Robert Bushman Complex Deals Class 10 RJR Nabisco Deal structuring in the face of significant default risk Structural subordination of debt claims Fresh Start Accounting: Emergence from Bankruptcy Bankruptcy and Acquisition Accounting Structure of Fresh Start Reporting

RJRN LBO: Distress Risk as a Determinant of Deal Structure Consideration: $81 In Cash 18 Group Preferred Stock 10 Senior Converting Debentures $109 Total Per Common Share Deal stage 1. The Tender Offer  74% of RJR’s common @ $109per share in cash => Total Cash Outlay = $18,169,000,000 Deal Stage 2. The Merger Each remaining RJR common share ( 26%) gets: Shares of Group Preferred Stock (this is actually more like debt than equity) Senior Converting Debentures

How do we reconcile these mechanics with the final deal terms described above? Did some shareholders get all cash and others just securities? The answer is that a pro-rata distribution occurred: In the tender offer close to 100% of RJR's shares were tendered. So KKR accepted 74% of each shareholder's tendered shares and paid cash for them. This coincides with the fact that 74% of the total payment in the final deal is cash. That is, $81/$109  74%.

The Purchase Price for RJRN $24,589 Paid for Common Stock 135 Paid for Preferred Stock 1,100 Total Fees Incurred 254 Other $26,078 Total Pro-Forma Purchase Price Purchase Price $26,000 Pre-Deal Market Cap <12,000> $14,000 What does this mean?

The Purchase Price for RJRN $24,589 Paid for Common Stock 135 Paid for Preferred Stock 1,100 Total Fees Incurred 254 Other $26,078 Total Pro-Forma Purchase Price Purchase Price $26,000 Pre-Deal Market Cap <12,000> $14,000 Paid more than double the pre-deal market cap!! => KKR has to more than double the expected future cash flows generated by RJRN to simply break even on their equity investment! Think about the perceived risk of the deal not meeting this incredible threshold.

The Acquisition Vehicle: Four Corporate Shells RJRN Holdings Stock of RJRN Holdings $1500 (KKR LBO Fund) 100% of Group cash RJRN Group $1500 Equity 100% of Capital RJRN Capital $1500 Equity 100% of Acquisition The Target RJRN Acquisition $1500 Equity RJR Nabisco $1,500 in cash

Financing the Tender Offer RJRN Holdings Equity $1500 100% of Group RJRN Group Debt Financing at Capital $11,925 Tender Offer Bank Credit 5,000 Increasing Rate Loans 500 Partnership Debt (756) Fees $16,669 100% of Capital RJRN Capital cash 100% of Acquisition RJRN Acquisition RJR Nabisco $16,669 Debt $ 1,500 Equity $18,169 Cash 74.5% of RJRN RJR Shareholders

The Merger and Issuance of “the paper” Holdings RJRN Holdings Equity $1500 9% of RJR 9% of RJR $2,259 Senior Converting Debentures To RJR Shareholders in exchange for 9% of RJRN stock 100% of Group 100% of Group Group Preferred Stock is exchangeable, solely at the option of Group, into Subordinated Exchange Debentures of Group. Group Preferred Stock is not exchangeable or convertible at the option of the holder. It is basically debt! Group RJRN Group 16.5% of RJR 16.5% of RJR $4,067 Group Preferred Stock To RJR Shareholders in exchange for 16.5% of RJRN stock 100% of Capital 100% of Capital Capital RJRN Capital $11,925 Tender Offer Bank Credit $5,000 Increasing Rate Loans $500 Partnership Debt 74.5% of RJRN 74.5% of RJR Acquisition Merges Into RJR Nabisco

Why would KKR choose this structure to carry out the deal Why would KKR choose this structure to carry out the deal? What do they gain? Why not a single shell where debt contracts are contractually prioritized?

