Make yourself comfortable on "Dr." Arqala's metaphorical couch as we delve into the darker recesses of the "psyche" of finance – those connected with restructurings.
We'll conduct our forensic study by tracing the various stages in the restructuring process with tongue firmly in cheek. A planned subsequent post, "Great Moments in Restructurings" will provide some concrete examples from case studies.
Restructurings are usually thrust on the participants. Sometimes this occurs in a rather violent fashion with an unexpected failure to make a payment. Whatever the triggering event, restructurings heighten a wide range of latent pathologies, both traditional as well as those associated with behavioral finance.
Stage 1: "Houston, We Have A Problem"
When confronted with a serious problem (before the payment failure), the borrower's first reaction is to ignore it. "It's just a temporary setback." "When the market recovers, so will we." If I pretend it isn't there, it won't be.
But when the problem refuses to go away and the date of the payment inexorably approaches, the obligor develops an almost religious faith in miracles. "We'll sell our newly formed subsidiary in Waziristan." Or maybe just 40%. "We're going to IPO our not yet created affiliate in Marjah (Afghanistan)." "Our lenders will gladly refinance their loans to allow enough time for our assets to regain their value."
Sometimes borrowers recognize the problem themselves. But usually they don't. Many hire an advisor in the belief that a new loan or a quick refinancing will solve the problem. AA's particular favorite is a bond exchange. In such cases the advisor's first task becomes convincing the obligor that the problem is really serious – two aspirin and a band-aid won't do the trick. At this point the advisor is well advised to refrain from pointing out that in large measure the problem is self-made. That can be dealt with later. And then presented as a remarkable contribution made by the client to finance theory. Through his pioneering efforts the world has discovered heretofore unknown financial principles such as the danger of too much leverage or the risk of financing long term or illiquid assets with short term money. Or that markets and asset prices sometimes go down. Who could have imagined?
Stage 2: "From Hero To Zero"
A great relationship with one's creditors is contingent on there being no problems. The old saw about commercial bankers sums this up quite nicely: "A commercial banker is someone who gladly lends you an umbrella on a sunny day. And then at the first sign of rain demands it back immediately."
The natural tendency for the borrower is to presume that his lenders will understand. "Why they told me that I'm a strategic customer". "I have a personal relationship with their (insert as appropriate) Chairman, Deputy Chairman, Global Head of Syndications, etc. and they won't treat me the way they did (insert name of another company in difficulty)"
Creditors don't react well to the unfortunate news that payments cannot be made on time, particularly if the "news" is delivered by the non payment itself. It's not just a matter of disappointment. A solemn promise has been broken. What could be more sacred than the vows in a financial contract? What sort of person would break them? "How could you do this to me? I trusted you" is not only the lament of the betrayed spouse but the disappointed banker.
Often such events lead to equally startling revelations about the character of one's client. He is suddenly unmasked as incompetent, a habitual liar, and perhaps even a crook. Particularly if the customer has previously told his bankers that there wasn't a big problem. Or that one or more miraculous events would occur. Financial takfir is often pronounced. Or, if not spoken, at least thought.
You can imagine the shock of the borrower at his great fall. And the psychological damage it causes. "How could they turn on me? It wasn't my fault." Betrayal it seems is a two-way street – at least in the borrower's mind.
Stage 3: "And Where The Offense Is, Let The Great Axe Fall"
Such an outrage must have consequences – dire consequences. A virgin or one or more members of senior management must be thrown into the volcano to appease now angry lenders. Since management is the more likely of the two to be handy, a member of management is tossed in.
In some cases professions of contrition and suitably fast talk may secure some reprieve and avoid a sacrifice.
In some lesser emotionally developed markets, the lenders insist that the obligor feel acute pain, even if it is evidently but a pale reflection of their own profound distress. Sometimes the crudest financial revenge is sought – "to obliterate, to punish and to discourage others". Not necessarily at the outset. Perhaps later when the restructuring is being crafted. Hell hath no fury like a scorned banker.
Sometimes the borrower unilaterally takes such an action to show it is serious about the restructuring. A pre-emptive sacrifice to dispose of a senior manager whose credibility with the bankers may be such that he is more a liability than an asset in the negotiations.
Stage 4: "Send In The Clowns"
Negotiations begin.
If the creditor group is large enough, a "Steering Committee" or "Creditors' Committee" is formed to facilitate the process.
