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Review of Corporate Financial Restructuring
Prof. Ian Giddy New York University
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Corporate Financial Restructuring
Why Restructure? Proactive Example: Sealed Air Defensive Example: Loewen 1996 Distress Example: Loewen 1999 Management acts to preserve or enhance shareholder value Management acts to protect company, stakeholders and management from change in control Lenders and shareholders lose, but try to work out best way to minimize loss
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Corporate Financial Restructuring
Corporate restructuring – business and financial Structured financing techniques Proactive restructuring Distress-induced restructuring Mergers, divestitures and LBOs
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A Simple Framework A company is a “nexus of contracts” with shareholders, creditors, managers, employees, suppliers, etc Restructuring is the process by which these contracts are changed – to increase the value of all claims. Applications: restructuring creditor claims (Conseco); restructuring shareholder claims (AT&T); restructuring employee claims (UAL)
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TDI “Nexus of Contracts” Franchisors Senior lenders
Subordinated lenders Salespeople TDI Management Shareholders
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Examples SAP – upgrading shareholder control rights Sealed Air – exploiting free cash flow Marvel – post-bankruptcy negotiations Westpac – structured finance Novartis – merged and divested Alphatec – rescuing residual value
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Novartis: Financial Restructuring
Fixed the cash and working capital Fixed the capital structure Assets Liabilities Cash Debt Equity Fixed Assets Divested Non-core business
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Restructuring Checklist
Figure out what the business is worth now Use valuation model – present value of free cash flows Fix the business mix – divestitures Value assets to be sold Fix the business – strategic partner or merger Value the merged firm with synergies Fix the financing – improve D/E structure Revalue firm under different leverage assumptions – lowest WACC Fix the kind of equity What can be done to make the equity more valuable to investors? Fix the kind of debt or hybrid financing What mix of debt is best suited to this business? Fix management or control Value the changes new control would produce
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Valuation is a Key to Unlock Value
Value with and without restructuring Consider means and obstacles Who gets what? Minimum is liquidation value Valuation Going Concern After Restructuring Liquidation
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Getting the Financing Right Step 1: The Proportion of Equity & Debt
Achieve lowest weighted average cost of capital May also affect the business side Debt Equity
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Getting the Financing Right Step 2: The Kind of Equity & Debt
Short term? Long term? Baht? Dollar? Yen? Debt Bonds? Asset-backed? Convertibles? Hybrids? Equity Debt/Equity Swaps? Private? Public? Strategic partner? Domestic? ADRs? Ownership & control?
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Capital Structure: Optimal Range?
Nestle Loewen VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO
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Cost of Capital and Leverage: Method
Equity Debt Estimated Beta With current leverage From regression Leverage, EBITDA And interest cost Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Interest Coverage EBITDA/Interest Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Rating (other factors too!) Cost of equity With different leverage E(R)=Rf+Bl(Rm-Rf) Cost of debt With different leverage Rate=Rf+Spread+?
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Ratings and Spreads
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Interest Coverage Ratios, Spreads and Ratings: Small Firms
Note that smaller firms need much higher interest coverage ratios to get the same ratings as large firms.
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Optimal Debt Ratio for a Private Company: Example
The optimal debt ratio for the private firm is 30%. The firm value is maximized at that point. This is, however, based upon a cost of equity estimated from a market beta (which measures only the non-diversifiable risk). To the extent that private business owners view default risk more seriously than stockholders in a publicly traded firm, they will probably be more cautious about moving to the optimal. We can extend the argument to closely held publicly traded firms. We would expect these firms to have lower debt ratios than publicly traded firms with diverse stockholdings. Damodaran’s spreadsheets:
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TDI Financial History
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Restructuring Debt and Equity at TDI (A & B)
Evaluate the financial restructuring taking place at TDI: Effect of the LBO on capital structure? How did LBO lenders protect their interests? Alternative restructuring plans? Post Dec 89 operational, portfolio and financial restructuring proposals? restructuring, before-and-after comparison
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Restructuring Debt and Equity at TDI (C)
Consider the choices facing TDI in 1994: Evaluate the alternatives available to take best advantage of TDI’s free cash flow: Leveraged buyout Leveraged ESOP Leveraged recapitalization Or: Invest cash or debt in growth opportunities Or: Do nothing to retain flexibility
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Restructuring Debt and Equity at TDI (D)
Evaluate the possible means for cashing out shareholder value in a private company such as TDI in 1996: Leveraged recap IPO Sale to financial buyer Sale to strategic buyer Which when?
