®2002 prentice hall publishing 1 chapter 24 corporate and distress restructuring

1®2002 Prentice Hall Publishing

Chapter 24Corporate and Distress

Restructuring


Divestitures in General

• Involuntary divestiture usually is the result Involuntary divestiture usually is the result of an antitrust ruling by the governmentof an antitrust ruling by the government

• Voluntary divestiture is a willful decision Voluntary divestiture is a willful decision by management to divestby management to divest

• Include sell-offs, spin-offs and equity Include sell-offs, spin-offs and equity carve-outscarve-outs


Reasons for Voluntary Divestitures

• Efficiency gains and refocusEfficiency gains and refocus– Reverse synergy (4 - 2 = 3)Reverse synergy (4 - 2 = 3)– Strategic change by the companyStrategic change by the company

• Information it conveys to investorsInformation it conveys to investors• Wealth transfer from debt to stockholdersWealth transfer from debt to stockholders• Tax reasonsTax reasons

– Tax shield advantageTax shield advantage– Employee stock ownership plan (ESOP)Employee stock ownership plan (ESOP)


Voluntary Liquidation and Sell-Offs

• Liquidating the overall firmLiquidating the overall firm

• Partial sell-offsPartial sell-offs

• Empirical studies Empirical studies – Indicate a large abnormal return(15%) to Indicate a large abnormal return(15%) to

stockholders of the liquidating companystockholders of the liquidating company– Partial sell-off studies indicate a modest positive (2-Partial sell-off studies indicate a modest positive (2-

3%) abnormal return to the seller’s stock3%) abnormal return to the seller’s stock– Stockholders of the buying company seem to Stockholders of the buying company seem to

experience a positive abnormal return experience a positive abnormal return


Spin-Offs• Complete divestiture of a business unit to existing Complete divestiture of a business unit to existing

shareholdersshareholders• ReasonsReasons

– Operating efficienciesOperating efficiencies– May increase value and reduce information asymmetryMay increase value and reduce information asymmetry– Obtain greater flexibility and improve productivityObtain greater flexibility and improve productivity– May make financial markets more completeMay make financial markets more complete– May have a scarcity value in the stock market and be May have a scarcity value in the stock market and be

accorded a premiumaccorded a premium• Empirical evidence suggests a significant and positive Empirical evidence suggests a significant and positive

stock price effect to a spin-off due to the perception stock price effect to a spin-off due to the perception of greater efficiencyof greater efficiency


Equity Carve-Outs• Divest part of a business unit with an IPODivest part of a business unit with an IPO• Two-stage carve out/spin-offTwo-stage carve out/spin-off• MotivationsMotivations

– Managers may have more incentive to perform wellManagers may have more incentive to perform well– May reduce asymmetric information between managers May reduce asymmetric information between managers

and investorsand investors– Eliminate the cross-subsidization of business unitsEliminate the cross-subsidization of business units– Favorable means for financing growthFavorable means for financing growth– Favorable information effect for a parentFavorable information effect for a parent

• Empirical testing document an average excess Empirical testing document an average excess return return (2%)(2%) around the time of a carve-out around the time of a carve-out announcementannouncement


Going Private• Company ceases to exist as a publicly held entity and Company ceases to exist as a publicly held entity and

the stockholders receive a valuable consideration for the stockholders receive a valuable consideration for their sharestheir shares

• Stockholders must agreeStockholders must agree• MotivationsMotivations

– Avoid costs of being a publicly held companyAvoid costs of being a publicly held company– May improve resource allocation decisions and thereby May improve resource allocation decisions and thereby

enhance valueenhance value– Realign and improve management incentivesRealign and improve management incentives

• Greater the performance and profitability, the greater the Greater the performance and profitability, the greater the rewardreward

• Offsetting argumentsOffsetting arguments– Transaction costs and lack of liquidityTransaction costs and lack of liquidity


Leveraged Buyouts (LBO)

• Take a company private by buying out public Take a company private by buying out public stockholders and taking on a large amount of stockholders and taking on a large amount of debtdebt

• Debt is secured by the assets of the companyDebt is secured by the assets of the company

• Cash purchasesCash purchases


Characteristics of Successful LBOs

• Must be able to dedicate cash flow to debt service, so Must be able to dedicate cash flow to debt service, so competing needs for funds cannot be largecompeting needs for funds cannot be large

• Subsidiary assets that can be sold without adversely Subsidiary assets that can be sold without adversely impacting the core businessimpacting the core business

