preserve pe portfolio value in ‘distressed’ times

Preserve PE portfolio value in ‘distressed’ times

Preserving private equity portfolio company value in “distressed” situations requires many calculations and much analysis around four key components: making operational changes to reduce costs and increase revenue, optimizing capital, making new growth-driving investments and ensuring you have the right tax planning and structuring. Different stakeholders bring their own special issues — and interests — to the table, and you should be careful and diligent in sorting out all the details. Complicating an already intricate process are numerous changes as a result of the Tax Cuts and Jobs Act (TCJA) of 2017.

A comprehensive look minimizes cash drains in private equity portfolio companies

DRAFT

A long history in our economy Borrowing money and surviving downturns have always been part of the U.S. economy. What is different today is the TCJA, the most significant tax change in the United States in 30 years. The TCJA has changed the process of assessing, preserving and creating future value around the tax assets of a financially distressed business. New rules abound around net operating loss (NOL) and the deductibility of interest expense, among many other areas. Modeling based on your specific situation has become critical.

“The TCJA has made modeling various debt restructuring scenarios, including having a good understanding of the assumptions around tax and financial inputs, more important than ever.” Chris Schenkenberg, Grant Thornton National Managing Partner, M&A Tax Services

2 Preserve PE portfolio value in ‘distressed’ times

Going through a debt restructuring requires a targeted assessment starting with what may be the most critical element of the restructuring — operational changes. Such a review means journeying back to basics, like looking at working capital and how you are managing current assets and liabilities. Are you able to quickly convert accounts receivables into cash? Do you have products that don’t generate sufficient profit or can be streamlined or modified, leading to other revenue streams?

“You have to delicately balance working capital management and other reductions such as personnel,” said Bryan Benoit, Grant Thornton national managing partner, Corporate Value Consulting, and partner-in-charge, U.S. Energy and Advisory Services. “It could be the elimination of idle assets or the elimination of idle people, all depending on what industry you are in.”

Another path to cost savings is to streamline the structure of a business made up of multiple legal entities. Said Barry Grandon, Grant Thornton managing director, M&A Tax Services: “The industry benchmark is that every time you can eliminate an operating entity, you’ll get about $25,000 to $35,000 of internal and external cost savings.”

Stakeholders vary Different stakeholders will have different interests in distressed situations. Stakeholders may include:

• Growth/private equity investors

• Secured lenders

• Mezzanine lenders

• Distressed debt investors such as special opportunity and vulture funds

So what do these stakeholders have in common, and how does this play out in terms of equity value? Benoit explained. “All four have capital optimization in mind. Any type of capital structure is going to include what proportions would be optimal for the best cost of capital, but also for the greatest likelihood of the company’s success.” At the same time, he said, “a capital structure in a distressed situation kind of burns from the bottom up, and that leaves very little for equity.”


Basic questions for stakeholders in a financial reorganization

• Is the business worth saving or will there be better recovery through liquidation?

• What are the rights of a stakeholder’s position and leverage compared with other creditors and stakeholders?

• How will changes affect cash flow, net income and the balance sheet? How does GAAP apply?

• What is the impact of taxes on current and future cash flows and reported income?

You shouldn’t lose sight of tax planning and structuring when trying to maximize valuable tax attributes coming out of a distressed situation, Benoit said. Tax strategy depends largely on the financial performance of the company. “You’ve got to measure overall enterprise value against the value of the individual assets within the organization.”

“You shouldn’t lose sight of tax planning and structuring when trying to maximize valuable tax attributes coming out of a distressed situation.” Bryan Benoit, Grant Thornton National Managing Partner, Corporate Value Consulting, and Partner-in-Charge, U.S. Energy and Advisory Services


Debt takes many forms Any valuation for debt instruments has to first consider what type of debt it is — and the types of debt range broadly. To name a few — straight debt, debt with an equity redemption option, convertible debt, redeemable preferred debt or a kind of debt in default. Features include public versus private debt; secured or unsecured debt; senior, subordinated or fixed- or variable-rate debt; amortizing or nonamortizing debt; interest paid in cash or paid in kind; convertible or nonconvertible; and enhancements or no enhancements. Added Benoit: “When we look at key drivers of debt value, we get into company-specific factors, instrument-specific factors and market factors. Company-specific factors might be the credit risk, default risk or nonperformance risk. It might include the risk of loss resulting from a borrower’s inability to fulfill a contractual obligation. There are a number of different credit loss possibilities.”

