Approaching financial stress: maximising value

October 2020  |  SPECIAL REPORT: BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

October 2020 Issue

Portfolio company distress is a thorny subject. Leveraged acquisitions are designed carefully to maximise returns while minimising the prospect of insolvency, and usually they do. Sometimes, however, the winds of fortune blow cold. Eight US private equity-backed companies filed bankruptcy during Q2 2020, twice as many as in the previous quarter. The risks posed by distress are therefore real, and boards of directors must act with dispatch in the ‘zone of insolvency’, the twilight region between healthy operations and actual insolvency, to maximise the value of their company. During periods of financial stress, a critical goal should be to create a ‘zone of safety’ in which directors and sponsors have the time, information and ability to consider their strategic options and implement their final decisions. Creating this space requires pristine corporate governance and building a liquidity runway.

Responding to distress: from the ‘zone of insolvency’ to the ‘zone of safety’

Governance. Once a company becomes insolvent, the focus of its directors’ fiduciary duties shifts from maximising long-term shareholder value to maximising the value of the enterprise for the benefit of all residual claimholders. This may significantly limit the scope of restructuring options. It is therefore imperative that the board act carefully and efficiently, on an impeccable record of informed decision making, to authorise runway-extending measures. Best practices dictate that the board begin to meet more frequently or consider a restructuring committee to focus on recapitalisation efforts, or if the circumstances require, a special committee of independent directors. A good rule of thumb is that if the company must negotiate across from the sponsor, each party should use independent fiduciaries. Board decisions that appear to benefit the sponsor at the expense of the company, such as transactions that transfer value to the sponsor, will be scrutinised with the provision of 20/20 vision. In those cases, the board should appoint an independent director or create a special committee when considering any such transaction. Depending on the circumstances, the scope of authority delegated to an independent director or a special committee will vary but can encompass overall responsibility for a restructuring or Chapter 11 proceeding, or in many cases, making a final recommendation for full board approval or retaining veto power.

Once independent fiduciaries are put in place, they must be equipped with advisers who are independent of the sponsor. This relationship should be documented explicitly to clarify the roles of the respective parties and updated when necessary. Without the presence of disinterested advisers, there is risk that a court will not give business judgment deference to independent director or special committee decisions. In certain cases, this could necessitate three sets of advisers, but the facts of each situation will dictate how adviser relationships should be managed and structured.

Building a liquidity runway. These adjustments to governance lay the groundwork for the sponsor’s operational response, which will be dictated by three high-level considerations: the severity and underlying sources of distress, the sponsor’s willingness to invest additional capital, and the sponsor’s appetite for litigation. Within the boundaries set by these considerations, the sponsor can seek to extend the runway, invest new capital, make a strategic disposition or obtain third-party financing. Often, some or all these strategies are best employed in tandem.

Extending runway. Management teams should begin to explore restructuring possibilities and strategic alternatives as far as possible in advance of liquidity crunches or debt maturities. Restructuring transactions require time to plan and execute. Where possible, boards should manage cash outflows in the form of distributions and fees or seek covenant modifications or holidays. Curtailing cash outflows has the added advantage of reducing the risk of potential future fraudulent conveyance or avoidance actions. Finally, boards should monitor liquidity and performance, because deeper distress often leads to increased legal risk as out-of-the-money creditors may choose to take a puncher’s chance on speculative litigation.

Investing new capital. Sponsors also may choose to invest new capital in their portfolio companies. Among the available options are the issuance of new debt, equity cures and debt buybacks.

New debt often presents the simplest investment strategy. To minimise the risk of subordination, recharacterisation or clawback, the debt should be properly documented on terms similar to those customary in third-party debt contracts of similar priority. Alternatively, the vast majority of sponsor credit agreements permit ‘equity cures’ for financial maintenance covenant breaches. Equity cures are subject to certain common limitations, notably that they do not expand the company’s capacity to make restricted payments or count for cash netting purposes. Moreover, lenders may interpret their use as adversarial and be reluctant to wave covenants in the future. They are best used in situations where the decline in financial performance is temporary, rather than the result of deeper structural factors.

Finally, distress might create an opportunity for the sponsor to reduce company liabilities by acquiring company debt at a discount. Corporate opportunity or insider-trading-related legal concerns can be addressed or mitigated through a corporate opportunity waiver and a company board resolution supporting the sponsor buyback, implementation of a ‘10b-5 plan’, or a ‘big-boy’ letter, as the case may be. Boards also should be attentive to the risk that provisions in company financing documents may deem affiliate-owned debt to have been retired or repaid or may restrict its transfer or voting rights. Sponsors also need to assess the risk of equitable subordination in bankruptcy and note that an insider’s vote on a Chapter 11 plan cannot sway the class if the insider’s class is the only impaired accepting class.

