Financial Distress

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Financial Distress

• Lecture 5(2)
• Saeid Samiei
• Portsmouth Business School

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Executive Summary

• This lecture focuses on financial distress,
  private workouts, and bankruptcy.
• A firm that defaults on a required payment may be
  forced to liquidate its assets. More often, a
  defaulting firm will reorganize.
• Financial restructuring involves replacing old
  financial claims with new ones and takes place
  with private workouts or legal bankruptcy.

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Lecture Outline

• What is Financial Distress?
• What Happens in Financial Distress?
• Bankruptcy Liquidation and Reorganization
• Private Workout or Bankruptcy Which is Best?
• Prepackaged Bankruptcy
• Summary and Conclusions

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1 What is Financial Distress?

• A situation where a firms operating cash flows
  are not sufficient to satisfy current obligations
  and the firm is forced to take corrective
  action.
• Financial distress may lead a firm to default on
  a contract, and it may involve financial
  restructuring between the firm, its creditors,
  and its equity investors.

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Stock-Base Insolvency

• Stock-base insolvency the value of the firms
  assets is less than the value of the debt.

Debt
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Flow-Base Insolvency

• Flow-base insolvency occurs when the firms cash
  flows are insufficient to cover contractually
  required payments.

Firm cash flow
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2 What Happens in Financial Distress?

• Financial distress does not usually result in the
  firms death.
• Firms deal with distress by
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and research and
  development.
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

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What Happens in Financial Distress
Financialdistress
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Responses to Financial Distress

• Think of the two sides of the balance sheet.
• Asset Restructuring
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and RD spending.
• Financial Restructuring
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

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3 Bankruptcy Liquidation and Reorganization

• Firms that cannot meet their obligations have two
  choices liquidation or reorganization.
• Liquidation (Chapter 7) means termination of the
  firm as a going concern.
• It involves selling the assets of the firm for
  salvage value.
• The proceeds, net of transactions costs, are
  distributed to creditors in order of priority.
• Reorganization (Chapter 11) is the option of
  keeping the firm a going concern.
• Reorganization sometimes involves issuing new
  securities to replace old ones.

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Bankruptcy Liquidation

• Straight liquidation under Chapter 7 usually
  involves
• A petition is filed in a federal court. The
  debtor firm could file a voluntary petition or
  the creditors could file an involuntary petition
  against the firm.
• A trustee-in-bankruptcy is elected by the
  creditors to take over the assets of the debtor
  firm. The trustee will attempt to liquidate the
  firms assets.
• After the assets are sold, after payment of the
  costs of administration, money is distributed to
  the creditors.
• If any money is left over, the shareholders get
  it.

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Bankruptcy Liquidation Priority of Claims

• Administration expenses associated with
  liquidation.
• Unsecured claims arising after the filing of an
  involuntary bankruptcy petition.
• Wages earned within 90 days before the filing
  date, not to exceed 2,000 per claimant.
• Contributions to employee benefit plans arising
  with 180 days before the filing date.
• Consumer claims, not exceeding 900.
• Tax claims.
• Secured and unsecured creditors claims.
• Preferred stockholders claims.
• Common stockholders claims.

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APR Example

• Suppose the B.O. Drug Co. decides to liquidate
  under Chapter 7.
• Assume that the liquidation value is 2.7
  million.
• Bonds worth 1.5 million are secured by a
  mortgage on the corporate headquarters building,
  which is sold for 1 million.
• 200,000 is used to cover administrative costs
  and other claims
• After paying this, 2.5 million is available to
  pay creditors.
• The only problem is that the unpaid debt is 4
  million.

