Debt Restructuring - An Overview
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By Vicente J. Sarza
I. What is Debt Restructuring?
Debt is defined as “something that is owed or that one is bound to pay to or perform for another”, according to Webster’s dictionary. Restructuring comes from two words, re meaning “again” and structura, Latin for “to put together”. So from the dictionary, restructuring is “to effect a fundamental change in (as on organization of system). But before you begin to think this is an English etymological treatise, DEBT RESTRUCTURING is just what the combination of the two words means, which is to effect a fundamental change in the original structure of the debt. Simple in meaning isn’t it? You’ll be surprised, so read on and indulge the writer.
II. Why do debts need to be restructured anyway?
Debts need to be restructured for two very simple reasons—the borrower has defaulted or is in danger of defaulting on the original terms of payment agreed upon with the lender and both the lender/s and the borrower agree that they have to restructure the debt in order for the borrower to continue payments to his outstanding obligation and eventually settle it in full and of course for the lender to recover his investment. The compelling force here is the deep-seated commercial interest of both the lender/s and the borrower to have the obligation settled in full.
There seems to be many variables here. You might say, doesn’t a debt have to be in default first before you can restructure? Not necessarily. A debt can be restructured in anticipation of an imminent default. An ounce of prevention is worth a pound of cure. Then you will ask, do both the lender and the borrower have to agree for a debt to be restructured? Legally yes, since this is a two party contract. But in the end, assuming there is default already and the borrower is still in denial that there is a problem with the servicing of his debt to the lender, he may have little choice but to agree to a proposed restructuring if he desires to keep his credit rating intact, his integrity unblemished, or his business altogether still his.
III. Why do debts turn sour hence need restructuring?
Debts turn “sour” for a myriad of reasons. (“Sour” is an old banking term for a loan that is in default or been in default. Its origin is unknown, but may be traced to the acidic taste it leaves in the mouth of the bankers or the acerbic way it rubs their composure. Either way, sour loans are never pleasant. The modern and politically correct term is non-performing loan but it sounds too clinical. Just allow me to use sour, not that it’s a better term nor using it means all restructured loans come from banks.). The causes then most attributed to loans turning sour are:
1) Loss of market share and/or competitive position translating to lost revenues and profits
A lost product or the entry of a shining new competitor can wreak havoc on any industry player, and affect his profit and loss and his payment capacity.
2) Deteriorating or poor funds management
A typical example is poor collection of receivables which puts a strain on payables resulting in defaults on some or all payments to suppliers or lenders.
3) Sudden or unanticipated change in technology that caused drop in demand for the company’s product
Although this doesn’t happen too often, this is something that any management should keep a watchful eye on as sometimes new technology comes up so fast and gets introduced in the market before any industry player can come up with his own strategy.
4) Company is overborrowed (alright I will give the modern term this time-overgeared. Rather snooty though)
Any company who borrows more than it should is really inviting trouble. It can be emboldened to invest in projects when it shouldn’t and similarly, it can be tempted to do something unwise with the money.
5) The flip side to #4- overlending by the lenders
This has happened to some industries in our country when lenders doled out a lot of credits to certain industries which somehow encouraged unwise investments.
6) Ineffective or loose monitoring and control systems
This has many ill effects, like inaccurate cash balances, poor records on revenues or income, etc, that can erode the confidence of management and the lenders on the company.
7) Ineffective governance (the old term is harsher- mismanagement)
There are many examples, some of the more prominent ones being: bad strategy, misreading of the market direction, bad product pricing, poor cost control, etc.
8) In the case of specific projects, poor matching of funds
Concisely translated, the debt was in short term form but the project was long term. Repayment becomes a problem when the loan becomes due or the cash flows from the project do not come in time to pay off the debt.
IV. What are the ways to restructure debt?
There are many ways to restructure debt as there are ways to cut or style a woman’s hair or as there are as many shoes in any woman’s closet. And that means countless. Lenders are forever reinventing the wheel here so to speak, and new creative ways are being implemented regularly. It will be worthwhile to look at the simple, to the rather complex and to the extremely complex.
