There is a lot of chatter around the water cooler about how falling energy prices puts energy companies and service companies into distress, and—importantly for private equity investors with liquidity—provides an opportunity to acquire energy assets at distressed prices. In part one of this posting, I provided a very basic hypothetical to help laymen understand how falling energy prices often results in energy companies needing to restructure their debts and their assets being offered for sale at distressed prices. In this part two, I continue the hypothetical to illustrate typical types of workouts and restructurings of E&P Co.’s debt and some of the different ways private equity investors can make a play.
Beginnings of Restructuring
With E&P Co.’s stock in the tank and the Notes trading at less than par, distressed debt investors enter the picture. Distressed debt investors will have enough liquidity to acquire assets at distressed prices and hold them until energy prices recover. The distressed debt investors will start to acquire the Notes at less than par (often 40-60% of face value).
Once a large chunk of Notes have been acquired (usually seeking at least two-thirds of the outstanding Notes), the distressed debt investors (now Noteholders) will seek to form an ad hoc group of 3-4 (sometimes more) Noteholders. The Noteholders may also acquire portions of the RBL (sometimes at a discount) to obtain more leverage over E&P Co. If E&P Co. files bankruptcy, most likely the Notes will be placed in a separate “class” for purposes of voting on a chapter 11 plan (which governs how E&P Co.’s debt will be treated). The Noteholders want at least two-thirds of the Notes because (i) it provides greater bargaining power, and (ii) the Bankruptcy Code provides that a class’s vote is determined by two-thirds in amount and one-half in number of creditors voting. By acquiring two-thirds of the Notes, the distressed debt investors obtain a blocking position on any vote, should E&P Co. ultimately file bankruptcy.
Once the Noteholders have acquired a large chunk of the Notes and formed an ad hoc group, they will hire an investment banker and want to begin negotiating with E&P Co. about a work-out of the debt. (This is done after the parties have signed a confidentiality agreement.) Note, even though the Notes are unsecured, the cross-default provisions give the Noteholders leverage (beyond declaring a default and triggering a default interest rate) in that if the Noteholders declare a default, the RBL will also be in default, and the lender under the RBL can seek to foreclose on E&P Co.’s assets.
The Noteholders may wait for E&P Co. to make a “technical default” by tripping any of the various covenants (interest coverage, borrowing base, or more minor covenants), and will declare such default to obtain bargaining leverage.
A restructuring of the debt can take many forms. The form chosen is influenced by many factors, including the amount of cash E&P Co. has on hand, the level of cooperation between E&P Co. and (i) the RBL lender and/or (ii) Noteholders, commodity prices, etc. The restructuring or “workout” can be in-court or out-of-court.
Out-of-court workouts are easier to accomplish when the discussion between E&P Co. and its creditors begins early (before E&P Co. is completely out of cash or in default). They are also easier when most of the Notes are held by only a few parties. For example, the “indentures” governing many Notes may require the agreement of 90-100% of the Noteholders before the terms of the Notes can be amended (such as extending maturity, giving covenant relief, etc.).
Assuming an out-of-court workout is possible, there are many types of relief (and opportunities for private equity investors to jump in).
If the Bank is patient and believes that E&P Co. will be financially healthy once depressed energy prices rebound, a forbearance (in return for cash fees) or a refinance to extend the RBL maturity (at a higher interest rate plus cash fees) is a common workout. However, if Bank is not interested in extending the term, this may present an opportunity for a private equity investor to become involved by purchasing the RBL from Bank and negotiating a workout directly with E&P Co.
A refinance and/or forbearance applies to other forms of covenant relief, as well. For example, E&P Co. may be well within the borrowing base but not be generating sufficient cash flow (given depressed prices) to meet the interest coverage ratio. There are opportunities for private investors to negotiate with E&P Co. to provide replacement financing (either in the form of an RBL or a term loan) or negotiate directly with Bank to purchase some, or all, of the RBL. These types of workouts can also apply to the Notes (remember, however, that an agreement to deviate from the original terms of the Notes may require between 90-100% approval by all noteholders).
