Jobs are being slashed, consumers are losing confidence, corporate profits are being squeezed, financial institutions are announcing huge write-downs and talk of a recession gets stronger every day. Against this backdrop, Wall Street's big investment banks are building their restructuring departments in a bid to provide financial advice and financing to companies in distress -- and to earn fat fees along the way.
"Everybody is gearing up," says UBS head of restructuring Steve Smith.
Among the big investment banks, Morgan Stanley at the end of last year hired Blake O'Dowd from Lazard to head the restructuring effort within its investment bank. Lehman Brothers Inc. in May set up an integrated restructuring and finance group, a joint venture between its investment bank and fixed-income units.
UBS recently hired Matthew French, a restructuring partner at British law firm Lovells LLP, to head its restructuring group for Europe, the Middle East and Africa. And Goldman, Sachs & Co., which made a splash in the business two years ago, when it lured high-profile bankruptcy lawyer James Sprayregen from Kirkland & Ellis LLP, recently opened a restructuring shop in Sydney, moving insider Lachlan Edwards from London to run it.
These big firms join a coterie of Wall Street boutiques, including Lazard, Blackstone Group LP, Rothschild and Miller Buckfire & Co. LLC, that have long headlined the restructuring advisory business. For years, a U.S. company's traditional investment banker was restricted from representing that company after it filed for bankruptcy, since the banker was considered an "interested" party. That allowed boutiques to dominate the bankruptcy advisory business, since they were more likely not to have underwritten financing for a company in the three years before a bankruptcy filing. The Bankruptcy Reform Act of 2005, however, eliminated the provision that effectively had disqualified a company's longtime investment banker from being its bankruptcy adviser.
Despite the legal change, the bulge-bracket firms aren't looking to displace boutique restructuring firms, at least for now. One reason is that the boutiques are often clients of the bigger banks. For example, when independent power producer Calpine Corp. filed for Chapter 11 protection in 2005, its financial adviser, Miller Buckfire, turned to Credit Suisse Group, Goldman Sachs, Deutsche Bank AG and Morgan Stanley to provide $7.3 billion in exit financing. And while the 2005 bankruptcy law loosened the definition of "disinterested," investment banks still have to make a choice when a client enters bankruptcy: Either finance the company or advise it, but not both. Even under the new law, "you can't be the provider of capital solutions and be the bankruptcy adviser," says Deutsche Bank's head of restructuring, Mark Cohen. "You have to be on one side or the other."
So instead of competing head-to-head against the boutiques, most larger firms are carving out advisory roles that focus on providing capital solutions to distressed companies before they file for bankruptcy. Firms including Deutsche Bank and Lehman Brothers advise companies looking to deal with looming covenant issues or nearing maturity dates, as well as those seeking strategic alternatives, including asset sales or a sale of the whole company. Deutsche Bank, for example, recently engineered a $193.1 million rights offering for auto brakes maker Hayes Lemmerz International Inc. as part of its balance-sheet restructuring. And Goldman and Lehman Brothers packaged a $400 million exchange offer for amusement park operator Six Flags Inc. in June.
Once a company's problems have gone beyond such remedies, the larger banks tend to operate as a source of financing, providing liquidity with debtor-in-possession loans, exit financing and the like. Goldman and UBS say they do both out-of-court and in-bankruptcy advisory work but focus mostly on out-of-court advisory. "We tend to do more exchange offers, prepackages or prenegotiated deals," says UBS' Smith, though the firm is now engaged as an adviser to bankrupt printing company Quebecor World. Goldman, meanwhile, was sole financial adviser on relocation services company Sirva Inc.'s $563 million prepackaged bankruptcy filing in February, which, hopefully, will work to prevent a protracted bankruptcy. Sirva, owned partly by Clayton, Dubilier & Rice Inc. and ValueAct Capital Master Fund LP, got its DIP and exit financing from prepetition lenders led by J.P. Morgan Chase Bank NA and J.P. Morgan Securities Inc.
Still, not all the big Wall Street banks have jumped on the distressed advisory bandwagon. Firms such as Credit Suisse, Citigroup Inc. and J.P. Morgan are content to simply provide financing to distressed companies, veering away from offering restructuring advisory services. In fact, Credit Suisse has actually spent five years exiting the business of advising distressed companies. Phil Jacob, the firm's co-head of restructuring, says it would rather have distressed advisers, whether boutiques or bulge-bracket firms, tap Credit Suisse for their restructuring finance needs than compete against it for advisory work. Richard Banziger, managing director and head of asset-based finance at Citigroup, agrees. "Restructuring financing is a profitable business for us," explains Banziger. "It wouldn't make sense for us to impair those opportunities" by getting into bankruptcy advisory. Last month, Citi, along with J.P Morgan, Bank of America Corp. and Royal Bank of Scotland Group plc, led a $60 billion refinancing, the biggest ever, for GMAC Financial Services and its troubled mortgage unit Residential Capital LLC.
