Restructuring: credit limit

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

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

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