Preparing PE sponsors and private lenders for a possible wave of bankruptcies
Fear of an impending recession has increased recently as inflation persists, interest rates rise, global supply chain disruptions persist and commodity price volatility continues in the middle of the war in Ukraine.
Add to that a list of privately-funded middle-market companies with over-leveraged balance sheets that have ballooned over the past 18 months, and it’s clear that private capital providers should prepare for a down economic cycle in the states. -United. and increased Chapter 11 bankruptcy filings.
Some of that distress already surfaced when Revlon, Inc., backed by MacAndrews & Forbes, filed for Chapter 11 on June 15, 2022 in the U.S. Bankruptcy Court for the Southern District of New York.
Therefore, private equity sponsors and private lenders should keep several principles regarding Chapter 11 bankruptcy in mind to ensure that they are in the best position to maximize value in the event that a portfolio would experience financial difficulties.
Private capital providers should prepare for a bear economic cycle in the United States and a rise in Chapter 11 bankruptcy filings.
Out-of-court restructuring trumps chapter 11
Chapter 11 is a court-supervised process by which a business can restructure its liabilities (eg, debt, liability, supplier and customer claims) and reorganize into a healthy business. Chapter 11 also allows a business to sell some or all of its assets free and clear of liens, claims, encumbrances, and most successor liability claims.
Notwithstanding the benefits of Chapter 11, if a sponsor-backed company experiences financial difficulty and the board of directors determines, on the advice of counsel, that a restructuring of debt and other corporate obligations business is necessary, the business should seek an out-of-court solution before proceeding with Chapter 11.
There are several reasons why companies, lenders and sponsors might want to avoid Chapter 11 and restructure out of court.
First, an out-of-court restructuring is generally faster and cheaper for the company and its lenders than Chapter 11.
Additionally, in Chapter 11, the company must provide detailed information to the bankruptcy court about its financial condition and conduct prior to bankruptcy, which can be cumbersome and invasive.
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Finally, and perhaps most importantly from the perspective of private equity providers, existing equity is frequently written off in Chapter 11 and holders of funded debt often have their rights changed without their consent. Following its exit from Chapter 11, the holding company has no obligation to restore the integrity of former creditors and shareholders.
In most cases, therefore, private capital providers and their advisors should work with the troubled firm’s advisors to avoid Chapter 11 wherever possible. The best way to do this is to be proactive. The sooner the company, its sponsor and all of its relevant lenders are able to retain professionals and begin to engage in substantive discussions on the terms of an agreement, the better off all parties are likely to be, as this will ensure that there is sufficient time to explore all options for maximizing value.
For this reason, private lenders should consider temporarily waiving their right to seek remedies in the event of a debt security default in order to allow the parties time to negotiate a mutually beneficial out-of-court settlement.
Further, given the time and attention required to do so, the troubled holding company should seriously consider having its advisers prepare the pleadings and perform the due diligence required to file for Chapter 11 if necessary. This will not only avoid a haphazard bankruptcy filing, but allow the company and its equity sponsor to incentivize a consensual deal that leaves former shareholders in place. To do so, he credibly threatens to open a Chapter 11 case that would leave lenders with a pale recovery compared to what they could have obtained through consensual, out-of-court restructuring.
Reorganization via Chapter 11
In some cases, however, a voluntary filing under Chapter 11 is unavoidable. Even in the private credit environment where loan relief makes it less likely that a holding company will breach a debt document, a company may simply run out of cash and have to file for Chapter 11 to obtain bridge financing. In other situations, even if a non-bank junior lender is willing to agree to an out-of-court settlement, senior lenders may not be as agreeable. In this case, without the unanimous consent of the lender for an out-of-court settlement – which is generally required by most corporate debt documents – a company may need to file a Chapter 11 petition to obtain an automatic stay of debt. adverse action by creditors.
From the perspective of a distressed holding company, Chapter 11 offers several key benefits intended to facilitate its reorganization.
First, in certain circumstances, a Chapter 11 debtor may impose its restructuring plan on creditors against their will, even if those dissenting creditors do not receive full recovery. Additionally, because of the special protections the law extends to lenders who provide financing in the event of bankruptcy, it may be easier for a business to get a Chapter 11 liquidity lifeline.
A company may also get rid of unprofitable contracts and leases (for example, those based on commodity prices that differ from the current market price) and leave the counterparty with an unsecured claim that often goes unpaid. totality.
Actively participate in a portfolio company’s Chapter 11 case
Just because there are circumstances where equity sponsors and private lenders may receive little or no clawback in the case of a Chapter 11 holding company doesn’t mean they shouldn’t be actively involved. to the process. Indeed, the exact opposite is true.
Just because there are circumstances where equity sponsors and private lenders may receive little or no clawback in the case of a Chapter 11 holding company doesn’t mean they shouldn’t be actively involved. to the process.
For example, with the assistance of competent advisers, junior lenders or owners of shares that are partially “in-the-money” may be able to acquire shares in the reorganized company by reason of their claims and interests. . It is also not uncommon to see a Chapter 11 debtor issue new securities on favorable terms to sponsors and equity lenders prior to bankruptcy if they are willing to invest fresh money.
In addition, Sponsors and Lenders may each be able to obtain valid releases of certain claims and causes of action held by Company and third parties. It is common for a Chapter 11 restructuring plan to provide for the release of a company’s officers and directors, private equity sponsor and its willing lenders. This is extremely important protection for private capital providers should other interested parties threaten to bring fraudulent transfer demands against the fund in, for example, a leveraged buyout prior to bankruptcy. or a dividend recapitalization transaction.
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Likewise, these same parties may also threaten to sue based on alleged breaches of fiduciary duties by board members affiliated with private equity funds that have invested in the company. In a relatively consensual Chapter 11 restructuring, these claims are also frequently released.
The foregoing discussion is simply intended to provide providers of private capital with a brief introduction to some of the most important principles of Chapter 11. It is not intended to be the final word in bankruptcy or to replace the advice of a experienced restructuring lawyer. Hopefully, however, the principles discussed above will help funds avoid being caught off guard in the next downturn.
Bryan V. Uelk is a member of the finance and bankruptcy team at Sheppard, Mullin, Richter & Hampton LLP. He represents companies, creditors, distressed buyers and other key stakeholders in all aspects of corporate restructuring, bankruptcy and financial distress. He has considerable experience in guiding clients towards value-added results in out-of-court and in-court restructurings, including numerous Chapter 11 reorganizations across the country. Bryan also served as a JAG officer in the Air National Guard for several years, during which he advised wing and squadron level commanders with various personnel actions and provided all types of assistance. legal aid to airmen and their families.