case study: an interactive negotiation of a distressed ... valuation fundamentals workshop case...

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Valuation Fundamentals Workshop

Case Study: An Interactive Negotiation of a Distressed Company Restructuring TR

AC

K A

Case Study: An Interactive Negotiation of a Distressed Company Restructuring

Prof. Jim Nolen, Presiding OfficerThe University of Texas at Austin, McCombs School of Business Austin, Texas

Michael Friedman, ModeratorChapman and Cutler LLP; New York

Larry G. HalperinChapman and Cutler LLP; New York

Prof. David C. SmithUniversity of Virginia, McIntire School of Commerce Charlottesville, Va.

Franklin H. Top, IIIChapman and Cutler LLP; Chicago

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Michael FriedmanLarry G. HalperinDavid C. SmithFranklin H. Top, IIIFebruary 25, 2015

Can We Work This Out? An Interactive Case Study: The Restructuring of Danfurn LLC

Danfurn LLC

§  Family-founded, high-end Scandinavian furniture company

§  Sold to private equity sponsor in 2007 §  Products are discretionary. Business does well in good

times and not so well in bad times §  Now March 2011

1

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Exhibit 1 The Restructuring of Danfurn LLC

Danfurn Organizational Structure

Danfurn Management

LLC

Danfurn LLC

Danfurn Stores LLC

Danfurn Manufacturing

LLC

100%

Source: Created by case writer.

2


LBO Debt Financing Structure

Source: Company documents.

Tranche Borrowing Entity

Amount ($ millions) Rate Maturity Relevant Covenants Guarantee?

M&L Senior Secured Revolving Loan

Danfurn LLC

15.0 LIBOR + 425

March 2014 Maintenance-based limitations on the incurrence of additional indebtedness and liens, payment of dividends, repurchases of capital stock, sales of assets, and changes in control. Financial covenants include: consolidated adjusted EBITDA must exceed $8.5 million; capital expenditures cannot exceed $3.0 million.

Danfurn Management LLC

M&L Senior Secured Term B Loan

Danfurn LLC 85.0 LIBOR + 450

March 2015 Maintenance-based limitations on the incurrence of additional indebtedness and liens, payment of dividends, repurchases of capital stock, sales of assets, and changes in control. Financial covenants include: consolidated adjusted EBITDA must exceed $8.5 million; capital expenditures cannot exceed $3.0 million.


10.345% Senior Mezzanine Notes + Equity Warrants


30.0 10.35% August 2015 Incurrence-based restrictions on additional indebtedness and liens and changes in control. Notes also contain cross-acceleration and cross-default provisions tied to the Senior Credit Facilities.

None

3


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3


Consolidated Statement of Operations (in thousands of dollars)

* Excludes bad debt charges. Source: Company documents.

2010 2009 2008 2007 2006 Net sales $ 332,843 $ 425,706 $ 503,295 $ 454,905 $ 294,321 Cost of sales 241,977 303,954 339,724 309,335 191,309

Gross profit 90,866 121,752 163,571 145,570 103,012 Selling, general, and administrative expenses excluding bad debt and notes receivable valuation charges 90,200 117,495 142,432 129,648 92,858 Bad debt charges 6,567 15,205 11,769 (2,135) (1,549) Profit (Loss) from operations (5,901) (10,948) 9,369 18,057 11,704 Interest expense (7,516) (7,722) (9,084) (232) (125) Loss before income taxes (13,417) (18,670) 285 17,825 11,579 Income tax benefit (provision) 4,696 6,534 (100) (6,239) (4,052)

Net gain (loss) $ (8,721) $ (12,135) $ 186 $ 11,586 $ 7,526

Depreciation & amortization 5,966 6,604 8,089 9,089 9,253 EBITDA* 6,632 10,861 29,227 25,011 19,408 Capital expenditures (net of sales of PP&E) 2,234 (967) (2,698) (2,743) (5,202)

4

Danfurn profitability, 2006-2010

5

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2006 2007 2008 2009 2010

$ 0

00s

EBITDA* EBITDA Margin

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Consolidated Balance Sheet (in thousands of dollars)

Source: Company documents.