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Leveraged Recapitalization
Strategy where a company takes on significant additional debt with the purpose of paying a large dividend (or repurchasing shares) Result is a far more leveraged company -- usually in excess of the "optimal" debt capacity After the large dividend has been paid, the market value of the shares will drop.
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Leveraged Recapitalizations
Motivations: Defensive Proactive Ownership transition/liquidity Which produces what value?
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Exchange Offers Give one or more classes of claimholders the option to trade their holdings for a different class of securities of the firm. Typical examples are allowing common shareholders to exchange their shares for bonds or preferred stock, Or vice-versa Motivations?
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Exchange Offers-- Effect Depends On:
Leverage increasing or decreasing Implied increases or decreases in future operating cash flows Implied undervaluation or overvaluation of common stock Increase or decrease in management share ownership Increase or decrease in management control over cash usage Positive or negative signalling effects.
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Asset-Backed Securities:
Ford Credit Owner Trust 1999-A
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Credit Enhancement: Guarantee Method
Finance Co.’s Customers Rating Agency Hire-Purchase Agreement Top Rating Servicing Agreement Finance Co. Ltd (Seller) Proceeds FCL 1997-A (Special Purpose Co.) Proceeds Investors Sale of Assets Asset-Backed Securities Trustee Financial Guarantee Provider (if required) Trust Agreement Guarantee Agreement
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Credit Enhancement: An Alternative Approach
Rating Agency Top Rating Senior Lower Rating Finance Co. Ltd (Seller) Proceeds FCL 1997-A (Special Purpose Co.) Subordinated Sale of Assets No Rating More Subordinated Financial Guarantee Provider (if required) Guarantee Agreement
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The Alternative: Synthetic ABS
DB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES
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Corporate Financial Restructuring
Why Restructure? Proactive Example: Sealed Air Defensive Example: Loewen 1996 Distress Example: Loewen 1999 Management acts to preserve or enhance shareholder value Management acts to protect company, stakeholders and management from change in control Lenders and shareholders lose, but try to work out best way to minimize loss
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Match the Solution to the Problem
Trouble! The financing is bad Business mix is bad The company is bad Reason Raise equity, or Do debt/equity swap Or change debt mix Sell some businesses or assets to pay down debt Change control or management through M&A Remedy
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Reorganization Processes
Out-of-court negotiated settlement Firm continues Exchange: equity for debt Extension: pay later Composition: creditors agree to take less Firm ceases to exist: assignee liquidates assets and distibutes proceeds on a pro-rate basis Merger into another firm (which assumes or pays off debt) Continues as subsidiary Absorbed into other operations Formal legal proceedings Firm continues: Ch 11, court supervises composition or modification of claims Firm ceases to exist Statutory assignment: assignee liquidates assets under formal legal procedures Ch 7 liquidation: bankruptcy court supervises liquidation
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When Default Threatens, Value the Company
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Zombie Inc Valuation
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Valuation in Distress Restructuring
Liquidation value Acquisition price Enterprise value
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Enterprise Valuation in Distress Restructuring
Multiples FCFF discounted at WACC APV Capital Cash Flows Option Value
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Marvel Secured and senior Get fully repaid under plan Choices:
Banks Secured and senior Get fully repaid under plan Icahn et al. Choices: Accept Perelman’s plan Sell the debt at $.14-$.17 Reject plan and propose own Perelman Controls Marvel equity NPV is negative Option value may be positive
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Marvel’s Option Value, Nov. 96
Breakeven stock price =Debt value/No. of collateral shares Debt value=Mkt price*face value (Ex 6) Collateral shares=77.3m =$709.5/77.3 =$9.18 Option Value When Marvel’s stock price is below $9.18, Perelman’s investment in the Holding Companies is worthless on a liquidation basis, but still has option value. Breakeven stock price Marvel Ent. Price $4.63 $9.18 Nov 96 stock price
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Mergers and Acquisitions
Gains from merger Synergies Control Top line Bottom line Financial restructuring Business Restructuring (M&A)
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AOL-Time Warner Possible motivations Economies of scale and scope
Diversification Access to new technology Regulatory arbitrage Hubris Possible problems Overestimating synergy Slow pace of integration Poor strategy Payment in stock Overpaying Poor postmerger communication Conflicting corporate cultures Weak core business Large size of target company Inadequate due diligence Poor assessment of technology
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AMP/AlliedSignal/Tyco
What defenses did AMP employ? Who won? Who lost?
