One constant runs through, however, this ever-changing dynamic. The
story of bankruptcy this past decade is in many ways the story of
liquidity. At times, this torrent of cash and credit gushed out of
control, like some broken water main. In the past year or so, it
narrowed to a trickle. Both extremes wreaked havoc. "Liquidity -- or the
lack there of -- creates the problem in many cases," says Heller. "It
goes too fast, then everything seizes up."
Too much liquidity sowed the seeds for the current cycle of
bankruptcy and distress. Abundant liquidity offered easy and available
credit to acquire assets at inflated values and then more debt to paper
over any financial shortfall.
"It always fascinated me that thoughtful, sophisticated corporate
executives or private equity firms would believe that the solution to
resolving the problems of a company that was 7 times leverage was to
add another turn and a half leverage," says Henry Miller, the chairman
and managing director of New York investment bank Miller Buckfire & Co. LLC, with more than a trace of sarcasm.
Too little liquidity threw all sorts of companies over the edge.
"It's simple. If you don't have access to capital, you're not going to
survive," Jones says.
Liquidity this decade was either absent or overly abundant, but
rarely, it seems, in any kind of "normal" equilibrium. When talking of
bankruptcies, many practitioners divide the decade into two distinct
periods: The first was the dot-com bust that began in late 2000,
accentuated by huge fraud-related failures and a telecom collapse a
year later. The second was last year's systemic failure of the
financial system, which was "credit-market led as opposed to
equity-market led. It was generalized, not just sectoral," says Edward
Casas, a restructuring specialist who heads Navigant Capital Advisors LLC.
Mass liquidation marked the dot-com fall. Most Internet-related
concerns simply disappeared. "When those imploded, they didn't have
brick and mortar, they didn't have assets to sell," says Jones. "There
was nothing left to restructure." Plus, she and others stress, the
Internet bubble was largely equity-driven.
The accompanying telecom collapse was a different story. With
expectations of unlimited demand, telecommunications companies piled
billions of borrowed dollars into laying fiber and building exchanges.
At one point, one-third of all high-yield debt was plowed into telecom,
according to one investment banker.
When it became obvious supply far exceeded demand for years to come,
the entire telecom sector crumbled, most notably WorldCom Inc. and Global Crossing Ltd.,
in many cases in a miasma of Enron-like fraud charges. According to a
study by Cecilia Wagner Ricci, an economics professor at New Jersey's
Montclair State University, 49% of all competitive local exchange
carriers filed for Chapter 11 between January 2000 and September 2002.
Still, cuts in that cycle were mostly clean, especially compared with
what's happening today.
The two cycles were, of course, linked by excessive liquidity,
spawning twin bubbles. As the dot-com bubble burst, the Federal Reserve
Board began to prime liquidity by reducing interest rates. An
unprecedented wave of available cash began to wash through the system,
whether through petrodollars, sovereign wealth funds or high commodity
prices. All this was worsened by the rapid adoption of securitization,
which stoked lending. The end result was years of easy money and an
extraordinary liquidity bubble. For everyone from real estate owners to
private equity shops, from consumers to corporations, debt became the
drug of choice.
Then, as one restructuring banker puts it, "liquidity just
disappeared." That sudden shift took down financial institutions and
threatened businesses across the entire corporate landscape.
In some ways, it looks like a simple case of cause and effect. Pile
on too much debt, no matter how beneficial the terms, and eventually
there'll be trouble in River City. "The more you leverage the world,
the more restructurings there will be," declares Jeffrey Werbalowsky, Houlihan, Lokey, Howard & Zukin Inc. co-chief executive and global co-director of its restructuring practice.
The liquidity issue may distort the bankruptcy process itself. When
money flows, a bankrupt company can obtain financing that offers an
operational runway, providing time to work through problems.
With even superpriority debtor-in-possession loans and exit
financing hard to find -- that is, a lack of liquidity -- more bankrupt
companies get forced into quick asset sales or liquidations. That's
what has happened in the ongong recession.
Take retailers Linens 'n Things Inc., which liquidated late last
year, and Circuit City Stores Inc., which took the same path earlier
this year. "They didn't have access to new money," says Jones, who
maintains that quick asset sales represent the "only exit strategy
lenders are now willing to fund." In times past, "somebody would have
bought them."
In this environment, even companies that escape liquidation can pay a huge price. Consider Lyondell Chemical Co.,
which obtained a mammoth $8.5 billion DIP financing early this year.
Half the $6.5 billion term loan is, in fact, its existing debt rolled
up the priority ladder and carries a stratospheric interest rate of
LIBOR plus 1,000 basis points.
