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When gambling house Tropicana Entertainment LLC leaned toward insolvency this winter and early spring, its management faced what has become an increasingly common problem: locking up Chapter 11 financing.
Tropicana reached out to its lenders in mid-February. Credit Suisse Group, agent for the secured lenders, showed no interest. It solicited a dozen other potential financiers in early March. Five signed confidentiality agreements. Only one, hedge fund Silver Point Finance LLC, would proceed without the consent of pre-bankruptcy lenders for a so-called priming lien, which would require lenders to surrender some of their collateral to support Tropicana's debtor-in-possession financing. Welcome to bankruptcy '08. Tropicana is one among many new bankruptcy debtors that have struggled to fund their cases. The parent of the Linens 'n Things chain, backed by Silver Point and Apollo Management LP, had a similar quest for funding. Linens 'n Things sought a loan from Silver Point, General Electric Capital Corp., J.P. Morgan Chase & Co., Credit Suisse and Ableco Finance LLC, an entity created by Cerberus Capital Management LP to fund leveraged buyouts, recaps and loans that finance bankruptcies and Chapter 11 exits. Only GE Capital had ready financing, court papers state. Debtor-in-possession loans are highly collateralized -- even fraud-tainted companies such as WorldCom Inc. and Enron Corp. had been able to line up financing for their reorganizations in previous bankruptcy cycles. But while several financial luminaries, from Warren Buffett to Treasury Secretary Henry Paulson, have suggested that the worst of the crisis on Wall Street has passed, credit market unease still looms in the realm of bankruptcy. Auto parts maker Delphi Corp. has had to scramble for financing after its exit package tanked, and health insurer Solutia Inc. sued its banks to make them come good on the funding that it would allow it to emerge. Concerns about exit financing have made lenders cautious, even in the insulated realm of DIP financing, for fear of backing a company that may not be able to emerge from bankruptcy. Complexity is hardly new to bankruptcy and distressed investing. In the last wave of restructurings, which peaked in 2002, the industry waded through the fraud at WorldCom, Enron, Adelphia Communications Corp. and others, lawsuits against asbestos companies, the regulatory scrutiny of energy traders and other numerous complications. But since then, there have been developments that distressed debtors, advisers and investors must weigh. New bankruptcy laws, put in place after the debacles of WorldCom and Enron, make it more difficult for companies to extend their exclusive hold on a bankruptcy and create the potential for creditors to put forth rival plans of reorganization. The second-lien, covenant-lite and collateralized debt obligation instruments that have come into vogue in recent years have at times introduced more complexity into negotiations before and after bankruptcy filings. Rising prices for commodities and raw materials, fears of recession, lowered auction valuations and tightened financing that restricts PE buyers all compound matters. As distressed investing opportunities proliferate, the successes of Carl Icahn, Eddie Lampert, Steve Feinberg, David Tepper and Philip Falcone may lure new competitors into the field. All of this comes as debt-ratings agencies are expecting default rates to triple in the coming year. "The changes to the Bankruptcy Code, while they do not make it impossible to reorganize in any sense of the word, require that companies have more cash because there are more cash obligations that have to be satisfied to emerge from bankruptcy," says Weil, Gotshal & Manges LLP bankruptcy chair Marcia Goldstein, the lead counsel in the WorldCom bankruptcy. "At the same time you have a tightening of credit. You also have more and more companies that have capital structures with layered liens and therefore fewer free assets. This may leave less room for a debtor to maneuver. In some cases, that has resulted in sales of assets rather than reorganizations." There have been prominent struggles for exit financing this year. St. Louis chemicals maker Solutia faced an unexpected problem as it attempted to put four years of bankruptcy behind it in February. Solutia sued Citigroup Global Markets Inc., Goldman Sachs Credit Partners LP and Deutsche Bank Securities Inc. in February when the firms balked on a $2 billion exit financing commitment. The parties litigated through much of the month before settling on a $2.05 billion package that allowed Solutia to leave Chapter 11 on Feb. 28. uto parts maker Dura Automotive Systems Inc. had