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Questions and Answers
What triggers a default in debt contracts?
What triggers a default in debt contracts?
Debt restructuring involves the renegotiation of existing debt contracts only to change their interest rate.
Debt restructuring involves the renegotiation of existing debt contracts only to change their interest rate.
False
Debt restructuring is suitable for firms facing ______________________________ distress.
Debt restructuring is suitable for firms facing ______________________________ distress.
pure financial
Match the following debt restructuring procedures with their characteristics:
Match the following debt restructuring procedures with their characteristics:
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What are the key features of Chapter 11 bankruptcy?
What are the key features of Chapter 11 bankruptcy?
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What are the consequences of coordination problems in debt restructuring?
What are the consequences of coordination problems in debt restructuring?
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Lenders can be 'soft' by increasing interest payments or collateral.
Lenders can be 'soft' by increasing interest payments or collateral.
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The two main procedures for debt restructuring are ______________________________ and formal bankruptcy.
The two main procedures for debt restructuring are ______________________________ and formal bankruptcy.
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What is the main purpose of a Leveraged Buyout (LBO)?
What is the main purpose of a Leveraged Buyout (LBO)?
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LBOs are considered low-risk investments.
LBOs are considered low-risk investments.
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What is a key characteristic of a good LBO target?
What is a key characteristic of a good LBO target?
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The typical holding period for an LBO investment usually ranges from __ to __ years.
The typical holding period for an LBO investment usually ranges from __ to __ years.
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What is the primary goal of an LBO sponsor?
What is the primary goal of an LBO sponsor?
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Match the following famous examples of LBOs with their respective acquirers:
Match the following famous examples of LBOs with their respective acquirers:
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Management fees in private equity funds are typically 5% of funds under management.
Management fees in private equity funds are typically 5% of funds under management.
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What was the outcome of Eurotunnel's financial restructuring efforts?
What was the outcome of Eurotunnel's financial restructuring efforts?
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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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