M&A Blog #08 – debt (Part III – lender’s view, debt rating, liquidity, and distressed company)

How many of us know people who lost their homes in the 2008 mortgage crisis? When people borrow well above their means of paying back, the banks would seize the properties when they don't get paid back properly and timely. It is no different in the world of M&A. We have spent the last few posts looking at debt and it can be useful to a corporate borrower; as well as negative impacts debt can pose to the capital structure. In this post, we will evaluate the lenders’ side of borrowing: how they view a potential borrower, their use of the company’s debt rating, liquidity scenarios, and what they do when the company is in distress.

There are many different kinds of debt providers: banks, bondholders, hedge funds, etc. Each has its own set of interests, but all with one main goal: to get their money back at some point with an interest rate commensurate with the level of risk they are taking. Thus, a debt provider is more interested in the downside risks associated with a transaction (as opposed to the upside potential that an equity holder would be interested in). A lender’s willingness to extend credit is based on how it would get paid:

1. Through business cash flow:

A lender of this type would want to see companies that generate enough available cash over the loan period to be able to make the loan payments.

2. Through the sale of the business:

A lender of this type gets paid when the company is sold; it gets priority over any distributions to shareholders.

3. Through the sale of the assets:

A lender of this type (asset-based lenders) is “guaranteed” a payment even when a company goes bankrupt. The payment comes from the sale of specific business assets, either piecemeal or full liquidation. The lender can negotiate for a secured interest in specific corporate assets and then liquidate those assets for its payment.

Regardless of the type, lenders look at a company’s credit rating when determining the interest rate they would charge for a piece of debt. A company’s credit rating also serves as management’s guide to how far they can push their capital structure without a ratings downgrade. One can’t have a discussion around debt rating without discussing the trade-off between minimizing the cost of debt and minimizing the weighted average cost of capital (WACC). Low debt level implies high WACC. High debt level implies lower WACC. In general, a debt rated between AAA and BB is considered investment grade, while anything under is considered junk bond. The relationship between debt level and WACC, classified by their rating / grade, is shown below:

The reason why the Cost of Debt increases as Total Debt to Total Capitalization increases is simple: lenders want to protect themselves against the risk of company’s bankruptcy. In a distressed situation, companies face deep financial problems and constrained capital availability (a situation referred to as “illiquid”). Liquidity is a company’s ability to meet its financial obligations in a timely fashion and fund ongoing operations. In the illiquid situation, companies have entered the death spiral of financial problems that drive up the cost of borrowing and reduce borrowing capacity. In this situation, debt providers will act according to the size and probability of default their loans have in the distressed company:

• Suppliers: acquiring a target one can ill afford can strain supplier and vendor relations. The drawdown of cash to pay acquisition-created-debt can force policies that hurt the acquiring companies, for example, extending payments due to those external parties. Suppliers and vendors need to be protected so they can go on providing goods and services on credit. Otherwise, the company won’t be able to stay in business. Few distressed companies can provide cash on delivery for new inventory. Trade credit is required to maintain business viability.

• Secured Lenders: should allow distressed companies time to restructure. Since they have first claim on company’s assets, they might be made whole in liquidation. This type of lender might be willing to push a company into bankruptcy to recover their investment. This might be detrimental to other capital providers, so the company should encourage patience from its secured lenders to continue operations.

• Unsecured / Junior Bondholders: often the lynchpin capital in a restructuring. They are exposed to losses in bankruptcy / liquidation, so would typically be more patient and focused in investment maximization via letting the company reorganize. Bondholders use approaches such as quick sale, methodical sale, and capital reinvestment. Depending on their take on the situation, they may race for exit through a sale, try to stabilize the company, or exchange their position for equity and invest in the company’s growth.

A company in distressed should undertake the following steps to get back to normal:

1. Stabilize: stop the bleeding of cash / operating losses

2. Monetize: immediately sell off any assets that can be sold without undermining value

3. Reorganize: restructure the business around positive cash flow from operations and aim the capital structure towards future sustainability

Illiquidity is the result of operating problems that led to a shortage of cash; and often the primary issue in:

• Early on, it signals deeper issues

• On the bankruptcy filing date, it is used to determine the bankruptcy period financing required to support and stabilize the company

• On emergence, it is used to determine debt capacity and working capital need

In distressed situation, equity holders can help by injecting capital into the distressed company. However, equity holders should assess if the situation is permanent or transitory; that is if they want their money back. There are two strategies that current equity holders can undertake to improve their position:

1. Buy time: pushing off reckoning with creditors as long as possible while reducing debt to improve enterprise value. Suppliers can usually  be cajoled to negotiate payment terms. Debtors can usually be cajoled to revise credit terms in exchange for higher interest rates and additional fees.

2. Go after a high-risk, high-reward investments: in distressed situation, equity holders won’t get enough benefits from lower return projects (those benefits go to bondholders). In this situation, it is in the equity holders’ interest to push for a large project or pivot from the company’s current plan. Bondholders would obviously push back due to concerns around recovering their loans.

One other option for a distressed company is to solicit bids from potentially interested buyers. The level of insolvency, the amount of current equity, and the patience of various debt providers will dictate this process.

In conclusion, there are many types of debt providers. Each has its own set of interest and perspective. The credit rating is very important in managing the cost of debt and WACC. Lenders will protect themselves in bankruptcy / distressed scenario. It is important to protect suppliers while working with various debt and equity holders in stabilizing, monetizing, and reorganizing a distressed company. Equity holders can help distressed companies buy time and pivot / reorganize. An option for a distressed company is to sell itself to other buyers. There are a variety of considerations and stakeholders in this situation.