In the first half of 2009, M&A activity in the United States was down 45% from the first six months of 2008 (according to Deallogic). This statistic is focused on traditional M&A. However, focusing on the world of traditional M&A misses the story. The real story is Chapter 11 and bankruptcy courts, which, together, are the new platform for M&A, with the difference between Chapter 11 M&A and traditional M&A being that purchasers in Chapter 11 are taking control of companies by owning or purchasing debt and converting it to equity and control.
The truth is that significant opportunities exist for investors - both strategic and financial - to “purchase” distressed companies at good prices. And, if the recent past is prelude for the future, then the control transactions being consummated through Chapter 11 M&A activity will increase.
Why is M&A occuring in Chapter 11? Here are three key facts:
- Default rates continue to rise, which is evidenced by the latest S&P report showing that 9.2% of speculative grade companies in the United States defaulted on their loans on a trailing 12-month basis, and S&P predicts that the default rate will increase to 14.3% within the next year;
- Companies took advantage of the credit bubble to execute leveraged recapitalizations and, now, due to the current economic conditions, are having trouble servicing the debt and need to repair their balance sheets; and
- Chapter 11 of the Bankruptcy Code provides financially distressed companies with powerful tools and a strong platform to bring their stakeholders together to effectuate both operational and balance sheet restructurings.
Taking these facts together, an investor quickly realizes good, but over-levered, companies will use Chapter 11 to fix their balance sheets and position themselves for success. As these companies are fixing their balance sheets (i.e., reducing their debt by converting it to equity) investors who purchase the right debt (i.e., the fulcrum security) at the right price will become the new owners with the opportunity for meaningful returns.
What types of deals are being done in bankruptcy? Here are three examples of recent Chapter 11 M&A transactions:
- American Color Graphics and Vertis merged through pre-packaged Chapter 11 plans, with debt holders Avenue Capital and Goldman Sachs becoming the majority owners of the combined company;
- Wellman Corporation consummated a Chapter 11 plan, after both an operational and balance sheet restructuring, with a new money investment from Sola Capital and BlackRock, both holders of second lien debt, and a conversion of debt to convertible debt and equity; and
- Hayes Lemmerz recently filed a plan of reorganization, which contemplates converting its $100 million DIP loan into 87.5% of the equity of the new company.
These are just three examples of a trend that is occurring quite frequently in Chapter 11. This trend demonstrates that M&A activity has not stopped or even necessarily slowed down; rather, it has just moved venues. Rather than taking place in a boardroom where one company decides to merge with or be acquired by another company or investment firm, the transaction is taking place in a courthouse where creditors and the debtor company negotiate a conversion of debt to equity of the new reorganized company. In addition to the venue changing, the negotiating dynamics are different. The staid, polite and market-based terms of the traditional M&A world are replaced by the loud, aggressive and gritty tactics of the restructuring world. However, at the end of the day, the result is the same - the company has new owners.
So what do Chapter 11 “purchasers” need to do? They need to engage in the three main phases of a Chapter 11 M&A transaction (this is greatly simplified for this article):
- Identify the fulcrum security. The purchaser needs to identify the place in the capital structure that is “in the money” and, therefore, could be converted into equity. For example, if a company has $200 million of first lien bank debt, $100 million of unsecured, high yield bonds and an enterprise value of $150 million, then the bank debt would be the fulcrum security and the bonds will likely be “out of the money.” To determine this requires an extensive analysis of the capital structure and a valuation of the business (the investor would also want to review the debt documents in detail, understand unfunded liabilities, such as pension, environmental and tort liabilities, and focus on potential upcoming defaults and liquidity needs of the company);
- Purchase the fulcrum security. Here, the purchaser needs to make a tactical decision about how much of the fulcrum security to purchase. For instance, does the purchaser want to buy a “toe hold” position to get into the game and see how it is being played before jumping in with both feet or buy a significant amount to have real influence from day one; and
- Negotiate the deal. The purchaser needs to engage in the complex negotiations of Chapter 11 M&A to close the deal through a plan of reorganization. To do this effectively, the purchaser needs a keen understanding of the Bankruptcy Code and the Chapter 11 process, flexibility, creativity and thick skin.
When the activities in these three phases are done well, the purchaser in the Chapter 11 M&A process can end up owning a strong company with a strong balance sheet. In today’s economic environment, repairing a company’s balance sheet and enabling it to emerge from Chapter 11 with little to no debt may be the difference between success and failure. It also provides for optionality and opportunity as a company with little or no debt can survive a prolonged recession and also engage in many different transactions in the future for the benefit of its new shareholders. As a result of these opportunities, M&A is not dead, it has just moved from the boardroom to the bankruptcy court.
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.