By and large the same great minds – both among the lenders and the borrower - that made the original loan are involved in its restructuring. Who better to straighten out the mess than those who created it in the first place? After all, they've already demonstrated their competence in matters financial.
The process begins with a mutual show of lack of trust. The bankers for the unmasked miscreant who days before was their "best customer". The borrower shocked to find that all the prior assurances of relationship were empty words. Blame needs to be assigned. Feelings must be vented.
Then comes the hard part of agreeing the way forward. The borrower wants nothing simpler than to continue his previous path – the sound business strategy and vision that got him into his predicament not through his own fault but due to the manifest errors of others. The bankers want their money and want it now. Business empires have to be dismantled. Plans for the future all have to be shelved to achieve this end.
Generally the borrower's unrealistic ambitions and delusions can be made to surrender to the creditors'.
The problem often is that often the most difficult negotiations take place among the creditors themselves. A process described as trying to herd cats.
During negotiations, the borrower is often told something can't be done because the syndicate won't accept it. "We understand your request, but not all the banks will accept it." A rather convenient excuse to deflect criticism from the Steering Committee for imposing harsh conditions on the borrower or ignoring its requests. As with many commercial negotiations the bankers' "kalaam" on this topic isn't always "sharif". But what duty of honesty does one owe to someone who doesn't honor solemn bond regarding his debts?
Creditors who evidenced scant understanding of banking during underwriting now step forward boldly to advocate a variety of really silly and/or trivial things. No longer quieted by the prospect of joining a "great deal" as they were at the underwriting, they give free rein to their imaginations and lack of knowledge to develop "great ideas". The task of the Steering Committee is to try and bat down the silliest or least useful of these. But to get a deal done sometimes compromises are made. In other cases there is no will. Ultimately it is the borrower who suffers. And what better person to suffer in such a case than the "faithless one"?
Great amounts of time and money are spent in the process. It is here that one can observe "Abu Arqala's Law of the Conservation of Due Diligence" in action. If creditors by and large failed to do a reasonable level of due diligence at the underwriting stage, they will more than make up for it now. With overcompensation directly proportional to the extent of their earlier failure. Legal issues are parsed with Talmudic zeal. Legal and accounting fees pile one upon another.
As usual, the only guaranteed winners from every restructuring are the legal and accounting firms. They get richly compensated no matter what happens. And collect their fees before the first principal repayment is made. The advisors in the Lehman restructuring have already been paid over US$642 million for 16 months' work. And their labors have not yet ceased!
Stage 5: "This Is A Court Of Law, Young Man, Not A Court Of Justice"
A major factor affecting the course of the negotiations is local law and the state of the judicial system. Laws and legal systems that favor the borrower can lead to prolonged negotiations. In some cases the borrower is almost immune from creditor efforts to liquidate it. A strategy of delay to wear down the creditors can work well here. Where the law gives creditors the upper hand, the process can be quicker. If it's too quick, it can turn into a lynching. A general rule of thumb is that the longer it takes to conclude the restructuring the more value that is lost (or more aptly squandered) in the firm and in the ultimate recovery of the lenders' funds.
As well, if the legal system is deficient or can be gamed, the party able to take advantages of these defects has a strong advantage. This applies not only to creditors versus borrower but within the creditor group itself as discussed in Stage 8 below.
Stage 6: "Do You Want to Know A Secret?"
Just like people, companies, all companies, have secrets they would like to keep. Behavior they're not especially proud of and would rather not have come to light. Or be the subject of open discussion. The due diligence process generally exposes these embarrassments. In a restructuring one's kimono is not just open. It's taken off.
These can be "simple" things like that expensive redecoration of the executive floor or more "complicated" things like uses of corporate resources for private projects. Or that "performing" asset that really isn't performing so well. In one view being provided intensive care and nurtured to recovery. In another view, a failure disguised. The lapses in procedures. The special deal for a friend.
Though they have their own similar behavior, banks naturally react with horror and often feigned indignation to the moral shortcomings of their borrowers. I once was involved in a creditors' group which contained a very outraged banker who complained unceasingly about the borrower's moral and business failings. As we all were, that chap was billing that borrower for his attendance at meetings – travel, lodging, meals. His expenses also included rather frequent in room "massages" at his hotel. Apparently, he had a very sore "back". And to ensure his ability to function properly at the meetings during the day required at least one and sometimes two "massages" a night. He was also apparently quite generous in providing beverages for the masseuse.
