Defaults and Restructuring

Introduction

What is Default?

• Occurs when borrowers fail to meet contractual obligations under credit agreements
• Triggering lender remedies and potentially leading to restructuring, bankruptcy, or liquidation

Introduction

What is Default?

• Defaults arise from various causes including payment failures, covenant breaches
• Bankruptcy filings, or material adverse changes
• Understanding default mechanics and restructuring alternatives is essential for managing distressed credits

Types of Defaults

Payment Default:

• Failure to pay principal, interest, or fees when due
• Represents the most serious default type
• Credit agreements typically include grace periods (often 3-5 business days) before payment failures constitute events of default

Types of Defaults

Covenant Default:

• Breach of financial maintenance covenants (leverage, coverage ratios)
• Or violation of negative covenants (additional debt, restricted payments)
• Without obtaining waivers or cures

Types of Defaults

Cross-Default:

• Default under other material debt agreements
• Triggers default under the subject facility
• Preventing borrowers from selectively defaulting on specific obligations while maintaining others current

Types of Defaults

Representation and Warranty Breach:

• Material misrepresentations in borrowing requests
• Compliance certificates, or financial statements
• Can constitute default events

Types of Defaults

Bankruptcy Default:

• Voluntary bankruptcy filings, involuntary bankruptcy petitions
• Or appointment of receivers
• Automatically trigger default regardless of payment status or covenant compliance

Types of Defaults

Material Adverse Change:

• Significant deterioration in business, financial condition, or prospects
• That materially impairs repayment ability
• Though MAC clauses are difficult to enforce absent clear contractual definitions

Events of Default

Monetary Defaults:

• Non-payment of principal on maturity dates
• Interest on scheduled payment dates, or fees within specified timeframes
• Beyond grace periods

Events of Default

Covenant Violations:

• Failure to maintain required financial ratios
• Breach of operational covenants
• Or violation of negative covenants restricting specific actions

Events of Default

Misrepresentation:

• Discovery that representations or warranties were materially false when made
• Or that compliance certificates
• Contained material inaccuracies

Events of Default

Judgment Default:

• Entry of final judgments against borrowers exceeding specified thresholds
• Typically $5-25 million
• That remain unsatisfied or unstayed beyond specified periods

Events of Default

ERISA Violations:

• Material violations of employee benefit plan requirements
• Creating potential liabilities
• Exceeding specified thresholds

Events of Default

Change of Control:

• Ownership changes, management transitions
• Or loss of sponsor control
• Triggering change of control provisions

Events of Default

Collateral Impairment:

• Material adverse changes in collateral value
• Validity of security interests
• Or enforceability of guarantees

Default Remedies

Acceleration:

• Upon default, lenders can declare all principal, interest, and fees immediately due and payable
• Converting term debt into demand obligations

Default Remedies

Payment Blockage:

• Stop making advances under revolving facilities
• Preventing borrowers from drawing additional funds
• Despite technical availability

Default Remedies

Interest Rate Increases:

• Default interest rates (typically 200 basis points above standard rates)
• Automatically apply to overdue amounts
• Or all outstanding obligations following default

Default Remedies

Foreclosure Rights:

• Secured lenders can foreclose on collateral
• Taking possession and selling assets to satisfy obligations
• Subject to applicable legal requirements

Default Remedies

Guarantee Enforcement:

• Pursue guarantors for payment
• Foreclose on pledged subsidiary equity
• Or exercise other guarantee remedies

Default Remedies

Set-Off Rights:

• Apply borrower deposits or other amounts owed by lenders
• Against outstanding obligations
• Reducing exposure through netting

Default Remedies

Replacement of Management:

• In extreme situations with board representation or covenant violations
• Lenders may influence management changes
• Or operational decisions

Forbearance and Standstill

Forbearance Agreements:

• Lenders agree not to exercise default remedies for specified periods
• While borrowers implement remedial actions, cure defaults
• Or negotiate permanent solutions

