Given the steady flow of bad news trickling out of the credit markets over the last five months, the long virtuous cycle enjoyed by the financial markets between 2002 and the summer of 2007 seems like a distant memory.

The run of cheap and abundant credit which fuelled investment and expenditure, and lead to re-leveraging, ever-higher asset prices and increased demand for credit, are likely to come back to bite many investors this year as the economic storm clouds begin to gather. It may not be welcome news, but 2008 is likely to bring a slew of company restructurings.

Last year’s shut down of the credit market is now beginning to feed through to the real economy in earnest, and defaults are set to rise. Many of the leveraged buy-outs closed in 2005, 2006 and the first half of 2007 will come under financial pressure as covenants are breached and equity cushions are reduced or disappear entirely.

In many deals, financial covenant levels will have been set with significant headroom against budget, meaning that by the time these companies do breach their covenants, a significant erosion in value will have already happened.

The relaxed credit conditions pre-August 2007 also enabled deals to go through that would not normally pass muster in a tighter credit market, so a cooling economy in 2008 will inevitably produce casualties and the need for companies to re-negotiate their debts.

Fewer options

The fundamentals of the restructuring market have changed, and going through the process in these market conditions will present ailing companies with a whole new set of problems.

There has been a swing in the balance of power away from the deal-doers and sponsors towards the lenders. The banks, which were previously falling over each other to lend, now have increasingly hawkish credit-based approach, and any company that finds itself renegotiating its covenants will not only face higher interest rates and fees, but will also have to demonstrate that solid action is being taken to effect a business turnaround: not any easy task given the cooling economic conditions.

This time last year a company facing restructuring would have had the option of auctioning off a subsidiary to generate cash. Now, however, this is a less attractive option; private equity firms, previously the most likely candidates to make the acquisition are no longer buying, and trade buyers, who have re-entered the market, tend to take longer over acquisitions to provide a timely solution in a restructuring situation.

In the benign conditions prior to August last year, significant restructurings were more often than not going down the route of aggressive refinancing, Ontex and Schefenacker being prime examples, using a variety of high-yielding debt instruments, such as PIK or ‘pay if you can’ notes.

Companies were able to refinance debt and preserve the shareholders’ option over the equity. This is no longer a possibility, as banks increasingly ask company owners to pump more money into the business or looking for a debt-for-equity swap.

Greater Challenges

The increased activity in bank loan trading over the last few years has also introduced greater challenges for companies undergoing restructurings. In many cases companies are unable to identify the real holders of their debt and consequently whether they are talking to the people who can actually deliver a deal.

Bank debt restructurings were traditionally led by the specialist work-out teams at the lead or agent banks. They would be the main company liaison, as well as take on the syndicate management role.

More recently the trend has been for these banks to syndicate deals widely, resulting in only a small, ongoing exposure for the arranging banks. They no longer have the economic incentive to drive a complex restructuring process and it may make sense for them to sell their debt in the secondary market, like any other lender. Companies may end up in a situation where they want to engage with their lenders, but no-one in the lending groups wants to spend the time and effort engaging with them. This problem will increase as defaults rise and debt participants have less time to focus on one particular deal.

This year is set to be a tough one for most businesses and a busy one for restructuring professionals. Deals which need to be reached quickly to preserve the value of a company’s depreciating assets, could ironically end up taking longer. One thing is certain; the demand for advisers who are able to drive restructurings from the front and maximise value will be very strong indeed.

Tips on restructuring

1. Check that a proper financing structure with sufficient headroom is in place when you get the job. This is the best way to avoid difficult restructuring as complex debt structure can only be addressed when there is sufficient time ahead. Waiting until the last possible moment reduces the chances of being able to secure a refinancing and lessens the company's negotiating position in any refinancing/ restructuring.

2. Prepare reporting and budget by business/product/entity in order to understand easily where the losses are coming from. This differs from the set of accounts at year end and gives an analytic and economic view of the business.

3. Prepare monthly variance reports against budget for early identification of issues. Include financial indicators, but also other KPIs to identify problems before they hit the financial statements.

4. Prepare a proper rolling monthly cash flow (receipts and payments instead of a cash flow derived from EBITDA) in order to understand how much time is left before the 'trigger event'.

5. Conduct a detailed analysis of debt documentation to assess covenants, potential pitfalls and the extent of creditors' rights

6. Monitor secondary trading in the company's debt. Debt trading at below par can give an indication of the market's view on the value of the business.

7. Monitor debt holders. Try to find out and profile who holds the company's debt. This can give some indication as to the likely objectives and behaviour of debt holders.

Matthew Prest is head of European special situations group at Close Brothers Corporate Finance