen last year to give way to an approximate 17 percent increase this year, with the metals, mining, energy, and real-estate sectors cited as especially vulnerable. Meanwhile, some bankruptcy-law firms and investment banks are beefing up their restructuring staffs.

When and if a wave of restructurings happens, it could get ugly. Anders J. Maxwell, a managing director at investment banking advisory firm Peter J. Solomon Co., compares the possibility with the last two waves in 1989 and 2001 this way: “In 1989, we had great companies but bad balance sheets. In 2001, we had bad companies but okay balance sheets. This time around we have bad companies and bad balance sheets — a double whammy.”

Waiting for a Trigger

Restructurings in 2007 confront a far different business environment than those from 2001, a year marked by corporate scandals, terrorism, and the bursting of the technology bubble — the trigger for PSINet’s problems. A new bankruptcy law has taken effect, one predicated on speeding up the process. In addition, the nature of financing has changed. Rather than rely on a primary lender, as they typically did in 2001, companies have contracted with a plethora of lenders in multiple tranches, “guaranteeing a knife fight down at the bankruptcy court,” quips bankruptcy lawyer John Penn, a partner at law firm Haynes and Boone.

Before any battle, however, there has to be an opening salvo. But respondents to the ABI survey, which included attorneys, distressed-debt investors, bankers, and financial advisers, disagreed on the trigger, with 48 percent citing interest rates and the remainder pointing to home prices, commodity prices, global competition, and a bear equity market as factors.

To some observers, the low rate of bankruptcy filings could itself be the catalyst. Business bankruptcies were down last year, owing to a strong economy, low interest rates, and excess liquidity via hedge funds, private equity, and other sources. According to statistics compiled by New Generation Research, bankruptcy filings fell from a high of 263 in 2001 to 74 last year, the lowest since 70 bankruptcies in 1994.

“The default rates can’t go any lower, so logically they have to go up,” says Peter J. Solomon’s Maxwell. “It’s a cyclical thing. You can look at default statistics or sheer volumes and yield spreads and conclude we will have a ramp-up in defaults. The only questions are how much of a ramp-up and whether it’s this year or next.”

Penn, on the other hand, predicts a restructuring wave based on “unusual financings.” He explains, “The number of junior liens out there tells me that companies are starting to get stretched. Almost every bankruptcy seems to show up with a junior lien. After a boom time, people get the mentality that it’s impossible to fail. They either get into a market they shouldn’t get into or expand a product line that’s unwise, and take on too much leverage.” The second lien market, in fact, skyrocketed to $23 billion in loans in 2006, up from $16 billion in 2005.

Of course, the largest purveyors of those second liens — hedge funds — are also standing ready to bail out companies that get into trouble. Take the case of hedge fund Highland Capital, which owns 8.9 percent of troubled auto supplier Delphi in different ways, including stock, bonds, and bank debt. Highland recently presented Delphi’s board with a $4.7 billion rights offering to refinance the company, which filed for bankruptcy protection in 2005. Under the plan, existing stockholders with more than 0.5 percent of the common shares would be given the right to purchase Delphi’s unsubscribed shares. Highland is not alone in its bid; its offer represents an alternative to the $3.4 billion deal presented by another hedge-fund group that includes Cerberus Capital Management and Harbinger Capital Partners Master Fund.

In the end, though, it could come down to one event tipping the scales to a restructuring bonanza. “I think the market will be hit by an electrifying event that is impossible to anticipate today, but in hindsight will be very clear,” says Maxwell. “In 1989, the event was the collapse of a leveraged buyout of United Airlines. That’s when the markets realized the emperor had no clothes.”

Watch Your Elbow

If companies do get into trouble this year, the courtrooms will be crammed. “There are all these layers of financing in different tranches and different types of collateral changing character, which is sure to drive an intramural fight among creditors,” says Penn. Among these different players are senior secured creditors, junior secured creditors (a lot of them junk bonds), the bondholders (also junk bonds, depending on whether the junior debt is secured or unsecured), and the trade creditors. “On top of this you have the claim-trading business and loans on the bank side that are basically syndicated. You end up with syndicated lenders that can change regularly, sometimes from one morning to the next.”

Al Koch, managing director at restructuring advisory firm AlixPartners LLP, concurs. “The numerous tranches add a singular complication,” he says. “In 2001, you didn’t see nearly as many lenders as you do today. Many more hedge funds hold significant positions, and the fights between the senior secured [lenders]; the hedge funds, which hold second liens; and the unsecured debt are a dynamic that is only beginning to play out.”

The new bankruptcy law may ease the process. It sets an 18-month deadline on a debtor’s exclusive right to file a bankruptcy reorganization plan and a 20-month deadline on having it accepted by creditors and the bankruptcy court. The limitation “means companies have to get in and out quickly, and doing all their planning ahead of time before they actually file will be more important than ever,” says Bill Hass, CEO of TeamWork Technologies. “When you plan ahead you often find alternatives to avoid bankruptcy, such as a partner or another lender.”

Hass cites the example of troubled privately owned Bay Furniture Co. in Chicago. “It’s a 66-year-old, six-store chain that has been family-owned for decades and was basically liquidating itself,” he says. Rather than file for an in-court bankruptcy, it chose instead to initiate an “assignment for the benefit of creditors,” an out-of-court bankruptcy that allows a debtor to settle up with creditors. Recently, Great American Group lined up to buy the company, allowing it to avoid the costs of bankruptcy. And creditors were able to get what they could from Great American. Bay Furniture had listed $11.2 million in assets and $14.4 million in liabilities.

The new law could also change the destinies of bankrupt companies in another way. Bill Repko, senior managing director at investment banking boutique Evercore Partners Inc., predicts that the shortened bankruptcy-filing process will spur an increase in mergers and takeovers prior to and during restructuring. “You can’t afford to ignore strategic issues anymore, which will drive merger-and-acquisition techniques as part of the restructuring, something that typically came later in the process,” he says.

PSINet trod the well-worn path of restructuring followed by a sale, rather than a sale midway through the process. Hyatt agrees M&A scenarios might come into play earlier were he shepherding PSINet through bankruptcy today, if for no other reason than companies’ underlying businesses are now likely to be profitable and, therefore, attractive. “In 2001, that wasn’t the case,” he says. “We were focusing on restructuring businesses at the same time that we were restructuring balance sheets. This time around the focus will be a lot more on the balance sheets than the business, which is inherently healthy.”

Not that PSINet didn’t have a suitor as it contemplated Chapter 11. The company actually held off its bankruptcy filing for a full month to study an offer from an unlikely bidder — Enron. “We were negotiating with Enron to buy PSINet,” Hyatt confides. “They laid out an off-balance-sheet accounting plan that would somehow allow us to recognize a gain. It just smelled wrong. We went so far as to consult with outside counsel.”

PSINet never finalized its thinking about the deal. Instead, Enron finalized it for them. “We had a bunch of Enron and [Arthur] Andersen guys in our headquarters for weeks, and one day they just vanished,” Hyatt says. “At that point, the deal died.”

A few weeks later, he knew why.

Russ Banham is a contributing editor of CFO.