Debt Restructuring – what options are there?
Most debt restructurings involve borrowers that are (or that suddenly become!) over-leveraged and unable to service current debt levels. Lenders and borrowers that can reach agreement on a restructuring plan can, in many cases, stop value being eroded in a formal insolvency procedure and ensure that a fundamentally viable business continues to comply with its debt obligations.
However, there are advantages and disadvantages to consensual restructurings, and the appropriate course of action will always depend upon the circumstances of the borrower in distress and its creditors. Care needs to be taken, whether before or after any loan default, to ensure all relevant insolvency rules are complied with and that (where relevant) company directors are mindful of their duties both to the company and to the creditors as a whole.
The key stages of a debt restructuring are usually:
- stabilising the borrower by ensuring that its creditors enter into a standstill agreement
- preparing valuations and the information needed to show that the restructuring will result in a viable borrower – this often includes due diligence, business plans and forecasts etc., and
- signing and implementing the restructuring agreement (the form of which will depend upon the type of restructuring which is to be adopted)
In simple terms a standstill agreement is an agreement between the borrower and its creditors restraining creditor enforcement action.
If a restructuring is considered to be a feasible way forward by the stakeholders in a borrower (rather than accepting that formal insolvency proceedings are the only option), they will want to ensure that all relevant parties quickly enter a standstill agreement to give the borrower some breathing space to develop a restructuring plan.
A standstill agreement will reflect the underlying finance documents and will set out the actions necessary to maintain an effective standstill on enforcement. It is likely to include any necessary consents to the standstill and any formal waivers of breaches or events of default by the debtor. Creditors may require fees or additional security/guarantees as conditions precedent to agreeing to forego enforcement action under the standstill agreement.
Identifying where the value lies in a borrower’s business will dictate the shape of any restructuring deal and will determine the relative strengths of the parties involved at the negotiating table. The revised forecasts and business plan will need to show an acceptable level of return for both debt and equity providers, which can be a challenge to achieve.
Different interested parties often commission their own valuations and this can inevitably lead to conflicting ideas of how best to restructure the debt and the borrower’s business. It can save time and be more productive for all parties to agree a common valuation approach at the outset, if this is possible.
Debt restructurings typically involve one or more of the following approaches:
- a covenant waiver and reset
- a debt rescheduling
- a new debt injection
- a refinancing by new lenders
- a break up/sale of non-core assets
- a new equity injection/recapitalisation
- a debt for equity swap, and
- a transfer to a Newco
Existing equity holders generally prefer the restructuring to take the form of a covenant waiver/reset or a debt rescheduling rather than, for example, a debt for equity swap, where their equity may be diluted or totally extinguished.
Whether one of these approaches is acceptable to the debt providers will of course depend on the circumstances. For them to be possibilities, the lenders will need to recognise that the distressed position of the borrower is a temporary one and be prepared to accept that by rescheduling or waiving some or all of their debt the overall likelihood of them being repaid is improved.
A debt rescheduling or a covenant waiver will also have the benefit of avoiding the debt being accelerated or cross-defaulted into any other finance agreements that the borrower may have. They can both also be done relatively cheaply and discretely.
One of the initial signs of distress is usually some sort of covenant breach by the borrower. The debt providers may agree to a simple waiver, to cure a temporary blip in the borrower’s performance, or maybe to buy some time before a more extensive restructuring to come.
Sometimes the parties can agree that the existing debt can be rescheduled – this can be achieved by altering the repayment profile of the debt (ie by giving a capital repayment holiday, reducing or adjusting repayment instalment amounts or extending the final maturity date of the loan).
It may be possible to persuade a supportive lender to lend new monies to a borrower or to waive some of its existing debt or accrued interest if there is a clear plan and strong supporting argument for it. A borrower may, for example, be given a bridging loan to give it (and its stakeholders) time to assess the viability of the business or to organise a further injection of equity.
Refinancing with new lenders
If the existing lender has no appetite (or wants to restructure in a way that the existing stakeholders find unpalatable) it may be possible to persuade another lender to step in to support a restructuring plan for the business. The existing lender would need to agree to a standstill while the new funds are lined up and is likely to want to be refinanced in full (including any early redemption fees).