Simple or no-brainer
- Rescheduling of amortizations
Simple company problems like maybe a temporary liquidity crunch can be solved by simple restructuring ways like changing the tenor of the promissory note, where in all cases lengthening is done. (Tenor is not the higher voice than alto but the length of time within which the debt must be repaid, e.g., 1 year loan, or 5 year loan.). Another is to change the amount of the amortization to temporarily suit the cash flow of the borrower. These can allow the borrower some needed breathing space to source the cash to pay off the debt.
In a few cases, the problem was solved by a simple lowering of the interest rate. In times when the interest rates were very prohibitive, or the times when the rates rose to about 45% many years back, some loans turned sour because the companies who borrowed could not churn out enough profits to offset these exorbitant rates. When the rates decreased after some time, these sour loans became healthy again. This could be termed as economy-driven restructuring but there were a few lenders who initiated the lowering of rates just to drive the process.
Rather complex or headache-type restructuring
- Sale of some of borrower’s assets to pay off part of debt, then reschedule the remaining debt
Alright, we are off to the difficult ones! This method has been employed many times in many restructurings and with the best results. It is straightforward and somehow easy to implement. The only key here is the quick marketability of the asset being sold since time is of the essence in any restructuring.
Latin for “payment in kind”. Not the kind most men think of but the surrender or the voluntary ceding of property, such as land, buildings, cars, corporate shares, country club shares, etc. to partially or fully pay off an outstanding debtto any, some or all of the lenders just to ease up on the pressure to regularly pay the interest and principal. This is a little more complex than the method above since the buyer is the lender and the critical issue is always the price at which the property is being ceded for. Price determination is where the bottleneck most always resides. Assuming the property is “clean”, meaning not encumbered or mortgaged, then the lender and the borrower will most often battle it out over the price. Lenders often want a lower valuation, and borrowers will always want a higher one both for obvious reasons. Nevertheless, this has been and is a successful way of restructuring.
Extremely complex or the brain-damage type restructuring
- Debt to equity conversions
These are definitely Alzheimer’s or brain tumor type material! This is when an existing creditor converts his debt into equity of the borrower, or when a third party buys the debt and converts that debt into equity of the borrower. There are more counter parties here and more transactions or steps to follow than the normal or simple type of restructuring hence this becomes more intricate and so requires deft handling. There are many critical issues here; e.g., in almost all cases the debt is “bought” at a discount or what finance people call a “haircut”, then translated at face value to the equity side, so there generally is a tedious and sometimes lengthy deliberation on the haircut before the deal is inked. There is also the issue of who the new equity partner is, and how much he will be allowed to own in the company, the covenants by which he will come in, etc. In other deals, the debt is converted into preferred shares, so there are other variables that come into play like what interest rate the shares would earn, if these would be voting or non voting, etc. These types of transactions are better handled by experienced officials or dealmakers since they require specific skills. There have been quite a number of successful deals fashioned out in this way.
- Creation of a new company then only the debt and some assets are transferred to this new company.
There are a few cases where the new strategic investor would not want to carry on all the baggage of the existing company and would specify that he gets to assume only the debt and buys some of the assets in exchange for such assumption. It can get more complex as he can choose to either just assume the repayment of the debt or again, convert this into equity. Again there are many permutations in cases like this. Almost endless actually if the one doing the deal is creative enough. But this is a very useful restructuring device to use in cases where the existing company possesses a lot of baggage and that baggage, whether in the form of financial, contractual or operational is not at all acceptable to the purchasing entity.
- A combination of some of the above or for that ultimate thrill, all of the above
There have actually been cases where, for the restructuring to succeed, the lenders did employ many of the schemes available and even came up with novel ways. I have worked on a restructuring where some assets of the borrower were sold, then a new company was formed to carry on the business, the franchise was sold to this new company, then majority of the debt was converted into equity of the new company, then the remaining debts of the lenders who did not want to convert were rescheduled. And this took more than 2 years to bring to a close. This just shows that the possibilities in restructuring are almost infinite.
V. What are the fundamental principles to follow in pursuing a restructuring exercise?
There are two very important principles to follow when pursuing a restructuring engagement.
