21 January 2008
Has credit dried up? Are we in a credit crisis? Well, nothing lasts forever, not even global liquidity and easy credit. We have all seen this play before.
A highly priced leveraged buyout of a company is done at a very high debt level based on expected growth in profit; actually, growth in 'earnings before interest, taxes, depreciation and amortisation' (Ebitda). That strategy offers major rewards, but also leaves little room for error regarding revenue or cashflow. Even a slight slowdown in revenue growth (heaven forbid a decline) might push this highly leveraged company towards default.
Last year's solution was so easy: another group of lenders would happily refinance the debt, maybe even provide more to delay the day of reckoning. Credit was easy, debt was liquid and the queue of willing lenders seemed endless.
Now all that has changed. We leave it to the experts to predict whether a 2008 recession looms, but if lenders are losing money hand-over-fist in subprime and a variety of structured debt obligations and related derivatives, then surely they are not likely to take on more credit risk for a highly leveraged company showing a decline in Ebitda and looking to refinance.
The credit downturn looks more like a return to normalcy in the commercial credit markets, but if it is your turn to refinance once unheard of debt ratios of eight times Ebitda when the market now offers the more traditional five to six-times level, then you surely have a crisis. Those missing 'two-three turns' of debt to Ebitda for new credit can only mean one thing: time to restructure the company, sell it, or perhaps both. That is a crisis for some, but an opportunity for others.
In the early 1990s in the US, crashing values for inflated commercial real estate and corporate junk bonds crushed the balance sheets of many banks and regulated lenders. Many lenders failed and were taken over by government regulators, who sold the distressed assets (loan portfolios and foreclosed properties) at deep discounts. Many might debate when distressed debt investing began, but it surely took a deep hold then in response to the high defaults and bank failures of the decade's early years. In the mid to late 1990s, the defaults on emerging market debt in Asia, Latin America and Russia spread their way to Europe and the US in 2000-02, reminding us that credit supply and investor confidence (or lack thereof) are global in scope.
This time around
So here we go again, watching the subprime and credit losses of 2007 wind their way around the global credit markets. Suddenly, but for good reason, banks, hedge funds, insurance companies, bond funds, regulators and - always last, but never least - rating agencies have become conservative again.
While today's credit cycle is probably a return to normalcy, it nevertheless creates a crisis for those who relied on the euphoric and liberal credit optimism of the past few years. We will no doubt see at least a year or two of higher default rates and restructurings of corporate debt as a result. Will anything be different this time around? Plenty. Lenders, investors and advisers should heed five trends on the horizon.
An abundant, eclectic mix of financial players now hold debt, equity and derivatives at all levels of the capital structure. Each may have different perspectives and recovery strategies and may be willing to buy or sell more at a moment's notice. They will make for strange bedfellows, heady intercreditor struggles and intense competition (including litigation) for distressed assets with intrinsic value. Warning: with all the exotic derivatives and off-balance sheet instruments out there, it will be harder to determine who the real creditors are and what drives their motivation.
Distressed M&A has become the vehicle of choice for realising value on an operating company. The buyer may be a strategic player with cash, but just as often will be some or all of the creditors who convert debt to equity with an eye to sell the company in 12-24 months at a profit. Time, money and patience have waned considerably for the risk and lengthy holding (hiding?) pattern of a freefall insolvency proceeding. Prenegotiated reorganisations of deleveraging, new capital and change of control, or sale, will be the norm.
Most sizeable businesses have international assets, operations or key constituents, and so will their restructurings. Forum shopping and governing laws have gone global and no country, not even the US or the UK, is an island in the restructuring world (with apologies to the British Isles). Cross-border and international issues are now the norm in almost every large restructuring and introduce complexities of conflicting laws, constituents and cultures.
A globalised market
Global insolvency regimes have changed. For better or for worse the global financial markets are becoming 'westernised'. For many Asian economies, particularly Japan, this trend results in traumatic shifts in the way business is done. But if you are an investor with a US or European perspective, westernisation often means more consistent, predictable legal systems, a more congenial regard for property rights and commercial and bankruptcy laws that are grounded on familiar legal principles. But beware the temptation to act like a westerner in every foreign land - it can backfire quickly. Now more than ever in the international arena, when in Rome, try not to be an American. Foreign investors with no-holds-barred mentalities have discovered to their cost that local cultural values can be critical, even in workouts.
Workout advisers and investors will need the experience and ability to skilfully handle all of the above. Knowing how and when to avoid, settle or quickly win fights among competing constituents, align their interests, bring M&A and corporate governance skills to the table and deliver expertise and creativity on a global basis will often mean the difference between a successful global restructuring and a self-destructive exercise in bravado, asset liquidations and expense. The right adviser will influence not only on the structure of a transaction, but also on its pace and tone, and therefore its likely success.
So what next?
The coming downturn and workout transactions will reflect the euphoria that preceded and propelled it: more complex structures on and off balance sheet, more players, more constituencies, more cross-border aspects, more forum shopping, but, frankly, fewer experienced professionals and investors who have seen it before and know what works and what does not. Perhaps workout investors and advisers should dust off their insolvency codes, passports, diplomacy skills and cultural perspectives. It is going to be an interesting year.
Michael Reilly and James Roome are co-chairs of Bingham McCutchen's global financial restructuring group