Restructuring

Contributed by Jordan Bryk
This past Friday, the Bankruptcy Blog was down in Philadelphia covering the Wharton Restructuring and Distressed Investing Conference.  This year’s theme, Health of Nations: Distress, Recovery, or Revival, hit on a variety of timely topics and captured a general sentiment of skepticism balanced by opportunity.  Marcia Goldstein, Gary Holtzer, and Garrett Fail represented Weil on the Legal Restructuring and Operational Restructuring panels.  Here are some of the key takeaways.
Keynote 1 – Edward Altman, Professor, NYU Stern (State of the Markets)
Professor Altman characterized the present state of the markets as a benign environment that will likely continue through 2013, but he predicted that distress will pick up in 2014.  Professor Altman pegged this year’s corporate default rate at 3.2% (on a dollar denominated basis), which is consistent with this blog’s 2013 Restructuring Outlook Survey.  He hedged that a sudden shock to the system raising interest rates could accelerate the deterioration of the markets in this year.  On the other hand, if the Fed keeps its foot on the accelerator, the actual default rate will likely be lower.
Professor Altman linked today’s mild default rate to the Federal Reserve’s bond buying programs, which have kept interest rates at record lows and have allowed companies of poor credit quality to refinance cheaply.  He warned that the Fed’s policies have failed to generate robust macroeconomic growth and have instead led to a rapid expansion of the high yield bond and leveraged loan markets, which could result in a painful bubble burst down the line. 
Professor Altman identified four significant market risks going forward: (1) a global economic slowdown; (2) a deteriorating European sovereign debt crisis; (3) contagion; and (4) LBO / covenant-lite expansion.  On the topic of European debt, Professor Altman criticized the traditional macroeconomic indicators of sovereign health and default (e.g., credit default swap spreads, debt/GDP, deficit/GDP) as notoriously late in anticipating a crisis.  As an alternative, Professor Altman advocated an analysis of the probability of default in each country’s private sector.  Through this lens, Professor Altman sees little fundamental improvement in the European economy.
Professor Altman is concerned that history is repeating itself when it comes to the LBO market and pervasiveness of covenant-lite loans.  Today’s purchase prices and debt-to-EBITDA multiples look eerily similar to those of ’05 and ’06, and the market has once again become “promiscuous” in its willingness to finance low quality credit and dump it in the CDO market.  All these risks aside, Professor Altman pointed out that, from an investor’s perspective, distressed debt investing has outperformed most other asset classes, including the S&P 500, over a 10-, 5-, and 3-year period.
Keynote 2 – Lee Buchheit, Partner, Cleary Gottlieb
Lee Buchheit framed the difficult choices facing today’s European leaders in the historical context of the 1980s Latin American debt crisis.  The bailout mechanism employed at the time was simply to extend maturities without haircutting principal or interest.  Expecting a short-lived problem, Latin American policymakers failed to anticipate that maturities would require recurring extensions over the course of the following decade.
Mr. Buchheit fears that the European Central Bank’s low interest rate bond-buying program is a huge gamble that carries substantial risks.  Namely, if the ECB had to buy bonds for an extended period of time, an unanticipated market shock that spikes the yield curve could bankrupt Europe.  Moreover, the decision to buy bonds in the short part of the yield curve encourages an unsafe number of refinancings in the two-three year period and leads Europe down a dangerous road.
Mr. Buchheit encourages restructuring professionals to keep a close eye on how policymakers handle the Cyprus debt crisis.  While the amount of money involved is relatively de minimis from a sovereign debt perspective (2 billion EUR), the precedent that will be set for other European nations will be critical.  Mr. Buchheit ultimately believes that a gross bailout from the public sector is the most effective mechanism to resolve Europe’s debt crisis.  Yet, with a dash of British humor, he acknowledged that this approach effectively takes money from the pockets of a poor taxpaying German frau to line the pockets of a Greenwich, Connecticut hedge fund manager.
