The (re)negotiator

Simon Johnson, a partner at Freshfields Bruckhaus Deringer, explains financial restructuring

Why might a company need to undergo financial restructuring?

A financial restructuring will most commonly take place when a good business which is performing relatively well ends up being saddled with too much debt.

How might that happen?

We all know that during the period leading up to the financial crisis there was a boom in the availability of credit. What happened was that owners (typically private equity firms) would load up their businesses with as much debt as could feasibly be serviced in order to increase the return on their investment. If you can service debt and then repay it at the end of the relevant period, and you manage to sell the business at a profit, then your return on the equity is greatly increased.

I often use the analogy of buying a house: let's say for £500,000 with a 10 per cent deposit (£50,000) and 90 per cent mortgage (£450,000). When you come to sell you have to pay back the debt, plus interest - we'll assume a total repayment of £500,000. However, if the house has doubled in value to £1million by the time you sell, then (after paying back the half-million) you have made £500,000 on your initial equity of just £50,000: a ten-fold return on your investment. But if, on the other hand, you lose your job in the meantime and become unable to make your mortgage repayments, you're a bit stuffed.

The equivalent of losing your job - and therefore being unable to make your repayments - in the commercial private equity context is a relatively modest drop in earnings, leading to a breach of the financial covenants (the equivalent of breaching the terms of your mortgage). This will trigger restructuring discussions.

With your house there are two ways out of your debt. One way is to remortgage, the other is to sell it. However, as a result of a lack of liquidity in the credit markets, both options in the context of private equity have now been cut off. These businesses could not be refinanced (which is the equivalent of remortgaging) because no other lenders would be prepared to provide new debt. A sale is difficult for two reasons. Firstly, it's not a great time to sell a business (as prices are low, meaning you're likely to lose money on your investment) and secondly, during a downturn people are unable to raise the sort of sums needed to buy a business. That means that company values come plummeting down, which was what you saw after Lehman Brothers collapsed.

So what options does a company have?

If it's a good business with a bad balance sheet then it will be restructured. If it's a bad business with a bad balance sheet then it will probably go to the wall.

What does restructuring mean in lay terms?

The most minor type of restructuring is an alteration of the terms applicable to the debt. So you might amend the financial covenant (contained within the legal agreement governing the basis upon which the loan has been made) so that the company can meet its obligations in the future, perhaps based on a revised business plan. In simple terms, it might pay the debt back in smaller installments but over a longer period. In return for an alteration to the terms, the price of the debt will increase.

Where the problems are more significant (i.e. profit has been hit to a greater extent) then there must be real doubts as to the company's ability to service its debt. In these circumstances, and if the owners of the business are not willing to put more money in to pay off some of the debt, the creditors (usually banks) might say, "this business cannot sustain this amount of debt, you won't put any more money in, so we're going to execute a debt-for equity-swap". In this scenario the creditors take some or all of the shares in the business in exchange for writing off all or part of the debt, making them full or part-owners of the business going forward.

And your role in all this would be to recommend which option to take?

Because we see quite a lot of these situations we know what is normal. One of the ways we can add value is to help clients appreciate what is usual in particular circumstances, and whether what is being asked of them is outrageous, normal or quite generous. It's a question of us being able to express what market practice is. We're also involved in the development and documentation of the deal. We would be very closely involved in the negotiation of the terms. In most instances there is more than one layer of debt. This makes the negotiations more complex because you have to bear in mind the relative positions of the different lenders. The negotiations have an impact on the value of what they're owed.

Who are your typical clients?

It's a mixture of banks, corporates and private equity sponsors. As a firm we also work for the Bank of England. We advised then, for example, on Northern Rock. So we have a wide range of clients and that's what makes this work so interesting.

How has your work changed as a result of the financial crisis?

There's as much of it as before the crisis, but it's of a different type because the problems companies have faced in this recession have been so extreme. In ordinary times there is always restructuring and insolvency work, but it tends only to affect bad businesses. Good businesses, even if they had a lot of debt, tended to be fine during the boom times. That changed as a result of the financial crisis.

Do you expect that trend to continue into 2010, even if the economy continues to improve?

After any recession the first thing that happens is the stock market recovers and then the general economy follows. But there remains a tail of work for up to three to five years dealing with fallout from the recession. To begin with it's mainly restructuring work and then after three to five years perhaps disputes have arisen as a result of going through these processes. In these instances, court cases will inevitably follow.

What sort of exposure would trainees get in this kind of work?

They would be involved in the discussions with the clients and in the drafting and preparation of revised documentation to reflect the new deal. They would play a role in making sure the process runs smoothly - setting up and participating in calls and meetings. They'd also be involved in the legal analysis, looking at the documentation. In a cross border case, for example, they might be required to liaise with local lawyers to understand how the law applies in the different jurisdictions.

Comments