If a company files for bankruptcy, there is a strong likelihood that its creditors will not be paid in full. Upon such a filing, the “best interests of creditors” test is performed. The best interests test determines whether a sale of all of the company’s assets should be pursued, with the proceeds paying off creditors in their respective priorities. If a liquidation is expected to generate less value than a restructuring of the business’s balance sheet, then the company is reorganized as a going concern and continues to operate.

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To The Secured Creditors

Typically, secured creditors (with collateral backing their claims) are paid first from the proceeds of a liquidation of the assets backing their loan. Any deficiency, or shortfall, may leave the balance of the debt to be lumped in with other unsecured creditors. An example might be a car loan. The sale of the car may provide only enough cash to pay part of the obligation, as the car’s value may have declined below the outstanding loan amount. Only secured loans continue to accrue interest (up to the value of the underlying collateral) during a bankruptcy process.

 

To The Unsecured Creditors

In a restructuring, a company’s projected income is determined in order to establish how much debt the business is able to support. Unsecured creditors, whose claims against the bankrupt company (i.e., the debtor) are in jeopardy of not being paid, are re-categorized as a current liability titled “liabilities subject to compromise.”

The liabilities subject to compromise often wind up with new loans that have a longer payout period and/or a smaller face amount than their “pre-petition” (before bankruptcy petition filing) claims plus a portion of the company’s ownership. The amount of the reduction in their loans will determine how much of the business they will own after the reorganization. The previous owners’ stake will be reduced, or diluted, by the equity granted to the creditors. In many cases, the pre-petition equity is wiped out entirely.

 

To The Securities Investors

Sometimes, an investor may purchase securities in a company that is likely to be reorganized or liquidated. In this case, the buyer (sometimes referred to as a “vulture investor”) will seek to acquire the debt securities (bank debt, bonds, or vendor “trade” claims) at a significant discount to the claim amount owed by the debtor. The vulture investor then determines what the liquidation value of the assets might be, keeping in mind that the process of liquidation is costly.

Companies that dispose of inventory often take as much as a 50 percent commission for the disposition process. Selling a house, which might be listed on the balance sheet at cost, would require a 5 percent selling fee to a real estate agent plus legal fees. A paid trustee often oversees the disposition of assets to maximize the recovery to creditors. In short, the company’s asset book values may be reduced, or haircut, to compensate for the liquidation expenses. These costs must be factored in to determine how much money (i.e., how much of a discount) a vulture investor would be willing to pay to achieve an acceptable rate of return.

Case Example

Let’s look at a business with book values of $500,000 of cash, $1 million of inventory, $1 million of accounts receivable, and $2 million of real estate. There are $5 million of liabilities, $2.5 million of which is a mortgage on the real estate. The property may be sold for $2 million less 5 percent in expenses, leaving $1,900,000 of net value from the disposition of the real estate.

Since the mortgage had a first lien on the property that has not been satisfied, the mortgage holder would receive all of these proceeds.

The difference, or $600,000, would be lumped together with the unsecured creditor pool, leaving a total of $3.1 million of total unsecured liabilities to share equally (or “pari passu”) the liquidation proceeds of the remaining assets.

If the liquidation trustees fees are estimated to be $300,000, there would be $200,000 of cash remaining. Adding this remaining cash ($200,000) to the 50 cents on the dollar realized from the distressed sale of the inventory ($500,000, half of the book value) and 80 percent recovery realized on the accounts receivable ($800,000, or 80 percent of $1 million—customers are less likely to pay a liquidating vendor) leaves $1.5 million of ultimate liquidation proceeds. This $1.5 million must be shared among the $3.1 million in total unsecured claims, resulting in a 48 percent recovery at some point in the future.

In order to make a sufficient profit and to justify the wait until getting paid as well as the possibility that the claim pool rises (increasing the denominator) through subsequent claim declarations, the vulture might offer to pay pre-petition unsecured creditors 25 cents on the dollar. Equity holders would then be wiped out.

 

Reorganized Company

In the case of a reorganized company, the value of the pie does not come from the disposition of the business assets. To the extent that the company can continue to operate as a going concern while paying its daily expenses with something left over for stakeholders such as lenders and shareholders, the recoveries are generally much higher for all. In this case, projected income statements and balance sheets must be created using “reasonable” assumptions. (“Reasonable” assumptions often include ridiculous notions such as revenue will double every month forever.) Companies generally underperform the expectations set by such forecasts.