The Purchase Price for RJRN $24,589 Paid for Common Stock 135 Paid for Preferred Stock 1,100 Total Fees Incurred 254 Other $26,078 Total Pro-Forma Purchase Price Purchase Price $26,000 Pre-Deal Market Cap <12,000> $14,000 Debt Financing of Deal $11,925 Tender Offer Bank Credit $5,000 Increasing Rate Loans $500 Partnership Debt $2,259 Senior Converting Debentures $4,067 Group Preferred Stock $23,751 Total Debt Ability to pay-off debt depends on $12,000 of these new cash flows actually materializing!! If not, they will have to default on some of their debt payments

Assets = Liabilities + Owners’ Equity Aspects of Credit Risk Assets = Liabilities + Owners’ Equity What is the risk of asset values falling enough to cause creditors to start eating losses? Residual claimholders Eat the first losses, before debt But this is very thin in RJRN deal! Credit Risk can be conceptualized in terms of Expected Losses Probability of Default * Loss Given Default

Structural Subordination: Reducing the Probability of Bankruptcy + = $6,326 = $17,425 Purchase Price $26,000 Pre-Deal Market Cap <12,000> $14,000 Capital’s Debt $17,425 $ 5,425 RJRN has to generate $17,425 to satisfy debt claims and avoid bankruptcy at RJRN Capital. Pulling $6,326 in financing out of Capital reduces the probability of bankruptcy at Capital. Deal only has to generate $5,425 in excess of pre-deal market cap to protect Capital’s lenders!

Bankruptcy and Acquisition Accounting Consider 2 Possibilities Auction Debtor Firm Reorganize Debtor Firm (i.e., Chapter 11) - Sell Firm Via Auction - Court Mediated Valuation Distribute Proceeds to creditors - Settle pre-petition claims based on priority - Equity of survivor firm given to debt-holders Auctions involve an arm’s length sale of the firm to an acquirer => acquirer applies acquisition accounting to the deal. Companies can be acquired directly out of Chapter 11 ( Deal voted on using voting rules of Chapter 11). 363 Asset Sales. Basically an auction of the assets that circumvents the plan of reorganization process. Requires only approval of Bankruptcy Judge. Reorganizations can also generate control changes: Debt-holders may gain control by taking over equity in surviving firm

Emerging from Bankruptcy: Financial Reporting The central feature of the Plan of Reorganization is to determine and compute the Reorganization Value (RV) of the firm. RV is the enterprise value of the firm (i.e., size of the economic ‘pie’). RV is the amount of assets available to satisfy all classes of allowed bankruptcy claims RV determined through an extensive, adversarial valuation process: Consideration of the amount to be received for assets that will not be needed by the reorganized business. Computation of the present value of cash flows that the reorganized business is expected to generate for some time into the future. Computation of the terminal value of the reorganized business at the end of the period for which cash flows are estimated.

Emerging from Chapter 11: Financial Reporting Plan of Reorganization accepted and approved by court => firm emerges. Under specific circumstances the firm will use Fresh Start Accounting Fresh Start Accounting is very similar to accounting for business combinations. Treats emerging firm as an entirely new entity. To use Fresh Start Accounting, the following two criteria must be met: RV < Post-Petition Liabilities + Allowed Pre-Petition Liabilities Old equity holders receive < 50% of new equity in entity emerging from Chapter 11.

Fresh Start Accounting Fresh Start Accounting treats the emergent company as if it were acquired for purchase price = Reorganization Value (RV) Tangible and separately identifiable intangible assets of emerging entity recorded at their fair values. Any excess of RV over the fair value of identifiable assets is Goodwill All post-petition and secured liabilities of emerging entity recorded at the present value of amounts to be paid.

