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Debt Restructuring and Financial Distress

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What is debt restructuring?

The renegotiation of existing debt contracts to change their characteristics or converting debt into equity

A firm in economic distress is a suitable candidate for debt restructuring.

False

What are the two main procedures for debt restructuring?

Private workout and formal bankruptcy (Chapter 7 or Chapter 11)

Default occurs when a firm fails to make scheduled payments or violates debt ______________________.

covenants

Match the following debt restructuring procedures with their characteristics:

Private Workout = Lower legal and professional fees, shorter duration, no information leakage, and no judge intervention Formal Bankruptcy (Chapter 11) = Debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge

What is a benefit of a private workout compared to formal bankruptcy?

No judge intervention

Lenders can be 'soft' by increasing interest payments or collateral during debt restructuring.

False

What is an example of a coordination problem in debt restructuring?

Bank runs or holdout problems

What is the primary purpose of an LBO?

To acquire a company using a significant amount of borrowed money

LBOs are considered low-risk investments.

False

What are the typical sources of financing for an LBO?

Equity from the sponsor and a significant amount of debt raised from banks

The high level of debt in an LBO creates a risk of ______________________.

bankruptcy

Match the following characteristics with the type of LBO target:

Resilient cash flows = Good LBO target Strong earnings history = Good LBO target Market-leading position = Good LBO target High debt = Bad LBO target

What is the typical holding period for an LBO investment?

5 to 7 years

The outcome of Eurotunnel's financial restructuring efforts was successful.

False

What is the basic principle behind LBOs?

Sponsors aim to achieve high returns on equity by acquiring a target with significant leverage, paying back debt using the target’s dividends, and exiting at a higher value.

Study Notes

Debt Restructuring

  • Debt restructuring involves renegotiating existing debt contracts to change characteristics (e.g., interest rate, maturity) or converting debt into equity.

Default and Financial Distress

  • Default occurs when a firm fails to make scheduled payments or violates debt covenants.
  • Direct costs of financial distress include lawyers' fees, consultant fees, and transaction costs to liquidate assets.
  • Indirect costs involve reluctance from non-financial stakeholders to do business with the distressed firm.

Applicability and Procedures

  • Debt restructuring is suitable for firms facing pure financial distress (temporary payment issues), but not for those in economic distress (negative NPV projects or declining performance).
  • Two main procedures for debt restructuring: private workout and formal bankruptcy (Chapter 7 or Chapter 11).

Private Workout vs. Formal Bankruptcy

  • Private workouts have lower legal and professional fees, shorter duration, no information leakage, and no judge intervention.

Chapter 11 Bankruptcy

  • Under Chapter 11, debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge.

Lender Behavior and Coordination Problems

  • Lenders can be "tough" by increasing interest payments or collateral or "soft" by reducing interest or principal amounts and extending maturity.
  • Coordination problems in debt restructuring include bank runs and holdout problems, where creditors might not cooperate or rush to claim their share.

Case Study: Eurotunnel

  • Despite multiple restructurings, Eurotunnel remained over-indebted, leading to a significant debt buy-back strategy and eventual placement under judicial protection in 2006.

Leveraged Buyouts (LBOs)

  • An LBO is the acquisition of a controlling interest in a company using a significant amount of borrowed money (debt) along with equity from the sponsor.

Financing and Characteristics

  • Financing typically includes equity from the sponsor and a significant amount of debt raised from banks.
  • LBOs are considered high-risk but potentially high-reward investments, with the high level of debt creating a risk of bankruptcy.

Target Characteristics and Exit Strategies

  • Good LBO targets have resilient cash flows, strong earnings history, market-leading position, growth potential, and strong management.
  • Exits can be through an IPO, sale to another LBO fund, or a trade sale.

LBO Principles and Leverage

  • Sponsors aim to achieve high returns on equity by acquiring a target with significant leverage, paying back debt using the target’s dividends, and exiting at a higher value.
  • Leverage increases ROE by magnifying returns from equity investment, but it also increases the risk of financial distress.

Examples and Holding Period

  • Famous examples of LBOs include KKR's buyout of RJR Nabisco and Blackstone's acquisition of Hilton Hotels.
  • The typical holding period for an LBO investment ranges from 5 to 7 years, during which the debt is paid back and the target is prepared for exit.

Private Equity Fund Management

  • General Partners charge 1.5%-2% management fees on funds under management and 20% carried interest, provided the hurdle return (often 8% per annum) is exceeded.

Understand debt restructuring, default triggers, and costs of financial distress. Learn how to renegotiate debt contracts and manage financial difficulties.

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