Houlihan Lokey Case Study Restructuring Companies
Hi WSO Community,
I had a question from a paragraph contained in the Houlihan Lokey Case Study, "Buying and Selling the Troubled Company." I was hoping someone could steer me in the right direction:
In the case of an asset sale (like those pursuant to Section 363 of the Bankruptcy
Code),the buyer hasthe ability to choose not to assume typical operating liabilities
such as trade accounts payable. Under Section 363, for example, a debtor with
Court approval may sell assets free and clear of all liens, claims and encumbrances
(which attach only to the proceeds of such sales). In such cases, the debtor's estate,
and not the buyer as in the case of a sale of the common stock of the seller,
will have the burden of satisfying obligations to creditors incurred through the
close of the asset sale. By not assuming such pre-close operating liabilities as part
of the asset purchase structure, the buyer has effectively created excess working
capital (current assets less current liabilities). The buyer will then benefit from the
resumption of trade credit to the newly deleveraged business, with its improved
credit rating. This post-sale transition, financed by newly available trade credit,
will turn excess working capital to cash, which may be reinvested in the business,
used to reduce debt or (financing covenants permitting) be withdrawn from the
business. In an asset acquisition, the additional value of impairing such current
liabilities (less the disruption caused by any vendor dissatisfaction) is represented
by the present value of the net cash generated by a resumption of trade credit and
should be added to the multiples-based valuation.
In reading this paragraph, I believe it is saying that since the buyer is only assuming the assets, this transaction will create excess working capital for the buyer and enable them to receive trade credit again? Is this the correct interpretation? If this is the case, why would the buyer be deleveraged as a result of this transaction?
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A broken business model, a discarded piece of manufacturing equipment that still has 80% of its useful life,
and a determined reader, pursuing expertise in restructuring.
This is not just another industry or product group article.
The Restructuring Zone.
Normally, restructuring investment banking is known as a standalone group – but every now and then it may be combined with other groups.
At one firm, the team is known as “Financial sponsors, restructuring, and leveraged finance” (I guess the common theme is “debt”).
Here’s what we’ll tackle as we drive past the goal posts in the Restructuring Zone:
- What you actually do in a restructuring, reorganization or recapitalization function.
- Market conditions that lead companies into restructuring.
- Typical assignments, and advising the debtor vs. the creditor.
- Restructuring-specific analysis and financial modeling.
- How to turn around a failing business… if you can.
Pre-Apocalyptic Times: A Brief Introduction
Q: So how’d you get started in Restructuring?
A: I actually joined a well-known group via on-campus recruiting.
But a lot of bankers end up here after working in related groups, such as Leveraged Finance or M&A; you join our group because you decide you want to work on more complex or unusual deals.
Q: Great. So what does your group actually do, at a high level?
A: Mainly valuations, operations forecasting, and liquidity assessments.
The team can also assist with financing, such as for debtor-in-possession (DIP) financing, but for the most part we focus on the 3 items I just mentioned.
Understanding debt is critical for all the analysis in this group: it explains why companies get into trouble, and what they can do to get out of trouble.
Q: On that note, what leads to these restructuring assignments in the first place?
A: The need to “restructure” – to dramatically change a company’s capital structure and/or operations in order to survive – often comes up when:
- A market heads toward a structural downturn where companies must radically change their business model in order to survive (ex: typewriters, film for cameras, a brick-and-mortar bookstore opens an online page to sell books, a chain of video rental stores opens on online channel to deliver video rentals).
- A sponsor-owned portfolio company becomes unable to meet interest payments and required principal repayments. In most cases, the company was acquired in a leveraged buyout (LBO) during a frothy market, and then the market crashed or the company’s business took a turn for the worst immediately after.
- A company raises debt when there’s a “window of opportunity” (read: decides to raise debt just because comparable firms are raising debt), but is unable to service its debt commitments later on.
You’ll often see discussions of these conditions in the pitch books written by restructuring investment banking teams.
