Source: Investment Dealers Digest
 
The next wave of bankruptcies may see companies exit Chapter 11 more quickly than they have in previous cycles, according to Andrew Miller, senior managing director at Houlihan Lokey Howard & Zukin, who works on restructuring the balance sheets of troubled companies.
 
Because companies have borrowed more money against their assets, the lenders who have a claim to those assets will be reluctant to extend material debtor-in-possession financing as they have traditionally done, for fear they will not be able to recoup their money if the company cannot turn things around. Instead, he says, they will push for fast exits and perhaps a sale of the company. "DIP financing can be a low-risk way to earn additional fees, but it may not be low-risk if the debtors' assets are insufficient to cover the secure debt," Miller says.
 
Whether or not bankruptcies turn out to be quicker than in the past, it is clear that the next restructuring wave will be very different from the last one, which kicked off late in 2001 and included the collapse of such giants as Enron and WorldCom due to fraudulent accounting and unsustainable debt loads.
 
Three things will be different this time around, bankers say. First, bankruptcy laws have changed. Under the Bankruptcy and Consumer Protection Act (BACPA) passed in 2005, companies will have just an 18-month "exclusivity" period to come up with a reorganization plan and get it approved by creditors and the courts. In the past, it was easier for companies to receive extensions, allowing them to drag out the process. Second, companies have issued a great deal of second-lien debt, most of which has ended up in the hands of hedge funds. Holders of these debt obligations are not first in the line of creditors, but they have more rights than all the unsecured creditors.
 
"The flavor du jour in the financing market in the last three to four years has been second-lien paper, which didn't exist in the last wave, really," says Jim Millstein, co-head of restructuring at Lazard. "Bondholders holding mere unsecured paper are just part of the great unwashed mass of unsecured creditors, whereas second-lien paper holders can walk around with a little more swagger because they're separately classifiable from the other unsecured creditors and they don't necessarily have to kowtow or be patient with them," Millstein says.
 
One theory is that sophisticated investors in the secondary market, such as distressed and relative value hedge fund investors will pile into second-lien pieces of paper and use the rights that those afford them to cram unsecured creditors out of the case and walk away with huge profit opportunities, Millstein says. Such a result might be achieved in a so-called 363 sale - the sale of a company under Chapter 11 protection.
 
Marc Puntus, managing director at Miller Buckfire, a restructuring specialist, believes that in many cases, these sophisticated investors have a different agenda. "I think the distressed funds that move into that paper do so with a view toward owning the company, and that means you'll have a more traditional reorganization and conversion to equity," Puntus says. "While there will be some section 363 sales, as there always are, I don't believe that the abundance of second-lien debt, the associated capital structure complexities and the truncation of exclusivity under BACPA will lead to a disproportionate number of quick whole-company asset sales in Chapter 11."
 
The other big difference between the coming default cycle and the last one is that leveraged loan and high-yield bond issues have fewer investor protections than in the past, according to Neil Augustine, managing director at Rothschild. "In prior default cycles, you had various amendments where banks were planning for the debtor to run into trouble. Now, if there are no covenants allowing banks to manage a company into a workout or an out-of-court restructuring, they can't shut off the revolver, and the company is out of money by the time people get around the table. Once you run out of money, you're in a situation with limited alternatives."
 
The result, Augustine says, is "more chaos," making it harder for a company to get debtor-in possession financing to work its way out of bankruptcy. That may lead to more companies seeking to sell the business.
 
Still, it is unclear whether all these new elements will add up to faster restructurings, says Lazard's Millstein. "Who knows how it plays out? Every case is going to be sui generis, as it always is. It will depend on the value of the assets and what the future projections look like before there can be any hard and fast rules that can be stated."