It's rough out there

When speaking of ?restructuring?, different people mean different things. But there is little doubt that at the moment, it concerns a wide range of people and is an evocative term for most. To many, it has painful associations ? just ask board members of Marconi or Energis. To others, it represents opportunity. To members of the European private equity community, it can actually mean both.

My own perspective, based on experience I gained around 10 years ago whilst working for a large American commercial bank that at the time was very active in the European buyout market, is more the former than the latter. One of my enduring memories is a conversation in November 1992, when I had to inform the directors of a company that the bank could no longer offer support and that they should therefore seek to appoint a receiver. This was not a proud moment ? there was about a month to go to Christmas and I knew that some of the staff would lose their jobs. The managing director and I had spent over six months attempting to figure out a way of making the requirements of the business fit its cash flow, including a couple of abortive attempts to merge it with others. Ultimately, the outcome was reasonably positive. It is no small consolation that today, under new ownership, the business appears to be thriving.

?You could look at a restructuring simply as a potential change of ownership of a business?

What I also remember is a strange cosiness that many conversations, such as the one between myself and the managing director, had about them in those days, even though a huge amount would often be at stake. Today this appears to have changed, at least if the nature of the restructuring work presently being undertaken by private equity firms and others is anything to go by. The field of play, and those engaged on it, is now broader and more complex than ever before, bringing with it different rules and a change in approach.

Looking for a definition
So what has the term ?restructuring? now come to mean? As Martin Gudgeon, co-head of the corporate restructuring team at Close Brothers Corporate Finance, puts it: ?You could look at a restructuring simply as a potential change of ownership of a business,? albeit one generally prompted by stress or indeed distress on the part of the current owners. Essentially, whether it be as a result of ?good company, bad balance sheet? (as may be the case with a private equity backed transaction experiencing difficulties), a corporation forced into a disposal to generate cash or family owners seeking to exit, in Gudgeon's view the result is the same: a change in ownership of the business and a new financing structure.

With such a broadly inclusive definition, attempting to put a value on the assets in Europe that are currently in need of a restructuring is like nailing jelly to the wall, further complicated by the profound difficulties in valuing these assets. But there are some telling indicators. According to Standard & Poor's, the volume of defaulted debt obligations in Europe for the twelve months to the end of the third quarter 2002 was $8.7bn. The recovery rate of such obligations is typically around 30 per cent, which in this case yields a figure of $2.6bn. However, this number only represents traded debt, in other words bonds, and ignores other financing that has been provided to the borrowers such as equity capital. Any equity in these companies is probably worthless. Assuming that they have taken on at least as much bank debt as they have procured in the bond market gives a rough estimation of the corporate value that is currently involved of $5.2bn.

But this only includes obligations that are actually in default, and not those that have not yet crossed that line but are dangerously close. Taking a wider view therefore, S&P recorded $46.2bn worth of rated debt downgrades among European industrials (excluding telecommunications) in the third quarter alone. It is quite likely that the majority of these companies are undertaking, or at least considering, some kind of restructuring event. Yet again, this figure is almost certainly underestimating the current size of the restructuring universe, partly because it is based on data for one quarter only, but also because, by number, unrated companies in Europe vastly outweigh rated ones.

?Most private equity houses are hands off when the investment is made?

There is also anecdotal evidence of the depth of the problem ? or opportunity ? that is currently bubbling up in Europe. The most prominent example are the telecoms companies, the majority of which are currently experiencing acute pain on the back of investment in mobile technology. In media, Vivendi Universal has already embarked upon a €10bn disposal programme. Siemens, the German electrical and engineering conglomerate, is also a regular visitor to the corporate sales room, making numerous disposals over recent years, including a €1.7bn sale to KKR over the summer, with yet another involving the same buyer rumoured at the time of writing (involving Siemens' network management interests in France, Italy and the UK). UK-based Invensys too has taken significant steps towards its aim of reducing debt by £1.5bn through disposals – mainly to private equity firms.

These are headline numbers, but the picture is clear: the values involved are huge. Whilst technology and communications were the buzzwords of the late 1990's, restructuring looks set to be the M&A trend of the near future. And private equity houses look certain to be heavily involved

Too hands off?
A large part of the restructuring deal flow that financial buyers will come across over the coming months is going to involve at least some financial trouble, and they are also likely to encounter it in their existing portfolio of investee companies. Getting to grips with distress is a messy process. It is also a process that, at the larger end of the buyout spectrum, has become more complicated and arguably more aggressive on the part of those involved, especially when different parties looking to protect their own interests are pursuing conflicting agendas.

