Creating Advantageous Restructuring Tactics for Debtors
Gordian Group has a unique investment banking practice in financially challenged and restructuring situations: we only represent financial sponsors and boards of public and private companies seeking to right-size their capital structures, while minimally diluting shareholders. To enable us to render unconflicted advice to our clients, we believe, we alone in our field, eschew financial creditor representations.
Said differently, we garner a disproportionately large piece of the value “pie” for shareholders (and Management), at the expense of junior and senior creditors – the latter usually fully secured. We do this consistent with any fiduciary duties we might have, and we work with counsel to maximize board protection under the business judgment rule.
In distressed situations, it is critical to, among other things:
- Understand the motives, agendas, strengths, weaknesses, concerns and constraints of the constituencies around the table;
- Develop defensible and credible alternatives that the creditors will both not like and will need to take seriously (the “sticks”); and
- Present one or more alternatives that creditors will view as a better outcome relative to the sticks (the “carrot”).
Our outsized results for shareholders in tough capital structure situations are achieved by our lack of creditor conflicts and, relatedly, our design and use of restructuring carrots and sticks.
A Novel Restructuring Carrot
We have been thought leaders in recently creating a novel “carrot” strategy – the “Debt Spring Back” and “Debt Spring Down” structures. While having certain roots in the old “cash flow note” concept, these structures go much further in terms of recapitalization strategies.
In short, these provide optionality to debtors in times of uncertainty, and can assist in bridging negotiating gaps with lenders in restructuring scenarios.
The Debt Spring Back is part of an overall immediate rightsizing of a company’s capital structure, which can also be accompanied by permanently shedding a portion of the lender’s debt stack through a simple write-down ($X).
The Debt Spring Back (in its basic form) works as follows:
- An amount of the debt facility (“$Y”) is allocated into a contingent liability that effectively sits in the ‘ether’;
- In return, the lenders receive some warrants in the company (potentially along with a commitment for junior capital from shareholders);
- If the company achieves certain agreed-upon operational benchmarks down the road, the lender can elect to “spring back” into pre-existing debt up to the full amount of the contingent liability; and
- As the debt “springs back”, the warrants (or some percentage of them) ratably decrease.
A variant of this approach is the Debt Spring Down. This option can include the same $X debt write down but leaves the rest of the principal amount of the capital stack undisturbed at close.
However, if after an agreed-upon term (perhaps two years), the company has not achieved the agreed-upon operational metrics, then $Y million of the debt “springs down” (i.e., is written off as well).
In short: the Spring Back right-sizes the capital structure immediately while providing a debt reinstatement option to the lenders should performance come back as hoped for. Sponsors and Management much prefer this approach, particularly if the Sponsor is considering investing more money in connection with a recapitalization.
Conversely, the Spring Down gives the company an option to right-size the capital structure long-term, while allowing the lenders to avoid an immediate write-down. This functionally is a variation of a “kick the can” strategy that provides a hedged outcome. Sponsors prefer this less than lenders do.
One or the other of Debt Spring Down or Debt Spring Up is often appropriate for a given set of circumstances.
(There are of course tax and regulatory considerations, and other structural and implementation mechanics and issues that, as the progenitors of the approach, we are well-versed in addressing advantageously.)
There is necessarily a tension that exists in any financial restructuring, particularly in the current environment:
- Creditors want to both avoid an immediate write down (particularly if it believes the business may rebound in the near- to mid-term) and also have the shareholders fund additional equity to support the business and keep the company on a short forbearance leash
- Conversely, Boards, shareholders and management do not want to work solely to preserve, and create, value for the benefit of their creditors, or to invest additional capital behind “Mt. Debt” (particularly given uncertainty as to the timing and extent of a turnaround).
Nimble companies today want to take advantage of market uncertainty to achieve advantageous global solutions, while creditors seek to avoid that.
We find that the Spring Up and Spring Down can help lubricate the wheels of commerce and be a valuable tool in lender negotiations. Why would lenders accept either form of this “carrot”? Because they will find it much more appealing than facing the sticks we alone can bring to the party due to our experience, company-centric practice and our unique lack of creditor conflicts.
And that is why we introduce this as part of the carrot together with credible stick alternatives that creditors believe can be implemented over their objection.
We will discuss specific sticks in another blog. A good example of this carrot follows.
Below are examples of a restructuring transaction including the Spring Back (Exhibit A) and the Spring Down (Exhibit B). Both assume the following:
- Total debt of $120 million;
- LTM EBITDA of $10 million and Target EBITDA of $20 million;
- A permanent write-off of $20 million, together with $50 million subject to the Spring Down or Spring Back.
Exhibit A – Spring Back
Leverage is reduced to 5.0x leverage at close. Lenders have $50 million subject to the Spring Back and are awarded warrants equal to 20% of the fully diluted equity (10% subject to pro rata reduction for the Spring Back amount).
The Spring Back calculation is set so that for every $1 that EBITDA exceeds $10 million, $5 of debt gets reinstated (up to $50 million). Assuming $20 million of Test Year EBITDA, the full $50 million is reinstated and warrants are reduced to 10%.
Exhibit B – Spring Down
$100 million of debt remains on the balance sheet at close, so leverage is elevated at 10x. The restructuring Spring Down is set so that the Company can reduce its debt load $5 for every $1 that EBITDA is below $20 million, up to a cap of $50 million. Lenders receive no warrants at close, but when the Spring Down occurs, they receive warrants for up to 10% of the fully diluted equity (pro rata).
Assuming $10 million of Test Year EBITDA, the full $50 million is written off and the lenders would hold warrants for 10% of the equity of the Company.
Want to Discuss This Further?
This post and the accompanying exhibits were produced in-house by Peter S. Kaufman and members of the Gordian team. Clients, potential clients and members of the media can book a call or meeting to learn more by contacting Leslie Glassman directly.