Had the debtor rejected those terms, it would have been liquidated,
restructuring professionals say. Bankruptcy restructuring "is entirely
dependent on liquidity. It's the lifeblood," says Heller, who adds: "A
lot of restructuring is a function of when you're lucky enough to go
bust."
Looking at bankruptcy filings alone, however, misses important
aspects of the mechanisms of corporate distress, especially in the
current environment. Credit may be hard to find at a reasonable price,
but attempts at out-of-court restructurings are more commonplace, in
many cases precisely because of the absence of liquidity. "There tends
to be at least some effort in most situations to accomplish solutions
that avoid Chapter 11," says Miller. "Even though the financing markets
have largely been absent, the conversion of debt to equity out of court
has become much more prevalent, sort of a back to the future, which is
what took place in the mid-to late '80s."
But multiple debt tranches and collateralized debt obligations
complicate creditor agreement. "A complex capital structure makes
[creditor agreements] virtually impossible" in a consensual,
out-of-court restructuring, says Navigant's Casas.
Adds William Derrough (pictured above), the managing director and co-head of recapitalization and restructuring for Moelis & Co. LLC:
"Given the increased utilization of credit default swaps and other
derivatives, executing a traditional debt-equity swap out of court can
be nearly impossible."
The role of liquidity is central as well to the more narrowly
defined world of bankruptcy law and its arena, the bankruptcy court.
This past decade has featured a transformation of the bankruptcy
process, occasionally accompanied by high drama.
One obvious highlight -- or lowlight -- is Lehman Brothers Holdings Inc.
It became easily the largest-ever bankruptcy, with assets and
liabilities each exceeding $600 billion, when it filed last Sept. 15.
Four days later, bankruptcy lawyers and other hangers-on jammed into a
downtown Manhattan court for a marathon hearing to dismantle Lehman
under Chapter 11 through a blisteringly fast and unprecedented sale to Barclays Capital.
Harvey Miller, the dean of the bankruptcy bar and a partner at Weil, Gotshal & Manges LLP,
stood as Lehman's debtor counsel. In his usual modulated tones, with
just a slight tinge of strain to his voice, Miller explained to U.S.
Bankruptcy Court Judge James Peck that institutions had summarily
pulled Lehman's credit lines. Value was eroding by the hour, and there
was real concern that any additional delay would mean there was nothing
left to reorganize. "It was the melting ice cube," Miller recalls.
Lehman sold its investment bank and headquarters under Section 363
of the Bankruptcy Code, which allows for asset sales free of liability.
That mechanism gained popularity even before the credit crunch and is
now common. Weil's Miller bemoans this trend and believes the Lehman
sale marks "a logical extension to the atmosphere we've seen in
bankruptcy courts."
Quick 363 asset sales also marked the megabankruptcies this year of General Motors Corp. and Chrysler LLC.
During the week The Deal first published, the biggest Chapter 11
bankruptcy involved WestStar Cinemas Inc., which owned Mann Theatres.
Bruce Bennett, a prominent Los Angeles-based bankruptcy lawyer, served
as debtor counsel. Bennett recalls the initial filing was eventful only
because Hurricane Floyd struck the East Coast, and the clerk's office
at the U.S. Bankruptcy Court in Delaware couldn't open. That delayed
filing for a day. (The era of electronic filing had yet to arrive.)
The bankruptcy itself "wasn't a big deal. It was emblematic of the
time. Everyone [in cinemas] was getting clobbered," Bennett recalls.
However, "never was there any suggestion that it would be forced to
liquidate. Never was there a suggestion that there would be material
job loss. It did take a while for a deal to get done. But a deal got
done. The cinemas still exist."
Those days seem quaint and almost genteel. "Restructuring has become
a much more technically complex process," says Moelis' Derrough.
To begin with, the classic reorganization is far less common. In
part, that's because companies piled on so much debt that they left few
if any assets with breathing space. "In the older days, the cold cuts
of the market were cut very thick," says James Bromley, a New
York-based partner at Cleary Gottlieb Steen & Hamilton LLP. More recently, "assets have been pledged two, three times. ... The margin for error is razor thin."
The 2005 changes to the Bankruptcy Code made reorganization even
more difficult, especially among retailers. Most notably, the new law
shortened the time for accepting and rejecting leases.
"The so-called reform of the Bankruptcy Code in 2005," says Kenneth
Buckfire, a Miller Buckfire co-founder, "made it far more creditor and
bank friendly than it had been before."
