CorporateFinancial Restructuring:Summary Prof. Ian Giddy New York University
Restructuring Improve capitalization Improve debt composition Change ownership and control What is Corporate Restructuring? • Any substantial change in a company’s financial structure, or ownership or control, or business portfolio. • Designed to increase the value of the firm
The Paths to Value Creation • Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced: • The cost of capital can be reduced • The cash flows from existing assets to the firm can be increased • The expected growth rate in these cash flows can be increased • The length of the high growth period can be extended.
Getting the Financing Right 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?
Operating Leverage Financial Leverage Operating Leverage Financial Leverage Information availability The Financing Life Cycle Size Maturity
Asia in 5 years? The Wrong Capital Structure: East vs West Intel TPI Optimal debt ratio? VALUE OFTHE FIRM DEBT RATIO
A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Actual < Optimal Overlevered Underlevered Is the firm under bankruptcy threat? Is the firm a takeover target? Yes No Yes No Reduce Debt quickly Increase leverage Does the firm have good Does the firm have good 1. Equity for Debt swap quickly projects? projects? 2. Sell Assets; use cash 1. Debt/Equity swaps ROE > Cost of Equity ROE > Cost of Equity to pay off debt 2. Borrow money& ROC > Cost of Capital ROC > Cost of Capital 3. Renegotiate with lenders buy shares. Yes No Yes No Take good projects with 1. Pay off debt with retained Take good projects with new equity or with retained earnings. debt. earnings. 2. Reduce or eliminate dividends. Do your stockholders like 3. Issue new equity and pay off dividends? debt. Yes No Pay Dividends Buy back stock
When The Creditors are Prowling Time for a Tiger 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
The Financing Spectrum Equity Preferred equity Convertible debt Expected Return Subordinated debt Senior unsecured debt Senior secured debt Risk
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
Siam Commercial Bank: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.“ • "When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."
New Equity for Asia • 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?
Designing Debt: Match the Business • Fixed/floating: • How certain are the cash flows? Are operating profits linked to interest rates or inflation? • Currency: • Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. • Maturity or availability: • Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing?
Designing Debt Start with the Cyclicality & Cash Flows Growth Patterns Other Effects Duration Currency Effect of Inflation on Assets/ Uncertainty about Future Projects Fixed vs. Floating Rate Straight versus Special Features Commodity Bonds * More floating rate Convertible on Debt Catastrophe Notes Duration/ Currency Define Debt - if CF move with - Convertible if - Options to make Maturity Mix Characteristics inflation cash flows low cash flows on debt - with greater uncertainty now but high match cash flows on future exp. growth on assets Design debt to have cash flows that match up to cash flows on the assets financed Deductibility of cash flows Differences in tax rates Overlay tax Zero Coupons for tax purposes across different locales preferences If tax advantages are large enough, you might override results of previous step Consider Analyst Concerns Ratings Agency Regulatory Concerns ratings agency Operating Leases - Effect on EPS - Effect on Ratios - Measures used & analyst concerns MIPs - Value relative to comparables - Ratios relative to comparables Surplus Notes Can securities be designed that can make these different entities happy? Observability of Cash Flows Type of Assets financed Existing Debt covenants Convertibiles by Lenders - Tangible and liquid assets Factor in agency - Restrictions on Financing Puttable Bonds - Less observable cash flows create less agency problems conflicts between stock Rating Sensitive lead to more conflicts and bond holders Notes LYONs If agency problems are substantial, consider issuing convertible bonds Consider Information Uncertainty about Future Cashflows Credibility & Quality of the Firm Asymmetries - When there is more uncertainty, it - Firms with credibility problems may be better to use short term debt will issue more short term debt
