Since the world is falling apart we figured we would put something like this together. Thanks to our many friends in RX.
NOTE: This is a work in progress and the questions are scattered. A lot of these questions are more advanced than what you would see in a restructuring interview, but can be good for building up your understanding. We will edit this later to have more easy, entry-level questions.
Restructuring Market Questions
What’s going on right now in capital markets (restructuring)?
Equity markets are mostly closed and companies are reluctant to issue today given the extreme dilution to shareholders. There are exceptions such as Carnival Cruise Lines, where they need the money that badly (I don’t know a lot of people hopping on cruises given recent history).
Debt capital markets are closed except to strong investment grade issuers who are rushing out to raise today in order to have liquidity to ride out this storm.
Leveraged finance yields have blown up, spreads are extremely wide versus risk-free government bonds. In fact, government bond yields have actually decreased owing to monetary policy and a flight to safety.
Leveraged finance DCM issuance is closed except for the most quality (good liquidity, cash flow) borrowers. Yum! Brands, Restaurant Brands International and Wynn Resources have all priced deals lately.
Risk premiums on CCC bonds have blown out the widest since 2009 while banks are preparing to take over the keys of some distressed oil and gas companies instead of selling in a down market.
How are buy-side investors responding to the COVID-19 crisis?
Plenty of funds who have stayed on the sidelines before are looking to raise fresh capital and dry powder for cheap valuations.
The 2-20 model that was dying (has been 1-15 lately) now has a reason to start up – picking the right hedge fund during this time has given incredible returns in a time of distress while many long, long-shorts (who are really long) and other strategy hedge funds have been wiped out, especially if they were levered.
What industries are most vulnerable to restructuring during COVID-19?
Leisure & travel, consumer discretionary and retail, oil and gas, airlines, live entertainment (Live Nation), commercial real estate (office, retail), anything with a lot of leverage.
What industries are in good shape during COVID-19?
Healthcare, technology (especially cloud), grocers, warehousing and storage, sales & trading!
What are more interest rate sensitive? Investment grade bonds or high yield bonds?
Investment grade bonds tend to trade more closely with the reference risk free security (same duration or interpolated US Treasuries). High yield bonds are priced more off of their individual credit profile and what constitutes an acceptable return on investment.
Duration and convexity are more associated with less risky bonds.
Why are oil prices down?
No one needs to drive a car or get on a plane or make plastic (petrochemicals).
Leveraged Finance Interview Questions
What is a discounted offering?
Bonds are usually issued at par with the coupon being the market clearing yield for the company – however when bankers see the OID or original issue discount, this means that the bond was issued at a discount to achieve a lower coupon.
It is structured to have lower debt service requirements for the duration of the bond.
What are some characteristics that will determine how debt will price?
Maturity and term structure – in theory, if a bond has a nearer maturity than another series, it has a higher certainty of being paid provided that there is enough liquidity for the company. If the company is going to default before that maturity, then it should in theory be trading the same as the longer dated bond.
Collateral – If certain assets are ring fenced for a particular class of debt, they will generally realize stronger recoveries than unsecured creditors
Seniority – If higher on the capital stack (senior unsecured versus expressly subordinated notes), expect the senior notes to trade closer to par.
If the noteholder is allowed to put the bond if there is a credit rating event (downgraded to BB+ or lower), should it trade with a tighter or wider coupon?
It should trade tighter – this is an option to the benefit of the bondholder. Many institutional investors cannot hold sub-investment grade debt and this is an out for them if credit quality deteriorates.
Restructuring Investment Banking Questions
Would you include other distressed companies in your market trading comparables?
No, you want to see what a healthy company looks like in terms of ascertaining your value.
What is value break/where is the fulcrum security?
This is the tranche of the capital stack where the security will not get full recovery as valued.
As a simplified example, if a corporate is valued at $300 million and there is $100 million of secured bank debt, $300 million of unsecured bonds and $100 million of subordinated convertibles, value breaks at the bonds and they will in theory only be worth 200/300 or 67 cents on the dollar. The subordinated convertibles are worth nothing in this example (or option value).
What is Value Break?
Value breaks at the fulcrum security. The higher priority debt will get full recoveries.
A cyclical company has EBITDA of $100 million and has $500 million of debt. If healthy peers are trading at 4x EBITDA, where should the debt be priced?