2010 2009 2010 2009 Assets Liabilities and Stockholders’ Equity Current assets Current liabilities Cash and cash equivalents $ 6,017 $ 10,574 Accounts payable $ 15,786 $ 11,523 Accounts receivable 33,621 38,225 Accrued compensation and benefits 6,322 6,157 Inventories 41,810 33,388 Other accrued liabilities 14,983 11,730 Other current assets 6,969 13,312 Current portion of bank loan 2,200 2,500

Total current assets 88,417 95,499 Total current liabilities 39,291 31,910

Long-term assets Long-term liabilities Property and equipment, net 65,950 70,636 Post-employment benefit obligations 5,920 4,328 Retail real estate 27,513 28,793 Bank debt 90,895 95,595 Other 3,465 3,034 10.345% senior mezzanine notes 30,000 30,000

Total long-term assets 96,928 102,463 Other long-term liabilities 3,256 8,877

Total assets $ 185,345 $ 197,962 Total long-term liabilities 130,071 138,800 Commitments and Contingencies Stockholders’ equity Common stock 15,733 15,733 Retained earnings 199 8,920 Additional paid-in capital 478 481 Accumulated other comprehensive income (loss) (427) 2,118

Total stockholders’ equity 15,983 27,252

Total liabilities and stockholders’ equity $ 185,345 $ 197,962

6

Exhibit 5 Danfurn LLC

Preliminary Waterfall Model as of March 2011

7


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This document has been prepared by Chapman and Cutler LLP attorneys for informational purposes

only. It is general in nature and based on authorities that are subject to change. It is not intended as

legal advice. Accordingly, readers should consult with, and seek the advice of, their own counsel with

respect to any individual situation that involves the material contained in this document, the application

of such material to their specific circumstances, or any questions relating to their own affairs that may

be raised by such material.

© 2015 Chapman and Cutler LLP

8


147

UVA-F-1688 Rev. Dec. 13, 2013

This fictional case was prepared by Michael Friedman and Larry G. Halperin, partners in the law firm of Chapman and Cutler e LLP, and David C. Smith, Professor of Commerce at the University of Virginia. The authors would like to thank Jason Pan for his input and assistance. The case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2013 by the University of Virginia McIntire School of Commerce Foundation. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the McIntire School Foundation.

THE RESTRUCTURING OF DANFURN LLC1

In March 2011, Dan Bruckmuller reviewed the options presented to the board of Danfurn LLC by the company’s advisers. Danfurn LLC, a manufacturer and retailer of high-end Scandinavian furniture, had been hit hard by the downturn in the U.S. economy that followed the 2007–08 financial crisis. Over the last two years, sales and operating cash flows had dropped precipitously. The nearly 50-year-old company had recently blown through cash flow covenants on its $100 million senior secured financing agreement. M&L Bank, the administrative agent on the loan, had made it clear to the Danfurn board that further waivers to covenant violations would not be forthcoming, ensuring that Danfurn would be in default under the agreement by the end of the month.

While M&L wanted to reach a consensual agreement on how to restructure, Danfurn now faced the threat that the bank would “accelerate” the loan—demanding immediate repayment—or seek some other remedy that would force Danfurn down a path to bankruptcy and perhaps liquidation. As a member of the board, Bruckmuller understood that negotiations over the next few days would be crucial in determining the fate of Danfurn as a going concern. Company History

Danfurn LLC was founded in Madison, Wisconsin, in 1964 by Jens Peder Rasmussen, who had recently arrived in Wisconsin from Århus, Denmark. Rasmussen was a young protégé of the famed Danish furniture designer Finn Juhl, a leading inspiration for the “Danish Modern” craze that swept across the U.S. interior design scene during the late 1950s. Shortly after his move to Wisconsin, Rasmussen met and married June Charlotte Keillor, an Oregon resident (and third cousin of famed author and radio personality Garrison Keillor).

1 Danfurn is a fictitious company name that does not intentionally represent any real company.

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Shortly after settling in Wisconsin, Rasmussen began making and selling furniture out of an uncle’s basement. The furniture was an instant hit with the progressive residents of Madison. By 1962, Rasmussen had opened a workshop in the small community of Oregon, Wisconsin, located 11 miles south of Madison. The furniture that Rasmussen built in the workshop—ranging from simple bedside tables to large commercial cabinets, desks, and bookshelves—quickly gained a reputation for being sleek and daring, yet highly functional. The business expanded quickly, and Rasmussen moved his operations to a larger warehouse in Oregon and hired a group of 10 carpenters to begin building his designs on a larger scale. In 1964, Rasmussen incorporated the company under Wisconsin law, named it “Danfurn Inc.,” and opened its first retail store in downtown Madison. That same year, Rasmussen and his wife welcomed their only child, John Martin Rasmussen (Johnny).

