Goldman Sachs’ co-head of restructuring in Europe talks to Geraldine Lambe about the effect an increasingly complex financial structure will have on companies’ survival in the future.
No-one can predict when the next downturn will be, nor how deep it will dig. But one thing is certain: it will be completely different from the last one. Companies use their assets and structure their liabilities in a radically different way; the regulatory environment is a movable feast under which few norms have been established; and the complexity of financial markets has increased exponentially.
Unknown territory
“[These developments] have combined to increase complexity and introduce greater uncertainty. In the next downturn, restructuring professionals will have to feel their way through unknown territory. It will be very tough on companies trying to survive,” says Lachlan Edwards, co-head of restructuring in Europe at Goldman Sachs.
In the past four to five years, he says, capital markets have enabled companies to maximise the way in which they leverage their assets – for example, a broader range of companies are securitising a more diverse range of receivables. Plus, the wall of money going into private equity and hedge funds has enabled the capital structure to be stretched and, in the process, has replaced simple debt with umpteen layers of different types of debt.
“The complexity shouldn’t be overstated – 2nd lien may sound exotic, but it’s rather like a second mortgage and nobody raises an eyebrow at that. It’s clear that the grey zone between debt and equity has become much more finely spliced; and that’s partly because there are increasingly different types of investors with a greater appetite for risk, and a greater appetite for such products. When debt was just provided by banks, you didn’t get this variety of instruments,” says Mr Edwards.
Derivatives will further muddy the waters. In the last downturn, credit default swaps (CDS) made little impact. This time, the story will be entirely different, he says. A company in distress may think its lending bank wants to save it, but the case for doing so may not be straightforward. “A bank’s first requirement is to get its money back and, if it has bought CDS protection, that protection may only be realised if the CDS is triggered when the company goes into bankruptcy.”
Multiple relationships
Additionally, market participants may have multiple relationships or touchpoints with the company: a bank, for example, could be a lender, a bondholder, a CD underwriter, a CD buyer and an investor. And each representative will have a different profit centre to account to. “This complexity skews motivations and actions as well as the idea and nature of value,” says Mr Edwards.
For example, if someone bought into subordinated debt trading at 10p in the pound, acquiring £1bn of face value debt for £100m, they could also buy a much smaller amount of senior debt, which nonetheless offers opportunities to block or frustrate the restructuring process by using covenants. They may therefore be happy to sacrifice one cent of value in the senior debt, in order to create two cents of value at the subordinate debt level where it offers a higher return.
“That didn’t happen years ago. Now, it’s not common but it does happen. You cannot make assumptions about people’s motivation. In a workout, what appear to be illogical acts or positions are not always what they seem,” says Mr Edwards.
The negotiating table is now a much more crowded place and, because no-one can be sure of what anyone else will do, everyone has their own lawyer or consultant at the table, bloating the cost of the process. Besides a bank’s debt portfolio and its lawyer, and a bond desk and its lawyer, for example, creditors may ask for a turnaround company to work alongside the management; another group may want an accountants report, while another tier of creditors will demand their own representation.
Negotiations are further complicated by positions changing overnight: one desk may sell its position to another desk, or another bank, or a hedge fund. “In the morning, the agreement that was tentatively hammered out with one party, may be rejected by a new participant,” says Mr Edwards.
Risk has been broken down into much smaller parts and, says Mr Edwards, “everyone is trying to achieve the best outcome for his own business”.
For example, the portfolio management approach to how banks’ manage their exposure means that where once credit decisions used to be made by committees, now they are governed by internal rates of borrowing, established to incentivise people to generate profit. So, one part of the bank borrows money from the bank’s debt portfolio at a given rate – they may lend it out to their client for less, but must then generate profit through hedging fees or selling other products and services. And, where once the workout team’s primary responsibility was to minimise loss and reputational risk, it is now primarily a profit centre.
“If a loan has been transferred to the workout team at a price of, say, 75 basis points (bp), then their focus is to get more than 75bp. If they can sell it for 85bp or more, then they probably will. In the new world of restructuring, nobody can guarantee that the same people will still be there at the end of the process.”
