turnaround financing

Prof. Ian GiddyNew York University

Turnaround Financing

Copyright ©2000 Ian H. Giddy Financing Turnarounds 2

Corporate Finance

CORPORATE FINANCEDECISONS

INVESTMENT RISK MGTFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


Capital Structure: East vs West

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?

Intel TPI


Fixing the Capital Structure

Too little debt Managers like to control

shareholders’ funds Underestimate the cost

of equityProduces Less discipline Excessive cost of

capital Takeover risk

Too much debt Close control of equity Easy money Underestimate business

or financial risksProduces Risk of financial distress Excessive cost of

capital Destroy operating value Takeover risk


The Three Excesses

Labor Capacity Debt


TPI’s Refinancing

Asia’s biggest debtor Almost $4 billion in foreign currency

debt financing domestic revenues Protracted rescheduling results in $360

million debt/equity swap No change in management or effective

control Still needs $1.2 billion new equity


Debt-Equity Swaps

Cosmetic or real? Choices for company under siege

Raise new equity to pay off creditorsExample: IridiumGive creditors equity in place of debtExample: Sammi


What Do Debt-Equity Swaps Do?

Overleverage creates financial distress

Actual or potential default

Lenders take equity in lieu of repayment

Lenders hold equity passively Lenders replace management Lenders sell equity

Existing management buys time Change of controlmeans restructuring

Financial engineering Bottom line “rationalization” Divestitures & outsourcing


What Are The Alternatives?

Key: Make the new securities attractive to:Existing lendersNew lendersNew bond investorsNew equity investors


The Financing SpectrumEx

pect

ed R

etur

n

Risk

Senior Debt Returns independent

of the value of the business

Control through covenants

Equity Residual returns

after contractual claims

Control through voting rights



pect

ed R

etur

n

Risk

Senior secured debt

Equity

Senior unsecured debt

Subordinated debt

Preferred equity

Convertible debt



pect

ed R

etur

n

Risk

Senior secured debt

Equity

Senior unsecured debt

Subordinated debt

Preferred equity

Convertible debt

Asian bank NPLs


What Are The Alternatives?

Asset-backed or cash flow-backed debt Senior debt Subordinated debt Subordinated debt with upside

participation Subordinated debt with equity option Preferred equity Restricted shares Common stock


Subordinated High Yield Debt

“Junk bonds” – like equity, but allow increased financial leverage

Tax advantage over equity Big market in USA (institutional investors) and

increasing in Europe Leveraged loans favored by certain

commercial banks Often used in connection with M&A and LBOs Behave like equity – and often have equity

participation


Sub Debt -- Motivations

Optimization of financial leverage Regulatory-driven capital requirements Rated asset securitizations (senior-sub

structure in asset-backed securities) Insider or supplier-credit subordination

(eg in project finance) Work-outs and restructurings (existing

borrowers agree to seniority of new loans, to buy time)


Sub Debt’s Big Problem: High Interest!

Solutions Deep discount subordinated debt Subordinated debt with equity warrants Convertible subordinated debt Participating subordinated debt Puttable subordinated debt


Preferred Equity

Legally a form of equity Claim senior to ordinary equity May have fixed dividend, or may be

“participating” But cannot trigger liquidation if payment

missed Par value determines liquidation claim


Convertible Preferred

Used by venture capital firms Permit investors to participate in growth But give preference in liquidation if the

venture fails And disguise share value (tax!) A variant – PERCS* give issuer right to

convert into common stock

*Preferred equity redemption cumulative stock


Preferred Stock: Pros and Cons

Advantages No dilution of control Dividends

conditional on availability of earnings

Omission cannot force liquidation

Disadvantages Higher after-tax cost

than debt Lower return on

equity Limited investor

interest


The Difference “The Ministry of Finance received a preferred

share while investors received a preferred share and a warrant allowing them to purchase the ministry's share at a 13.3% premium (equivalent to the cost of carry) during a three-year period. The preferred shares carry a 5.25% dividend and full voting rights”

"When institutions started buying the story, they bought the convertible bonds, the sub debt - you name it, they bought it."

Alternatives: Thai Farmers Bank: SLIPS, Bankok Bank: CAPs


Transparency and Disclosure

A 275-page prospectus, which provided a breadth and depth of information previously unseen in an Asian issue.

