The following article is Part Two of a two-part series and was written by Gordian Group LLC president Peter Kaufman, partner David Herman and managing director Liam Ahearn. The views expressed here are entirely their own.
As we have seen, portfolio companies experiencing capital structure challenges give private equity firms opportunities.
Gordian, working with counsel, devises bespoke private equity restructuring strategies — usually comprising what we term “carrots and sticks” — to push lenders to be accommodative of the sponsor’s goals.
One novel carrot strategy that we have employed in these situations involves the “debt spring back” and “debt spring down” structures. Of course, any form of “spring” only works if the sponsor has conveyed “stick” strategies that the lenders will fear, and hence a spring approach connotes a superior outcome than the more draconian alternatives for the lenders.
While having certain roots in the old “cash flow note” concept, these spring structures go much further in terms of recapitalization strategies and have regulatory and tax implications. Notably, the upside for creditors does not need to include warrants or equity. This limits creditor upside. Instead, lenders gain the option of having debt reinstated should the company meet certain financial metrics.
The springing debt strategies provide optionality to debtors in times of uncertainty and can assist in bridging negotiating gaps with lenders in restructuring scenarios.
The debt spring-back is part of an overall immediate right-sizing of a company’s capital structure, which can also be accompanied by permanently shedding a portion of the lender’s debt stack through a simple write-down ($X).
The debt spring-back, in its basic form, works as follows:
- A portion of the debt facility ($Y) is allocated into a contingent liability that effectively sits in the ether.
- If the company achieves certain agreed-upon operational benchmarks down the road, the lender “springs back” into preexisting debt up to the full amount of the contingent liability.
A variant of this approach is the debt spring-down, which includes the same amount of debt write-down but leaves the principal amount of the capital stack undisturbed at close. But if after an agreed-upon term (perhaps two years) the company has not achieved the agreed-upon operational metrics, then $Y of the debt “springs down” — it’s written off as well.
In short, the spring-back right-sizes the capital structure immediately while providing a debt reinstatement option to the lenders should performance come back as hoped. Conversely, the spring-down gives the company an option to right-size the capital structure over the long term, while allowing the lenders to avoid an immediate write-down. This functionally is a variation of a kick-the-can strategy that provides a hedged outcome.
Companies, boards of directors and sponsors — together with financial and legal professionals experienced in these types of situations — must analyze the limitations and constraints facing their financial creditors. And they must be prepared to be firm, and creative, to develop not only negotiating sticks (borne of lack of conflicts and a will to achieve considerable creditor concessions) but a proposed restructuring that is a better outcome for the creditors than the alternative “or else” (what we call “Plan B”).