On a more granular level, they’ll discuss points like the market demand for a company’s products/services and changes in the underlying raw materials costs, and they’ll use those points to explain why the market suddenly shifted (these areas are typically covered by a coverage team).
Q: So those are the trends that lead to restructuring – what about specific catalysts, though?
What events make a firm green light a restructuring process and hire bankers?
A: Here are the most common events:
- Credit rating downgrade (e.g., the company was rated ‘A’ by S&P and then it gets downgraded to ‘BBB’ or ‘BBB-’… or likely something worse than that).
- The company’s customers start delaying payments, or cash collection becomes more difficult (e.g., Accounts Receivable Days doubles within a quarter).
- Limits established by debt covenants are exceeded (e.g., Net Debt / EBITDA cannot exceed 4x but then it increases to 5x or 6x in one quarter).
The decision to restructure is based on a company’s leverage and coverage ratios.
In some cases, a company can be “saved,” but in other cases, a liquidation or a distressed sale might be the only viable alternative.
Q: And what if I don’t want to go through with the restructuring process?
A: You could always bet on multiple expansion, but I recommend against that one unless you can time travel back to the 1999 stock market…
Q: Good point… finally, where do new restructuring clients come from?
A: Often, they come from industry coverage teams. I have seen cases where the deal team consists of just a sole senior coverage banker, plus a much larger restructuring team.
This is because the restructuring process does not require as much sector coverage as a capital raise or advisory assignment would call for.
The Restructuring Landscape: Who Wins at the End of the Game?
Q: What makes a top restructuring team, and what do you need as an adviser?
A: Rapport and empathy. A lot of investment banking professionals claim their work is on the client’s behalf, but there are often conflicts of interests – similar to the principal vs. agent dynamic in the insurance sector.
So when a management team picks restructuring bankers, it’s based on the lack of conflicts of interest, the quality of the work the team has done in the past, and how comfortable executives are with the bankers.
Some of it also comes down to the team’s expertise.
Just like there are buy-side and sell-side M&A deals, there are creditor and debtor deals in restructuring. If you’re advising the management team of a company, they’ll almost always prefer teams with more debtor experience.
If you’ve mostly advised creditors in the past, you won’t have as much insight into companies’ operations (which directly factors into the all-important short-term cash flow projections you often create in this industry).
Q: On that note, what are the typical assignments given to restructuring teams?
A few examples:
- Chapter 7 Assignments: These involve a lot of valuation work, which we can discuss later, but essentially you help the company sell off its assets to pay creditors.
- Chapter 11 Assignments: Here, you help the company to change the terms of its debt, possibly raise new debt, and renegotiate to stay afloat and eventually repay its creditors.
- Out of Court Assignments: These let a company avoid (or postpone) a formal bankruptcy filing and they reduce operational disruption, but the company also loses some flexibility and negotiating leverage.
- Creditor Assignments: You put on your “due diligence” hat and look for reasons the company will not be able to pay off its debt. These items are frequently related to cash flow generation, such as contracts to customers or even labor agreements.
There are other deal types – for example, restructuring assignments often turn into sell-side M&A deals or debt or equity raises, but you’ve covered those before.
And there are other possible outcomes as well, such as a Section 363 asset sale (a faster / less risky form of a normal asset sale), as well as “general assignment” (a faster alternative to bankruptcy).
Q: And what do you do as an analyst or associate when working on those deals?
A: The most basic assignment is… reading through a list of the company’s credit agreements and keeping track of the terms (sometimes called an “indenture analysis”).
You know how the advisory (read: mergers and acquisitions) team has a database of precedent transactions?
This is the restructuring equivalent.
You keep track of the terms, including covenants, for companies in your universe and current and potential clients.
This is by far the most common work assignment no matter the group or role.
Beyond this, in debtor mandates you focus on telling (read: rewriting) the client’s story and demonstrating that the company can continue to operate and pay off its debt.