The more outrageous "sins" are of course terminated. In some cases, tolerated as the "price" of a restructuring. Restructurings are often not the step to financial soundness but moral as well. At least for the borrower.
Stage 7: "Let's Make A Deal"
At some point, often mutual exhaustion, the parties decide it's better to strike a deal than continue negotiating in circles. Sometimes one side can take advantage of the other's greater predisposition to exhaustion to secure an advantage on this or that point. This is where the nature of the legal system can play a major role.
In any case, once the moment arrives, the borrower and the Steering Committee become serious and hammer out a draft termsheet - a document that contains the basic terms of the rescheduling but is not the formal loan agreement. One that does not include all the details. Often the termsheet is agreed with what appears to be unnatural speed, particularly when the time taken to reach this point is considered.
Since the termsheet is the result of a process of "give and take" by the two sides, one might think it was the product of careful analysis of reality and agreement on reasonable projections for the future forged in the furnace of debate. One would be disappointed. Repayment schedules are more often based on what is acceptable to the banks rather than what is required. One simple example: a borrower might need seven years to repay. Banks will insist on five years. To avoid a problem in the early years, payments will begin at modest levels with the problematical amounts shifted to the latter years in large unrealistic payments. Why? Because it is easier to sell such terms to credit committees. "It's a five year deal, honest." And one doesn't really want to harm one's career by advocating the longer (required) tenor. The hope, as I've posted before, is that if any problem occurs it will be on someone else's watch not one's own. And thus by good business logic, the fault of that person.
But this is only a small step forward. The terms must be agreed by all the creditors.
Stage 8: Herding Cats
As the title implies a difficult process. Primarily because individual banks now hold more power than they did at the inception of the loan. Then, if they raised too many issues, they would be dropped and another "wise" lender would take their place. Deadlines for decisions were cast in stone. A failure to respond could cost one's place in the deal. Now there are no such constraints. The lender is already in the deal. Its vote is critically important.
At this point, an institution may require more time to come to a decision. Analytic skills which atrophied due to lack of use in the underwriting stage may need a bit more time to regain their full vigor. Decision making which proceeded with alacrity at underwriting may now need to proceed at a more thoughtful measured pace – much more thoughtful and measured.
What suddenly gives an individual bank such power?
Legal matters which often give a single bank a right of veto.
The first of these has to do with the legal regime in the country of the borrower. Some jurisdictions have mechanisms that allow a specified majority of creditors - but less than 100% - to approve a restructuring. Under this regime, dissenters are forced to go along with the majority vote. They are "crammed down". The old loan contract is superseded by the new one. And thus all creditors lose their right to sue to enforce the old loan contract. If other jurisdictions recognize the validity and integrity of this procedure, they will also deny dissenters the right to bring suit in their jurisdictions.
On the other hand, other jurisdictions, for example the GCC states, require 100% creditor approval to abrogate the old contract. So despite the fact that The Investment Dar has a "deal" in Kuwait, its dissenting creditors still have the right to sue under their old loan agreements for payment and potentially overturn the deal. That's why the strong preference of lenders is to secure the requisite number of votes to preclude such actions.
The second of these has to do with approval on facilities that have more than one bank as lender. Syndicated loans require that 100% of the creditors must agree to any material change in the terms of the financing for it to be binding. These would include final maturity, the amount and pattern of principal repayments, the interest rate, or other material deal terms. One bank can therefore hold up the approval of a syndicated facility even if it only has a very small portion. And, just to be clear, cram downs don't apply at this level unless specifically provided for in the original loan documentation. I've never seen a loan agreement that allows this.
As you might expect, where a single creditor or a relatively small number of creditors can make a problem by delaying a deal, they may exercise this power in the hopes of causing enough trouble so that someone buys them out. Larger creditors with much more at stake who can't let the deal fail. Or the borrower or a "friend" of the borrower. The "friend" because loan agreement covenants prohibit preferential payments (like buyouts) - those not made to all of the syndicate members.
One example of the potential power of the dissenting creditor – though in a (different) pre default context - is the Nakheel Bond where QVT put together a group sufficient in size (usually bond indentures have a low 25% threshold for acceleration) that Nakheel could not strike a deal for a payment standstill or rollover because the QVT group would call default – triggering cross default on other Nakheel obligations. Here the power stopped a default from happening and secured on time payment of 100% of the amounts due.