When Debt and Equity are Not Enough Alternatives Assets Liabilities Collateralized Asset-securitized Project financing Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Preferred Warrants Convertible Equity Residual payments Upside and downside Residual claims Voting control rights
Why Use a Hybrid? Motivations for Hybrids Linked to business risk Driven by investor needs Linked to market risk Company hedges Company does not hedge Cannot hedge with derivatives Debt or equity are Not good enough
Corporation or Financial Institution requires additional funds to give customers financing or to finance a future revenue stream. Asset Securitization:The Decision Process Yes Are funds freely available from banks ? Borrow from banks No No Does the firm/FI have good, self-liquidating assets ? Issue equity or mezzanine capital Yes No Do the assets have a sufficiently high yield to cover servicing and other costs ? Get out of the financing business Yes Would the assets be worth more (have a cheaper all-in funding cost) if they were isolated from the company/FI ? Use assets as collateral for on-balance sheet debt No Yes Securitize the assets
What’s a Company Worth?The Options Approach Value of the Firm or project Present Value of Expected Cash Flows if Option Excercised
T h e Va l u e E n ha n c em e nt Ch ai n G i mme ’ Odd s on . Cou l d wo r k if. . A ss et s in P l a c e 1. D i ve st a s se ts/ pro j e c t s w it h 1. R e duce n et wo r k i ng c a pi ta l 1. Ch a nge p ri c i ng st r a t e gy t o D i ve st i t u r e Va l ue > r equ i r e m e n t s , by redu c ing m ax imi ze t he p r oduc t o f Con ti nu i ng Va l ue i nven t o r y and accoun ts p r of it m a rg i n s and t urnov e r 2. T er mi na t e p r oj e c t s w it h r ece i vab l e , o r by i nc r ea si ng r a ti o. L iqu i d a t i on Va l ue > ac c ount s p a yab l e. Con ti nu i ng Va l ue 2. R e duce c ap it a l m a i n t enan c e 3. E l imi na t e ope r a ti ng expend it u r es on a s s e t s i n expen s es t ha t g e ne r a t e no p l ace . cu r r e n t r evenue s and no g r ow t h. E xpec t ed Gro wt h E l imi na t e new cap it a l I ncr e as e r e i nves tm en t r at e o r I ncr e as e r e i nves tm en t r at e o r expend it u r es t ha t a re expe c t e d m a r g i na l r e t u r n on cap it a l o r m a r g i na l r e t u r n on cap it a l o r t o e arn l es s t h a n t he cos t of bo t h i n f irm’ s e x i s ti ng bo t h i n new bus i ne s se s . cap it a l bus i n e ss e s . L eng t h o f H i gh G r ow t h Pe ri od I f any o f t he fi r m’ s p r oduc t s or U s e e c ono m i e s of sc a l e o r co st 1. Bu il d up b r and n am e s e rv i c e s can b e pa t en t ed and advan t ag e s t o c r ea t e h i ghe r 2. I ncr e as e t he cos t of p r o t ec t ed , do so r e t urn on c ap it a l . s w i tc hing f ro m produc t and r educe cos t of sw it ch i ng t o it . Co st o f F i nanc i ng 1. U s e s waps and de r iv a t i v e s 1. Ch a nge fi nanc i ng typ e and R e duce t h e ope r a ti ng ri sk of t he t o m a tc h deb t m ore c l os el y us e i nnova ti ve se c ur iti e s t o fi r m, by m a k i ng p r oduc t s l es s t o fir m ’s a s se ts r ef le c t t he t ypes of a s se ts d i s c re ti ona r y to cu s to me r s . 2. R e cap it a li ze to m ove th e be i ng f i nan c ed fi r m to w ard s its op tim a l 2. U s e t he op tim a l fi nanc i ng deb t ra ti o . mi x t o f i nan c e ne w i nve s t me nt s . 3. M a ke c os t st ru c tu r e m or e fl ex i b l e t o redu c e op e ra ti ng l eve r age .
The Gains From an Acquisition Gains from merger Synergies Control Top line Bottom line Financial restructuring Business Restructuring (M&A)
The Final Question How do we get paid?