But it's more than safeguarding their restructuring finance businesses that keeps some large firms from going head-to-head against the restructuring boutiques. "Bankruptcy ... has its legacy customs," Deutsche's Cohen says. Though the legal code that kept a company's investment bank from providing bankruptcy advice is essentially gone, its spirit remains. Many companies facing a bankruptcy filing would rather go with a tried and tested restructuring adviser than gamble on someone new to the game. Thus many distressed companies may engage a large investment bank for capital advisory work but will still hire a specialized restructuring firm once bankruptcy becomes a real possibility.
"So far, we haven't seen any big corporate bankruptcies go exclusively with a bulge-bracket restructuring adviser in a bankruptcy context," says Cohen. "Time will tell, but I think we'll only see shifts around the margin."
Indeed, financing remains the largest part of the restructuring business even for large investment banks that engage in bankruptcy advisory. Goldman, for example, still does more financing than advisory work. So why are firms taking the trouble to enter the advisory business at all?
They are simply following the money or, more specifically, the capital structures, of their corporate clients.
Corporate America, having gorged for years on free-flowing capital, is highly levered. Many companies carry debt with few covenants, benefiting from the cov-lite mania that swept Wall Street before the credit freeze.Meanwhile, the credit markets remain chilled, with no end in sight. According to research firm Dealogic, U.S. debt refinancings, for both distressed and healthy companies, plunged 80% in the first half, to $67 billion, from $338 billion one year ago. That means there will likely be less new bank money chasing bankrupt companies, as lenders who aren't part of a company's capital structure before bankruptcy won't want to get in during bankruptcy.
So the lenders are pursuing advisory work. After all, it's only in bankruptcy that investment banks can't advise as well as finance. Before a filing, they can do both, though if a bank wants to provide DIP or exit financing to a bankrupt client, they would be wise to avoid the advisory mandate.
By entering the advisory business, some full-service investment banks look to leverage their expertise in the capital markets as well as the Rolodexes of their top-flight bankers. At Bear Stearns Cos., former head of financial restructuring chief Daniel Celentano boasted General Motors Corp. as a client. When the firm imploded, Evercore Partners Inc. snapped him up. At Evercore, Celentano joins co-heads Bill Repko and David Ying, who are also big-bank alumni: Repko was the former head of restructuring at J.P. Morgan Chase and Ying ran Donaldson, Lufkin & Jenrette's restructuring group.
Another reason for the restructuring push on Wall Street is the downturn in other investment banking businesses. "When M&A and private equity go south or constrict, [investment banks] look for new revenue streams," says restructuring lawyer Harvey Miller of Weil, Gotshal & Manges LLP. Banks, always looking to bump up fees, are even hungrier now. Though the economic forecast is gloomy, giving financial advice to companies in distress can generate fees.
The scramble for restructuring talent, particularly on the advisory side, reflects that. "Restructuring bankers are very much in demand," says UBS' Smith. "I do know our competitors are searching." In this downsizing climate, restructuring is one of a few banking areas with a reason to expand, through new hires or transfers from other parts of a firm.
Headhunters' calls, though, will most likely go to those whose expertise lies in distressed advisory work, rather than financing. Morgan Stanley, for example, lured O'Dowd from Lazard strictly to ignite its restructuring advisory effort; the firm, like others on Wall Street, has enough financing expertise in house. Indeed, many big investment banks house their restructuring groups within their leveraged finance efforts, putting together two products that are countercycle. Credit Suisse's current restructuring group, for one, was formed in 2006 as a combination of its leveraged finance origination group and its restructuring group, which had been around since the bank acquired DLJ. At UBS, restructuring head Smith is also head of global leveraged finance.
At Goldman, the ramp-up has been a few years in the making. Four years ago, the firm began to shift from doing restructuring work on an opportunistic basis to what its co-head of restructuring, Dhurv Narain, calls an all-weather strategy. "In 2004, in the midst of a bull market, we started preparing ourselves for all markets," says Narain, who joined that year from Credit Suisse. "In the past few years, the group has grown," adds co-head Sprayregen.
