Debt Restructuring and Financial Distress

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Questions and Answers

What is debt restructuring?

The process of securing new debt to pay off existing debt

The process of filing for bankruptcy

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

The process of liquidating assets to pay off debt

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 Signup and view all the answers

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 Signup and view all the answers

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

No judge intervention Signup and view all the answers

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

False Signup and view all the answers

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

Bank runs or holdout problems Signup and view all the answers

What is the primary purpose of an LBO?

To acquire a company using a significant amount of borrowed money Signup and view all the answers

LBOs are considered low-risk investments.

False Signup and view all the answers

What are the typical sources of financing for an LBO?

Equity from the sponsor and a significant amount of debt raised from banks Signup and view all the answers

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

bankruptcy Signup and view all the answers

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 Signup and view all the answers

What is the typical holding period for an LBO investment?

5 to 7 years Signup and view all the answers

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

False Signup and view all the answers

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. Signup and view all the answers

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.

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Description

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