Turnaround financing
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Turnaround Financing. Prof. Ian Giddy New York University. Corporate Finance. CORPORATE FINANCE DECISONS. INVESTMENT. FINANCING. RISK MGT. PORTFOLIO. MEASUREMENT. CAPITAL. DEBT. EQUITY. TOOLS. M&A. Capital Structure: East vs West. Intel. TPI. Optimal debt ratio?.

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Turnaround Financing

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Turnaround financing

Turnaround Financing

Prof. Ian Giddy

New York University


Corporate finance

Corporate Finance

CORPORATE FINANCE

DECISONS

INVESTMENT

FINANCING

RISK MGT

PORTFOLIO

MEASUREMENT

CAPITAL

DEBT

EQUITY

TOOLS

M&A


Capital structure east vs west

Capital Structure: East vs West

Intel

TPI

Optimal debt ratio?

VALUE OFTHE FIRM

DEBT

RATIO


Fixing the capital structure

Too little debt

Managers like to control shareholders’ funds

Underestimate the cost of equity

Produces

Less discipline

Excessive cost of capital

Takeover risk

Too much debt

Close control of equity

Easy money

Underestimate business or financial risks

Produces

Risk of financial distress

Excessive cost of capital

Destroy operating value

Takeover risk

Fixing the Capital Structure


The three excesses

The Three Excesses

  • Labor

  • Capacity

  • Debt


Tpi s refinancing

TPI’s Refinancing

  • Asia’s biggest debtor

  • Almost $4 billion in foreign currency debt financing domestic revenues

  • Protracted rescheduling results in $360 million debt/equity swap

  • No change in management or effective control

  • Still needs $1.2 billion new equity


Debt equity swaps

Debt-Equity Swaps

  • Cosmetic or real?

  • Choices for company under siege

    • Raise new equity to pay off creditors

      Example: Iridium

    • Give creditors equity in place of debt

      Example: Sammi


What do debt equity swaps do

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


What are the alternatives

What Are The Alternatives?

  • Key: Make the new securities attractive to:

    • Existing lenders

    • New lenders

    • New bond investors

    • New equity investors


The financing spectrum

The Financing Spectrum

  • Equity

  • Residual returns after contractual claims

  • Control through voting rights

Expected Return

  • Senior Debt

  • Returns independent of the value of the business

  • Control through covenants

Risk


The financing spectrum1

The Financing Spectrum

Equity

Preferred equity

Convertible debt

Expected Return

Subordinated debt

Senior unsecured debt

Senior secured debt

Risk


The financing spectrum2

The Financing Spectrum

Equity

Preferred equity

Convertible debt

Expected Return

Subordinated debt

Senior unsecured debt

Asian bank NPLs

Senior secured debt

Risk


What are the alternatives1

What Are The Alternatives?

  • Asset-backed or cash flow-backed debt

  • Senior debt

  • Subordinated debt

  • Subordinated debt with upside participation

  • Subordinated debt with equity option

  • Preferred equity

  • Restricted shares

  • Common stock


Subordinated high yield debt

Subordinated High Yield Debt

  • “Junk bonds” – like equity, but allow increased financial leverage

  • Tax advantage over equity

  • Big market in USA (institutional investors) and increasing in Europe

  • Leveraged loans favored by certain commercial banks

  • Often used in connection with M&A and LBOs

  • Behave like equity – and often have equity participation


Sub debt motivations

Sub Debt -- Motivations

  • Optimization of financial leverage

  • Regulatory-driven capital requirements

  • Rated asset securitizations (senior-sub structure in asset-backed securities)

  • Insider or supplier-credit subordination (eg in project finance)

  • Work-outs and restructurings (existing borrowers agree to seniority of new loans, to buy time)


Sub debt s big problem high interest

Sub Debt’s Big Problem: High Interest!

Solutions

  • Deep discount subordinated debt

  • Subordinated debt with equity warrants

  • Convertible subordinated debt

  • Participating subordinated debt

  • Puttable subordinated debt


Preferred equity

Preferred Equity

  • Legally a form of equity

  • Claim senior to ordinary equity

  • May have fixed dividend, or may be “participating”

  • But cannot trigger liquidation if payment missed

  • Par value determines liquidation claim


Convertible preferred

Convertible Preferred

  • Used by venture capital firms

  • Permit investors to participate in growth

  • But give preference in liquidation if the venture fails

  • And disguise share value (tax!)

  • A variant – PERCS* give issuer right to convert into common stock

    *Preferred equity redemption cumulative stock


Preferred stock pros and cons

Advantages

No dilution of control

Dividends conditional on availability of earnings

Omission cannot force liquidation

Disadvantages

Higher after-tax cost than debt

Lower return on equity

Limited investor interest

Preferred Stock: Pros and Cons


The difference

The Difference

  • “The Ministry of Finance received a preferred share while investors received a preferred share and a warrant allowing them to purchase the ministry's share at a 13.3% premium (equivalent to the cost of carry) during a three-year period. The preferred shares carry a 5.25% dividend and full voting rights”

  • "When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."