Fresh Start Accounting: An Illustration Balance sheet of firm prior to confirmation of Reorganization Plan by court: Book Fair Value Value Cash $ 200 $ 200 Other Assets 900 960 Goodwill 0 Total Assets $ 1,100 Post-petition DIP Financing $ 300 $ 300 Liabilities Subject to Compromise 1,100 Common Stock (Old Equity) 400 Retained Earnings (700) Total Liabilities & Equity $ 1,100

Use Fresh Start Accounting? Criterion 1 RV < Post-Petition Liabilities + Allowed Pre-Petition Liabilities? From the Reorganization Plan: RV = $1,300 < $300 + $1,100, so condition 1 of fresh start is met. Excess Assets to be Distributed: $ 150* + Value of Assets to be Retained: 1,150 = Reorganization Value: $ 1,300 *Excess assets are those assets deemed unnecessary to successful future operations of the reorganized company. These excess assets will be distributed to creditors as part of the plan of reorganization.

Use Fresh Start Accounting? Criterion 2 Old equity holders receive < 50% of new equity? New capital structure outlined in the Reorganization Plan is as follows: Pre-petition creditors get 86% of new equity, $150 in cash & $500 new debt Old equity holders receive remaining 14% of new equity. Change in ownership is over 50%, so condition #2 of fresh start is also met. Exit Financing (refinance DIP loans) $ 300 New Debt 500 New Equity 350 $ 1,150

Accounting for Emergence: 3 Main Entries Fresh Start Revaluation Entry Adjust Assets and Liabilities to fair value, booking any gains/(losses) on the revaluation in the last income statement of the Old Company. Debt Discharge Entry Make entry to record debt discharge per the plan of reorganization and record Gain on Debt Discharge as an extraordinary item in last income statement of the Old Company. Cancelation of Old Entry Record entry to cancel old equity of Old Company. GOAL: Create the opening balance sheet of the New Company by reflecting the terms of the Plan of Reorganization and Fresh Start Accounting.

Fresh Start Entries: Revaluing Net Assets, Establishing Goodwill Fresh Start: The Purchase Price Allocation: Corresponding journal entry: Reorganization Value (RV): $ 1,300 – Book Value of Identifiable Assets: (1,100) (Balance Sheet) – Step-up of Identifiable Assets: (60) (Other Assets $900 to $960) = Goodwill: $ 140 Goodwill $ 140 Other Assets 60 Fresh Start Adjustment Gain (IS) $ 200

Debt Discharge & Cancel Old equity: Journal Entries Liabilities Subject to Compromise $ 1,100 Cash (excess cash paid to creditors) $ 150 New Equity 301 = ($350 × 0.86) New Debt 500 Gain on Debt Discharge (IS) 149 (plug) For debtors in bankruptcy, taxes payable due to gains on debt discharge at emergence can be deferred to later periods. Generally, the deferral of income requires a respective reduction of the debtor's tax basis in assets and/or other tax attributes such as loss carry-forwards. Cancel Old Equity 3) Cancel Old Equity Common Stock (Old Equity) $ 400 New Equity $ 49 = ($350 × 0.14) Gain (IS) 351 (plug)

Fresh Start Balance Sheet Predecessor Adjustments Successor Cash $ 200 ($150) $ 50 Other Assets 900 60 960 Goodwill 0 140 140 Total Assets $ 1,100 $ 50 $ 1,150 Post-Petition Debt $ 300 – $ 300 Liab. Sub. to Compromise 1,100 ($1,100) – New Debt – 500 500 Common Stock 400 (50) 350 Retained Earnings (700) 700 0 Total Liabilities & Equity $ 1,100 $ 50 $ 1,150

‘Clean Slate’ Retained Earnings Pre-confirmation Retained Earnings: ($700) + (1) Fresh Start Adjustment Gain: 200 + (2) Gain on Debt Discharge: 149 + (3) Gain on Cancellation of Old Equity 351 = Fresh Start Retained Earnings $ 0

e. Reflects the issuance of new Successor Company common stock to pre-petition creditors, the cancellation of old common stock and treasury stock, and the gain on the discharge of liabilities subject to compromise. g. Reflects changes to the carrying values of assets and liabilities to reflect fair values. h. Reflects the elimination of historical accumulated deficit and other equity accounts and an adjustment to shareholder’s equity to result in the estimated reorganized equity value.

(Pre-petition liability claim adjustments)