Exit Facilities in Bankruptcy

When a company is in the process of planning its bankruptcy exit, discussions on how the company will raise capital to fund administrative and DIP claims (among many others) begin to be heard in the market. Will the company do a bond offering? What about a rights offering? All this will be stipulated in a company's disclosure statement and bankruptcy plan.

One thing for certain though: Debtors want to raise the cheapest, least restrictive debt that its creditors will allow. And we are seeing a lot of that in the high yield and leveraged loan primary markets: Smurfit Stone, Six Flags, and Reader's Digest are a few of the more topical examples.

What is interesting to me: How cheap these financings are actually coming to market. Now I know bankruptcy is to be a cathartic process...but can one really justify an exit term loan with only incurrence based covenants? Or term loans with 7-8% rate when the DIP came at 13%?

This is all well and good for the debtors. They get cheap financing, with lenient covenants (to say the least), that is generally locked in for at least a 5 year term. The problem though: A lot of time potential lenders are looking at the disclosure statement's projections and taking them at face value. Let's look at Reader's Digest's projections (from their disclosure statement):

Now, if you can't read that, here is what you need to know:

Cash EBITDA grows from FY 2011 $184.3M to $198.8M in FY2014. Maybe I am mistaken (and I haven't read the roadshow or offering docs on this particular new deal), but I think potential bond investors in the new RDA deal (or any exit deal for that matter) may be using this cash flow to ascertain leverage metrics and free cash flow potential through the life of the new bond issue.

This disclaimer comes with the projections:

THE PROJECTIONS HAVE BEEN PREPARED EXCLUSIVELY BY THE DEBTORS, WITH ASSISTANCE OF ALIXPARTNERS. THESE PROJECTIONS, WHILE PRESENTED WITH NUMERICAL SPECIFICITY, ARE NECESSARILY BASED ON A VARIETY OF ESTIMATES AND ASSUMPTIONS WHICH, THOUGH CONSIDERED REASONABLE BY MANAGEMENT AT THE TIME AND TO THE BEST OF THEIR KNOWLEDGE, MAY NOT BE REALIZED, AND ARE INHERENTLY SUBJECT TO SIGNIFICANT BUSINESS, ECONOMIC AND COMPETITIVE UNCERTAINTIES AND CONTINGENCIES, MANY OF WHICH ARE BEYOND THE DEBTORS’ CONTROL. THE DEBTORS CAUTION THAT NO REPRESENTATIONS CAN BE MADE AS TO THE REORGANIZED DEBTORS’ ABILITY TO ACHIEVE THE PROJECTED RESULTS. SOME ASSUMPTIONS INEVITABLY WILL NOT MATERIALIZE, AND EVENTS AND CIRCUMSTANCES OCCURRING SUBSEQUENT TO THE DATE ON WHICH THESE PROJECTIONS WERE PREPARED MAY BE DIFFERENT FROM THOSE ASSUMED OR MAY BE UNANTICIPATED, AND THUS MAY AFFECT FINANCIAL RESULTS IN A MATERIAL AND POSSIBLY ADVERSE MANNER. THE PROJECTIONS, THEREFORE, MAY NOT BE RELIED UPON AS A GUARANTY OR OTHER ASSURANCE OF THE ACTUAL RESULTS THAT WILL OCCUR.

And yes it is in "All Caps" in the disclosure statement. And what about the Management Equity Plan:

Management Equity Plan. The Plan provides that the New Board will grant equity awards in the form of restricted stock, options and/or warrants for 7.5% of the New Common Stock (on a fully diluted basis) to continuing employees and directors of the Reorganized Debtors; provided that such equity grants will not include more than 2.5% in the form of restricted New Common Stock.

Now the specifications on what/when/how these options will be awarded has yet to be determined. But remember, we like to think about incentives here...what would be the incentives for showing an optimistic plan? (Note: I have no idea if RDA's cash flow will grow over the foreseeable future...I am just using them as an example).

Bottom line: It helps with emergence. It is much easier raising capital for a company that is growing versus a company that is not. Therefore, if projections do not turn out to be as rosy as defined in the disclosure statement, who gets hurt: The new lenders of course. Management has their equity (probably more than they owned PRIOR to the bankruptcy) and the company is out of bankruptcy. But if events begin to unfold that do not mesh with what was projected, someone is left holding the bag.

So when you are seeing all these new exit facilities come to market (and I am hearing there are A LOT in the pipeline), remember these disclosure statement projections can sometimes be clouded by the various players incentives in the bankruptcy case. Go over the assumptions with a fine toothed comb and run scenarios where you think management's assumptions on gross margins, or subscribers, or unit costs are different from your own: On that basis, and that basis alone should you be lending you and your investor's hard earned capital to companies emerging from bankruptcy.