A Primer on Restructuring Your Company’s Finances

by Mike Harmon - June 09, 2020

Government responses to the Covid-19 pandemic have closed down a significant portion of the global economy, creating severe liquidity problems for many companies at a time when the corporate sector is historically highly leveraged across the board.  So while the 2001 and 2008 economic downturns put only a relatively limited number of companies under serious cash-flow pressure - those that were both leveraged and whose earnings were sensitive to the economic cycle - the current crisis has left swathes of companies scrambling for cash.

Plan A for most companies has been to operate within the constraints of their existing financing agreements, which in practice means drawing as much as they can from their existing revolving lines of credit.  However, when this and other resources run dry, many companies will find that their liquidity needs, combined with continued earnings pressure, will render their current highly leveraged capital structures untenable, especially with a gradual reopening of the U.S. and other economies.  A lot of companies, therefore, will have no choice but to restructure.

What Does Restructuring Involve?

At its most basic level, restructuring is the process of renegotiating a firm’s key contracts - in fact, Michael Jensen and William Meckling have famously characterized the firm as a “nexus of contracts.” The key contracts may be operational (joint-venture agreements, employee contracts, supplier contracts, and so forth) or financial (terms and conditions of short-term credit facilities, loans, bond issues, and various categories of stock).  It is the financial contracts that I will discuss here.

Renegotiating financial contracts helps firms short of cash in two ways. First, it allows them to realign the financial and contractual burden associated with their financial obligations so that it matches their current values and cash flows. Second, it facilitates the infusion of new capital into the business.

The role of the board of directors in this undertaking will depend on whether the company is solvent or not. If it is solvent, the board will emphasize the interests of shareholders, but if it is insolvent, the board must consider the interests of creditors. Either way, a key objective for the board is to maximize the value of its enterprise, which may include facilitating access to the liquidity a company needs to fund viable operations and projects.

From the perspective of a company’s creditors, those at risk of losing capital can mitigate those losses in three ways: They can permit the company to take actions that maximize enterprise value; they can demand higher share of that value; and they can insist that the form of this share be structured so as to improve the likelihood that they recover or maximize their investment over time.

Wherever a party finds itself in a restructuring, it will access the same collection of tools to accomplish its objectives. I call this group of tools the “restructuring tool set,” and I will describe each of the methods here.  I am not offering a complete list, but these are the most effective tools that a company or its creditors can use to change the financial position. Also note that these tools as described are those that are applicable under U.S. law, but many international jurisdictions permit similar ones.

The tools fall into two categories: those that can be used in an out-of-court context and those that take place in the context of an in-court process.

The Restructuring Tool Set

Out of court	In court
Amendment/waiver	Chapter 11 reorganization
Asset sale	Contract rejection
Debt-for-debt exchange	Debtor-in-possession financing
Debt-for-equity swap	Exit financing
Debt repurchase	Section 363 asset sale
New financing	Section 363 whole company sale
Sale leaseback
Sale of company
Source: Mike Harmon	© HBR.org

Out-of-court Restructuring

Out of court restructurings are typically less expensive than in-court ones, but they usually require close to unanimous consent from creditors on material changes, such as those to the interest charged on debt or its maturity. This agreement can be difficult to obtain, especially when interests of shareholders and debt-holders conflict, which they may often do. They are more likely to succeed if creditors perceive that the alternative to a negotiated deal has adverse consequences for their claims.  The principal tools of an out-of-court restructuring are:

• A waiver or amendment of debt agreements. Typically, the first step in a restructuring, particularly if the symptoms of distress are less severe, is to seek temporary relief from certain covenants in the company’s debt agreements or to recontract with debt holders within the structure of its existing obligations, with the goal of modifying key terms in its agreements. This may provide relief from maintenance covenants (the obligation, for instance, to maintain a given debt-to-EBITDA ratio) or allow an increase in any limits on the amount of new debt the company can take on.
• Debt-for-debt exchange. When waivers or amendments are not possible, a debt-for-debt exchange can be a powerful tool to facilitate material change to a capital structure.  It works like this: The company agrees with its debt holders to exchange existing obligations for new ones that have a lower principal amount, a lower interest rate interest burden, or a longer maturity (or some combination of these).  These exchanges often involve both a carrot and a stick.  New debt with a longer maturity could, for example, have priority over the old debt it’s exchanged for in the event of a bankruptcy.
• New debt or equity financing. With the Fed’s recent intervention in debt markets, many companies have been able to restructure by raising new debt capital to meet their liquidity needs. This has exacerbated their leverage problem, but has had the benefit of preventing dilution to shareholders. The company can also raise new equity to pay down debt or fund business obligations, which dilutes the interests of current shareholders unless they participate in the new equity. Alternatively, companies may issue a “hybrid” instrument, such as a bond convertible into equity. With instruments of this kind, the amount of equity dilution to existing shareholdings will be less than if new capital were raised through an issue of common stock, due to the benefits of interest payments and seniority offered to investors.
• Deleveraging through debt repurchase. Instead of simply injecting more capital into the company as cash, shareholders can instead agree to repurchase the company’s debt, usually at a discount to the debt’s face value, and then cancel it in exchange for additional equity, thereby deleveraging the company and allowing it to use the interest payments saved to fund operations.
• Debt-for-equity swap. Certain debt holders could agree to convert all or a portion of their debt obligations into equity instruments, which would have the same deleveraging effect on the company as debt repurchases, but would dilute the ownership of existing shareholders.
• Asset sales and sale-leasebacks. If an asset is not essential to a company’s future business plan, the company can simply sell it and use the proceeds to deleverage the company, or provide cash for use in the business (subject to approval from any secured lenders), such as financing payroll or purchasing supplies essential to maintaining operations. A company can also sell an asset that is essential to operations by simultaneously leasing the asset back from its purchaser. Scope for asset sales and sale-leasebacks may be limited in the current circumstances; industry purchasers of assets will likely be in the same challenged position as the seller, and financial purchasers may be in a position to negotiate steep discounts in the prices of the assets involved.
• Sale of the company. Finally, a board may determine that the best way to maximize value and access liquidity is to sell the company to a third party who possesses more resources, and potentially synergies, with which it can achieve superior value for stakeholders than the company could achieve on its own.  Private equity funds, which currently have fairly sizable funds to invest, would certainly be potential purchasers in these situations. Many commercial buyers, however, might themselves be too strapped for cash in the current environment to take advantage of the opportunities afforded by the crisis.

