Chapter 24 corporate and distress restructuring
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Chapter 24 Corporate and Distress Restructuring . Divestitures in General. Involuntary divestiture usually is the result of an antitrust ruling by the government Voluntary divestiture is a willful decision by management to divest Include sell-offs, spin-offs and equity carve-outs.

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Chapter 24 Corporate and Distress Restructuring

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Chapter 24Corporate and Distress Restructuring

Divestitures in General

  • Involuntary divestiture usually is the result of an antitrust ruling by the government

  • Voluntary divestiture is a willful decision by management to divest

  • Include sell-offs, spin-offs and equity carve-outs

Reasons for Voluntary Divestitures

  • Efficiency gains and refocus

    • Reverse synergy (4 - 2 = 3)

    • Strategic change by the company

  • Information it conveys to investors

  • Wealth transfer from debt to stockholders

  • Tax reasons

    • Tax shield advantage

    • Employee stock ownership plan (ESOP)

Voluntary Liquidation and Sell-Offs

  • Liquidating the overall firm

  • Partial sell-offs

  • Empirical studies

    • Indicate a large abnormal return(15%) to stockholders of the liquidating company

    • Partial sell-off studies indicate a modest positive (2-3%) abnormal return to the seller’s stock

    • Stockholders of the buying company seem to experience a positive abnormal return


  • Complete divestiture of a business unit to existing shareholders

  • Reasons

    • Operating efficiencies

    • May increase value and reduce information asymmetry

    • Obtain greater flexibility and improve productivity

    • May make financial markets more complete

    • May have a scarcity value in the stock market and be accorded a premium

  • Empirical evidence suggests a significant and positive stock price effect to a spin-off due to the perception of greater efficiency

Equity Carve-Outs

  • Divest part of a business unit with an IPO

  • Two-stage carve out/spin-off

  • Motivations

    • Managers may have more incentive to perform well

    • May reduce asymmetric information between managers and investors

    • Eliminate the cross-subsidization of business units

    • Favorable means for financing growth

    • Favorable information effect for a parent

  • Empirical testing document an average excess return (2%) around the time of a carve-out announcement

Going Private

  • Company ceases to exist as a publicly held entity and the stockholders receive a valuable consideration for their shares

  • Stockholders must agree

  • Motivations

    • Avoid costs of being a publicly held company

    • May improve resource allocation decisions and thereby enhance value

    • Realign and improve management incentives

      • Greater the performance and profitability, the greater the reward

  • Offsetting arguments

    • Transaction costs and lack of liquidity

Leveraged Buyouts (LBO)

  • Take a company private by buying out public stockholders and taking on a large amount of debt

  • Debt is secured by the assets of the company

  • Cash purchases

Characteristics of Successful LBOs

  • Must be able to dedicate cash flow to debt service, so competing needs for funds cannot be large

  • Subsidiary assets that can be sold without adversely impacting the core business

  • Stable, predictable operating cash flows

  • Proven historical performance with an established market position

  • Experience and quality of senior management

  • Absence of significant pre-existing leverage

Financing the LBO

  • Debt service and equity commitment

    • Determine likely cash throw-off sufficient to service maximum debt

    • Limited partnership for additional equity

  • Debt financing

    • Senior debt including revolving credit

    • Junior subordinated debt

      • Mezzanine-layer financing

Empirical Evidence on LBOs

  • Stockholders typically receive a sizable premium for their stock when a company goes private

    • Gains shared between pre-buyout stockholders and post-buyout owners

  • Operating performance, productivity of capital, and cash flows have been found to improve after the buyout

  • Efficiency gains

    • Improved management incentives

    • Tax benefits

    • Small wealth transfers from pre-buyout bondholders to post-buyout equity holders

    • Reducing agency problems

Observations on LBOs

  • Permit going private with only moderate equity

  • Assets used to secure a large amount of debt

  • If the company can make its debt payments, the interest burden declines over time as operating profits improve