"We went and looked back at US bank holding company offers - those that were US SEC Grade 3 compliant. We also went back and looked at a lot of the prospectuses for the recaps of US banks, like Mellon and Citibank. We looked at the level of disclosure they achieved and committed ourselves to exceeding that -- which SCB did."


MacroFactors

• Currency overvaluation• Capital restrictions

StructuralFactors

• Acctg & disclosure requirements• IAS compliance• Bankruptcy regime• Creditor rights• Govt-corporate nexus• Trading infrastructure

• Price-Value ratio, Sharpe ratio, EVA• D/E ratio• Currency & maturity mismatch• IAS conformity• Insider control• Objective research coverage• Trading liquidity

Firm-levelFactors

What Globally Mobile Investors Look At


Debt

Equity

Domestic market

Foreign market(Depositary Receipts)

BNY ADR Index

-7.47%-13.54%-19.28%

MSCI Index

-28.23%-25.64%-36.53%

AsiaLat AmerEmerging Markets

(1996-98)

Can the Form of Foreign Participation Make a Difference?


Debt

Equity

Domestic market

Foreign market(Depositary Receipts)

Unsponsored Private placement

Exchange traded

Exchange traded IPO

Private placement IPO

Global issue or GDR

Can the Form of Foreign Participation Make a Difference?


Tracking Stock

Tracking stock, sometimes known as letter stock or alphabet stock, is a class of stock designed to reflect the value and track the performance of a part of the issuer's assets, usually a separate business or group of businesses. Claimed advantages:preservation of the efficiencies of a single

corporationability of the market to more accurately value the

respective businesses of the issuer What does it really add?


Restricted Stock: Pros and Cons

Advantages Overcome foreign

control restrictions Insiders retain

control If company well run,

value of control may be low

Disadvantages Nonvoting stock

trades at a discount Dual-class recaps

hurt stock price May allow

management to avoid needed reforms


The New Equity Option

Key: Make the new equity attractive to: Portfolio investors

DomesticInternationalReduce agency costs or we’ll “Just say no!”

Strategic/direct investorsDomesticInternationalCede control or we’ll go elsewhere


PT Astra International

?


PT Astra International

1997: Almost $2 billion USD debt 1998: Steep losses Mostly IDR revenues 1999: Debt restructuring, return to

profitability Bina Busana Internusa: February 1999 US $1 mio PT Astra International: June 1999 US $1,149 mio. Fuji Technica Indonesia: September 1999 US $16 mio Federal International Finance: December 1999 US $107 mio. Traktor Nusantara: December 1999 US $ 21 mio. Astra Graphia: December 1999 US $82 mio.


New Equity for Astra

What investors?Portfolio investorsFinancial investorsCorporate investors

What returns should they expect?= Risk-free rate+ Corporate risk+ Financial risk (leverage/debt mismatch)+ “Agency cost” premium+ Country risk

What restructuring?


How Risky is Astra?

Mean

The riskier the better!


Common Stock as a Call Option

The equity in a firm is a residual claim, i.e., equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc.) have been satisfied.

If a firm is liquidated, the same principle applies, with equity investors receiving whatever is left over in the firm after all outstanding debts and other financial claims are paid off.

The principle of limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than the value of the outstanding debt, and they cannot lose more than their investment in the firm.


Payoffs to Shareholders on Liquidation


The Conflict Between Bondholders and Stockholders Stockholders and bondholders have different

objective functions, and this can lead to conflicts between the two. For instance, stockholders have an incentive to take riskier

projects than bondholders do, and to pay more out in dividends than bondholders would like them to.

Since equity is a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity. It is therefore conceivable that stockholders can take risky

projects with negative net present values, which while making them better off, may make the bondholders and the firm less valuable.


The Creditors are Prowling

Trouble!

The financingis bad

The companyis bad

Businessmix is bad

Raise equityor

Change debt mix

Change controlor management

through M&A

Sell some businessesor assets

to pay down debt

Reason

Remedy


www.giddy.org

Ian GiddyNYU Stern School of BusinessTel 212-998-0332; 917-930-0291Fax 212-995-4233; [email protected]://www.giddy.org

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