financing in place to leave bankruptcy protection, but the package unraveled and thwarted the company's exit. The company had to get a new DIP package from Ablecoand rework its regorganization plan, which recently won confirmation. Fellow parts maker Delphi Corp. had to get an extension on its DIP loans when an investment from a group led by Appaloosa Management LP that would have funded its exit from bankruptcy faltered. Concern that some debtors may not be able to exit have trickled into the market for DIP loans that finance the heavy lifting of Chapter 11 cases and allow companies to fix their balance sheets and operations. "Right now the dynamics of the market are you can go out and maybe get a DIP loan that is incredibly expensive. But we are seeing more and more that that's not happening," says Jonathan Henes of Kirkland & Ellis LLP, who represented Solutia among other debtors. "You go to your incumbent lenders and say I need a loan. They don't want to take more exposure. They say fine but you've got four months to sell the company." Resin and polyester fibers supplier Wellman Inc. obtained a DIP loan that prescribed an auction schedule. Meanwhile, vitamins and nutritional supplement company Leiner Health Products Inc. launched an expedited sale because of financing hitches. Lawrence Young of AlixPartners LLP says there is a truncated risk curve in the market for DIP loans, which is a new occurrence. "Historically, at just about any risk level, you could borrow at some price. You just had to be ready and able to pay the required rate and be able to justify that price of debt," Young says. "In this market, there are risk levels that people will not finance, and the risk is not necessarily that great. If you're in a DIP, you are superpriority. That's about as safe as it gets, given the fees and duration, and in many cases you still can't get a deal." Some debtors have found creative ways to buy time in bankruptcy court. Homebuilders Tousa Inc. and Kimball Hill Inc. have used tax refunds for financing. Financing has in some cases led to a search for unencumbered assets. Frontier Airline Holdings Inc. is selling four jets to Russian transportation equipment company OAO VTB-Leasing for $106 million. Most of the funds will be applied to Frontier's mortgage obligations. "The current dynamic is companies that are stuck having to file but either with an expensive DIP or a very restrictive DIP," Henes says. "Now we're hopefully going to enter a third phase, although it will take some time. And, unfortunately, some companies don't have time." Companies that are "even starting to smell distress and smell potential violations of covenants" should start focusing on their problems well ahead of time, Henes says. On top of the credit market conditions, there are changes to the Bankruptcy Code. Debtors have less freedom to continually extend their exclusive control of the reorganization. There are also restrictions on leases, vendor contracts and their ability to retain management and other key employees. Henes says the biggest impact has been the addition of section 503(b)(9) of the Bankruptcy Code. Under that section, vendors who delivered goods within 20 days of a bankruptcy are granted administrative claims, which must be paid in full before a company can exit bankruptcy protection. Protecting vendors who delivered goods on the eve of bankruptcy is a laudible goal. Creating a greater number of creditors who must be cashed out is another complicating factor. Alongside an increase in second-lien debt and the difficult market for DIP financing, the rule adds to pressure on debtors. "Now in a market where we have very little if any liquidity, you enter a case," Henes says. "You look at it right away and say, 'How are we going to get this done? We don't have any liquidity, we've got a huge administrative claim that we've got to pay and our DIP lenders are probably pressing us for a quick sale.' " The Bankruptcy Code's limits on the debtors' extension of exclusive control of the reorganization opens the door for competing plans of reorganization. Again, it is not a bad thing to give creditors more of a say in a reorganization, especially if progress has been slow. Limits on exclusive periods may force companies to decide more quickly whether they will reorganize or liquidate. They also give creditors something to hold over a debtor. By causing negotiations to drag, a group of investors could cause management's period of exclusive control to expire. Veterans of the last wave of bankruptcies have experienced dramatic levels of risk and may scoff at the suggestion that the current situation is more complicated than previous reorganizations. WorldCom, a metabankruptcy among mega-bankruptcies, was