Many market practitioners ? even some GPs ? believe that private equity sponsors are neither very good at spotting problems nor very effective in figuring out what to do once they become apparent. ?Most private equity houses are hands off when the investment is made: ?we are backing a management team? is their view. Some smaller ones may be more active, but most just move on to the next deal,? observes Bob Ward, a partner in the affirmatively named business regeneration team at PricewaterhouseCoopers, who has also worked with banks involved in private equity backed transactions.

Granted, the details of a problem company can blur the paths open to a sponsor involved in a deteriorating situation, but the feeling that more could be done on their part turned out to be remarkably widespread among those interviewed for this article, ranging from advisers to bankers.

Another striking observation made by many was that debt providers are deploying more aggressive tactics in such situations than they did in the past. Special mention was reserved for the attitudes of bondholders, particularly the specialist distressed or ?vulture? funds largely originating in the US. In the words of Nick Angel, a partner at Ashurst Morris Crisp in London, these operators are ?tough and purely after their money ? they aren't English gentlemen who live by the London rules any more.?

Such funds typically enter the fray late in the day. ?We've seen a number of situations involving bondholders,? says Ward, ?they've bought in at 20 to 30 pence in the pound and are looking for a turn. They may not be interested in the underlying business and whether it remains viable or not. There are currently a number of situations where the bondholders could make more money from administration than if the business survived.?

What about the banks?
Opinions vary as to how the senior debt providers are behaving in the restructuring arena. Some believe that the strong position of investment banks as arrangers in many large deals is not helpful when things turn sour. Given their limited lending capacity compared to their commercial banking competitors and the resulting need to syndicate deals, their ultimate position in the transaction can be small and hence their interest in helping to manage a problem low. Overall though, there is also a sense that banks have in fact improved in their attitude towards problem credits, even though sometimes a more proactive approach can translate into greater aggression. ?They are much better than ten to twelve years ago. Banks generally are very clear [in their approach] and take leadership,? states Greg MacLeod of London-based advisory boutique MacLeod Phillips.

As far as flexibility and adaptability are concerned, there are examples of situations where both debt and equity providers have taken positive steps and supported the underlying business, though not always to the liking of everyone involved. Gudgeon at Close Brothers uses Polestar, a UK printing business that came close to collapsing under its debt burden before being restructured in 2001, as an example of where the private equity sponsor ? in this case Investcorp ? injected further funding ?because they believed in the business and in the value of their investment going forward.? One group that didn't benefit from the turnaround were the bondholders, who were taken out in an exchange offer involving a small cash payment and the receipt of a long dated zero coupon note, an outcome that still rankles with some of those unfortunate enough to have held on to the original bonds for too long.

PwC's Ward cites another example where it was the banks that were involved that helped solve a company's operational difficulties: ?They allowed a considerable reduction in working capital in order to generate cash, despite the fact that this reduced the value of their security. The company was also permitted to use the cash to restructure the business.?

?It all depends where the value breaks ? in the senior debt or below?

These are hardly acts of selflessness. In the case of private equity houses working hard to rescue a deal, they will also have a great deal to do with the preservation of value, or to reflect broader concerns, such as future fundraising prospects. There may also be a feeling that a transaction is too big or too difficult to walk away from. As MacLeod puts it, ?there's more of a ?public policy? reason to solving problems.?

It's leverage ? but not as we know it
Ultimately, what determines the tactics and approach of the parties involved is economic reality. If the sponsor's original investment is clearly underwater and the problem, financial or operational, is not readily fixable, what interest is there in remaining loyal? By the same token, if there remains value in the business but the price paid was simply too high, why shouldn't a savvy investor buy the bonds in order to end up owning the company?

Close Brothers' Gudgeon provides a very succinct summary of this view: ?It depends where the value breaks ? in the senior debt or below.? In other words the negotiating position of any party to the transaction, and their likely attitude to the problem, is determined by how deeply underwater their money is. ?It's all about finding, persuading and educating [those involved] about the true level of their negotiating leverage.?

In practice, this is more of a moving target than might be imagined, and not just for financial reasons. Often the relevant legal system(s) can make the situation worse, or at least more difficult to control or predict. In the words of one European distressed asset investor who wished to remain nameless but was wistful for the US Chapter 11 bankruptcy code: ?Chapter 11 requires existing creditors to stand still. It therefore reduces the need for a swift resolution because the company is able to continue to trade. In Europe, however, there is always more tension in the situation, which is often created by the banks if they are fully covered by their collateral. European restructurings generally have to be consensual. The reality is that the last thing needed is statutory insolvency proceedings.?