Funding is a central issue. Again, liquidity is key. Before the late
1990s, money center banks dominated creditor ranks and, by extension,
the bankruptcy process. But with the rise of hedge funds as distressed
investors and creditors in the beginning of this decade, that old order
was upended. No longer were lenders solely interested in getting loans
repaid. Some creditors saw debt as a mechanism to gain control of the
company itself. "Loan to own" became the new buzz.
Those new lenders cranked up the liquidity even more, providing a market for second- and even third-lien debt issuance.
As valuations fell dramatically over the past year or so, many
junior lenders found themselves out of the money. "We have seen the
overleveraged secured capital structures that have been constructed in
the last few years for cyclical companies blow up repeatedly," says
Houlihan's Werbalowsky. What that means, he continues, is that "the
senior-most secured creditors who are in the money call the shots and
often opt for liquidation, which can take the form of prompt sales, and
second- and third-lien creditors are getting wiped out in historically
large measure."
Robert Lawless, a professor at the University of Illinois College of
Law, calls this "the emergence of the dominant creditor," which he
maintains is a dominant theme in bankruptcy today.
DIP financing illustrates the liquidity phenomenon within
bankruptcy. Until the collapse of the credit markets, companies could
use Chapter 11 to finance themselves through a rough period. A DIP loan
"really dictated the course of the bankruptcy," says David Skeel, law
professor at the University of Pennsylvania Law School. "That became
the paradigm."
As money flowed more easily in the middle years of this decade, DIP
loans became not only more plentiful, but cheaper. DIPs were once the
exclusive domain of senior lenders. Restructured companies found
lenders were actually vying to provide DIPs, sometimes offering rates
lower than existing debt.
After last September's financial meltdown, the DIP market collapsed.
That, in part, reflects lack of funds and in part a basic lack of
collateral. "DIP financing used to be considered money good," says
Casas. "In this environment of massive deleveraging, in parallel with a
significant volatility in valuation, there's real concern whether it's
money good or not."
"In the old days, you could just do a DIP, but you still had to have
free assets," adds Derrough. "Some of the limitations put on the
debtors are the debtors' own fault."
The DIP market has begun to come back, although senior lenders are
again the only ones making money available. "You're seeing prepetition
to DIP to exit financing all in one go," says Jeff Stegenga, managing
director and chairman of North American restructuring at Alvarez & Marsal LLC.
Those DIPs tend to be short-term and reflect the truncated nature of
Chapter 11s. "There's a defined trend in the nature of the filing
itself," Stegenga says. "It's prepackaged, pre-arranged, prenegotiated."
Bankruptcy tends to be a lagging economic indicator, "the last layer
in the economic downturn," says Skeel, the closest we have to a
historian of U.S. bankruptcy.
So much liquidity during the run-up to the current bust cycle means that lag time may be more pronounced than usual.
Lenders extended easy credit to the riskiest of borrowers. Companies
that in other times would have failed have been able to stay solvent
and hang on far longer.
"Businesses in difficulty always had a way to raise money," says Skeel. "Companies had nine lives."
What's more, loans were being issued with few or no covenants. So
defaults often don't take place until loans mature. Companies aren't
pressured to file for bankruptcy in the interim. In fact, "most lenders
do anything they can to put off the day of reckoning," says Anders
Maxwell, managing director at Peter J. Solomon Co. LP. "It's denial syndrome. Not so much companies as creditors are paying a serious game of kick the can down the road."
Stegenga says he's even seeing debtors threaten bankruptcy as a way
to better pressure for DIP financing. "They've become aggressive," he
says.
All this means the fallout from last year's financial catastrophe
and the credit frenzy that preceded it will linger for years to come.
"The dominoes are still falling," says Maxwell, who for years before
the collapse had been one of the most outspoken critics of the culture
of easy money. "The process has just barely begun. ... You're looking
at at least a decade of major restructuring."
What's more, predicts Werbalowsky, "for all of these massive,
supposedly once-in-a-lifetime restructuring situations, the one thing
you can count on is it will happen again."
Which is why they call it a cycle.
Also see:
Alvarez & Marsal ride the turnaround wave
Richard Cieri and the ubiquity of failure
Miller Buckfire on restructuring's learning curve
See the Complete: 10 Years of The Deal Economy
Ten Years After
Nice work if you can get it
Between reality and the mirage
Bubble, trouble, toil and muddle
Many themes underlay the past 10 years of insolvency and bankruptcy: Easy money begat monumentally high and ultimately unsustainable debt levels that collapsed under their own weight. Derivatives became a Frankenstein-like experiment that spun monstrously out of control. Bubbles inflated, stretched, burst. Entire sectors imploded. The federal government emerged as arbiter, capital provider of last resort and major shareholder in failed companies deemed too big to fail.