• Stable, predictable operating cash flowsStable, predictable operating cash flows• Proven historical performance with an established Proven historical performance with an established

market positionmarket position• Experience and quality of senior managementExperience and quality of senior management• Absence of significant pre-existing leverageAbsence of significant pre-existing leverage


Financing the LBO• Debt service and equity commitmentDebt service and equity commitment

– Determine likely cash throw-off sufficient to Determine likely cash throw-off sufficient to service maximum debtservice maximum debt

– Limited partnership for additional equityLimited partnership for additional equity

• Debt financingDebt financing

– Senior debt including revolving creditSenior debt including revolving credit

– Junior subordinated debtJunior subordinated debt

• Mezzanine-layer financingMezzanine-layer financing


Empirical Evidence on LBOs• Stockholders typically receive a sizable premium for Stockholders typically receive a sizable premium for

their stock when a company goes privatetheir stock when a company goes private– Gains shared between pre-buyout stockholders and post-Gains shared between pre-buyout stockholders and post-

buyout ownersbuyout owners• Operating performance, productivity of capital, and Operating performance, productivity of capital, and

cash flows have been found to improve after the cash flows have been found to improve after the buyoutbuyout

• Efficiency gainsEfficiency gains– Improved management incentivesImproved management incentives– Tax benefitsTax benefits– Small wealth transfers from pre-buyout bondholders to Small wealth transfers from pre-buyout bondholders to

post-buyout equity holderspost-buyout equity holders– Reducing agency problems Reducing agency problems


Observations on LBOs• Permit going private with only moderate equityPermit going private with only moderate equity• Assets used to secure a large amount of debtAssets used to secure a large amount of debt• If the company can make its debt payments, the interest If the company can make its debt payments, the interest

burden declines over time as operating profits improveburden declines over time as operating profits improve• Two kinds of riskTwo kinds of risk

– Business risk where operations may not go according to plan Business risk where operations may not go according to plan and the cash-flow to service debt may be lower than and the cash-flow to service debt may be lower than forecastedforecasted

– Sizable increase in interest costs may cause the firm to defaultSizable increase in interest costs may cause the firm to default• If capital expenditures are cut, the company may not be If capital expenditures are cut, the company may not be

competitive once the debt is paid offcompetitive once the debt is paid off


Enterprise Value Placed on an LBO

• Rule of thumb: no more than six to eight times Rule of thumb: no more than six to eight times operating cash flow (EBITDA)operating cash flow (EBITDA)

• If higher than eight, and if leverage is large, the If higher than eight, and if leverage is large, the probability of default may be unreasonableprobability of default may be unreasonable

• Rule of thumb can be stretched if significant Rule of thumb can be stretched if significant growth is expectedgrowth is expected

• Only moderate growth for most LBOs is in the Only moderate growth for most LBOs is in the offing and the rule holdsoffing and the rule holds


Leveraged Recapitalizations

• Fund a large dividend to stockholders with debt, Fund a large dividend to stockholders with debt, usually causing book equity to turn negativeusually causing book equity to turn negative

• The firm remains a public company with a traded The firm remains a public company with a traded stock known as stub sharesstock known as stub shares

• Management and other insiders do not participate in Management and other insiders do not participate in the payout but take additional shares insteadthe payout but take additional shares instead

• Often occur in response to a hostile takeover threatOften occur in response to a hostile takeover threat


Valuation Implications• May give management more incentive to manage May give management more incentive to manage

more efficiently and to reduce wasteful more efficiently and to reduce wasteful expendituresexpenditures

• Tax shield that accompanies the use of debtTax shield that accompanies the use of debt• Event studies have found excess returns somewhat Event studies have found excess returns somewhat

in excess of 30 percentin excess of 30 percent• Internal organization changes may now be possible Internal organization changes may now be possible

that lead to improvements in operating that lead to improvements in operating performanceperformance

• A number of levered recaps do not make itA number of levered recaps do not make it


Voluntary Settlements and Workouts

• Informal and occur outside the courtsInformal and occur outside the courts

• Extension involves creditors postponing the Extension involves creditors postponing the maturity of their obligationsmaturity of their obligations

• Composition involves a pro rata settlement Composition involves a pro rata settlement of creditors’ claims in cash or in cash and of creditors’ claims in cash or in cash and promissory notespromissory notes

• Voluntary liquidation represents an orderly Voluntary liquidation represents an orderly private liquidation of a companyprivate liquidation of a company