This means that in Europe, wherever you are in the capital structure, you may have ?nuisance value? and hence be able to play the situation to your benefit. Of course, ultimately none of this can change economic reality, and whilst there are examples where creditors lower down the pecking order have been able to secure some kind of pay-off, the ultimate survival or demise of the business may be largely unaffected. In short, the legal framework may simply influence procedures and timing, unless of course the investors involved have fundamentally misunderstood the nature of their rights when they entered into the transaction, which does happen on occasion. An example is the current situation facing the senior lenders to Callahan Nordrhein Westphalia in Germany, who suddenly discovered that they had lent some of their facility via a holding company and therefore, because in Germany shareholder loans are by law deemed subordinate, were ranked behind others who had provided funds directly to a subsidiary.

Where are the buyers?
With such a large universe of companies finding themselves in restructuring situations due to financial, strategic or operational reasons, surely this is the ultimate buyers' market where private equity firms could be plucking diamonds from the mire? From those prepared to take the plunge the answer appears to be a resounding yes, even though remarkably few seem prepared to do so.

?I'm surprised that more private equity funds have not looked more seriously at the market,? comments Gudgeon. As he points out, part of the reason may be that the terms of many partnerships' fund documentation actually precludes them from doing so. Also, the risks involved are seen as high, as is the effort that is required to make these investments work. ?GPs would rather overpay on an easy deal or underpay on a difficult situation.? In other words, even away from companies that are actually experiencing financial distress, dealing with turnarounds appears to be viewed as a job for a few noted specialists rather than the broader buyout community.

So why do some take the opposite view, and how do they deal with such high-risk situations? Hans Albrecht, who in the 1990s set up Carlyle's buyout operations in Germany and is currently raising money for the debut turnaround fund of his own company, Nordwind Capital, is clear about where the attraction lies: ?I believe the very high returns from private equity in the 90's are largely attributable to everrising markets and therefore over.? He is therefore concentrating his efforts on troubled parts of the German industrial sector, at the higher end of the Mittelstand bracket, targeting companies with turnover in the range of €500m to €1bn.

Nigel McConnell of Electra Partners puts his firm's ability to invest in mid-cap restructuring situations down to the ?de-risking? involved in the due diligence process. ?Our strength is in our ability to dig down into the business,? he says, ?We also involve operating partners, often people we have backed before. We are financial people and do a financial analysis. They give us a view of the business overall: its people, market position, and so on.?

What appears to be a common theme among managers willing to take on restructuring risk is that many prefer to stay away from companies in genuine financial distress and focus instead on fixing operational dysfunction. This is partly because the risks of dealing with the latter are seen as high enough without complicating the picture further with funding issues. There is also a perception that there are more realistic valuegenerating opportunities in this category. Albrecht explains why this may be so: ?If a company is on the edge of bankruptcy there is a tendency to fake the P&L and play with the balance sheet. If it's very highly leveraged, then everything will have been pretty squeezed already – no maintenance capital expenditure, no investment.?

?What's required are lots of small steps and a financial structure which can take some stress?

Underperforming or overleveraged businesses can also be difficult to value, because the future is so cloudy, although this isn't a turnoff to everyone. ?The right type of investment is as important as the price,? says McConnell. Albrecht's thesis is that valuations based on profit multiples are fundamentally flawed anyway, preferring instead to use a proportion of sales. He points to evidence of a close correlation between multiples and profit margins ? the higher the margin, the greater the value multiple.