  • Two kinds of risk

    • Business risk where operations may not go according to plan and the cash-flow to service debt may be lower than forecasted

    • Sizable increase in interest costs may cause the firm to default

  • If capital expenditures are cut, the company may not be competitive once the debt is paid off

Enterprise Value Placed on an LBO

  • Rule of thumb: no more than six to eight times operating cash flow (EBITDA)

  • If higher than eight, and if leverage is large, the probability of default may be unreasonable

  • Rule of thumb can be stretched if significant growth is expected

  • Only moderate growth for most LBOs is in the offing and the rule holds

Leveraged Recapitalizations

  • Fund a large dividend to stockholders with debt, usually causing book equity to turn negative

  • The firm remains a public company with a traded stock known as stub shares

  • Management and other insiders do not participate in the payout but take additional shares instead

  • Often occur in response to a hostile takeover threat

Valuation Implications

  • May give management more incentive to manage more efficiently and to reduce wasteful expenditures

  • Tax shield that accompanies the use of debt

  • Event studies have found excess returns somewhat in excess of 30 percent

  • Internal organization changes may now be possible that lead to improvements in operating performance

  • A number of levered recaps do not make it

Voluntary Settlements and Workouts

  • Informal and occur outside the courts

  • Extension involves creditors postponing the maturity of their obligations

  • Composition involves a pro rata settlement of creditors’ claims in cash or in cash and promissory notes

  • Voluntary liquidation represents an orderly private liquidation of a company

Legal Proceedings

  • Fall under bankruptcy law as carried out through bankruptcy courts

  • Chapter 7 deals with liquidation

  • Chapter 11 deals with rehabilitation of an organization through its reorganization

  • Voluntary proceedings gives the debtor immediate protection from creditors

  • With involuntary bankruptcy, the bankruptcy court must decide whether the involuntary petition has merit

Liquidation Under Chapter 7

  • Trustee has responsibility for liquidating the property of the company and distributing liquidating dividends to creditors

  • Priority of claims must be observed

  • If anything is left, a liquidating dividends can be paid to subordinated debt holders, preferred stockholders, and, finally, common stockholders

Reorganization Under Chapter 11

  • Effort to keep company alive by changing its capital structure

  • Should be viable when interest payments are pared

  • A high proportion of the companies that reorganize later must be liquidated

  • The idea is to reduce fixed charges by substituting equity and limited-income securities for fixed-income securities

  • Gives postpetition creditors priority over prepetition creditors known as debtor-in-possession (DIP) financing

Procedures Followed

  • Exclusivity period gives management the sole right to propose a reorganization plan within 120 days

  • If a plan is not proposed, the trustee has the responsibility

  • Plans must be submitted to creditors and stockholders for approval

  • The plan should be fair, equitable, and feasible

  • Cram downs of reorganization plans by judges seldom occur

Reorganization Plan

  • Total valuation of the reorganized company must be determined

    • Capitalization of prospective earnings

    • Valuation may be adjusted upward if the assets have substantial liquidating value

  • Formulate a new capital structure

    • Reduce fixed charges so that there will be an adequate coverage margin

  • The valuation of the old securities and their exchange for new securities

    • Total valuation figure arrived at sets an upper limit on the amount of securities that can be issued

Gaming With the Rule of Absolute Priority

  • The rule of absolute priority is often violated

  • The delay card of management is a powerful incentive for creditor concessions

  • Vulture capitalists prey on the fallen and use bullying tactics to extract value from other parties, known as bondmail

    • Break the log jam between various parties

    • Add value and lower restructuring cost

Prepackaged Bankruptcy

  • Management has struck an agreement with most creditors as to terms of the plan

  • Quicker and more efficient, but difficult if creditors are disperse

  • Problems with creditors who hold out can be reduced

  • Permits more flexible use of net operating loss carryforwards for tax purposes

  • Efficiency gains of prepackaged bankruptcy can be compelling to creditors

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