Ignoring bankruptcy dynamics and liability management options for the company to pull, you would expect the debt to be trading no more than 80 cents on the dollar. This is obviously an oversimplification
$100 million x 4x = $400 million enterprise value/$500 million face value of debt. In reality there should be deeper discount owing to investing frictions and complications to equitizing the debt or selling the company to realize the recovery.
If the debt is separated into a secured 1L $200 million bank revolver and $300 million in senior unsecured notes (SUNs), where does each tranche of debt trade?
The $400 million covers the full $200 million bank debt (assuming it is fully drawn) and the waterfall of payments means they will see full recovery. This leaves $200 million for the $300 million of SUNs and results in the notes trading around 66 cents.
What are some ways to spot distressed companies? What are some signs that a company may be distressed?
- Stock is trading under a dollar
- Market capitalization is less than 15% of enterprise value
- Very high yield-to-worst (YTW) or market value of debt well below par when risk free interest rates have not moved that much
Where are some areas that you would look at in terms of normalizing EBITDA for a distressed company?
- Above market leases (rents in better times)
- Non-recurring costs
- Restructuring related costs/professional fees (auditors, lawyers, restructuring consultants like AlixPartners, investment bankers)
- Bloated cost of goods sold from vendor issues (compare to a healthy company’s EBITDA margins)
- Above market salaries
To whom does a corporation have a fiduciary duty to?
In most cases when the company is a healthy going concern, the fiduciary duty is to the shareholders. This is why bondholders need to have covenants in place as protections – a court of law has repeatedly ruled in favor of the company when taking shareholder friendly actions in detriment to the bondholders. This is why covenants are so heavily negotiated – creditors do not see any upside when the company does well (unless it is an equity linked instrument) while management does not want to be constrained in terms of what they can do. The weaker the credit, the more elaborate the covenants (in theory).
However, when the equity has no value / value breaks in the debt stack of the capital structure, the company then has a fiduciary duty to the noteholders as well (who are arguably the new equity or shareholders, while the common equity holds option value at best).
What are some ways to assess if a company may or may not require a restructuring?
Liquidity – this is key in leveraged finance and restructuring. How much cash it has, how much bank revolver space it has, when the bank revolver maturity is, what the upcoming term debt maturities are, and how much cash it is burning.
Some companies with better businesses but near term large bond maturities coming up when capital markets are closed may be in much more trouble than terrible cash burning companies with maturities kicked out and a lot of room on their revolver as they can pray that capital markets open again or their business improves before then.
If the balance sheet needs to be right sized – if the debt capacity of a company is 500 million based on its cash flows, but it has $1 billion of debt, this level is not sustainable. This may be because of a shift in business environment or a fundamental change in the industry – if the business cannot adjust, it will need to restructure. For some industries that are dying (newspapers), a restructuring may not be the right solution versus a liquidation of assets for salvage value as the business may be worthless.
Some red flags are stretched accounts payables (days payables outstanding) which means they are being selective with which trade creditors they are paying and full drawdown of their revolver as they want to have ample cash and flexibility going into bankruptcy. Some loan documents will have anti-hoarding language specifically to prevent this – so there needs to be a legitimate business purpose for every draw (e.g. general corporate purposes)
Who can a financial adviser/advisor (investment bank) represent?
You can represent the debtor or a creditor class. Usually, investment banks will prefer the debtor mandate because the fee is usually negotiated to be based on the total debt value (which may exceed the enterprise value) versus a creditor class, where the fee is based on the quantum of debt outstanding for that creditor constituency.
So for example, if the company has $100 million of bank debt, $300 million of unsecured notes and $100 million of subordinated junior debt and the unsecured notes hire their own financial advisor, the debtor advisor will get paid based on $500 million and the creditor advisor will get paid on $300 million.
Also, should there be any asset sales or other corporate finance activity, usually the debtor side investment bank will get that mandate.
Usually, the company has to pay the financial advisor and legal advisor fees for the relevant creditor class.
Sometimes, more than one creditor class can hire a financial advisor/investment bank if it is less clear where value breaks/where the fulcrum security is.
You are putting together an overview presentation to analyse a special situations scenario for your team to look at – what goes into the pitch book / internal deck so that the senior bankers can get up to speed quickly?
