Being the financial advisor to a particular creditor (i.e. lender).
There is not a specific definition of capital structure for restructuring bankers. The capital structure is the different sources of funding of a company: equity and debt.
Restructuring bankers will pay more attention to the capital structure of a company (more than M&A bankers for example). Why? Because they will need to fully understand the interests of each stakeholders while advising their client. Who is the most senior lender? Who is the most secured? Etc…
In restructuring, understanding the capital structure, means understanding how the money/value will be split among equity and debt holders if things go bad.
A debtor side assignment is when the financial advisor (you) will advise the company (the debtor).
EBITDA can be adjusted for any type of companies in any type of situation. You will want to adjust EBITDA is you think it does not reflect the “normal” state of operation of a company.
When you adjust EBITDA, you will want to strip off any items which you deem not “normal”, such as advisors fees, restructuring charges etc… In the particular case of a distressed company, the items you may like to strip off would be advisors fees (advising on a restructuring), debts fees etc…
Your adjusted EBITDA will, in most cases, be higher.
Impact of an asset write-down on the 3 financial statements:
When an asset is written down you record it as a loss on the Income Statement – so Pre-Tax Income goes down by GBP 1,000m due to this write-down. Assuming a 40% tax rate, Net Income is down by GBP 600m.
On the Cash Flow Statement, Net Income is down by GBP 600m, but we need to add-back that asset write-down as it is a non- cash expense (GBP 1,000m) – so Cash Flow from Operations is up by GBP 400m, and Net Change in Cash is up by GBP 400m.
On the Balance Sheet, Cash is up by GBP 400m, so Assets are down by GBP 600m. On the other side, Shareholders’ Equity is down by GBP 600m (Retained Earnings) because the Net Income was down by GBP 600m – so Liabilities & Shareholders’ Equity is down by GBP 600m and it balances.
Enterprise Value is equal to the value of the Net Debt + the value of the Equity. If for some reasons, the company cash flows are decreasing and the outlook is bad, it Enterprise Value will decrease. As Equity is the most junior financing instrument, it will be the first to take a hit in term of value: Equity Value decreases.
In practice, if Enterprise Value decreases a lot, the debt will also take a hit (much less than equity). If debt holders and investors are too uncertain about the future of the company, debt will loose value (will the company be able to fully meet its obligations?).
Usually bank debt is cheaper than high yield debt. It will be cheaper because less risky than high yield debt (“junk bonds”). Bank debt will be more senior so in case of liquidation, banks will receive the money first. In addition, bank debt will be more likely to be secure against the company assets.
A debt for equity swap is when debt is converted into equity. It happens as potential outcome of a restructuring situations when debt is reduced (to allow the company to survive). As compensation, debt holders can receive Equity.
You would use the usual suspects: DCF, LBO, Comps.
Be careful to use adjusted aggregates (for instance EBITDA adjusted for exceptional items linked to the distressed situations such as advisors fees, debt fees etc…).
Doing restructuring you will gain:
The main restructuring advisors are:
Outcome of a restructuring process:
Distressed debt funds are also know as Vulture Funds. They invest in the debt of highly leveraged firms (they usually buy the debt at a discount). Their goal is to make a return through different strategies: being repaid at a higher price than the buy-in price, getting the ownership of the target company through a debt for equity swap etc.
Restructuring teams advise companies, shareholders in distressed companies, debt holders, and distressed debt funds.
A financial restructuring is typically required when a company can no longer repay its debts (principal or interests).
Typically occurs when a company’s enterprise value (that is, the total value of its operating assets and non-operating assets) is less than the value of its total debt and obligations.
Obligations can include bank debt, bonds, and other financial liabilities
In some situations a company may be able to meet all of its interest payments, but unable to satisfy debt maturities.
If a company is unable to repay or refinance its outstanding obligations it will typically have to restructure its balance sheet and this is where restructuring bankers play a role.
You mainly have 2 types of restructuring mandate:
Maintenance covenant: A bond or loan covenant that, unlike an incurrence covenant, is checked periodically or at all times.
Incurrence covenant: A covenant which is tested on the occurrence of some legally specified event.
Loan and bond covenants can be split into incurrence covenants and maintenance covenants. Incurrence covenants are legal restrictions on the actions of the issuing company that are written into the bond documentation or the loan credit agreement.
Many of these restrictions are based on financial ratios that involve the well-used financial figure known as EBITDA8, i.e. Earnings Before Interest, Tax, Depreciation and Amortisation.
The key feature of incurrence covenants that differentiates them from maintenance covenants is that they are only tested for compliance when the company undertakes one or more of several designated actions. These include taking on more debt or acquiring another business, either of which may weaken the creditors’ positioning. They are found in both high yield and leveraged loan credit agreements. There may also be restrictions on certain financial ratios such as those defined in the next section on maintenance covenants.