The popularity of the Scandinavian-styled Danfurn furniture grew steadily through the 1960s and 1970s. By 1980, the company had over 10 stores stretching across Wisconsin, Iowa, Illinois, Michigan, and Minnesota. The company expanded east into the New York and Boston markets in 1983 and opened its first stores in Texas and California in 1987. During this period, Rasmussen hired eight apprentice furniture designers—including two from his native Denmark—who would carry forward his artistic vision while eventually adding their own signature touches to the designs. Rasmussen also hired his son, now a young attorney at a Milwaukee law firm, to help manage and market the business. Danfurn’s steady growth continued through the 1990s and the first decade of the 21st century as it added an online catalog and shipping business. By 2006, the company’s Oregon, Wisconsin, manufacturing facility had grown to 120,000 square feet and employed close to 120 furniture makers. As of year-end 2006, the company owned 15 stores, leased 25 stores in 12 states, and employed a total of 562 workers.

Historically, Danfurn relied on retained earnings as its primary source of funding. The company also maintained a relatively small line of credit ($10 million) with a local bank, which Danfurn drew on periodically to cover seasonal fluctuations in receivables collections and during buildups of inventory; those funds were always paid off by fiscal year-end.

Although the company had experienced a steady upward trajectory in growth since its founding in the 1960s, Danfurn did experience some periods of poor performance. Rasmussen insisted that all his furniture be high quality, unique, and somewhat expensive, compared with other U.S. retail furniture choices. This made Danfurn furniture a discretionary product—a luxury item—whose sales were high during economic upturns but lagged during economic downturns. Danfurn experienced its most difficult decline in business during the 1981–82 recession; sales declined 20% in 1981 and 30% in 1982 and did not recover to prerecession levels before 1986. During this period, Danfurn was forced to lay off 10% of its work force, implement a two-year wage freeze on its salaried workers (including the salaries of Rasmussen and his son), and scale back some of its growth plans. During the 2001–02 economic downturn, Danfurn again had to implement cost-cutting measures as sales declined, but it avoided employee layoffs because sales improved markedly during the 2002 holiday season.


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Growth through the mid-1980s and early 1990s was also hampered by the entrance of IKEA into the U.S. market in 1985. IKEA, a Swedish company, offered modern Scandinavian-styled furniture at prices affordable enough for the masses. During the 1990s, Danfurn adapted its marketing and in-store sales strategies to highlight the durability and exclusive design of its products; the intention was to appeal to urban and suburban consumers with growing incomes. When asked about IKEA’s impact on Danfurn in a 1996 interview with Town and Country, Johnny Rasmussen (by then, Danfurn’s marketing director) said, “IKEA is great for decorating college dorms and the small apartments of twentysomethings. But we feel our loyal client base arises from the more grown-up sector of the market.” In that same article, a furniture industry analyst compared Danfurn to a high-performance Danish audio company: “Danfurn strives to be the Bang & Olufsen of the furniture market.”

In February 2007, Rasmussen was contacted by Birchtree Capital, a private equity fund based in Minneapolis, Minnesota, about acquiring Danfurn via the acquisition of Rasmussen’s 67% stake in the company plus all shares held by other Danfurn shareholders (23% were held by Johnny Rasmussen and other family members, and 10% were held by the remaining six of eight furniture designers hired in the 1980s and 1990s). Birchtree was willing to pay up to $150 million for all the shares. The offer also proposed a succession plan for Rasmussen and his son. Rasmussen could remain CEO for up to three more years, at which time he would be required to retire as CEO, but he could retain a board seat. Alternatively, Johnny Rasmussen could be appointed CEO of Danfurn for a five-year renewable term and sit on the board, along with his father, as long as he remained Danfurn’s CEO. The elder Rasmussen would retain his board seat until death. The remaining five board seats would be held either by general partners of Birchtree or by individuals selected by Birchtree.