If E&P Co.’s situation is higher risk, equity and/or warrants can be an attractive “kicker,” particularly for non-traditional lenders with extra upside potential once energy prices rebound. On the flipside, E&P Co. will consider awarding equity kickers (particularly the more “distressed” the company is) because, while it dilutes existing equity, it preserves some upside for existing ownership.
A very common form of workout is a debt-to-equity conversion. In our hypothetical, 100% of Notes would be converted to equity and E&P Co.’s existing equity would be wiped out. This arrangement is common in a bankruptcy context but can be difficult to accomplish out of court given the high voting thresholds needed to approve such a restructure of the Notes. If the Notes are widely held, it may be impossible to obtain the 90% approval either because (i) differing holders are unwilling to accept the deal or (ii) often, it is logistically impossible to locate and provide a voting ballot to all holders.
Many out-of-court workouts include sales of assets—either to generate cash to pay down debt or as part of a forbearance. For example, Bank may agree to extend RBL’s maturity or forbear on a covenant default so long as E&P Co. consummates a “strategic transaction” (either a sale of property or acquisition of cash-flow generating property) within an agreed (usually short) period of time. This can get a little tricky for E&P Co., however, because the Notes may contain restrictions on the level of assets that can be sold and what can be done with the proceeds (such as reinvestment or paydown of debt). Nuances notwithstanding, private investors may find an opportunity to acquire a portion of E&P Co.’s assets in an environment in which E&P Co. must sell assets by date certain to avoid a default under its debt obligations.
The voting requirements that often impede converting debt to equity out of court are less stringent in a bankruptcy proceeding. As mentioned above, many indentures governing notes require at least 90% agreement of the noteholders in order for the notes to be converted to equity. Within chapter 11, however, the thresholds can be much lower. Recall that the Bankruptcy Code provides that a class’s vote is determined by two-thirds in amount and one-half in number of creditors voting. (Note that the thresholds are determined by the number of creditors that actually vote, not the total number of creditors.) Thus, distressed debt investors that acquire at least two-thirds of E&P Co.’s Notes prior to a bankruptcy can “carry the class” as to dollar threshold and need only worry if many smaller noteholders vote against the plan.
Increasingly, distressed debt investors are obtaining more control over the restructuring process (and boosting their odds of owning the company, if they so choose) by providing additional financing during the chapter 11 and agreeing to convert that debt to equity at a discounted value. In our hypothetical, even if a private equity investor is not interested in acquiring the Notes, there may be an opportunity to participate in providing debtor-in-possession (“DIP”) financing to E&P Co. in chapter 11. The DIP financing can yield a decent return on a loan secured by all of E&P Co.’s assets. Alternatively, in a situation such as that described above, participation in providing the DIP financing may yield an opportunity for that loan to be converted to equity at a discounted value, thus resulting in ownership of stock in reorganized E&P Co. at a lower basis.
To minimize the expense and delay that can be associated with bankruptcy, a private investor (or group of investors) can acquire a majority block of the notes and negotiate a debt-for-equity swap with E&P Co. prior to filing chapter 11 and effectuate the swap in chapter 11 via a “prepackaged” bankruptcy (where votes on a chapter 11 plan are solicited prior to bankruptcy) or a “prearranged” bankruptcy (where the parties have agreed to material terms). Prepackaged and prearranged bankruptcies allow a smaller group of creditors holding a large percentage of the debt to negotiate directly with E&P Co. with much less influence by outside parties (such as trade creditors that will have a voice and forum to raise concerns with the bankruptcy court). Prepackaged and prearranged cases generally are shorter in duration than typical bankruptcy cases with less cost (in the form of attorney fees, bankruptcy fees, etc.).
In addition to debt-to-equity conversions, chapter 11 is also a strong forum for conducting sales of E&P Co.’s assets. In our hypothetical, E&P Co.’s RBL and Notes each contained restrictions on assets that could be sold and what could be done with the proceeds. In a chapter 11, however, E&P Co. will be free to sell assets notwithstanding any such restrictions in the RBL or Notes. A sale within chapter 11 will usually be free of liens and encumbrances, so purchasers are reassured that the assets acquired have been blessed with a federal court order as being free of liens. Sales within chapter 11 can be for all, or part, of E&P Co.’s assets, and can provide an excellent opportunity for private equity investors to acquire distressed assets free of legacy debt.