Legal Proceedings• Fall under bankruptcy law as carried out through Fall under bankruptcy law as carried out through

bankruptcy courtsbankruptcy courts• Chapter 7 deals with liquidationChapter 7 deals with liquidation• Chapter 11 deals with rehabilitation of an organization Chapter 11 deals with rehabilitation of an organization

through its reorganizationthrough its reorganization• Voluntary proceedings gives the debtor immediate Voluntary proceedings gives the debtor immediate

protection from creditorsprotection from creditors• With involuntary bankruptcy, the bankruptcy court With involuntary bankruptcy, the bankruptcy court

must decide whether the involuntary petition has meritmust decide whether the involuntary petition has merit


Liquidation Under Chapter 7

• Trustee has responsibility for liquidating the Trustee has responsibility for liquidating the property of the company and distributing property of the company and distributing liquidating dividends to creditorsliquidating dividends to creditors

• Priority of claims must be observedPriority of claims must be observed

• If anything is left, a liquidating dividends If anything is left, a liquidating dividends can be paid to subordinated debt holders, can be paid to subordinated debt holders, preferred stockholders, and, finally, preferred stockholders, and, finally, common stockholderscommon stockholders


Reorganization Under Chapter 11• Effort to keep company alive by changing its capital Effort to keep company alive by changing its capital

structurestructure• Should be viable when interest payments are paredShould be viable when interest payments are pared• A high proportion of the companies that reorganize A high proportion of the companies that reorganize

later must be liquidatedlater must be liquidated• The idea is to reduce fixed charges by substituting The idea is to reduce fixed charges by substituting

equity and limited-income securities for fixed-equity and limited-income securities for fixed-income securitiesincome securities

• Gives postpetition creditors priority over prepetition Gives postpetition creditors priority over prepetition creditors known as debtor-in-possession (DIP) creditors known as debtor-in-possession (DIP) financingfinancing


Procedures Followed• Exclusivity period gives management the sole Exclusivity period gives management the sole

right to propose a reorganization plan within 120 right to propose a reorganization plan within 120 daysdays

• If a plan is not proposed, the trustee has the If a plan is not proposed, the trustee has the responsibilityresponsibility

• Plans must be submitted to creditors and Plans must be submitted to creditors and stockholders for approvalstockholders for approval

• The plan should be fair, equitable, and feasibleThe plan should be fair, equitable, and feasible• Cram downs of reorganization plans by judges Cram downs of reorganization plans by judges

seldom occurseldom occur


Reorganization Plan• Total valuation of the reorganized company must be Total valuation of the reorganized company must be

determineddetermined– Capitalization of prospective earningsCapitalization of prospective earnings– Valuation may be adjusted upward if the assets have Valuation may be adjusted upward if the assets have

substantial liquidating valuesubstantial liquidating value• Formulate a new capital structureFormulate a new capital structure

– Reduce fixed charges so that there will be an adequate Reduce fixed charges so that there will be an adequate coverage margincoverage margin

• The valuation of the old securities and their exchange The valuation of the old securities and their exchange for new securitiesfor new securities– Total valuation figure arrived at sets an upper limit on the Total valuation figure arrived at sets an upper limit on the

amount of securities that can be issuedamount of securities that can be issued


Gaming With the Rule of Absolute Priority

• The rule of absolute priority is often violatedThe rule of absolute priority is often violated• The delay card of management is a powerful The delay card of management is a powerful

incentive for creditor concessionsincentive for creditor concessions• Vulture capitalists prey on the fallen and use Vulture capitalists prey on the fallen and use

bullying tactics to extract value from other bullying tactics to extract value from other parties, known as bondmailparties, known as bondmail– Break the log jam between various partiesBreak the log jam between various parties– Add value and lower restructuring costAdd value and lower restructuring cost


Prepackaged Bankruptcy• Management has struck an agreement with most Management has struck an agreement with most

creditors as to terms of the plancreditors as to terms of the plan• Quicker and more efficient, but difficult if creditors Quicker and more efficient, but difficult if creditors

are disperseare disperse• Problems with creditors who hold out can be reducedProblems with creditors who hold out can be reduced• Permits more flexible use of net operating loss Permits more flexible use of net operating loss

carryforwards for tax purposescarryforwards for tax purposes• Efficiency gains of prepackaged bankruptcy can be Efficiency gains of prepackaged bankruptcy can be

compelling to creditors compelling to creditors

®2002 prentice hall publishing 1 chapter 24 corporate and distress restructuring

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