In-court Restructuring

If a company and its creditors cannot reach agreement for a restructuring outside of court, they may have to pursue the transaction inside a Chapter 11 bankruptcy process. While bankruptcy is more expensive than an out-of-court agreed restructuring, in circumstances where the debt holders cannot agree quickly on a solution, Chapter 11 offers more scope for keeping the business afloat.  The key features specific to Chapter 11 restructurings are:

• Reorganization. In the Chapter 11 bankruptcy process, it is possible for a company to negotiate a “plan of reorganization,” which is essentially a court-approved restructuring along out-of-court lines but without full buy-in from creditors. The company and its debt holders agree on one or several of the various measures described above, such as debt exchanges or conversions. This can be done on a “pre-packaged” basis, where the votes are solicited prior to filing, to maximize speed and minimize the cost and impact to the business. Agreement in this context only requires two-thirds of the holders in each class by claim amount, and one-half in number, and under certain circumstances, it may even impose the measures on dissenting debt holders. After the vote, the plan of reorganization is then filed with the court, which must then confirm the deal.  The court confirmation can follow very quickly - in the case of Sungard Availability Services Capital, Inc., for example, the bankruptcy agreement was confirmed just 19 hours after filing in 2019.
• Debtor-in-possession (“DIP”) financing. Under Chapter 11, a debtor can raise debt capital when it might otherwise not be able to, as the debt may be issued on a super-secured basis, senior to existing secured debt (under certain conditions).
• 363 asset and whole company sales. Under Section 363 of the bankruptcy code, a debtor can sell some - or even all - of the company’s assets in bankruptcy, which has certain benefits to the buyers of those assets relative to a transaction executed outside of this process.  These include obtaining the assets free and clear of any liabilities and avoiding any risk of the transaction being reversed at a later date due to a fraudulent conveyance determination. (Under the bankruptcy code, transfers of assets by the debtor prior to bankruptcy can be later voided if, among other reasons, the debt was determined to (1) be insolvent at the time of transfer and (2) have received less than reasonably equivalent value.)  These benefits may make a buyer willing to pay a higher price than it would outside of bankruptcy or enter into a transaction where it otherwise would not.
• Contract rejection. Another unique aspect of Chapter 11 is that it enables a debtor to rescind certain contracts even if it is unable to provide the contractor compensation for doing so in full. For example, a retailer which has unprofitable stores may reject the leases for such stores, increasing the profitability of the overall enterprise. The lessor will, of course, recover the property, but may be unable to re-lease it at the same rate, a loss that it will have to shoulder.
• Exit financing. Chapter 11 also allows a company to raise capital as it exits bankruptcy in a way that wouldn’t have been possible without the bankruptcy. This is because such financing typically coincides with deleveraging transactions and the discharge of liabilities, which makes it more attractive to investors.

People often think about restructuring as just a different way to slice up the proverbial pie, which, to mix metaphors, results in it becoming a tug of war between companies and their various creditors, as each party tries to increase its share at the expense of others.  But in many cases restructuring the right (liabilities) side of the balance sheet can actually increase value on the left (assets) side of the balance sheet by

• Relieving or deferring debt obligations that may stifle investment and growth;
• Enabling the infusion of new capital into the business;
• Allowing the termination of unprofitable contracts; and
• Facilitating the sale of unproductive assets and the redeployment of resources into more productive areas.

The benefits accrue not only to the company: Creditors can also benefit from a restructuring that improves the value of the assets on which the they have claims. In entering a restructuring process, therefore, I would urge all parties to use it for mutual benefit by focusing, where possible, on those areas where there is a basis for a more sustainable - and potentially more valuable - business going forward, expanding the size of the pie for the benefit of all stakeholders.

Mike Harmon is the Managing Partner at Gaviota Advisors, LLC; his previous experience includes over twenty years as a special-situations investor with Oaktree Capital Management.