Legal Restructuring Panel – Financial Institution Failures: Challenges and Lessons Learned
Marcia Goldstein (Partner, Weil), the panel’s moderator, differentiated between commercial company failures, in which chapter 11 is used to rehabilitate the corporate enterprise, from financial institution failures, in which the various pieces of the corporate enterprise are inevitably sold and liquidated.  She pointed out that investors in failed financial institutions have access to an extraordinary amount of information made publicly available through the websites managed by chapter 11 administrators and SIPA trustees.  The result is often a very knowledgeable and sophisticated creditor base.
Stephen Lubben (Professor, Seton Hall Law School) discussed whether the Orderly Liquidation Authority (OLA) mandated by Dodd-Frank will effectively manage the severe market disruptions associated with financial institution failures.  He sees positives in the FDIC’s expanded receivership powers, a 24-hour stay to close out and transfer financial contracts, and a built in funding mechanism.  Given the FDIC’s lack of experience and the unknown interplay with international regimes, however, the first couple of OLA insolvencies are bound to be turbulent.
Gary Holtzer (Partner, Weil) described the difficulty, from an investor’s perspective, in predicting whether the OLA will be invoked.  In performing the waterfall analysis, investors must discount the estimated recovery to account for the probability of OLA involvement.  Investors should expect lower recoveries if the OLA is involved because its purpose is financial stability, not creditor recovery.  Mr. Holtzer added that another challenge for investors is figuring out which entity is the obligor on a given security and stressed the importance of considering how intercompany claims may impact the investment positively or negatively.  Mr. Holtzer also discussed the multidimensional challenges involved in winding down monoline insurance companies (e.g., FGIC) that insured toxic mortgage debt.  First, the uncharted waters of insurance insolvencies are governed by state law regimes that lack the clarity of chapter 11.  To complicate matters further, these insurance companies are often multinational enterprises, which implicate foreign insolvency proceedings.  Finally, the counterparties to the debt are often in insolvency proceedings of their own (e.g., FGIC insured the debt of Jefferson County).
Richard Wynne (Partner, Jones Day) discussed the nightmarish experience of managing a failing financial institution whose walls are rapidly falling down.  Corporate resources and systems that were once shared – employees, intellectual property, centralized cash management, books & records, NOLs – are suddenly fragmented and inaccessible in separate insolvency proceedings.  James Kobak Jr. (Partner, Hughes Hubbard) discussed his experience managing the SIPA insolvency proceedings of Lehman’s broker/dealer arm and MF Global.  He noted that the U.S. regime offers little flexibility to run the business and instead requires a transfer of customer accounts and a liquidation of assets.
Keynote 3 – Frederick Henderson, Chairman/CEO, SunCoke Energy
Frederick (Fritz) Henderson reflected on his experience as CEO of SunCoke Energy and former CEO of General Motors to discuss what can go right and what can go wrong when companies enter emerging markets.  While acknowledging that pro forma calculations are almost always wrong, he stressed the importance of “getting the big things right.” 
Companies entering an emerging market will face a number of strategic decisions, including: (1) build from scratch vs. buy & remodel; (2) partner with an existing enterprise vs. go it alone; and (3) empower local decision-making vs. centralized decision-making.  Mr. Henderson expressed a strong preference for local decision-making with global support.
Companies entering an emerging market must also be aware of the risks associated with the role of government, the role of foreign exchange, the cost of capital, the ethics and business environment, infrastructure deficiencies, industry nationalization, and the possibility of selecting the wrong local partners.  Speed, flexibility, and local knowledge are the most important factors in managing these risks.  Mr. Henderson ended on an optimistic note that, if you get these “big things right,” there is huge profit potential.