  • Alternatives: Thai Farmers Bank: SLIPS, Bankok Bank: CAPs


Transparency and disclosure

Transparency and Disclosure

  • A 275-page prospectus, which provided a breadth and depth of information previously unseen in an Asian issue.

  • "We went and looked back at US bank holding company offers - those that were US SEC Grade 3 compliant. We also went back and looked at a lot of the prospectuses for the recaps of US banks, like Mellon and Citibank. We looked at the level of disclosure they achieved and committed ourselves to exceeding that -- which SCB did."


What globally mobile investors look at

What Globally Mobile Investors Look At

Macro

Factors

  • Currency overvaluation

  • Capital restrictions

  • Acctg & disclosure requirements

  • IAS compliance

  • Bankruptcy regime

  • Creditor rights

  • Govt-corporate nexus

  • Trading infrastructure

Structural

Factors

  • Price-Value ratio, Sharpe ratio, EVA

  • D/E ratio

  • Currency & maturity mismatch

  • IAS conformity

  • Insider control

  • Objective research coverage

  • Trading liquidity

Firm-level

Factors


Turnaround financing

Can the Form of Foreign Participation

Make a Difference?

Debt

Equity

Domestic market

Foreign market

(Depositary Receipts)

Asia

Lat Amer

Emerging Markets

BNY ADR Index

-7.47%

-13.54%

-19.28%

MSCI Index

-28.23%

-25.64%

-36.53%

(1996-98)


Turnaround financing

Can the Form of Foreign Participation

Make a Difference?

Debt

Equity

Domestic market

Foreign market

(Depositary Receipts)

Unsponsored

Private placement

Exchange traded

Global issue or GDR

Private placement IPO

Exchange traded IPO


Tracking stock

Tracking Stock

  • Tracking stock, sometimes known as letter stock or alphabet stock, is a class of stock designed to reflect the value and track the performance of a part of the issuer's assets, usually a separate business or group of businesses. Claimed advantages:

    • preservation of the efficiencies of a single corporation

    • ability of the market to more accurately value the respective businesses of the issuer

  • What does it really add?


Restricted stock pros and cons

Advantages

Overcome foreign control restrictions

Insiders retain control

If company well run, value of control may be low

Disadvantages

Nonvoting stock trades at a discount

Dual-class recaps hurt stock price

May allow management to avoid needed reforms

Restricted Stock: Pros and Cons


The new equity option

The New Equity Option

  • Key: Make the new equity attractive to:

  • Portfolio investors

    • Domestic

    • International

    • Reduce agency costs or we’ll “Just say no!”

  • Strategic/direct investors

    • Domestic

    • International

    • Cede control or we’ll go elsewhere


Pt astra international

PT Astra International

?


Pt astra international1

PT Astra International

  • 1997: Almost $2 billion USD debt

  • 1998: Steep losses

  • Mostly IDR revenues

  • 1999: Debt restructuring, return to profitability

  • Bina Busana Internusa: February 1999 US $1 mio

  • PT Astra International: June 1999 US $1,149 mio.

  • Fuji Technica Indonesia: September 1999 US $16 mio

  • Federal International Finance: December 1999 US $107 mio.

  • Traktor Nusantara: December 1999 US $ 21 mio.

  • Astra Graphia: December 1999 US $82 mio.


New equity for astra

New Equity for Astra

  • What investors?

    • 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?


How risky is astra

How Risky is Astra?

The riskier the better!

Mean


Common stock as a call option

Common Stock as a Call Option

  • The equity in a firm is a residual claim, i.e., equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc.) have been satisfied.

  • If a firm is liquidated, the same principle applies, with equity investors receiving whatever is left over in the firm after all outstanding debts and other financial claims are paid off.

  • The principle of limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than the value of the outstanding debt, and they cannot lose more than their investment in the firm.


Payoffs to shareholders on liquidation

Payoffs to Shareholders on Liquidation


The conflict between bondholders and stockholders

The Conflict Between Bondholders and Stockholders

  • Stockholders and bondholders have different objective functions, and this can lead to conflicts between the two.

    • For instance, stockholders have an incentive to take riskier projects than bondholders do, and to pay more out in dividends than bondholders would like them to.

  • Since equity is a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity.

    • It is therefore conceivable that stockholders can take risky projects with negative net present values, which while making them better off, may make the bondholders and the firm less valuable.


The creditors are prowling

The Creditors are Prowling

Trouble!

The financing

is bad

Business

mix is bad

The company

is bad

Reason

Raise equity

or

Change debt mix

Sell some businesses

or assets

to pay down debt

Change control

or management

through M&A

Remedy


Turnaround financing

www.giddy.org

Ian Giddy

NYU Stern School of Business

Tel 212-998-0332; 917-930-0291

Fax 212-995-4233; 630-604-7413

[email protected]

http://www.giddy.org


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