- Overview of current special situation and liquidity event
- Corporate organizational chart (org chart) and where assets, liabilities and operations are located
- Historical key events and traded security prices – stock price, various series of notes perhaps annotated with aforementioned key events
- Historical financial analysis – last 5 years of financials highlighting cash flow, leverage, key operating drivers and industry trends
- Cash flow projections and liquidity event (bond maturity, interest payment, covenant breach) – can be scenarios analysis and sensitivities done
- Industry outlook (can be in the front as well as per normal investment banking but can also be in back or appendix for RX as it may be firm specific risk)
In-Court versus Out-of-Court Restructuring Questions
Why is an out-of-court restructuring or liability management preferred over Chapter 11?
It is generally preferred to in-court restructuring or Chapter 11. It is much cheaper (multiple lawyers and financial advisers/investment bankers fighting in court with corresponding professional fees can erode the value of the estate) and less time consuming as well as less negative press for a company’s operations. No dirty laundry is aired in courts.
Key customers and vendors are less likely to change payment terms and become restricted if the company’s details show up in a bankruptcy filing and regular news reports.
What is more likely to be settled out of court, a distressed company with a simple capital structure or a complex capital structure?
Simple capital structure as it is an easier negotiation. With a complex capital structure with various classes of debt, junior debt and equity, it is far more difficult to get everyone together and find a solution that appeases everyone – increasing the risk of holdouts.
There are also restrictions on what can be done because of the covenants of each tranche of debt.
What are some reasons to go with an in-court process?
Avoiding hold outs, options such as a cram down and the repudiation of onerous contracts.
How do you get to a settlement in an out-of-court restructuring?
In out-of-court RX, firm and major creditors (fulcrum security) discuss liability management solutions.
Ultimately there has to be a solution that works for everyone and shareholders and out of the money bondholders/junior creditors must be given a tip so to speak. Otherwise they can make the situation difficult, torpedo the discussions (as holdouts) and force an in-court restructuring.
What are some out of court restructuring solutions?
New money refinancings – can be someone injects new capital and some of the debt is redeemed for equity (see debt-equity swap).
Complete equitization may be required for firms that do not have current cash flow.
Can also involve cash (pay off a portion of the bonds – not necessarily at par, while the rest of the bonds stay in the capital stack).
Why would you perform a liquidation analysis?
It may be for the best interests test to demonstrate that no junior creditor would be worse off than in a liquidation scenario in order to enforce a cram down.
Generally speaking, a liquidation value will be lower than a continuing business, owing to factors including fire sale prices (both from investors wanting a deeper discount and the urgency of the seller) and costs of brokerage
What is a cram down?
Bankruptcy court involuntarily imposes the plan of reorganization over the objections of certain creditor classes.
In a plan of reorganization, who would prefer a lower valuation?
Senior creditors would prefer a lower valuation as it increases their share of the reorganized entity. The plan value may be very different from the actual true value of the company.
If a company has $300 million of senior debt and $200 million of junior debt, a plan value of $400 million with $200 million of debt could mean that the senior noteholders get all the debt and half the equity. A plan value of $600 million means that the senior debtholders may only get 1/3 of the equity. Conversely, junior creditors will push for a higher plan value.
The creditor mix also will determine their willingness to take equity versus new debt. Hedge funds, private equity and distressed specialists will generally be more willing to take equity. Traditional asset managers will want new debt.
Chapter 11 bankruptcy is reorganization – what is Chapter 7 bankruptcy?
Chapter 7 involves orderly liquidation.
Who would prefer Chapter 7?
An overcollateralized secured creditor who does not want value erosion via a bankruptcy process. Or if the business is at risk of obsolescence and stakeholders would be better off under a prompt liquidation rather than letting it drag out and being eaten up by lawyer and court fees.
What is a preplanned bankruptcy?
Key stakeholders (the potential fulcrum securities) have agreed upon a plan of reorganization before entering bankruptcy. This streamlines the process as opposed to a free fall bankruptcy where there is no plan and can drag out, eroding lots of value in the court process.
What is DIP financing?
Super-senior postpetition financing. Senior lenders prepetition often position themselves to become debtor-in-possession lenders.
Liability Management Interview Questions
Liability management is a key part of understanding corporate restructuring. This may be a standalone division in an investment bank.
What is a par-for-par exchange?
Par-for-par exchange – a bond can be exchanged for new consideration of notes.
As a sweetener, the bonds can offer a higher coupon, longer dated maturity (if it does not fix underlying problems, this may amount to kicking the can down the road), equity warrants – so bondholders can get derivatives of the company which may be immediately sold – effectively juicing the yield, or a switch to payment-in-kind or PIK interest.