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Comparables Value Indicator Earnings Cash Flow Revenues Book Average
Industry Firms Deals Target Company Numbers or Projections Estimated Value of Target
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What’s It Worth?
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Optika-Schirnding with Synergy
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Conrail: Obstacles to an Unfriendly Takeover
Pennsylvania “Fair Value” statute: bids >20% all get same price Bidder’s voting rights maxed at 20% unless management approves “Constituency” statute: protect unions Conrail Break-up fee to CSX CSX has “lock up” option to buy 16m new shares Poison pill (suspended for CSX): shareholders get new shares at half price if outsider buys 10% 6-month “no talk” clause
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Takeover Defenses Poison Pills Shark Repellants Golden parachutes
Preferred flip-over stock Flip-over rights Flip-in rights Poison put bonds Shark Repellants Limitations on board changes Limitations on shareholder actions Supermajority rules Anti-greenmail limits on share repurchases Fair-price provisions Supervoting stock exchange offers Reincorporation Golden parachutes
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Post-Takeover Bid Responses
“Just Say No” Litigation White Knight Greenmail ESOP Pac-Man Restructuring, including Leveraged Recapitalization Share Buybacks Using cash for acquisitions Divestitures Going private Liquidation
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Breaking Up Why—The business may be worth more outside the company than within How—Sell to another company, or to the public, or give it to existing shareholders Tax Aspects—As a rule if you get paid in cash you realize a taxable gain; not otherwise Effect on Shareholders—The bigger the part sold off, the greater the percentage gain
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Tax-Free Breakups Spin-offs—pro-rata distribution by a company of all its shares in a subsidiary to all its own shareholders Split-offs—some parent-company shareholders receive the subsidiary's shares in return for their shares in the parent Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist Tracking Stock—special stock issued as dividend: pays a dividend based on the performance of a wholly-owned division
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Taxable Breakups Divestitures—the sale of a division of the company to a third party Equity carve-outs—some of a subsidiary‘s shares are offered for sale to the general public Split-off IPOs—a private company offers a part of the company to the public Bust-ups—voluntary liquidation of all of the company’s business
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Break-up Computation Source: breakup.xls
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LBO: A Temporary Capital Structure
Stage 1: Pre-LBO Stage 2: LBO financing Stage 3: LBO refinancing Stage 4: Debt paydown COST OF CAPITAL DEBT RATIO
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Cost of the Deal lbocapacity.xls
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Borrowing Capacity From table lbocapacity.xls
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Cost of Debt lbocapacity.xls
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Capital Structure lbocapacity.xls
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LBO Financing NEWCO Senior debt $457 Cost of purchasing the business
What securities? What returns? What investors? Mezzanine Equity $25
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How much equity for management? How much for the VCs?
Case Case Does it work? How much equity for management? How much for the VCs? Management Bankers VC Investors
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How the Asian Bet Was Lost
The three excesses Too much debt Too much labor Too much capacity How the Asian Bet Was Lost Vulnerable economies, newly liberalized, succumbed to currency crises Vulnerable corporate financial structures Companies were unable to service even domestic debt, never mind foreign currency debt Many Asian companies resisted reform even after the crisis, and remain misfinanced
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What’s Needed? Corporations must implement the key principles of corporate finance – estimate realistic cost of capital and discard investments below the WACC Shareholders must exercise ownership rights Banks must break the link between loan origination and collection Governments have to leave insolvent borrowers to their fate Regulators should get tough on loan classification standards.
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What Do Debt-Equity Swaps Do?
Overleverage creates financial distress Actual or potential default Lenders take equity in lieu of repayment Lenders hold equity passively Lenders replace management Lenders sell equity Existing management buys time Change of control means restructuring Financial engineering Bottom line “rationalization” Divestitures & outsourcing
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New Equity for Astra What investors? What returns should they expect?
Portfolio investors Financial investors Corporate investors What returns should they expect? = Risk-free rate + Corporate risk + Financial risk (leverage/debt mismatch) + “Agency cost” premium + Country risk What restructuring?
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Contact Info Ian H. Giddy NYU Stern School of Business Tel ; Fax
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