Keynote 4 – Steven Tananbaum, CIO, GoldenTree Asset Management
Mr. Tananbaum discussed the strategies that work for distressed investors in today’s mid-cycle environment, which is characterized by cheap money, leverage, increased M&A activity, and a deterioration in financing discipline.  His general sentiment was that opportunities for distressed investors exist, but the degree of difficulty is high. 
His firm is focusing on the shipping, publishing, and information directory industries and is tailoring its “distressed playbook” to target the following opportunities:

• Good company, bad balance sheet (often driven by expensive LBO, e.g., TXU)
• Troubled but sustainable business (often driven by poor management, e.g., Chiquita)
• Companies with separable businesses
• Companies in liquidation
• Companies/Countries with unique issues (e.g., Spanish regional debt)
• Dislocation opportunities
• Acquisition opportunities
• DIP / rescue financing (e.g., Eastman Kodak)
• CLOs (e.g., European leveraged loans)

Operational Restructuring Panel – Operational Challenges in Cross-Border Insolvencies
Daniel Ehrmann (Managing Director, Alvarez & Marsal), the panel’s moderator, set the stage for the discussion with the theme that global businesses are run by business unit but fail by legal entity.  The biggest value destroyer in bankruptcy is the operational challenge that each legal entity’s administrator will only have access to the tools available in that legal entity (e.g., people, system, data, etc.).  When global financial institutions fail, that operational problem is exasperated by the sheer volume and overlap of legal entities as well as the complexity of the asset base (i.e., book entries vs. hard assets).
Jeffrey Donaldson (Managing Director, Alvarez & Marsal) discussed how the Dodd-Frank living wills requirement has led to a collective awareness that international financial institutions are very difficult to manage during insolvency.  That living wills must assume foreign jurisdictions will not provide any support displays the lack of coordination thus far with foreign insolvency regimes.
Garrett Fail (Partner, Weil) discussed the importance of establishing protocols to manage the various resources and systems of a global enterprise when the corporate walls come down in financial institution insolvencies.  He reflected on his experience advising Lehman to develop a non-binding international protocol between competing legal entities to govern information sharing and claims reconciliation.  Ultimately, Lehman’s diverse stakeholders found value in working together to increase the size of the corporate pie.  Mr. Fail also highlighted the efficacy of transition services agreements, which enable employee sharing across the disparate pieces of the fractured enterprise.
Owen Littman (General Counsel, Cowen Group) shed light on the vantage point of investors with large sums of money tied up in an insolvent broker/dealer.  The first major challenge is figuring out which legal entity one is facing, and the second is figuring out what is written in the fine print of your prime brokerage agreement (e.g., the limits of rehypothecation).
Patrick Cowley (Principal, KPMG China) discussed the challenges posed by culture differences when unwinding a global enterprise.  In his experience, cultures vary in their willingness to act flexibly with regard to court orders and timetables.
Financial Restructuring Panel – The Muni Storm on the Horizon
The panelists, led by moderator William Nolan (Managing Director, FTI), discussed the significant cultural differences that restructuring professionals must adapt to when managing municipal bankruptcies, including: (1) the prevalence of bureaucracies; (2) the focus on job preservation and budget protection as opposed to profit maximization; (3) the primacy of public opinion as opposed to the opinion of management, a board of directors, and creditors; and (4) the resistance to making difficult decisions out of fear of political backlash. 
Panelists included Jamie Baird (Managing Director, Blackstone), Lewis Feldman (Partner, Goodwin Procter), Sean Gumbs (Managing Director, FTI), James Pass (Portfolio Manager, Guggenheim Investments), and Rebecca Rhynhart (Budge Director, City of Philadelphia).  On an optimistic note, Mr. Baird shared his experience working with former Kansas Senator Sam Brownback to apply private sector cost savings tactics to a swelling public sector budget.
As it has for the past nine years, the Wharton Restructuring and Distressed Investing Conference brought together a variety of professionals from academia, business, and the law to share interesting perspectives on global economic issues facing the distressed investor.  We look forward to next year’s program in February 2014.