The possibility of a failed reorganization plan after a debtor exits bankruptcy appears to be increasing. Within a year of the reorganization plan being approved, we are seeing companies fail to achieve performance and debt service goals, and their lenders are confronted with difficult choices — an expensive refilling of the bankruptcy case, immediate liquidation via sale or auction or agreement to waive serious performance failures and fund losses. None of these choices are palatable, as all are pointed to a loss for the secured lender.
There is one important alternative to consider — an out of court orderly liquidation. This option does not receive as much discussion, most likely because it requires excellent coordination of various constituencies, serious operational planning and some level of upfront funding by the secured lender.
Let’s examine a few successful examples of the out of court orderly liquidation.
Case Study 1
In this case, a private equity group purchased a dye manufacturer for textile and paper out of bankruptcy. The company did not perform as expected and future prospects were weak. The equity sponsor did not see any reason to continue to invest in the company, but wanted to assist the lender in maximizing the recovery.
After much discussion, a turnaround management firm was hired to work with the owners to validate a cash-flow and review operational potential of the borrower. The path seemed to be moving toward a re-filing of the bankruptcy case, which was expected to result in conversion to a Chapter 7 and liquidation via a bankruptcy trustee.
The turnaround consulting firm worked with the borrower and the lenders to develop a less costly, yet effective strategy — putting the company into a receivership. The receiver was a member of the turnaround consulting firm experienced both in operational strategies and in financial management.
Under the receivership, a buyer in the same business was found to purchase the fixed assets, the intellectual property and the book of customers of the failing business. The buyer was allowed to transition to selling to the borrower’s customers; however, the borrower continued to manufacture product during an interim period. The trade-off allowed the buyer to fold the purchased company into its business operations, while allowing the borrower to convert assets to cash.
The approach that was developed created an environment where both the buyer and the borrower achieved a better outcome than would have occurred in a contested bankruptcy proceeding. The borrower was able to convert raw materials to finished goods and create additional accounts receivable. This resulted in conversion of a lower value asset to a high value asset and quickly to the best asset — cash. The buyer was able to smoothly transition new customers to its production lines, while using the borrower’s current production lines to ensure smooth delivery schedules exceeded customer expectations.
This case resulted in the borrower converting assets to higher value assets, and, therefore, creating additional cash to fund short-term operations and repay debt. The lender received a 100% recovery of the loan balance. This recovery would not have been achieved if the bankruptcy approach had been used. The assets purchased by the buyer (primarily customer relationships) would have devalued quickly, and the borrower would not have had the opportunity to covert lower value assets to higher value assets. Additionally, the court-related costs inherent in a bankruptcy proceeding were avoided.
Case Study 2
A furniture company exited bankruptcy in May with a plan of reorganization that quickly resulted in operating cash shortfalls. By October of that same year, the company was out of money. Initial efforts focused on a sale of the business; however, the best offer received was $18 million. The senior lender was owed $35 million.
Members of the senior debt lender group had previous experience working with a turnaround consulting firm experienced in both operations management and financial management. After an initial review of assets and capabilities to convert to cash, a plan to preserve maximum value was developed.
The turnaround consulting firm implemented a strategy of working with the large customers to preserve the book of business and working with the trade creditors to help them understand the potential recovery under a variety of shut down and liquidation options. In this example, the trade creditors were threatening a forced bankruptcy filing; therefore, the turnaround firm provided detailed information outlining the recovery possibility for the unsecured creditors under a re-filing of the bankruptcy case scenario.
Utilizing the value preservation strategy, the book of business was sold to a competitor. The borrower converted raw materials to finished goods, which filled outstanding purchase orders from the large customers and allowed the buyer to transition to manufacturing product under a gradual organized approach.
The borrower was able to convert raw materials to higher value assets and collect the accounts receivable. The borrower was able to auction equipment once the asset conversion was completed.
The final tally for the senior lender was a 95% recovery — resulting in a $33.5 million recovery on a $35 million loan, compared to the initial sales price offered of $18 million.
Lenders are all taught “the first loss is the best loss” and “don’t throw good money after bad.” The rules are there for a reason; therefore, any deviation from those rules should require careful consideration. Remember that in the case of a failed bankruptcy reorganization plan, the first loss strategy has already been played out. The lenders in these situations must be creative, as the assets of this second-time failed company are known to be weakened via the public nature of the bankruptcy case.
The two case studies above show examples of this careful consideration and creativity resulting in a successful outcome for the lender. In the first case, the lender’s recovery under a re-filing was estimated to be 10%. In the second case, the lenders’ recovery was estimated to be 50%. In both cases, after the expenses of the reorganization, the lender received a significantly higher recovery.
The ability to generate a higher recovery is not certain, and the planning required by all parties is important to the eventual positive outcome. From the lenders’ perspectives, to improve the probability of this strategy working, the turnaround firm being used must meet three key objectives:
- The firm must be experienced in both in-court and out-of-court restructuring.
- The firm must be experienced in operating and financial management.
- The firm must provide real time feedback to the lenders and must be able to quickly adapt and make decisions.
In-Court and Out-of-Court Restructuring
This is important because negotiations with interested parties require the negotiator to understand upside and downside risk under various scenarios. This is not to threaten the parties to the situation, but rather to help all parties understand the benefits of the approach, especially in comparison to other alternatives. In the second example above, a key aspect of the success of the orderly liquidation was the ability to communicate with the unsecured creditor group and help them understand their outcomes under various approaches.
Financial and Operating Management
The consulting firm will need to be able to lead the troops on the plant floor through a wind down and orderly liquidation, as well as minimize cash outlays during the process. Financial management, without operating experience, will result in slow decision making and an inability to understand the operating costs of financial management decisions. In the first example, the borrower was already feeling the impact of customers searching for alternative suppliers. The fast decision making and communication resulted in realizing value for an asset, the customer list, which would have quickly diminished to little, if any, value. In the second example, the communication with a large customer, and the consultant’s coordination between the borrower, the buyer and the customer, created a higher recovery for the lenders.
Real-Time Feedback to Lenders
The turnaround firm must provide real time feedback and communication to the secured lenders as strategies will quickly evolve, and the turn around firm must be able to quickly adapt and make decisions. Preplanning and careful consideration is certainly critical to success, but in these cases, immediate communication and fast, reasoned decision making is the difference between lenders experiencing a write off or a recovery.
The debtor with a failed reorganization plan is already seriously damaged. But, that does not mean the lenders should give up and walk away with the first purchase offer they receive. A fast, insightful analysis by a turnaround firm experienced in restructures, with financial and operating experience and an ability to quickly adapt and make decisions, will provide the lender group with key decision making information that may improve the recovery for all parties.
Outcomes are never certain, but in these examples it is clear that taking that first, low offer for a failing business is not necessarily the best approach, and immediately re-filing bankruptcy is not a requirement. These tactics are certainly on the table for consideration, but it is clear that quickly spending time considering alternative approaches could result in a better outcome than expected.
Juanita Schwartzkopf is a managing director at Focus Management Group. She has more than 25 years of experience in commercial banking, financial management and operations and systems management. She was awarded an MBA from the University of Wisconsin and a Bachelor’s degree in accounting from Carthage College. She is a Certified Fraud Examiner and holds a CPA certification.