Rasmussen was taken aback by the Birchtree offer. He had received offers in the past to sell his company, but these offers came from strategic buyers, typically large “box store” furniture retailers interested in folding Danfurn furniture into one of their own product lines. Rasmussen valued Danfurn’s independence and believed it to be an essential key to its success. Rasmussen also recognized that this was an opportune time to proceed with a succession plan for his company. He had recently turned 73, and although he was extremely fit and healthy for a man of his age, Rasmussen recognized that his ability to continue in the role of CEO, chief furniture designer, and chairman of the board of directors could not go on indefinitely. He had led the company for over 40 years and saw benefits in reducing his responsibilities. Meanwhile, Johnny Rasmussen had been with the company for 20 years and had shown himself to be an adept strategic and financial thinker and a decent furniture designer. Rasmussen felt reasonably comfortable turning the company over to his son.

The idea of selling Danfurn to Birchtree was appealing to Rasmussen for several reasons: First, he could cash in on his life’s work, making him and his family comfortably wealthy. Second, by retiring as part of the purchase agreement, Rasmussen could considerably reduce his own responsibilities while maintaining oversight of the company via his lifetime board seat. Third, the sale provided a succession plan that put his son in place as the new CEO but provided external checks on his son’s performance in the form of five-year performance reviews. Finally,

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the company could remain independently managed and owned, albeit by financial investors who were relatively unknown to Rasmussen.

The organizational structure of the entity resulting from the private equity acquisition is

depicted in Exhibit 1. The buyout would result in the creation of a holding company, Danfurn Management LLC, which would own 100% of the equity in the subsidiary operating entity, Danfurn LLC. Danfurn LLC would then wholly own two separate operating segments: the manufacturing company and the retail company.

Birchtree would finance the full $150 million acquisition using a combination of debt and its own equity. Specifically, Birchtree arranged $100 million in senior secured bank financing from M&L Bank, a growing regional bank also based in the Minneapolis-St. Paul area. The M&L deal package consisted of a $15 million revolving line of credit and an $85 million term loan to Danfurn LLC; both tranches would be secured by substantially all assets of the operating company, including the Oregon, Wisconsin, facility, the 15 store locations owned by the company, and all inventory and receivables held by Danfurn at any given point in time. The M&L loan was also guaranteed and secured in full by Danfurn Management LLC, whose only asset was the equity in Danfurn LLC. In the event of default, M&L’s rights against Danfurn Management LLC were governed, in part, by a pledge agreement similar to that shown in the supplemental handout (UVA-F-1688H).

Additionally, Birchtree raised $30 million in mezzanine financing in the form of senior unsecured notes from the Edina Group, a midsize Minneapolis hedge fund. The $30 million loan was made to Danfurn Management LLC and was governed in part by an intercreditor subordination agreement among M&L Bank, the Edina Group, and Danfurn Management LLC. As part of the $30 million financing deal, the Edina Group received equity warrants that could be exercised if Danfurn went public or if it was sold to another company. The warrants had a strike price that made them “in the money” if Danfurn’s equity value was $125 million or higher after going public. A sample subordination agreement is shown in the supplemental handout.

Finally, Birchtree contributed $20 million of its own capital to the deal in the form of common equity, $1.5 million of which was carved out for Johnny Rasmussen and the six furniture designers. Details of the debt portion of the financing structure are summarized in Exhibit 2.

The Birchtree acquisition of Danfurn was completed in June 2007 with the installation of Johnny Rasmussen as CEO, the retirement of his father and founder, Jens Peder Rasmussen, and the creation of a new Danfurn board consisting of three Birchtree general partners, Milwaukee attorney Dan Bruckmuller, Milwaukee accountant Bridget Urmanski, Jens Peder Rasmussen, and Johnny Rasmussen.


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Recent Troubles

Shortly after the Danfurn buyout was consummated, the subprime residential lending market collapsed, the effects of which led to a shutdown in commercial and consumer lending markets and—over the course of late 2007 and much of 2008—to the failure of such financial companies as Countrywide Financial, Bear Stearns, Washington Mutual, and Lehman Brothers, and to the receivership of the two largest U.S. government-sponsored enterprises, Fannie Mae and Freddie Mac. The resulting hit to the U.S. economy, touted by some as the Great Recession, halted economic growth beginning in June 2009. By March 2011, U.S. unemployment was still in the range of 9%.