And then you use that information to help it renegotiate with creditors, or to sell itself if things don’t go as planned.
In creditor mandates, you’re more critical and you find reasons why the group of creditors you’re representing should get their capital back… which often involves pointing out why the company is likely to default on its obligations.
Corporate Valuation Meets Financial Modeling
Q: How do you think about valuation when you’re representing a debtor and you’re trying to present its story as favorably as possible?
A: You can still use the same valuation methodologies: public comps, precedent transactions, and the Discounted Cash Flow (DCF)… but there are some differences.
For one, you may attempt to “adjust” the company’s expenses if some of them are higher / lower than they would be for a normal company (whether or not potential buyers and creditors accept this is a different story).
Sometimes companies have trouble receiving volume discounts when they’re undergoing financial troubles, so you might see elevated Cost of Goods Sold (COGS) – which you might argue should be adjusted downward.
Items like Operating Working Capital in a DCF often need to be adjusted because receivables are less likely to turn into cash, there might be excess inventory, and so on.
You tend to focus on Enterprise Value-based multiples because distressed companies’ equity is often worth disproportionately less.
You may even have to adjust Enterprise Value if the potential buyer is acquiring only selected assets and assuming only selected liabilities of the seller.
And then there’s the Liquidation Analysis, where you assume that all the company’s assets are sold off to pay for its liabilities.
You assume some type of “Recovery Factor” for each Asset by estimating how much it could be sold for, and you multiply that Recover Factor by the book value of the asset.
So cash might be 100%, but AR from customers delaying their payments might only get a value of 60-80%.
Something like PP&E might actually be stepped up from its book value, while the value of Other Intangible Assets would vary widely (Goodwill is usually assumed to be worth $0).
Then you multiply and add up all those values, and assume that the proceeds are used to repay the liquidation-related expenses, then the senior creditors, then the next most senior creditors, and so on until nothing is left.
You’ll look at a range of Recovery Factors for each asset to see how much creditors receive under different scenarios.
Note: You would not actually use the Liquidation Analysis in marketing material for the company – it’s more for internal use, bankruptcy filings, and negotiations with creditors.
Q: Thanks for that detailed explanation.
Beyond the Indenture Analysis and the Liquidation Analysis, what else is common?
A: Sure – there are a few others I’ll mention here:
Capital Structure, Leverage, and Coverage: This is pretty simple – you just look at traditional metrics such as the leverage ratio, interest coverage ratio, cash interest coverage ratio, and so on.
You’ll also list information like the pricing, maturity date, and market value of each tranche of debt.
This analysis is used for “prospecting” and seeing which companies may soon need your services as a restructuring advisor.
Bond Pricing and Yield Analysis: This one is used to calculate the implied return to bond investors based on different holding periods and redemption dates.
And then based on that yield, you figure out the implied bond prices.
You can also create a “make-whole” analysis where you calculate how much bondholders need to be compensated for early redemption of the bonds (based on the NPV of payments they lost out on due to the redemption).
You use these numbers to negotiate with creditors.
Covenant Analysis: Just like how you’d calculate normal credit metrics such as Debt / EBITDA and EBITDA / Interest in an LBO model and then highlight violated covenants with conditional formatting in Excel (Alt + H + L), you do the same thing here.
One difference is that you may calculate a “cushion” and a “cushion %” as well.
For example, if the maximum Debt / EBITDA is 4x and the company has $400 million of debt and $120 million of EBITDA, that’s a “cushion” of $20 million in EBITDA before it hits the limit.
These numbers are used to advise a company on its options, determine if it can “cut costs” to save itself, or if it has to actually restructure its debt commitments.
Liquidity Analysis: Not to be confused with a Liquidation Analysis, in this one you project a company’s cash flows on a quarterly or monthly basis and track how its cash balance declines over time.