As well, there can be other impediments to approval. A resolute creditor can revive its previously dismissed "bright" ideas. Where the Steering Committee is powerful and chooses to exercise its power, it may threaten retribution to recalcitrant banks. "Play nice or we'll cancel your lines." Where it is not or chooses not to, less than optimal creditor ideas are included in the restructuring.
Stage 9: The Devil Is In The Details
Once the termsheet is finally approved the creditors' lawyers begin their drafting of the rescheduling agreement. The creditors insist their counsel do this to ensure their control over the process.
This is not only a time for legal wordsmithing but an opportunity for a clever lawyer to try and recast the deal in the termsheet. Or sometimes for a sloppy lawyer to undo aspects of the deal.
In some cases concepts in termsheets are expanded beyond the original understanding of the parties – particularly the borrower's. The idea is that at this point as the train is moving forward to the station, the borrower will be reluctant to get off.
Sometimes what are thought to be brilliant ploys to impose new terms on the borrower turn out in retrospect to have been unintended favors – sometimes quite significant economically. Like the angry creditor who unintentionally gutted a cashflow sweep mechanism – significantly reducing the borrower's mandatory prepayments.
Documentation must be satisfactory to all parties. Once again a determined or slow responding lender can affect the time to complete the restructuring because it isn't legal until all the "bits of paper" are signed. Before signing them, a lender must find them acceptable. The borrower also has a chance here to object.
Another step in the process is the borrower complying with whatever "conditions precedent" it has agreed (or been forced to agree) as part of the deal with the lenders. In the Global Investment House restructuring, certain assets were to be transferred to two special purpose vehicles. No doubt, arranging those transfers was a condition precedent to the restructuring becoming effective. Until GIH did this, its restructuring deal wasn't complete.
Stage 10: "You're Only Using One Side Of The Toilet Paper?"
Lenders want to ensure that the borrower's funds are directed to repayment of their loans on a priority basis. As you'd expect this is a critical issue for creditors. To achieve it they impose a variety of restrictions. Major cashflow items like cash dividends or significant new capital expenditures are controlled by explicit limits or prohibited outright. Other expenses are scrutinized for ways to conserve cash. These restrictions along with financial undertakings and ratio maintenance are made covenants in the restructuring agreement. Violation of these gives a stated percentage of lenders (usually more than 50%) the right to call a "default" and accelerate the maturity of the (restructured) loan. Most of these controls make eminent sense.
But often minor expenses which have no real economic bearing on ultimate repayment are targeted. The borrower must be made to live a more frugal almost monastic lifestyle. More often than not the economic benefit to lenders is less than 1% of the amount of the obligation. Like the chap in one loan restructuring who wondered why certain members of management needed subscriptions to both the Financial Times and The Wall Street Journal. One rather wry and highly numerate fellow creditor thanked him noting that the impact of this simple action would ensure payment of the loan in 50,000 years. Whether the motive is "to obliterate, to punish and to discourage others" or simple stupidity is not always clear.
Elaborate and costly mechanisms are established to ensure that expenses are controlled. Frequently, an accounting firm is engaged to review expenses, charging as is their practice not only an engagement fee but by the hour billing. As you'd expect, it's relatively easy to control a few big items. Not much time or money need to be spent checking if dividends were or were not paid. Or a new building started.
But reviewing a myriad of small expenditures is highly labor intensive. Particularly if a limit is breached. Then offending expenditures have to be identified with elaborate analysis of the justification or lack thereof for each. And a suitably detailed explanatory write-up prepared and provided to the creditors. Not infrequently, the cost of the control becomes more than the face amount of many of these items. To say nothing of management's time diverted from running the business as it must justify each and every overage to avoid running afoul of some covenant in the restructuring agreement.
Unlike funds spent by the borrower, these expenses are always considered perfectly reasonable. As are, the expenses of lending banks: such items as first class airfare, fine hotels, and gourmet meals to attend meetings– all no doubt highly relevant to the restructuring process.
It's hard to find an economic reason for such behavior. A dollar spent however it is spent is in the final analysis a dollar spent.
Postscript
With luck the borrower makes the necessary repayments to the banks and retires the obligation.
Both emerge from the process suitably chastened for previous unwise behavior – though usually only temporarily.
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