Ultimately, if value is not assessed properly when the restructuring finishes again, the balance sheet has not been properly rightsized and there may be another restructuring down the horizon.
Depending on the terms of the transaction, credit rating agencies may deem it to be a distressed transaction and declare it to be a default (of which there are varying levels)
What is an uptier exchange?
An up-tier exchange is when a bond issuer offers a lower principal amount (and possibly interest) for more seniority in the capital structure.
A typical transaction could be AubreyCo offering its unsecured noteholders with $1,000 million of principal outstanding maturing 2025 a 40-100 exchange for second lien (2L) notes up to $600 million of total principal due 2027 (usually will be 2L or 1.5L as the banks will not let them get in front or be pari passu).
This is not necessarily viewed as an event of default (EoD) by the rating agencies if they consider it to be opportunistic and not inherently to stave off a bankruptcy (distressed transaction). Remember, the fiduciary duty of a company’s management is to its shareholders, not bondholders or employees.
This can be a way to reduce debt, reduce interest payments, reduce the amount of debt affected by covenants and kick out maturities.
Bondholders have to be careful to see how much of a basket of debt is allowed ahead of their debt in making an investing decision.
What could incentivise creditors to take up an up-tier exchange instead of being a holdout?
- Reduced liquidity of remaining original issue
- Early tender incentives offering more principal
- Tenders may require a 90% or other threshold so they cannot free ride
Debt for equity exchange or debt-equity swap?
A company can offer to exchange bonds for a certain % of the equity in the company.
What are some other liquidity management solutions to stave off distress and bankruptcy?
- Covenant waivers
- Obviously this cannot continue in perpetuity if the company just asks creditors to waive each time it is likely to breach its covenants
- Distressed debt repurchases
- An offer to buy back debt at a much reduced price to par
- Can be privately negotiated with creditors through a broker or discreetly on the open market
- Companies that are very distressed may avoid this to save cash and go into bankruptcy instead to preserve liquidity
- Subordinated repurchases may be limited by the revolver covenants
What is a coercive exchange offer?
Exchange offer that makes holdouts or non-participating creditors worse off or at the risk of being worse off as opposed to a non-coercive exchange offer which includes a sweetener
Restructuring and Bankruptcy Dynamics Questions
What may a corporate do right before they declare bankruptcy?
They will often fully draw on their revolvers so that they have cash and liquidity to breathe during their Chapter 11. Banks hate this, obviously. Revolving credit facilities may have anti-hoarding language to prevent this, so that banks may attain debtor-in-possession status during postpetition financing.
Does the management always only have a fiduciary duty to shareholders?
When a company is obviously in bankruptcy and the equity value is zero, management has a fiduciary duty to creditors as well (who are theoretically the new equityholders).
What happens if a potential debtor looking to restructure does not choose your bank?
You can pitch the creditors. The creditors’ adviser is paid for by the debtor, but the success fee is usually less as a percentage and the quantum of the capital stack you are representing is smaller (versus the entire estate for the debtor advisor).
The debtor side adviser would be the first choice in arranging private capital solutions or leading a distressed M&A or asset sale mandate for the company.
What is a standard required rate of return on distressed debt that goes into workout situations?
30% is often industry standards – distressed debt funds use this as a discount rate for workout situations which are usually short duration in nature (a few years max).
When does bank debt start to exit the capital structure?
Banks usually stay put because of their senior position and the debt is illiquid and thinly traded. Once a company becomes more distressed, they generally want to avoid workout situations and loan sales are auctioned off to hedge funds and other market participants well below par.
Capitalization Table Questions
If the enterprise value of the company is less than the face value of the debt, why is the equity market capitalization still positive (the shares still trade above zero)?
At some point equity value becomes option value as the theoretical equity value is zero. The securities in theory are priced based on the probability weighted outcomes. So while if there was a liquidation today, the equity is ascribed a value of zero, in theory if there is a 10% chance that there is equity value if the economy picks up or some major order goes through, the equity should be the probability weighted value of that outcome. Of course it is often mispriced.
When can you see a mispricing in the market?
Often times there is a mispricing in the market – either the equity is mispriced or the debt is. Or they both are, once institutional investors start running away.
A good example is a robust trading value for the equity in terms of market cap but the bonds are trading like they are going to go bankrupt.
If bonds are senior to equity and equity is trading at healthy levels, in theory the bonds should be at par. If the bonds are senior to the equity and the bonds are trading distressed, the equity should be trading at option value.