The key output is the “Total Availability” – in other words, if a company has a $100 million Revolver, how much of that is available at any given time to cover cash flow shortfalls?
And when does that availability imply that the company will need to raise additional funding?
So if the company can draw on $50 million of its Revolver and it’s burning $5 million in cash per month, it will need to raise additional funding within the next 10 months.
Just like in a DCF, this analysis comes down to EBITDA, interest expense paid on the Revolver and other existing debt, taxes, Capital Expenditures (CapEx), and Working Capital requirements.
Recovery or Hurdle Analysis: This is similar to the Liquidation Analysis, except now you assume that the company gets sold for a multiple of EBITDA – rather than selling off its individual assets – and then uses the proceeds to repay its creditors.
The idea is: “What do EBITDA and the EBITDA exit multiple need to be for the different classes of creditors to be repaid? What’s the maximum recovery creditors can expect?”
So you’ll see sensitivities with EBITDA and EBITDA multiples, with the implied recovery % to (unsecured) creditors in the middle of the table.
Example: The company has EBITDA of $200 million and gets sold for 5x EBITDA.
It also has a Revolver of $100 million and a Term Loan A of $200 million, with Unsecured Senior Notes of $1 billion.
In this case, the secured creditors get a recovery of 100% because the proceeds of $1 billion can be used to repay the Revolver and Term Loan A in full.
But then only $700 million is left for the Unsecured Senior Note investors – so their implied recovery is only 70%.
Debt Capacity Analysis: Very similar to the Covenant Analysis, except now you’re looking at the leverage and coverage ratios of peer companies and using those to figure out how much debt the company “should” be able to take on.
Q: I hope everyone is taking notes.
You also mentioned multiple expansion as highly unlikely in the beginning, but if it happens, where does it come from?
A: Multiple expansion is sort of like identifying a four-leaf clover: it is difficult to achieve, but certainly not impossible.
Sometimes you see it after management completes certain actions:
- They focus on core competencies by selling product lines or entire business units.
- They increase operating efficiency through a reconfiguration of human capital, fixed assets, and operating working capital improves.
Other times, it happens if the market itself starts performing better or if external factors like government policy changes result in more money flowing in.
Bankers: Do They Add Value, or Straight-Up Create It?
Q: What’s the point of hiring a restructuring and reorganization advisor?
Couldn’t a company just hire the Leveraged Finance and Mergers & Acquisitions teams?
A: The value-add is that restructuring requires a much more specialized skill set.
You do need to understand debt and transaction models, but you also need to understand how to do all the analyses I mentioned above, how to negotiate with creditors, and how to tell a “turnaround” story for a struggling company.
Plus, restructuring operates within a legal framework, and even as a banker you need to understand it – whereas legal knowledge would be less important in LevFin or M&A.
Q: Can restructuring advisors actually “save” a company’s business?
A: Yes, though sometimes it’s not possible and a liquidation is the end result.
If they do help the company turn around its operations, they do so by advising them on cost-cutting measures, ways to sell off non-core assets, or helping them raise equity or debt – or Debtor-in-Possession (DIP) financing (which has repayment priority over other forms of debt) to stay alive while reorganizing.
It’s always subjective how much value bankers add, but in my opinion, they add a lot more value in distressed situations than they do in plain-vanilla sell-side M&A deals.
Q: And where do distressed bankers go after saving failed companies?
A: Credit investment funds, debt funds, and distressed investing are the major exit opportunities.
It is somewhat difficult to move from restructuring to sector coverage.
It’s a lot easier to move from restructuring to Leveraged Finance, or to move into any group that is more credit-oriented.
Q: Any final words?
A: Restructuring is usually a method of resort.
Always try a turnaround before you proceed with an official restructuring! (Note: My group might not endorse that statement…)
About the Author
Luis Miguel Ochoa has facilitated a variety of strategic initiatives from corporate acquisitions to new market development. He earned his B.A. in economics from Stanford University where he was a member of the varsity fencing team.