Cross Border Insolvency/Restructuring Comparative Table

Jurisdiction UK US France
Principal Insolvency ? Administration ? Liquidation (Chapter 7) ? Judicial Recovery
Procedures ? Administrative Receivership ? Reorganisation (Chapter 11) ? Winding up
? ?LPA Receivership
? Insolvent Liquidation
? Solvent Liquidation
Principal ? Contractual arrangement ? Contractual arrangement ? Alert procedure
Restructuring with creditors with creditors ? Court-appointed go-between
Procedures ? Company Voluntary Arrangement ? Reorganisation (Chapter 11) ? Voluntary settlement
? Scheme of Arrangement
Order of Priority 1. Fixed charge creditors 1. Secured creditors Varies according to the
on Insolvency 2. Costs of insolvency process 2. Priority unsecured creditors procedure, in basic terms:
3. Insolvency practitioner's remuneration (see Preferential Creditors) 1. Employees of the company for
4. Preferential creditors 3. General unsecured creditors remuneration owed to them for
5. Floating charge creditors 4. Shareholders up to 60 days in arrears
6. Unsecured creditors 2. Creditors having claims which
7. Shareholders arise after the beginning of the
bankruptcy proceedings (see
Preferential Creditors)
3. Secured creditors
4. Unsecured creditors
Preferential 1. Employee wages 1. Administration expenses 1. Employee wages
Creditors 2. Certain VAT arrears 2. Creditors who extended 2. Court costs
3. Certain PAYE arrears credit after involuntary 3. Loans granted by lending
4. Certain other taxes/debts petition but before order for institutions and claims arising
to government relief or trustee appointed out of contracts including new
3. Employee wages payment terms
4. Employee benefit plans 4. Other creditors whose rights
5. Consumer creditors' arose post insolvency judgment
deposits
6. Certain taxes
Liability of ? Wrongful trading ? No concept of ?wrongful ? May be required to contribute to
directors ? May be disqualified trading? the liabilities of the company
? Owe fiduciary duties to ? Criminal sanctions in case of
creditors as well as fraudulent bankruptcy
shareholders ? May be banned for a minimum
of five years
? Transactions at an undervalue ? Preferences and fraudulent ? Transactions at an undervalue
Voidable ? Preferences conveyances and new security for old debts,
transactions ? Transactions defrauding creditors ? Chapter 11 – may when they occur during the
assume/reject ?executary? ?suspect period?
contracts and unexpired ? Any transactions if the party
leases contracting with the company
was aware of the company's
insolvency
Germany Italy Belgium Spain ? Liquidation ? Liquidation ? Bankruptcy ? Bankruptcy ? Reorganisation ? Bankruptcy ? Judicial composition ? Suspension of payments ? Compulsory administrative liquidation ? Extraordinary administration ? Within formal insolvency procedure: ? Preventive arrangement ? Judicial composition Sale of assets to NewCo which has ? Supervised administration ? Suspension of payment been incorporated by insolvency administrator 1. Costs of insolvency process 1. Costs of the insolvency 1. Costs of the insolvency process 1. Especially privileged 2. Creditors of insolvent estate process 2. Preferential creditors/ creditors (see Preferential including preferential creditors 2. Preferential creditors and Mortgagees/Pledgees Creditors) and employees' claims as of secured creditors 3. Unsecured creditors 2. Privileged creditors from the commencement of proceedings 3. Unsecured creditors 4. Shareholders Commercial Code 3. Unsecured creditors all settled 3. Privileged creditors from the with same quotas Civil Code 4. Creditors by virtue of public deed and a final judgment 5. Common creditors 1. Owner of assets can claim 1. Employee wages 1. Specific preferential creditors 1. Employee wages separation 2. Social contributions 2. General preferential creditors 2. Legal mortgagees 2. Security beneficiary can claim 3. Professional fees 3. Mortgagees 3. Amounts owed to the Inland preferential treatment, 4. Taxes 4. Pledgees Revenue and Social Security i.e. insolvency administrator realises payments asset and transfers the proceeds (less a fee of 9 % of the proceeds for the administrator) ? Maximum of 3 weeks to file petition ? Duty to place company in ? May be personally liable if ? Duty to call General Meeting once company insolvent bankruptcy once aware is gross negligence within 2 months once there ? Liable to creditors if assets given insolvent ? Can be liable in tort to is reason to believe equity is away after insolvency occurred ? May be criminal sanctions creditors less than that of the ? Liable to Inland Revenue if ? Liability in connection to registered share capital company bookkeeping/ accounting breach of fiduciary duties ? May be criminal and civil incomplete/incorrect sanctions ? Preferences given to creditors if ? Transactions at an ? Transactions at undervalue ? Preferences transaction within hardening period undervalue ? Transactions during ? Transactions at an undervalue (3 months to 10 years depending on ? Transactions for non-cash suspension of payment if ? Transactions defrauding the nature of the transaction) consideration counterparty was aware of creditors ? Securities such suspension ? Amounts settled 15 days ? Payments of any ? Security during suspect period before bankruptcy in relation outstanding credit for existing debt to liabilities falling due after ? Certain payments during suspect period ? Transactions defrauding creditors Source: Ashurst Morris Crisp