1. 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

2. 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 $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

3. 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%.

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

5. The Purchase Price for RJRN
$24,589 Paid for Common Stock
Paid for Preferred Stock
1, Total Fees Incurred
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.

6. 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

7. 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

8. 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

9. 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?

10. The Purchase Price for RJRN
$24,589 Paid for Common Stock
Paid for Preferred Stock
1, Total Fees Incurred
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, Increasing Rate Loans
$ 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

11. 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

12. 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!

13. 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

14. 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.

15. 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.

16. 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.

17. 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
Goodwill 0
Total Assets $ 1,100
Post-petition DIP Financing $ $ 300
Liabilities Subject to Compromise 1,100
Common Stock (Old Equity) Retained Earnings (700)
Total Liabilities & Equity $ 1,100

18. 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: $ *
+ 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.

19. 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) $
New Debt 500
New Equity 350
$ 1,150

20. 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.

21. 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

22. 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) $
New Equity $ = ($350 × 0.14)
Gain (IS) 351 (plug)

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

24. ‘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

27. 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.

28. (Pre-petition liability claim adjustments)