the largest Chapter 11 reorganization so far. Alongside the bankruptcy were investigations into the fraud that drove the company into Chapter 11. Watching over it were District Court-appointed corporate monitor Richard Breeden, who is a former Securities and Exchange Commission chairman, and Dick Thornburgh, a former U.S. attorney general, who also kept tabs on the company as bankruptcy examiner. There was also fraud at Enron, Global Crossing Ltd., Adelphia and Refco Inc., all of which pressed lawmakers to rewrite the Bankruptcy Code. Regulators scrutinized energy trading practices at Mirant Corp. and Calpine Corp. Asbestos companies W.R. Grace & Co. and Federal-Mogul Global Inc. faced mass tort litigation. Kmart Corp. confronted a difficult retailing environment and its own missteps through bankruptcy. The aftereffects of Sept. 11 wreaked havoc among the airlines. And, of course, the dot-com bubble put telecoms such as McLeodUSA Inc. and XO Communications Inc. in bankruptcy. In the coming year, Standard & Poor's expects March's default rate of 1.4% to increase to 4.7%. In S&P's bear scenario, the rate could reach 8.5%. It could be worse, however. "What we've seen over the last three years is a default rate that's been below 1.5%," Jeffrey Manning of Trenwith Group LLC says. Manning says the appetite in the debt and equity markets has kept those defaults down. "When you see major cyclical restructuring periods either created by recessions or by credit tightening -- which you are clearly seeing now -- you can see default rates that are more in the 30% rate." Distress has enveloped a number of industries and companies. For starters, there are the many leveraged buyouts, such as Linens 'n Things. Moody's Investors Service and S&P have concerns about the debt levels of Univision Communications Inc., which Madison Dearborn Partners LLC, Providence Equity Partners Inc., Saban Capital Group Inc., Thomas H. Lee Partners LP and TPG Capital purchased in 2006 and was levered at roughly 12.5 times Ebitda at the end of 2007. S&P downgraded Apollo Management-backed Claire's Stores Inc. in May, citing poor performance over the past year, and Moody's changed the outlook for Apollo's Realogy Corp., which owns the Century 21 and Coldwell Banker realty companies, to negative in December. The LBO list goes on. Moody's had a negative outlook for two-thirds of home-building debt issuers in the first quarter. The percentage of negative outlooks fell from the previous quarter because 22 companies had already been downgraded. The problems extend from builders such as Tousa Inc. to lenders including Residential Capital LLC, the home-lending arm of GMAC Financial Services, backed by Cerberus, and specialty finance companies such as jumbo mortgage lender Thornburg Mortgage Inc. Regional banks, insurers and credit insurers such as Ambac Financial Group Inc. and MBIA Inc. and mortgage insurers such as MGIC Investment Corp. are also distressed, as are paper, packaging, lumber, restaurants and gaming companies. The sale of Newsday to Cablevision Systems Corp. may have removed the danger of Sam Zell's Tribune Co. tripping its covenants later this year. Publishing remains a troubled sector, though. In Minneapolis-St. Paul, newspaper Star Tribune, for instance, hired Blackstone Group LP in May, less than two years after Avista Capital Partners purchased the Star Tribune Co. from McClatchy Co. for $530 million. "Success in this round of restructuring is going to depend on liquidity," says Edward Weisfelner of Brown Rudnick Berlack Israels LLP. In the last round of restructurings, Weisfelner's clients included the unsecured creditors' committee in Global Crossing and a group of trade claim holders of WorldCom's MCI unit. "I've got four gaming cases on our desk right now," he says. They include Tropicana bondholders; second lien holders in Legends Gaming LLC, which filed for bankruptcy protection in March; holders of second lien debt of Herbst Gaming Inc., which Moody's says may not be able to meet its financial covenants in fiscal 2008; and the lenders to Yonkers Raceway [parent Yonkers Racing Corp.]