1) Take stock of the company’s liquidity and solvency and determine if it is still a viable company in the long run
This is an imperative first step in any restructuring work. The objective is very clear here. The viability of the company which defaulted must be determined with an absolute certainly on the part of the lender/s. There should exist no doubt at all in the minds of any or all of the lenders that the company is solvent and viable before any restructuring is contemplated. If there is any doubt or if the lender/s find out that the company is not viable in the long run, then obviously the next step is liquidation or foreclosure. But there is a key issue here. Viability may not necessarily mean that the lender/s will get all of their credits repaid at full value. Why? There have been many cases where the recovery of the company will take such a long time that the repayment will take a longer time than what the lender anticipated or expects. A typical example is where the cash flows for the recovery period will only be enough to repay small portions of the outstanding debt for most of the period that the restructuring is being contemplated and that most of the payment will be done in the last two or three installments. In such a case, the present value all the cash flows is very low compared to the existing balance of the debt. The lender then doesn’t get full value. So why go through the restructuring if the lender/s is not assured of getting full value in the repayment of their debt? The reason is more for practical reasons than anything else. Any lender will still want to be repaid for his investment. Lenders have to realize though that unlike the first time he granted the loan to the borrower, he is now facing a larger risk of not getting repaid or not getting back full value. This is the inherent risk of restructuring. Restructuring objectives, for these to be achieved, are inextricably linked and must be congruent to the cash flows of the company whose debt is being restructured. And in some cases, if the cash flow can only afford to repay a certain portion of the outstanding debt over a certain period, or even the whole life of the company itself, then the lender/s must content with that. Restructurings are never ALL OR NOTHING AT ALL activities.
2) If the viability of the company has been determined and accepted by the lender/s, then the next step is to try and preserve the assets of the company and where possible, try to enhance the value of some or all of it, so that repayment is somehow assured or enhanced too.
In all my experience in restructuring especially in multi-institutional debts, I think this is the most unappreciated of all the basic principles of restructuring, yet this is also the most important. A dear friend of mine, Ray Davis, an international restructuring guru and who I had the honor and pleasure to work with on several restructuring deals, said that this is the least understood and accepted principle by lenders when working on multi-institutional debts. And he said it is this lack of understanding that causes some restructuring deals to be delayed unreasonably or to fail altogether.
The reasons for this lack of understanding or sometimes the unwillingness to accept are simple. A borrower who has defaulted in a loan in a legal sense has VIRTUALLY LOST ALL HIS RIGHTS to negotiate for anything with respect to that particular loan. Conversely the lender who is the counterparty to that loan now has GAINED, BY VIRTUE OF THE DEFAULT, ALL THE LEGAL RIGHTS TO CALL ON THE LOAN, TO FORECLOSE ON ANY OR ALL PROPERTY MORTGAGED TO HIM, AND TO EXECUTE ANY AND ALL COVENANTS IN THE COVERING CREDIT AGREEMENT.
So from a purely legal perspective, that lender is acting well within his rights in calling the loan or foreclosing. Morally also, since that lender is only a financial intermediary hence he is answerable to his depositors, capital providers and other stakeholders (including owners), he feels he has the primary obligation to protect the investment of these people. So under these two legal and moral bases, the lender feels justified in acting on his own and protecting his company’s interest.
But consider this example which has happened in some instances: the largest lender holds the operating property as collateral and institutes foreclosure proceedings when the borrower defaults even if this borrower has been determined to be viable in the long term. Or this lender is recalcitrant or uncooperative in any restructuring initiatives. What can possibly happen? All the other lenders scramble for possession of other free property of the borrower or become unyielding too, so you have a standoff. The borrower, due to this, doesn’t get the chance for any recovery whatsoever. The largest lender, in this case, may win financially, but in the end, all the other lenders and the borrower will definitely lose. Tough you might say? Or unfair? C’est la vie! The largest lender in this example, acted well within his rights and for that matter, every other lender did too. But only one may win or probably get his investment back. The borrower, who earlier lost his rights on the debt, stands to lose much more than these rights.
There is then a higher moral ground by which lenders should try to fathom, one that goes beyond self-preservation in many respects. And this is the motivation to give a second chance to a company to recover and prove itself, and help other lenders recover too.
If these two principles are understood and accepted by both the borrower and lenders, then the execution should be a straightforward and uncomplicated activity.
VI. The challenges to restructuring (assuming the company is viable)
1) To convincingly bring to and keep in the negotiating table the lender/s who individually has the right, legally and morally, to do anything other than restructure, and to renew their trust, this time collectively, in the borrower who has failed them in many ways.
