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
Chapter 24Corporate and Distress Restructuring

Divestitures in general
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
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
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

Spin offs

  • 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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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