The impact of the Great Recession on Danfurn’s sales and profitability is evident in its consolidated statement of operations over the period from 2006 through 2010 (Exhibit 3). During 2009, sales declined by 15% and earnings before interest, taxes, depreciation, and amortization (EBITDA) fell to $10.9 million, well below half the 2008 EBITDA level of $29.2 million. Despite its drop in performance, a temporary return of liquidity to corporate debt markets allowed Danfurn to amend its credit agreement and mezzanine debt in March 2009 to extend the maturity of the contracts and to change the credit agreement covenant structure to allow its leverage ratio to rise above the original limit of 6.0× EBITDA. The March 2009 amendment replaced the leverage ratio and interest coverage ratio covenants with a quarterly EBITDA covenant requiring that EBITDA over the previous four quarters remain above $10 million. Given that analysts expected a turnaround in consumer behavior by the 2009 Christmas season, this covenant appeared to show reasonable forbearance on the part of M&L—enough to give Danfurn some breathing room to turn sales around.

But the turnaround did not occur; sales and profitability continued their downward spiral in 2010. Sales declined 22% during 2010, and EBITDA fell to $6.6 million, well below the covenant set in the March 2009 amendment to the credit agreement. Meanwhile, as shown in Danfurn’s 2009 and 2010 consolidated balance sheets (Exhibit 4), inventories and payables continued to accumulate as Danfurn’s cash position narrowed.

Board duties

As the Danfurn board met to discuss what to do next, Dan Bruckmuller outlined some of the potential restructuring options available to Danfurn, along with questions that would need to be addressed for each respective option (Exhibit 5).

Bruckmuller also reminded the board that while the board of directors of a solvent

company owed fiduciary duties only to company equity, when a company became insolvent or entered the “zone of insolvency,” the board’s duties shifted to include creditors as well as equity. He went on to explain that the board’s duties included the “duty of care” (the amount of care a careful and prudent person would use in a similar circumstance, gathering all material information reasonably available before making a business decision) and the “duty of loyalty” (which prohibited self-dealing and usurpation of corporate opportunities).

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Exhibit 1

THE RESTRUCTURING OF DANFURN LLC Danfurn Organizational Structure


Danfurn Management

LLC

Danfurn LLC

Danfurn Stores LLC

Danfurn Manufacturing

LLC

100%


153

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pany

doc

umen

ts.

VALCON 2015

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Exhibit 3

THE RESTRUCTURING OF DANFURN LLC Consolidated Statement of Operations

(in thousands of dollars)

Net sales $ 332,843 $ 425,706 $ 503,295 $ 454,905 $ 294,321Cost of sales 241,977 303,954 339,724 309,335 191,309

Gross profit 90,866 121,752 163,571 145,570 103,012Selling, general, and administrative expenses excluding bad debt and notes receivable valuation charges 90,200 117,495 142,432 129,648 92,858Bad debt charges 6,567 15,205 11,769 (2,135) (1,549)Profit (Loss) from operations (5,901) (10,948) 9,369 18,057 11,704Interest expense (7,516) (7,722) (9,084) (232) (125)Loss before income taxes (13,417) (18,670) 285 17,825 11,579Income tax benefit (provision) 4,696 6,534 (100) (6,239) (4,052)

Net gain (loss) $ (8,721) $ (12,135) $ 186 $ 11,586 $ 7,526

Depreciation & amortization 5,966 6,604 8,089 9,089 9,253EBITDA* 6,632 10,861 29,227 25,011 19,408Capital expenditures (net of sales of PP&E) 2,234 (967) (2,698) (2,743) (5,202)

*Excludes bad debt charges.

Data source: Company documents.

2010 2009 2008 2007 2006


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2010

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VALCON 2015

156

-10- UVA-F-1688

Exhibit 5

THE RESTRUCTURING OF DANFURN LLC Restructuring Options

Refinance Debt Availability of financing? Amount? Required new equity infusion? How much debt can company support? Terms?

Sale Process

Marketing process Retain investment banker? Company’s operating burn rate? Need to fund process?

Bankruptcy

Goals? What would be achieved? Funding? How much? Who would provide? Sale process in bankruptcy? (Section 363 sale)

o Stalking horse bid? o Credit bid by bank?

Restructuring Plan? o Funding issues? o Cash collateral? o Potential for litigation with bank?

Dismissal for bad faith? Relief from automatic stay? o Exit financing? o New equity investment

Director/officer liability issues? Out of Court Restructure

Consensual foreclosure? Debt for equity swap? Sale by bank to third party? New equity investment? Director/officer liability issues? Wind-down costs, payment of unsecured claims? Priority tax and wages claims?


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