Billions of dollars of debt is coming due in 2009. Speculative-grade companies will not be able to refinance this debt. Moreover, corporate America is experiencing a covenant default epidemic. The main culprit is the leverage covenant. As the debt levels of companies remain the same, the treacherous economy and decline in spending is killing EBITDA generation. By definition, as debt levels stay the same and EBITDA plummets, leverage ratios rise.
There is no question that corporate America will experience a significant increase in defaults this year. Moody's predicts the global default rate for speculative grade companies in 2009 will be 15.1%, which would translate into defaults by approximately 300 companies.
In the first two weeks of 2009, 13 large companies, including Nortel Networks, Lyondell Chemical Co., Tronox Inc., Gottshalks and the Minneapolis Star Tribune, commenced Chapter 11 cases. And, many more will seek Chapter 11 protection in the near term. With so much distress, and with so many companies needing to delever their capital structures, many are asking: "What will today's corporate restructurings look like?"
Bad companies will liquidate. In the past, when the debtor-in-possession loan and exit loan markets were robust, certain companies with outdated business models and bad balance sheets could skate through Chapter 11 only to fail later. With today's constrained credit markets, bad companies will not be able to survive and, perhaps, will not be able to enter Chapter 11. Retailers in distress, even good ones, will also find it frustratingly difficult to survive if they need to enter Chapter 11. Part of the problem is macroeconomic: People are saving, rather than spending, thereby reducing consumption and exacerbating a recession, which is hammering retailers. But Congress is also to blame. Namely, certain 2005 amendments to the Bankruptcy Code -- the limitation on the time by which a company must assume or reject leases and the requirement that vendors who deliver goods within 20 days of the commencement of a Chapter 11 case be paid in full for a plan of reorganization to be confirmed -- make it almost impossible for a retailer to survive Chapter 11.
That's the bad news. Is there good news? Yes, there is. Good companies with bad balance sheets, and many of the over-leveraged distressed companies are good companies, will be able to reorganize and survive. However, these reorganizations will look different from bankruptcy booms of the past. Specifically, there will be five main characteristics.
First, despite the dysfunctional credit markets and dislocation in asset pricing, distressed companies will secure DIP loans. In general, these DIP loans will be provided by a company's incumbent lenders or other creditors. The DIP loans will be relatively short term and will have high rates and fees. For example, in Tronox, the term of the DIP is 12 months, the rate is Libor (3.5% floor) plus 950 basis points and requires the company to commence a sale process within six months of the filing. This is the new standard, only the terms will shorter and the restrictions will be tighter.
Second, certain companies in distress will begin to commence Chapter 11 cases earlier in the restructuring process. Boards and management teams understand that economic conditions are not going to get better anytime soon. With defaults looming, companies are focusing on liquidity and realizing that it is better to go through a restructuring with more liquidity rather than less. As a result of the constrained credit markets, companies with cash will begin to commence Chapter 11 cases earlier than they would in normal markets to operate, at least for a time, without the need for DIP financing.
Third, restructurings will need to "go through the banks." In other words, the so-called "fulcrum security," the debt instrument most likely to convert into equity of the reorganized company, in many cases will be the bank debt. In prior down cycles, bank debt generally was oversecured and "in the money." As such, the bank debt was either reinstated or refinanced under a plan of reorganization. Thus, the fulcrum security was held by a junior class of creditors (such as high-yield bondholders) and, therefore, distressed companies needed to negotiate a deal with these creditors. From 2003 through 2007, however, companies increasingly relied on the leveraged-loan market for financing. (In 2006 and 2007, the leveraged loan market was $485 billion and $535 billion, respectively.) Consequently, today, a typical distressed company's balance sheet is burdened with a substantial amount of secured bank debt. As today's restructurings require massive delevering, a plan of reorganization will need to contemplate a significant conversion of secured debt to equity. Bondholders will be left with no recovery or a tip to get a deal done without litigation.
Fourth, distressed companies will emerge from Chapter 11 smaller and leaner. Recognizing that they need to massively delever their balance sheets and suffering from, in the words of Nouriel Roubini, a "synchronized global recession," distressed companies and their secured debt holders will negotiate plans of reorganization that convert the vast majority of debt to equity. In addition, in the days of easy credit, companies borrowed and expanded their operations and their asset bases. With these expansions, companies often moved away from their core strengths. In an environment with no GDP growth, companies need to refocus on their core strengths and jettison or shut down non-core businesses, facilities and assets. The result will be smaller, stronger companies focused on their core operations with little or no debt and able to emerge from Chapter 11 and survive a longeconomic downturn.
Fifth, winners will emerge from the current downturn, even if it lasts longer than most experts predict. In today's capital structures, there are four main types of holders: banks, hedge funds, collateralized loan obligations and distressed private equity funds (this includes hedge funds with side pockets or other non-redemption arrangements). The only new member of the capital structure is the distressed private equity fund. The distressed private equity fund will be the winner. These funds buy the senior secured debt of good, but highly leveraged companies, cheaply. They are happy to convert their debt to equity. And their funds do not face redemptions, so they can hold the equity until the economy turns around and the companies can begin to grow again.
2009 will be a wild year in the world of restructurings. And everyone should realize that in today's environment, all deals are distressed deals.
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