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APR Example

• Under APR, all creditors are paid before
  shareholders, and the mortgage bondholders are
  first in line. The trustee proposes the following
  distribution

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Bankruptcy Reorganization Chapter 11

• A typical sequence
• A voluntary petition or an involuntary petition
  is filed.
• A federal judge either approves or denies the
  petition.
• In most cases the debtor continues to run the
  business.
• The firm is given 120 days to submit a
  reorganization plan.
• Creditors and shareholders are divided into
  classes. Requires only approval by 1/2 of
  creditors owning 2/3 of outstanding debt
• After acceptance by the creditors, the plan is
  confirmed by the court.
• Payments in cash, property, and securities are
  made to creditors and shareholders.

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Reorganization Example

• Suppose the B.O. Drug Co. decides to reorganize
  under Chapter 11.
• Assume that the going concern value is 3
  million and its balance sheet is shown.

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Reorganization Example

• The firm has proposed the following
  reorganization plan

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Reorganization Example

• And a distribution of new securities under a new
  claim with the reorganization plan

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Absolute Priority Rule in Practice
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Reasons for APR Violations

• Creditors want to avoid the expense of
  litigation. Debtors are given a 120-day window of
  opportunity to cause delay and harm value.
• Managers often own equity and demand to be
  compensated. They are in charge for at least the
  next 120 days.
• Bankruptcy judges like consensual plans (they
  dont clog the court calendar with appeals) and
  pressure parties to compromise.

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Predicting Corporate BankruptcyThe Z-Score model

• Edward Altman developed a model to predict
  bankruptcy
• Where Z is an index of bankruptcy.

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Predicting Corporate Bankruptcy

• Where
• Z gt 2.99 indicates no bankruptcy
• 1.81 Z 2.99 indicates a grey area
• Z lt 1.81 indicates bankruptcy

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The Z-Score model Private non-manufacturing
firms
Where Z gt 2.90 indicates no
bankruptcy 1.23 Z 2.90 indicates a grey area
Z lt 1.23 indicates bankruptcy
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Vultures

• Vultures are money managers that specialize in
  the securities of distressed and defaulted
  companies.
• There are between 50 and 60 institution vulture
  specialists, actively managing over 25 billion
  in 1998.
• Distressed debt investors have target annual
  rates of return of 2025 percent.
• Although some years are better than others, the
  overall annual rate of return from 1978-1997 has
  been about 12 percentsimilar to junk bonds but
  less than the stock market.

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4 Private Workout or Bankruptcy Which is Best?

• Both formal bankruptcy and private workouts
  involve exchanging new financial claims for old
  financial claims.
• Usually senior debt is replaced with junior debt
  and debt is replaced with equity.
• When they work, private workouts are better than
  a formal bankruptcy.
• Complex capital structures and lack of
  information make private workouts less likely.

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Advantages of Bankruptcy

• New credit is available - "debtor in possession"
  or "DIP" debt.
• Discontinued accrual of interest on
  pre-bankruptcy unsecured debt.
• An automatic stay provision.
• Tax advantages.
• Requires only approval by 1/2 of creditors owning
  2/3 of outstanding debt.

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Disadvantages of Bankruptcy

• A long and expensive process.
• Judges are required to approve major business
  decisions.
• Distraction to management.
• Hold out by stockholders.

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5 Prepackaged Bankruptcy

• Prepackaged Bankruptcy is a combination of a
  private workout and legal bankruptcy.
• The firm and most of its creditors agree to
  private reorganization outside the formal
  bankruptcy.
• After the private reorganization is put together
  (prepackaged) the firm files a formal bankruptcy
  under Chapter 11).
• The main benefit is that it forces holdouts to
  accept a bankruptcy reorganization.
• Offers many of the advantages of a formal
  bankruptcy, but is more efficient.

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6 Summary and Conclusions

• Financial distress is a situation where a firms
  operating cash flow is not sufficient to cover
  contractual obligations.
• Financial restructuring can be accomplished with
  a private workout or formal bankruptcy.
• Corporate bankruptcy involves Chapter 7
  liquidation or Chapter 11 reorganization. An
  essential feature of the U.S. Bankruptcy code is
  the absolute priority rule (APR).
• A hybrid of a private workout and formal
  bankruptcy is prepackaged bankruptcy.