Turnaround Financing

1. Turnaround Financing Prof. Ian Giddy New York University

2. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY TOOLS M&A

3. Capital Structure: East vs West Intel TPI Optimal debt ratio? VALUE OFTHE FIRM DEBT RATIO

4. 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

5. The Three Excesses • Labor • Capacity • Debt

6. 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

7. 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

8. 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

9. What Are The Alternatives? • Key: Make the new securities attractive to: • Existing lenders • New lenders • New bond investors • New equity investors

10. 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

11. The Financing Spectrum Equity Preferred equity Convertible debt Expected Return Subordinated debt Senior unsecured debt Senior secured debt Risk

12. The Financing Spectrum Equity Preferred equity Convertible debt Expected Return Subordinated debt Senior unsecured debt Asian bank NPLs Senior secured debt Risk

13. 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

14. 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

15. 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)

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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."

22. 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

23. 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)

24. 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

25. 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?

26. 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

27. 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

28. PT Astra International ?

29. 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.

30. 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?

31. How Risky is Astra? The riskier the better! Mean

32. 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.

33. Payoffs to Shareholders on Liquidation

34. 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.

35. 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

36. www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; 917-930-0291 Fax 212-995-4233; 630-604-7413 ian.giddy@nyu.edu http://www.giddy.org