By and large this is the most intimidating and thorny challenge to someone who proposes to undertake a restructuring. Be it a lead bank (the bank who comes forward and says I will lead this deal), a restructuring advisor, or consultant hired to execute the restructuring plan, this is the mother of all challenges. This is so because all that the restructuring leaders and advisors will ask of the lenders is TOTALLY COUNTER-INTUITIVE to all their individual rights as a lender. And to make it more difficult, the restructuring proponent will also ask that all of them put their trust again in the borrower who has not only failed to pay them, but maybe also, did not tell them the truth about some important items in the operations, in the revenues, in the profits, etc. This is just like asking your girlfriend to take you back right after she has caught you in flagrante delicto. Be prepared to dodge some bullets or many knives thrown at you.
2) Once everyone is on board, the next challenge is to make everyone understand and accept the 2 principles mentioned in V and to keep the focus of all the lenders and the borrower throughout the process
Restructuring is a time consuming and labor intensive process. As such it requires a lot of focus, energy and fortitude in getting the job done. In the most complicated deals where it involves a lot of institutions, it would be of help if restructuring advisors are taken in to guide and drive the process, and hopefully conclude it in the minimum amount of time. I have seen restructurings that took more than 2 years to conclude and in these cases, the leadership changed hands several times, friends became foes, enemies became mortal enemies, and foes became friends and collaborated against whomever and the files accumulated so much it could fill a small room. And in the end, everyone recovered only about 10 centavos to a peso.
3) Induce the borrower to tell the truth, if he hasn’t, or more challenging, gauge if he isn’t
This is the trickiest. As mentioned, the lender/s will probably have lost trust in the borrower once a default has occurred. Even if the lead in the restructuring process has managed to somehow renew the trust in the borrower, this trust is at best a shaky one. All means must be employed to impress upon the borrower that he must be thoroughly candid with the lender. After all, the future decisions of the lender/s will depend on the data coming from the borrower; e.g., projections, manufacturing data, ledgers, trial balances, etc. Hence, it is of vital importance that the data provided by the borrower are truthful.
VII. Are there any benefits to restructuring? Or can we just say to heck with it since it’s too time-consuming, tedious and cumbersome?
1) It will be good for the borrower’s and the lender’s industry and the economy. Liquidations and write offs are not good for any industry and any economy.
Some borrowers deserve a second chance. (Note: some and some only). Some do indeed as long as they are still viable, still cooperative, and candid, they do deserve a second chance.
2) A major account that is restructured is a wake up call to the lender/s and their industry.
The lender/s learns to strengthen his systems, policies, and his institution when he goes through a major restructured account. He has to or he will get hit again. The lender’s industry learns to police itself or to close ranks and assist each other in difficult times.
3) Many major accounts in any industry that are restructured are a wake up call to the country
This has happened unfortunately, in several industries and in several countries, often with very painful consequences.
4) By the same token, other companies in the borrower’s industry will also experience a wake up call
If the account being restructured is an industry leader, then they may have real cause to worry. They may be doing something wrong or they may be doing something right, which can only be proven if they either go into restructuring also or they stay afloat longer than the one who is undergoing the restructuring. Then they need to either revisit or strengthen their own systems, control measures, etc., so that they don’t go into the same path.
VIII. What happens after a successful restructuring is done?
Everybody happy?
Well, maybe not all. Some are bound to lose a little; some are bound to get more than the guy in the next seat. In multi-institutional debt restructuring and especially in cases where the best assets are held by a few lenders and the others are on a clean basis, no matter how hard the leader tries in obtaining parity for each and every lender, there will sometimes be some unhappy lender who feels he did not get the best deal for his institution. In cases like this, it becomes a very arduous task to please all the secured lenders and the unsecured lenders. Ray Davis further said “The best restructurings are the ones where everyone goes away unhappy but still agreed to do the deal”.
Bottom line, restructuring is never easy, never without conflict of some sort and never without pain. This is probably why restructurings are called WORKOUTS. They are tough, they are demanding in terms of discipline, focus and patience, they drain you physically and mentally. But it can be very rewarding and fulfilling to those who persevere.
Published in the Philippine Star, October 30, 2007
( Vicente J. Sarza is a Principal for Business & Financial Advisory Services of Manabat & Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email manila@kpmg.com.ph or vsarza@kpmg.com.)
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