These drivers should be viewed in the context of the company — from size, leverage, solvency and operating performance to management expertise, industry dynamics, financial performance and more. (For a more detailed look, listen to “Strategies to preserve portfolio value in uncertain times”.) Potential valuation challenges surround distressed debt. For example, if the enterprise value is below the underlying-asset value, “it’s an alarming situation, and you’re potentially looking at insolvency,” said Benoit. Subsequent calculation of asset values and the details of the balance sheet can be complicated and laborious, he said. “Another challenge is around identifying and quantifying additional costs and expense, which might be required to continue to operate a business successfully and try to come up with the right recovery period.”

“The takeaway is, there are a lot of ways to get it wrong and few ways to get it right, and you’re probably going to arrive at the wrong answer unless you invest time substantiating the gross recovery rate, recovery period and risk-adjusted discount rate.” Bryan Benoit, Grant Thornton National Managing Partner, Corporate Value Consulting, and Partner-in-Charge, U.S. Energy and Advisory Services

https://www.grantthornton.com/events/tax/2019/02-28-strategies-preserve-portfolio-value-uncertain-times.aspx

https://www.grantthornton.com/events/tax/2019/02-28-strategies-preserve-portfolio-value-uncertain-times.aspx


At the intersection of valuation, tax and financial issues Financially distressed companies often have valuable tax assets. According to Chris Schenkenberg, Grant Thornton’s national managing partner of M&A Tax Services: “One of the challenges when working with financially distressed companies is preserving tax attributes and looking toward the future use of those attributes.” Grandon concurred and added, “Valuation is the wrapper around everything. Tax, debt terms and GAAP all have competing objectives, and depending on where the value is — because valuations are usually in ranges — you can inadvertently help or hurt yourself, depending on what you’re trying to do.”

“Everything has a competing interest or objective. You really need to sit down and focus: ‘If I push it on the tax side, does that impact my GAAP analysis? Do I care, or does that tax analysis impact the debt terms?’ At the end of the day, they’re all connected.” Barry Grandon, Grant Thornton Managing Director, M&A Tax Services

Said Rich Liebman, Grant Thornton managing director, M&A Tax Services: “There are many ways that tax and valuation intersect when dealing with a leveraged company that finds itself with more debt than it can handle. The exact facts will vary, and the specific facts always shape planning and valuation considerations.”


Example of a distressed company and its debt Let’s look at a distressed company with a capital structure of common stock, senior secured bank debt and junior unsecured or mezzanine debt. Assume this was a private equity group’s growth investment; the group owns 100% of the equity for its capital infusion, with the senior bank debt held by a senior lender and the mezzanine debt. This example postulates that a number of individual funds are part of a fund family, each fund having signed up for a particular amount of the total debt; but as far as the borrower is concerned, it’s just one debt instrument. Contractually, the funds have decided how much each has invested in a particular part of the overall debt, and that one of them will have a first-out position, or will get paid in full before any of the other three funds recover anything. In this case, the three agreed that they will recover equally pro rata.

Base example

PrivateequitySenior

bankdebt

MezzA,B,C,D

Distressed Co

Operating subs

$100MconsolidatedNOL

$50Mdebt

$150Mmezzanine debt

• Senior bank debt of $50M is secured by all assets of Distressed Co and subsidiaries.

• The $150M mezzanine debt is held by a family of 4 funds (Mezzanine A, B, C and D) and represents a single debt instrument allocated among the 4 funds by an agreement between them.

• Mezzanine A has a first-out position. In default it will be paid first including accrued and unpaid interest. Mezzanine, B, C and D all hold equal last-out positions.


What happens later? Some years go by, the market has declined, and the distressed company is no longer able to service the mezzanine debt and is having trouble paying the interest on the senior debt. What should be done? This scenario assumes the parties negotiate among themselves and stay out of court. The mezzanine lender takes 95% of the equity for a nominal sum — just to provide legal consideration for contractual terms — and modifies its debt instrument so that the term is extended for three years. The interest rate is reduced. Instead of all cash interest, which was the original term, at least part of it becomes payment-in-kind interest. This is done at a time when the group as a whole had $100 million of consolidated NOLs; its tax deductions have cumulatively exceeded its taxable income by $100 million. There’s also some tax basis in depreciable property.

• The market has declined and Distressed Co’s pricing power has decreased as a result.