Other restructuring options involve taking actions that reduce the debt:equity ratio of the borrower with a view to putting it in a better position to meet its financial obligations going forward.
These options tend to be more attractive to lenders as increased equity will generally provide better protection to the debt in the business and can offer lenders more “reward” to reflect the increased “risk” involved in lending to a borrower that is (at least temporarily) distressed.
Break-up/Sale of non-core assets
A borrower may be able to alleviate its position by selling non-core assets or parts of the business and using the proceeds to pay down its debt (leaving the equity in place as is). A secured lender will need to give its consent to any break-up plan and be comfortable that (1) the amount realised from the sale is appropriate and (2) the remainder of the business will generate sufficient profits to repay its debt.
Equity stakeholders will retain their share of a smaller borrower, but the debt:equity ratio of that smaller borrower will have shifted as a result.
New equity injection/Recapitalisation
The starting point for many borrowers facing financial difficulty is likely to be to look to raise additional equity to fund the business through a downturn. This might be an attractive solution where it is felt that the business is fundamentally viable but is suffering temporarily from poor trading conditions and constrained cashflow. Any existing equity holder that does not participate in the new round risks being diluted as a result.
The term ‘recapitalisation’ refers to a company changing the proportions of its debt and equity or the make-up of its share capital structure, something which can be achieved in a variety of ways. This may be attractive to a distressed borrower seeking to make its outstanding debt burden more manageable, to raise new equity or to reflect the risk levels attached to different types of equity.
In a debt-for-equity swap financial creditors receive shares in the restructured borrower in return for reducing or cancelling their debt claims. The debt-for-equity swap reduces the borrower’s balance sheet liabilities and potentially allows a lender to take some of the upside once the restructured borrower returns to profit – either through being entitled to dividends or in the event of any subsequent sale or exit. The pre-existing equity holders will, of course, be diluted as a result of the swap.
Transfer to Newco
A variation of some of the above ideas is for all debt and equity stakeholders to agree to a plan to transfer the borrower’s good or performing assets or business to a newly formed company (Newco). In return for reducing or cancelling their debt claims against the borrower, financial creditors may take: (i) debt in Newco, (ii) equity in Newco or (iii) both. Sometimes this sort of structure is used in connection with a Pre-Pack (see below).
Any restructuring plan involving a transfer to a Newco will need to be executed with care. Insolvency laws on “preferences” and “transactions at an undervalue” (among others) may apply.
Schemes of arrangement
A “scheme of arrangement” is effectively a court-sanctioned compromise, governed by the Companies Act 2006, between a company and its creditors or members. The subject of a scheme of arrangement may cover anything that the company and its members or creditors would otherwise be able to agree between themselves.
The scheme of arrangement process allows a compromise to be implemented without the support of all of the interested parties. Because of their flexible nature, schemes of arrangement are often used in more complex restructurings involving different tiers of debt and equity that would struggle to achieve agreement otherwise.
A valuation in the context of a scheme of arrangement is used to estimate the value that would be obtained for the business if the scheme of arrangement were not to happen. The context and manner in which a business is sold can of course drastically affect the amount, or value, realised in a sale.
A “pre-pack” is a sale of a company’s business or assets, or both, which has been arranged in advance of a company entering administration.
Once an administrator is appointed over the company they will quickly close the sale so that the company should either not need to incur the costs of trading in administration, or if so, this is for a very limited time. The purchaser is identified and the terms of the sale are agreed before the administrator is appointed, although the proposed administrator will usually be involved prior to their appointment.
Sales in pre-pack situations are generally subject to far less due diligence than a standard corporate sale. Warranties or guarantees are rarely, if ever, given, and assets will be sold as seen. It is commonly used as a way of obtaining value from assets when the publicity of a formal insolvency may devalue those assets, such as goodwill.
If you require advice on an existing debt facility then please do get in touch and we will do our best to assist. We have a lot of experience in restructuring loans and the issues that arise and so please do give us a call or drop us an email if you would like to discuss anything covered in this note.