. "A lot of people in the last round thought gaming was something people were going to do regardless of how difficult the economic environment was," Weisfelner says. This round of bankruptcies may be more litigious as competing groups fight for value. "A lot of people believe that recoveries for subordinate bondholders in this round are going to be more difficult to come by because the companies aren't as well capitalized and their losses have been pretty significant by the time they get into a proceeding," he adds. The proliferation of second-lien debt and collateralized debt instruments makes negotiations even more deeply troublesome. "If a company had a first, second lien, plus junior debt underneath the senior debt, and it was held like it used to be by some funds -- call it 20 parties sitting in a room -- you could still cut a deal," Young of AlixPartners says. "The situations you are seeing now are where a company has three or four tranches of debt and there are 50 to 100 or more holders of each of those tranches. There is no way to get consensus. That's excluding any of the operational challenges." ebt that in recent years came into vogue, such as collateralized loan obligations and CDOs, not as prevalent in the last bankruptcy cycle, present another layer of complication. "In the CDO environment, the ultimate owners of that paper typically have trustees or management companies, and those agents have no authority to make any kind of deals or any kind of compromises outside of a formal bankruptcy process," says Manning of Trenwith Group. "If 1% of your portfolio is in bankruptcy, you can ignore it," he says. "As that number increases, the trustees and the managers of those programs have to adapt. They will get there somehow, but nobody knows how they will get there and how that will impact negotiations." The amount of covenant-lite debt extended in recent years may allow some companies that might have been forced to restructure to remain outside of bankruptcy. "We are getting calls from companies that realize they are having a liquidity crunch and that they are not going to be able to make payroll in a couple of months, but they haven't tripped a covenant yet," Manning says. Covenants served a useful purpose for senior lenders. "When you had a covenant default five years ago, it began a dialogue with the bank potentially well before you had to consider bankruptcy," Manning adds. Banks got a fee for waiving the covenant, he says. The senior lender could ask for outside consultants to vet the business plan and evaluate the assets and the working capital quality. "That tripwire isn't working anymore," he says. "The result is a much more perilous situation. Banks get nervous and are less willing to work with a borrower." To a bankruptcy lender, an auction presents the possibility for a quick reorganization. But forces in the market make competitive sales more difficult to obtain, at least in the current market. For one, Weisfelner says, "An auction assumes you have people out there who've got the financing to bid." If there isn't financing for private equity buyers, auctions will be less active. That creates less incentive for companies to bid aggressively. Partly as a result, valuations in general have come down in recent months, so if a debtor has accumulated significant secured debt, and auction prices have turned soft, it is less likely there will be much value to distribute among bondholders and other unsecured debt holders. That may lead to more reorganizations in which creditors swap their debt for equity, rather than outright sales. One hedge fund manager draws parallels between the types of companies that survived the last bankruptcy cycle and companies now in the clutches of insolvency. There were telecoms caught in the dot-com bubble that had no real value but had attracted funding because of a deregulation-fueled optimism. "We knew that the demand was far, far behind the capacity built into the system," he says. It was not clear how many billions of dollars in investment would vaporize. Still, there were also companies such as WorldCom that, despite all its problems, produced cash and had real value. A bankrupt homebuilder that has a reputation and experience in complex tasks such as acquiring land and getting permits may be a good comparison to some of the telecoms that found buyers. WorldCom and Global Crossing, however, each took two years to exit bankruptcy protection. With the dearth of liquidity to finance exits from Chapter 11 protection, such outcomes are now more problematic. "Our federal bankruptcy laws are established to promote the goals of having a debtor be able to continue on as a going concern and maximizing value for all stakeholders. To do that companies need liquidity. It's the gas that makes that car run," says Henes of Kirkland & Ellis. "In today's environment, with zero to little liquidity, companies that find themselves in distress and have not planned ahead are in an incredibly risky situation. They are not able to take advantage of the tools that the Bankruptcy Code offers to fix their operations and capital structure." - Chris Nolter CategoriesComments Deal Video
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Maybe you should get your facts straight before making claims. Global Crossing was never found to be guilty of any wrong doing.