• Net cash flow is no longer sufficient to service both the mezzanine and the bank debt.

• Options evaluated under Ch. 11 and out of court.

• Mezzanine lenders determine it’s possible to recoup investment and pursue out-of-court workout.

• Terms of the mezzanine debt are modified and equity acquired.

– 3-year extension of maturity, interest rate reduced and a portion paid in kind.

– Mezzanine lenders purchase 95% equity for $5,000.

PrivateequitySenior

bankdebt

MezzA,B,C,D

Distressed Co

Operating subs

$ 100MconsolidatedNOL

$50Mdebt 95% $50M

modified mezzanine debt

5%

Base example


Taking the perspective of the mezzanine debt Beyond the question of whether this business is worth salvaging there are several possibilities, said Liebman, including renegotiating the debt but not taking equity, renegotiating the debt and taking some or all of the equity, negotiating with the equity holder or going through a Chapter 11 bankruptcy process.

“What we’re seeing in the market is a preference for staying out of Chapter 11. That approach costs less and disrupts the business less. And if the mezzanine debt is a ‘unitranche’ structure, there could be concerns about how well it would fare in court.” Rich Liebman, Grant Thornton Managing Director, M&A Tax Services

Questions that come out of a debt modification, especially out-of-court debt modifications, include:

• Is there a gain? Finding the best answers can lead in many directions. There may be a gain for financial purposes for GAAP reporting, but there may or may not be a gain or cancellation of debt income for tax purposes. Valuation of debt helps determine the amount of gain and how that plays into the tax consequences.

• How insolvent is the company? Is it insolvent by an amount at least equal to any tax debt cancellation income that’s created? That’s important if an entity wants to exclude the debt cancellation income for taxable income because it’s excludable only up to the amount of the insolvency when not in Chapter 11.


More tax considerations Valuation of debt is important to determining the amount of gain and how that plays out in tax. NOLs carried forward are a significant potential tax asset that can reduce taxable income and, therefore, cash tax outlays in the future. Yet the government has created significant limitations on the use of NOLs after a change in control of a business has occurred — as defined in the tax law, not by the SEC or financial accounting concepts. And a change in control for tax purposes happens in the majority of restructurings. Take the case in the example (page 7), where 95% of equity was transferred from the private equity group (the original investor) to the mezzanine lenders (who owned no original stock). This is a change in control from a tax perspective. In a distressed situation such as that one, the base limit is the function of the value of the equity of the company that changed control. That value is going to be zero — meaning using an NOL carry-forward post-reorganization results in no value. None of the $100 million of consolidated NOL would be available to the company after the restructuring. Options can be found to increase value and the loss utilization limitation by comparing the fair market value on the entire left side of the balance sheet — including intangibles that may not be recorded, such as goodwill — with the tax basis of all those assets. If the fair market value of assets is greater than the tax basis, that difference can be employed to allow some of the pre-change, pre-reorganization NOLs to be used post-reorganization. Supporting this favorable tax result requires a complex analysis including careful consideration of the business valuation.


“Preserving the utility of NOLs in restructuring situations is significantly impacted by valuation of the assets. To the extent you can find ways to increase the value, you could be supporting a favorable tax result but setting yourself up for a financial impairment issue. Thinking about alternative structures and running the models for each is critical.” Rich Liebman, Grant Thornton Managing Director, M&A Tax Services

Complexities abound The economy and stock market are still strong, yet ups and downs in the economy are cyclical, and storm clouds may be on the horizon, as evidenced by more companies in distressed situations. Said Schenkenberg: “There is a lot of complexity when you take a company through in-court or out-of-court workouts. There’s tax complexity and risk. The need to model scenarios is more important than ever, one major factor being changes under the 2017 tax reform act. Be well prepared so you’re not caught in a situation you don’t want to be in.”


Contacts

Chris SchenkenbergGrant Thornton National Managing Partner, M&A Tax Services T +1 312 602 8987E [email protected]

Bryan BenoitGrant Thornton National Managing Partner, Corporate Value Consulting,Partner-in-Charge, U.S. Energy and Advisory Services T +1 832 476 3620E [email protected]

Barry GrandonGrant Thornton Managing Director, M&A Tax Services T +1 212 542 9690E [email protected]

Rich LiebmanGrant Thornton Managing Director, M&A Tax Services T +1 312 602 8220E [email protected]

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preserve pe portfolio value in ‘distressed’ times

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