Incurrence covenants are often called “negative covenants” because they impose restrictions on the activities of the company.
When a company borrows debt, it will sign debt contracts with the banks (or other debt providers). To protect the debt holders, clauses will be in the contract defining the event of default. An event of default is often linked to the fact that the company cannot pay the debt (principal or interests).
Usually, even if a company cannot pay the debt, it can benefit from a “grace period” or deb holders can decide to postpone the debt repayments etc…
In conclusion, an event of default is a specific event set out in the credit agreement which has not been remedied or waived after any grace period and which allows creditors to accelerate their debt (put the company in default and cease what they can cease).
There can be different types, “tranches” of debt in the total debt of a Company. All these tranches do not have the same priority on getting the cash from the company. The tranches are ordered by seniority. Thus the most senior debt will be paid first, and the most junior one will be paid last.
It does not really matter if everything goes according to plan. On the contrary, it is particularly important if the company has trouble repaying the debt. Seniority will indicate who gets paid first.
There can be different types, “tranches” of debt in the total debt of a Company. All these tranches do not have the same priority on getting the cash from the company. The tranches are ordered by seniority. Thus the most senior debt will be paid first, and the most junior one will be paid last.
It does not really matter if everything goes according to plan. On the contrary, it is particularly important if the company has trouble repaying the debt. Seniority will indicate who gets paid first.
It depends how you look at it. If you are the company and you want to assess your debt “burden”, you just need to look at how much interests you need to pay (cash or PIK) compared with the total debt outstanding.
If you are a looking at the company from the “outside” (a debt holder for instance), you would look at the current yield on each of the debt instruments. If the company is going through a distressed situation, it is fairly likely debt will lose some value as it becomes riskier. If debt is becoming riskier, yield would be higher (expected returns are higher). You can then calculate the average cost of debt using current yield if available.
“PIK” stands for Payment In Kind. A PIK interest means that the company does not have to pay the interest in cash at each period. PIK interest will add up and will have to be repaid at maturity.
When you look at the impact of a particular item on the 3 financial statements, you need to approach the financial statements one by one:
A covenant is a condition written into a loan agreement, which, if broken, can trigger an event of default. There are generally two sorts of covenant: maintenance covenants and incurrence covenants.
Covenants are check points, which have to be verified at specific dates. If the companies complies with the covenants, everything is fine, if it does not, the debt holders can take actions to recover their money.
The leverage is the amount of debt in a company.
When you decide to assess the leverage capacity of a company, you want to know the maximum leverage of the company.
When you want to assess a maximum leverage you need to make sure that the company can repay 1) interest expense and 2) the principal.
To do so, it is important to look at cash flow before debt service, its evolution and sensitivity to different parameters (sales growth, costs evolution etc…). This cash flow will have to be sufficient to 1) pay interest, 2) pay principal and 3) gives some headroom to allow the company to grow or face bad situations.
You can back-calculate the maximum leverage by taking the amount you can afford to give up to the debt holder.
To assess maximum leverage, you need to also look at the market: are companies in this sector very levered? Are banks landing money to this type of companies?
To assess leverage for a target, the financial sponsor need to be sure that the company can repay the debt quickly and gives space for equity value creation! If you have too much debt, equity value might get to 0 if things go badly!
Impact of a debt write-down on the 3 financial statements:
When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by GBP 1,000m due to this write-down. Assuming a 40% tax rate, Net Income is up by GBP 600m.
On the Cash Flow Statement, Net Income is up by GBP 600m, but we need to subtract that debt write-down (GBP 1,000m) – so Cash Flow from Operations is down by GBP 400m, and Net Change in Cash is down by GBP 400m.
On the Balance Sheet, Cash is down by GBP 400m so Assets are down by GBP 400m. On the other side, Debt is down by GBP 1,000m but Shareholders’ Equity is up by GBP 600m (Retained Earnings) because the Net Income was up by GBP 600m – so Liabilities & Shareholders’ Equity is down by GBP 400m and it balances.
A cash sweep is the use of excess free cash flow to repay debt. It means that there is no “fix” planned repayments for the debt, instead, whenever the company generates an excess in cash (above an agreed threshold), this excess cash is used to repay the debt.
A Revolving Credit Facility (“RCF”) is a line of credit where the Company pays a commitment fee and is then allow to draw on the facility whenever it has a need (generally operating need).
It means that the Company will pay a fee, to be able to borrow money (the amount is capped) whenever it wants, to finance particular swing in working capital or other operating needs. When the Company draws on the RCF (for example £20m out of a £50m RCF), it will pay interest on the drawn amount and will continue paying the commitment fee on the undrawn amount (£30m).
The company repays the drawn amount whenever it can (as it is the most expensive part of the RCF, vs. undrawn amount).
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