Time pressures
Overlaying such complexity on top of Europe’s multiple (and constantly changing) regulatory jurisdictions adds time pressure to the workout process. If participants fight every element of a European workout to the wire, they might find a company cannot be saved because there is not enough time left to secure the agreement that will enable the rescue package to be put in place.
“People will increasingly start to make judgement calls based on what will be their outcome in insolvency and the size of their position. If the process is blocked or agreement cannot be reached within the time laid down by law, we will see more companies filing for insolvency,” says Mr Edwards. And that’s why shareholders or management will need to take action earlier, he adds.
Hence the incentive for Goldman Sach’s restructuring efforts to be pre-emptive, rather than reactive. But pitching a solution is a delicate situation. A restructuring specialist once described this kind of pre-emptive work as “rather like a plastic surgeon approaching someone and saying ‘your nose is ugly! But don’t worry, I’m a plastic surgeon and I can help’.” With the potential for insult in mind, Goldman’s approach rarely mentions restructuring or distress.
Stress avoidance suggestions
“We identify those companies where there is potential for stress and approach them with a practical suggestion to avoid that stress. We could suggest, for example, that a company replace its existing bank debt facility with a floating rate note (FRN) that goes out to 2015; this would enable the company to preserve cash flow that would otherwise have to be earmarked for amortisation in 2008, for reinvestment in the business. Suddenly, the treasurer, who has been worrying about finding the cash for repayments, has a solution. But nobody has had to admit that there was stress on the company or that it would be stressed next year.
“We also look at options globally, so, in one recent case, we convinced a private company to raise debt in the US ‘covenant-lite’ loan market rather than a European FRN and keep its capital issuance in the private market.”
Ironically, the very products that make workouts more complex, such as payment-in-kind notes and credit derivatives, also provide specialists with solutions and alternatives. But often, rescue work simply means stripping out the complexity and reducing debt. Eurotunnel, for whom Goldman Sachs was a restructuring adviser, has gone from £6.5bn worth of debt in nine tiers, to £2.8bn of debt in a single tier, for example.
Mr Edwards denies there is any incongruity in the fact that workout teams are busy unwinding and reducing the complicated layers of debt that other divisions in their own banks may have put together for the companies in the first place.
“In fairness, a structure was not put in place to be complex, it was designed to be the most efficient and/or appropriate capital structure at the time. And for every such company that gets into distress, there are 100 for whom the same structure is working perfectly well. It is not because of complexity that companies go bust; it is more that when companies go bust these days, they are more complex to fix.”
Critics argue that there is so much money available to back financing structures that companies don’t get restructured any more, they get refinanced. And some may hint that many of the companies that have done major FRN issues this year only escaped trouble by replacing their bank debt with bulleted, un-covenanted FRNs. In the private equity space, this trend has resulted in the explosive growth of the covenant-lite bank loan market.
Mr Edwards says we should not leap to knee-jerk panic in response to such products or trends: “The use of highly leveraged structures creates a greater likelihood of distressed assets or companies in the future because it increases the fixed charges borne by a business.
“On the other hand, private equity has created an efficiency and a discipline in the way companies are managed, which has meant that the vast majority haven’t defaulted but have actually improved their margins and exploited their revenues to a much greater extent. This has created more sustainable employment and more value.”
He adds a caveat, however: “What remains to be seen is whether the covenant-lite phenomenon, in both the public and private markets, promotes ill-discipline and only defers problems, or whether it gives companies the time and ability to resolve problems and achieve their growth potential by riding through any volatility.”
CAREER HISTORY
2006 Joined Goldman Sachs as co-head of restructuring in the financing group. Co-founded the UK restructuring team
2000s Moved to London, helped to establish Rothschild's European restructuring group, and was later promoted to co-head of restructuring in Europe and head of restructuring in the UK
1990 Joined Rothschild, Australia, and had various roles in treasury credit and corporate lending, then moved to resources project finance, with responsibility for Indonesia, Papua New Guinea and the Pacific
1986 Joined IBM Australia as a marketing associate after graduating from Sydney University with a BSc