However, they are the basis for determining what a business is worth (most importantly: is it worth more to the most senior impaired creditor class as a going concern or in a liquidation?), how much debt it can afford to pay going forward, and what kind of profit will be left for post-petition shareholders in the reorganized company. If the projections are too optimistic and the new (even reduced) debt load is too cumbersome based on overly rosy anticipated financial results, another restructuring may await down the road.

The new, postpetition debt’s value is based on whether the stated interest rate compensates for the risk factoring in reduced overall leverage and the likelihood that projected cash flows will enable the business to repay the obligations from operations or enable the refinancing of the debt. Assuming that the market views the newly issued debt in the reorganized company to be worth par, or 100 cents on the dollar, any excess value would be allocated to the new preferred shareholders and then to common stockholders.

Keep in mind that the restructured debt and equity on the postpetition balance sheet are generally owned in different proportions. Those are based on the seniority of the stakeholders before the modifications and the extent to which the overall enterprise value is deemed to exceed the post-petition debt.

When Chrysler and General Motors went through the bankruptcy process in 2009, however, supposedly pari passu (legally equal in seniority) creditors were, in my view, not treated equally. Union claims were given precedence over financial investors like banks and bondholders.

It is my opinion that General Motors bondholders were thrown under the proverbial bus (trading at about 5 percent of claim upon filing), while supposedly equal union retirement claims were nearly made whole, according to Reuters. I wish that I could offer a reasonable justification for this lack of justice but I can’t. I’d urge you to stay away from investments in which the U.S. government controls the outcome because you don’t know what the rules are.

 

Companies Acquired Using Leverage

Many companies were acquired using lots of leverage in the era of easy money. In other words, the purchase prices were largely borrowed. The lenders accepted the projections put forth at the time to issue loans to help pay the shareholders of the businesses that were sold.

Unfortunately, while the acquired companies subsequently may generate positive operating profit, the cash flow has often been insufficient to cover the interest expense of the newly issued debt. For example:  Harrah’s Entertainment, the gaming giant, which was acquired by Apollo Management and TPG Capital for $31 billion in January 2008, saw the trading price of some of its debt obligations plummet to as low as 15 cents on the dollar a little more than a year after the company was sold according to Bloomberg.

Trying to avoid bankruptcy due to the enormous debt load, according to BusinessWeek, the company has sought debt exchange offers with bondholders. Such offers often include partial principal forgiveness and maturity extensions in exchange for a greater interest rate, a higher position in the capital structure, or both, increasing the likelihood that the bonds will receive at least a partial recovery should the company file for bankruptcy. Of course, such a “leapfrog” move may cause other creditors to lose their relatively senior status in the capital structure, and the moves may be contested. Special treatment or beneficial transactions for a certain creditor within three months (one year for insiders) prior to filing bankruptcy may be viewed by a bankruptcy judge as a “preference payment.”

Obviously, those businesses that carry high debt loads relative to their ability to generate cash flow are most susceptible to bankruptcy. The pressure to meet interest and debt payments often leads to the underfunding of equipment purchases, inability to take advantage of bulk inventory acquisition, and delaying the upgrading of plants or facilities.

Companies that do such things often were purchased with borrowed funds. In other words, the monies that are owed to creditors were used to pay the selling shareholders. This is a very different use of debt than borrowing money to buy an asset like a truck, forklift, building, or copy machine. These assets help make a company’s operations more efficient and generate a return on the investment. The process of buying a company using substantial debt and little equity capital is called a “leveraged buyout,” or LBO. LBOs saddle acquired businesses with heavy debt service burdens without the tangible assets to support operations. This financing of goodwill (purchase of a company for more than its tangible assets) using debt is a risky proposition in itself.

In addition, lenders are often induced to make such loans based on optimistic projected income statements. When and if the businesses do not meet these expectations, insufficient cash flow remains after direct and operating costs to pay debt service while simultaneously covering capital expenditure requirements. In addition, the sale of liquidated tangible assets is then insufficient to cover obligations owed due to the extensive goodwill on the post-acquisition balance sheet. Goodwill may not be amortized. When its value is clearly impaired, however, it may be written off. When a business fails and its tangible assets are liquidated, there is no longer any value to its goodwill.