Initiating a strategic disposition. Sponsors may consider a strategic disposition to reduce liabilities and increase cash on hand. Among the options are asset sales, spinouts and wholesale disposition of the company.

A simple asset sale may be viable. Most portfolio company credit agreements give the company broad latitude to sell assets. Typical covenant requirements for unlimited assets sales are: (i) receipt of fair market value; (ii) 75 percent cash consideration (with baskets); a­­­­nd (iii) either ‘reinvestment’ – typically defined broadly, but does not include restricted payments or discounted debt buybacks – of proceeds in the business within 12-18 months or repayment of the first lien debt. When contemplating an asset sale, it should be noted that buyers may be hesitant to deal with a distressed seller because of the risk of clawback litigation. Solvency opinions and an independent valuation can help to mitigate this risk, but cannot eliminate it altogether.

Sponsors might also consider a spinout transaction. Using its investment or asset sale capacity, the company can move business lines or assets to an unrestricted subsidiary before spinning them out to the sponsor. Credit documents should permit the unrestricted subsidiary to be sold to a third party without tripping asset sale covenant obligations. However, any such transfer of assets will be subject to potential clawback as a fraudulent transfer and must comply with state law dividend requirements. A company’s ability to execute on these types of transactions can be used as a bargaining chip in negotiations with lenders to help it achieve other goals.

Sponsors might also consider selling the distressed portfolio company as a whole, either outside or inside of bankruptcy. Outside of the Chapter 11 context, it is common for a sponsor to market a distressed portfolio company to third-party bidders. The out-of-court marketing process also may lead to transaction execution within Chapter 11, for a number of reasons. Section 363 of the Bankruptcy Code permits a sale ‘free and clear’ of claims, which maximises value and limits liability for the buyer. Secured lenders also have the right to ‘credit bid’ their debt in a Section 363 sale. Finally, a Section 363 sale allows the sponsor to drag along holdout lenders if a supermajority agree to take a haircut or roll their debt through to the new entity. In certain cases, the sponsor may be the logical bidder for the assets. In that case, absent consensus from material stakeholders on process, bankruptcy courts will insist that there be a robust bidding process and will want to ensure that the sponsor has not co-opted the process for its exclusive benefit to the exclusion of other bidders and the expense of creditors.

Third-party financing. Sponsors may also look for third-party financing to inject capital into a distressed portfolio company.

Sponsors may, for example, engage in an exchange offer to opportunistically ‘right size’ their capital structure, extend maturities or increase liquidity. Similarly, sponsors may wish to undertake term loan liability management transactions, such as refinancing. Both approaches can be supplemented by an exit consent strategy to strip covenants or make other significant changes to stub debt, but note that consents generally cannot release ‘all or substantially all’ collateral without a unanimous creditor vote.

Where a portfolio company is in serious distress, priming debt may be the only way to obtain cost-effective capital. Certain credit agreements and indentures may be amended to allow for priming debt with a simple majority vote, or for the creation of a super senior tranche within the confines of the original credit agreement. Boards should bear in mind both that creditors consider exit consents and priming transactions to be provocative restructuring measures, and that the possibility of using them may give boards a bargaining chip in negotiations.

Finally, it may be possible to create liquidity by incurring structurally senior debt. Many financing documents do not limit investments from loan parties to restricted subsidiaries, and assets may therefore be transferred to a newly-formed non-guarantor restricted subsidiary. However, most credit agreements impose limitations on the incurrence of non-loan party debt by restricted subsidiaries, so the usefulness of this approach may be limited. As an alternative, the debt could be incurred by unrestricted subsidiaries and sent back to the restricted group to rebuild investment capacity. However, certain financing agreements limit transfers to unrestricted subsidiaries, so the credit group must have sufficient asset sale or investment capacity in order to transfer the assets needed to secure the debt in the first place.

Conclusion

Financial distress brings with it a host of governance and operational considerations. Boards must act thoughtfully and efficiently in the zone of insolvency to ensure that they lay the groundwork for a successful recapitalisation response. With appropriate modification to ‘regular-way’ governance and careful attention to strategic alternatives, boards and sponsors should be able to maximise the value of their portfolio companies, even under difficult circumstances.

Michael H. Torkin is a partner at Simpson Thacher & Bartlett LLP. He can be contacted on +1 (212) 455 3752 or by email: michael.torkin@stblaw.com. The author would like to thank Constantine A. Valettas for his assistance in the preparation of this article.

© Financier Worldwide

BY

Michael H. Torkin

Simpson Thacher & Bartlett LLP

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