Forbearance and Standstill

Conditions to Forbearance:

• Typically require borrowers to acknowledge defaults, waive defenses
• Provide enhanced reporting, restrict operations
• And often pay forbearance fees

Forbearance and Standstill

Standstill Provisions:

• Borrowers agree not to make payments on subordinated debt
• Incur new obligations, or take specified actions
• Without lender consent during forbearance periods

Forbearance and Standstill

Professional Advisors:

• Lenders often require borrowers to engage financial advisors
• Restructuring consultants, or turnaround management
• At borrower expense during forbearance

Forbearance and Standstill

Milestones and Deliverables:

• Forbearance agreements specify operational milestones, liquidity targets
• Or restructuring deliverables
• Borrowers must achieve to maintain lender cooperation

Forbearance and Standstill

Enhanced Fees:

• Forbearance typically involves additional fees
• Including forbearance fees (1-3% of exposure)
• Increased interest margins, or professional fee reimbursements

Out-of-Court Restructuring

Amendment and Extension:

• Modify covenant levels, extend maturities
• Adjust amortization schedules, or restructure terms
• Consensually without formal bankruptcy proceedings

Out-of-Court Restructuring

Debt-for-Equity Swaps:

• Lenders receive equity in exchange for debt reduction
• Converting obligations into ownership stakes
• And deleveraging balance sheets

Out-of-Court Restructuring

Principal Reductions:

• Lenders forgive portions of outstanding principal
• In exchange for improved recovery prospects on remaining obligations
• Often combined with equity grants

Out-of-Court Restructuring

Payment Restructuring:

• Modify payment schedules, defer principal amortization
• Add PIK interest toggles, or extend maturities
• Providing near-term cash flow relief

Out-of-Court Restructuring

Asset Sales:

• Dispose of non-core assets, divisions, or subsidiaries
• With proceeds applied to debt reduction
• Improving leverage profiles and focusing operations

Out-of-Court Restructuring

Operational Restructuring:

• Implement cost reductions, working capital improvements
• Pricing changes, or strategic pivots
• Addressing underlying business challenges alongside financial restructuring

Bankruptcy Alternatives

Chapter 11 Reorganization:

• U.S. bankruptcy process enabling businesses to restructure debt
• While continuing operations under bankruptcy court protection
• Emerging with reduced debt and modified terms

Bankruptcy Alternatives

Prepackaged Bankruptcy:

• Negotiate restructuring terms with creditors before filing
• Then use bankruptcy to implement agreed terms quickly (often 30-90 days)
• Binding dissenting minorities

Bankruptcy Alternatives

Assignment for Benefit of Creditors (ABC):

• State law alternative to bankruptcy
• Where companies assign assets to trustees
• Who liquidate and distribute proceeds to creditors

Bankruptcy Alternatives

Receivership:

• Court-appointed receivers take control of businesses or assets
• Managing operations and maximizing value
• For creditor benefit

Bankruptcy Alternatives

Liquidation:

• Wind down operations, sell assets
• And distribute proceeds to creditors according to legal priorities
• When going-concern value cannot be preserved

Recovery Determinants

Capital Structure Position:

• Senior secured lenders typically recover 60-80% of claims
• Second lien 40-60%, unsecured 20-40%, and subordinated debt 10-30%
• With significant variation by situation

Recovery Determinants

Asset Quality:

• Businesses with substantial tangible assets (real estate, equipment, inventory)
• Provide higher recoveries than asset-light companies
• Dependent on goodwill or intellectual property

Recovery Determinants

Going-Concern Value:

• Companies restructured as going concerns generally provide higher creditor recoveries than liquidations
• As ongoing businesses capture operational value
• And avoid fire-sale discounts

Recovery Determinants

Industry Conditions:

• Defaults during industry downturns or sector distress
• Result in lower recoveries due to limited buyer demand
• And compressed asset values

Recovery Determinants

Speed of Resolution:

• Prolonged restructurings consume value through professional fees
• Operational deterioration, and customer/employee attrition
• Reducing ultimate recoveries

Recovery Determinants

Management Quality:

• Effective management teams maintaining operations and customer relationships during distress
• Preserve enterprise value
• While management failures accelerate deterioration

Intercreditor Dynamics

Control Rights:

• First lien lenders typically control restructuring processes
• Through intercreditor agreements granting enforcement control
• Strategy determination, and negotiation authority

Intercreditor Dynamics

Standstill Obligations:

• Junior creditors agree not to exercise remedies for specified periods
• (90-180 days)
• Allowing senior creditors to pursue strategies without interference

Intercreditor Dynamics

Payment Subordination:

• Junior creditors may not receive payments until senior obligations are satisfied
• With payment blockages during defaults
• Preventing value leakage

Intercreditor Dynamics

Amendment Restrictions:

• Junior lenders cannot modify their agreements in ways adversely affecting senior lenders
• Preventing structural or economic changes
• Benefiting junior creditors at senior expense

Intercreditor Dynamics

Purchase Rights:

• Senior lenders often hold rights to purchase junior debt at discounts during default
• Enabling them to eliminate competing claims
• And simplify restructurings

Intercreditor Dynamics

Strategic Conflicts:

• Differing recovery expectations create tensions
• With senior lenders favoring quick liquidations when well-secured
• While junior creditors prefer operational turnarounds offering potential value recovery

Workout Negotiations

Creditor Committees:

• Large defaults often involve ad hoc creditor groups or formal committees
• Negotiating collectively with borrowers
• Improving coordination and reducing free-rider problems

Workout Negotiations

Information Access:

• Lenders demand enhanced financial reporting, operational metrics
• Cash flow forecasts, and asset valuations
• To assess situations and evaluate restructuring alternatives

Workout Negotiations

Professional Advisors:

• Both borrowers and lender groups engage restructuring advisors
• Legal counsel, and valuation experts
• With professional fees often exceeding millions in complex situations

Workout Negotiations

Term Sheets:

• Initial restructuring proposals outlined in term sheets
• Specify debt reductions, equity grants, extended maturities
• And modified terms subject to definitive documentation

Workout Negotiations

Negotiations:

• Iterative discussions address recovery allocations across creditor classes
• Operational plans, management changes
• And structural terms acceptable to requisite majorities

Workout Negotiations

Holdout Problems:

• Minority creditors may reject proposed terms seeking better treatment
• Requiring super-majority approval provisions
• Or bankruptcy processes binding dissenters

Valuation in Default

Enterprise Value:

• Estimate going-concern value using distressed EBITDA multiples
• Typically 30-50% below normalized multiples
• Or discounted cash flow assuming restructured operations

Valuation in Default

Liquidation Value:

• Assess orderly or forced liquidation values for assets
• Applying recovery percentages to accounts receivable (70-85%), inventory (40-70%)
• Equipment (50-70%), and real estate (60-80%)

Valuation in Default

Net Asset Value:

• Calculate asset values minus liquidation costs
• Administrative expenses, and priority claims
• To determine amounts available for creditor distribution

Valuation in Default

Market Approaches:

• Analyze trading levels of comparable distressed debt
• Distressed M&A transaction multiples
• Or market participant perspectives on value

Valuation in Default

Fulcrum Security:

• Identify which debt tranche would receive equity in restructuring
• Based on enterprise value versus debt levels
• Creditors "at the fulcrum" receive equity while senior tranches receive cash or new debt

Common Restructuring Outcomes

Extend and Amend:

• Modify maturities, adjust covenants
• And provide operational latitude
• While maintaining existing debt levels and lender composition

Common Restructuring Outcomes

Deleveraging Restructuring:

• Reduce total debt through principal forgiveness
• Debt-for-equity swaps, or asset sale proceeds
• Improving sustainability

Common Restructuring Outcomes

Take-Under:

• Senior lenders receive full recovery
• While junior creditors receive equity stakes, new junior debt
• Or partial recovery reflecting economic realities

Common Restructuring Outcomes

Liquidation:

• Orderly wind-down and asset sale
• With proceeds distributed according to legal priorities
• When going-concern restructuring proves infeasible

Common Restructuring Outcomes

Sale Process:

• Market business for acquisition with proceeds satisfying creditors
• Either in bankruptcy (363 sale)
• Or out-of-court through negotiated transactions

Recovery Time Horizons

Quick Amendments:

• Simple covenant waivers or minor modifications
• Often resolve within weeks
• With modest lender fees

Recovery Time Horizons

Out-of-Court Restructurings:

• Comprehensive consensual restructurings
• Typically require 3-9 months of negotiation
• Documentation, and implementation

Recovery Time Horizons

Prepackaged Bankruptcies:

• Pre-negotiated bankruptcy processes
• Complete in 60-120 days
• Quickly implementing agreed restructuring terms

Recovery Time Horizons

Traditional Chapter 11:

• Complex reorganizations often extend 12-24 months
• With contentious situations
• Sometimes exceeding 36 months

Recovery Time Horizons

Liquidations:

• Orderly asset liquidations typically span 6-18 months
• Depending on asset types, market conditions
• And complexity

Default Prevention Strategies

Early Warning Monitoring:

• Track leading indicators including sales trends
• Customer concentration changes, working capital deterioration
• Or covenant trend analysis

Default Prevention Strategies

Proactive Amendments:

• Request covenant relief or structural modifications
• When projections indicate future breaches
• Negotiating from positions of relative strength

Default Prevention Strategies

Operational Improvements:

• Implement cost reductions, working capital optimization
• Pricing adjustments, or strategic changes
• Addressing underlying performance issues

Default Prevention Strategies

Asset Sales:

• Divest non-core assets, underperforming divisions
• Or excess real estate
• Generating deleveraging proceeds before covenant breaches occur

Default Prevention Strategies

Equity Contributions:

• Utilize equity cure rights, secure sponsor support commitments
• Or arrange equity injections
• Providing EBITDA addbacks or debt paydowns

Default Prevention Strategies

Liquidity Management:

• Maintain adequate cash reserves
• Manage revolver availability
• And preserve borrowing capacity for unexpected challenges

Lender Considerations

Economic Analysis:

• Evaluate whether restructuring modifications improve ultimate recovery expectations
• Versus immediate enforcement
• Or liquidation alternatives

Lender Considerations

Precedent Concerns:

• Consider whether accommodations create expectations
• For portfolio companies or other borrowers
• In similar situations

Lender Considerations

Legal Documentation:

• Ensure forbearance agreements, amendments, or restructurings
• Properly document terms, preserve rights
• And comply with intercreditor obligations

Lender Considerations

Tax and Accounting:

• Understand troubled debt restructuring accounting
• Cancellation of debt income
• And potential tax consequences for both parties

Lender Considerations

Regulatory Implications:

• Bank lenders must consider regulatory capital treatment
• Loan classification, and reserve requirements
• When restructuring credits

Conclusion

• Defaults represent critical junctures in credit relationships
• Requiring sophisticated navigation of legal frameworks, economic realities
• And negotiation dynamics to maximize recoveries and preserve value where possible

Conclusion

• Understanding default mechanics, available remedies, and restructuring alternatives
• Enables both lenders and borrowers to approach distressed situations strategically
• Rather than reactively

Conclusion

• Successful outcomes balance lender interests in recovery maximization
• With borrower interests in preserving going-concern value
• When economically justified

Conclusion

• Recovery outcomes vary dramatically based on capital structure position
• Asset quality, industry conditions, and process efficiency
• Making careful analysis essential to informed decision-making

Conclusion

• While defaults inevitably involve difficult conversations and economic losses
• Professional and constructive engagement between parties generally produces superior outcomes to adversarial approaches
• Preserving relationships and maximizing value recovery across the capital structure