But even as firms bulk up, they are still awaiting a long-anticipated surge in corporate defaults. One of the surprises of this economic downturn has been the dearth of defaults and, therefore, fewer than expected restructurings. According to Moody's Investors Service, defaults are up this year -- the U.S. speculative-grade default rate ended the second quarter at 2.4%, up from 1.8% in the first quarter -- but much less than anticipated. In the last two economic downturns, 1990 through 1991 and 2002 through 2003, default rates reached 10% to 12%. During the boom years of 2005 through 2007, default rates hovered at about 1%. Those times were also record years for refinancing. "Anyone who could, did," says Goldman's Narain.
With banks eager to lend, many borrowers got more liquidity than their businesses warranted and no covenants to trigger in their loans. The default rate became artificially depressed and borrowers that in normal times would have retooled their balance sheets, managements or business models were given a free ride. "A number of companies were able to get a greater degree of flexibility from the capital markets, and they are making use of that flexibility now," says Sprayregen. "Some will use the time intelligently, some will not use it as wisely."
In the meantime, the leaders of Wall Street's restructuring groups say they are busy. "Very busy," says Goldman's Narain. Adds Credit Suisse's Jacob, "We've done very well this year in what we categorize as restructuring finance, which is rescues, DIPs and exits. Notwithstanding the lousy market conditions for new issues, we are busy and expect to get busier." At UBS, Smith says his group is active due to "pockets of issues" in sectors including housing, auto suppliers and airlines.
Experts predict default rates will spike, probably as we near 2009, though they are not likely to reach the levels of past downturns. "For me, personally, unless the economy deteriorates more than I expect, we'll see 5 to 6%, rather than 10 to 12%, which seems awfully high," says Smith.
Adds Deutsche's Cohen: "Even absent a credit crisis, we would see an increase." The most likely areas for distress include all housing-related companies, of course, and those driven by consumers, such as restaurants, retailers and packagers as well as commodities, industrials and trucking companies. And "everyone is getting hurt by the high price of oil," adds Goldman's Narain.
Bankruptcy rumblings so far have mostly been contained to the middle market, often the first set of companies to veer into trouble. Being smaller, they are more vulnerable to the undertow of a downward economy. They have fewer assets to sell off, tend to have more concentrated customer bases and less market power with vendors and lenders. But if the weakness in the economy continues or worsens, expect to see defaults among bigger companies as well.
"Leverage levels eventually will catch up with people," UBS' Smith adds. "It's inevitable that some of these companies will succumb to restructuring."
The flexibility of more leverage and fewer covenants might give some companies time to bounce back, especially if the downturn is a short one. But companies could deteriorate more steadily because there is no trigger to start a restructuring. "It cuts both ways," says Sprayregen.
Even with no covenants, companies that run out of money will default, as they fail to make principal payments or meet looming maturity dates. AbitibiBowater Inc. is one example. Hit hard by declining demand for forestry products, AbitibiBowater has struggled since it was created through a merger of Canadian forestry giant Abitibi-Consolidated Inc. with rival Greenville, S.C., Bowater Inc. last year. With its senior notes maturing on April 1 and June 20, AbitibiBowater in May refinanced $1.456 billion of debt, led by Goldman Sachs.
The covenant-lite era will leave its mark on the restructuring process, bankers say. The benefit of covenants was the possibility to help address a company's problem before it worsened. "Ignoring the debtholders' advice is like pretending the lump on your neck will go away," says one restructuring pro.
So some distressed companies, with few or no covenants, will wind up in creditors' hands having destroyed more value than bankrupt companies historically. The era of increased leverage has also left companies holding more secured debt, and so companies may find it harder to raise new debt, since they have few unencumbered assets to pledge in exchange. Ultimately, the salvage value of the companies might lessen, weakening the creditors' potential to recoup their investments.
In addition to increased leverage and fewer covenants, the capital structure of many corporations has changed. The market experienced a greater shift to first- and second-lien secured debt facilities over the more traditional secured debt plus bond financing. The different types of capital structures popular today will pose a new set of problems for distressed companies in this down cycle, and for their advisers.
"The flavor is going to be different," says Sprayregen. Experts foresee quicker sales of bankrupt companies, first- and second-lien fights among creditors and higher financing costs. And then there are the hedge funds, which have become more prevalent players in capital structures. With their different strategy and process, hedge funds may make restructurings more contentious, resulting in more valuation fights.
"It won't be dull," says Smith. "That's one thing I know about this cycle."