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The following Q&A brings together the best thinking from Schuyler Carroll, partner at Loeb & Loeb, and Henry Owsley, co-founder and CEO of Gordian Group.
Schuyler Carroll serves as a trusted advisor to a wide range of clients, helping them develop solutions and strategic alternatives to their most complex restructuring matters. His practice focuses primarily on Chapter 11, 15 and 7 bankruptcy proceedings; distressed acquisitions; creditors’ rights enforcement; and litigation and advisory work. Clients also turn to him for out-of-court workouts and nonjudicial reorganizations and restructurings.
Henry Owsley is the co-founder and CEO of Gordian Group. With his partner, Peter Kaufman, he is the author of the definitive works in the field, Distressed Investment Banking: To the Abyss and Back, 2nd Edition and Equity Holders Under Siege: Strategies and Tactics for Distressed Businesses. Both books are must-reads for boards of directors, management teams and shareholders, and owners of financially stressed situations, as well as for buyers and professionals.
Gordian Group has successfully worked with Schuyler Carroll over the years on various matters.
How do you define a distressed situation to the board of directors of a company?
Carroll: Traditionally, we think of it as a financial stress that will result in an obstacle for the company, such as an approaching maturity of a substantial loan, where refinancing is not available. But it’s better to be ahead of problems, so you might think of it as any time you believe there’s a potentially negative financial change. That can be as small as your lead salesperson going to a competitor or the expiration of a lease on a significant facility, store or plant. Or, it can be as large as the pandemic we are all currently navigating.
These are moments when adjustments and significant decisions must be made, and they’re opportunities to think about worst- and best-case scenarios and develop a plan. The most important thing is to be proactive and be bold enough to examine the situation as soon as you’re aware. In normal times, that examination might result in taking no action, but today almost every company is building a plan in reaction to the pandemic. In the end, your examination of the situation should lead to an improved direction and a better understanding of your own company.
Owsley: In the age of coronavirus, most companies are digging into the effects of the economic shutdown on their own business, as well as on their customers and suppliers. Moreover, this pandemic has called into question the business models of entire industries (brick-and-mortar retail; commercial and office space; travel; green and nongreen energy) as the virus has accelerated changes already underway. In short, distress is pervasive, close at hand and pretty obvious to all.
For those companies more directly affected, the problems will manifest themselves as liquidity events, overwhelming debt obligations and business declines. Short-term liquidity issues on their own, while potentially devastating, can be solved at a cost in this environment of accommodative Fed policy. For those companies now facing demand uncertainty or unmeetable creditor obligations, it is time to recognize that they may be facing a financial distress crisis and that they will need experienced advice.
How does a board typically become aware of a distressed situation?
Carroll: In a best-case scenario, it’s going to be a combination of events that lead to an informed board. You’ll have regular, effective reporting from your officers and board members, who are actively asking questions in between the official reporting times. When the board receives the reports, they will, ideally, have everyone review the information at the same time, identify the issues, and come together to figure out solutions. In less-than-ideal situations, like the Enron scandal in 2001, data and information are hidden and the left hand doesn’t know what the right hand is doing—nobody has the full picture until it’s too late. If you are a board member, you want to establish a working relationship with management and other key stakeholders so issues can be identified and resolved quickly and so people feel free to bring up issues in the first place.
Owsley: As I indicated, all companies today are on notice that distress is all around them. But in other, more “normal,” times it may take a precipitating event for companies to truly recognize there are problems. Perhaps that event is a severe warning from the company’s CFO about an unavoidable situation. Perhaps it is an impending debt maturity, the cries of restive creditors or an increasing unwillingness of suppliers to continue extending credit. All of these are red flags, and a board would be unwise to ignore them. A recent article by Gordian Group, “Signs of Financial Distress in A Company,” outlines specific signs for which to watch.
What are some of the causes of distressed situations that can be avoided?
Carroll: One common and preventable situation is when a company tries to reverse a downturn in sales by borrowing additional funds. For example, a restaurant may try to renovate its space to increase foot traffic or a manufacturer may try to diversify its product line to increase sales. However, if the company borrows to solve the problem and still doesn’t see an increase in revenue, they’re in a worse situation than before, with a lender who is unlikely to be patient.
Often, in bankruptcy cases, officers and directors get sued when things don’t go well. In a court of law, they have to prove their decisions were as well informed as possible and advised by professionals. With the benefit of hindsight, the court can see that the decisions didn’t work; however, they will also be able to see if the board engaged in a fully informed process in an attempt to get to the right decisions, undertook sufficient diligence, was advised by proper professionals with experience in their industry and in distressed situations, and explored all options. The board should be able to point to that process to show they did the right things and cannot be questioned, even if the strategy wasn’t successful.
Owsley: Distress can occur due to industrywide events or as a result of company-specific factors.
For macro changes such as a precipitous drop in energy prices, companies can take various steps in advance such as hedging prices and having a conservative capital structure to offset the inherent commodity risk. But we note that an industry decline can be so severe that even these steps may be insufficient.
Individual companies under less industry pressure may also face distress. The precipitating event may be “unanticipated,” such as a major product failure (Boeing), a societal backlash (Purdue Pharma) or internal fraud (Enron). Or it may be the result of a slow-motion train wreck involving too much debt.
Whatever the underlying cause, a board needs to be on the lookout for red flags and take action sooner rather than later. In other words, the key question may not be whether or not the crisis could be avoided but rather whether the ensuing damage can be mitigated.
Are there any examples of distressed situations that couldn’t have been predicted, controlled or avoided?
Carroll: Right now, with the global pandemic, we are seeing an example of that. Nobody could have predicted that entire industries would grind to a halt. Aside from natural disasters and pandemics, history has shown us that about once a decade, there is an economic downturn. And we can’t predict exactly when it will happen or which industry is going to be hit hardest. In the late 80s and early 90s, the real estate industry was decimated. In 2001, it was technology and telecom and in 2008, it was finance. The important thing is to set up internal systems in advance and make sure there is a good working relationship between a board and officers with honest communication and discussions and open doors. When people fear being blamed, they are reluctant to mention a situation that should be addressed. Create the opposite environment so your company can weather the storms.
Owsley: Schuyler is on the money. You may not be able to predict, but you can and should be able to react to red flags. The board needs to make sure that the right internal feedback system is in place, management resources are adequate, and individuals are appropriately focused and incented.
Is it possible to resolve a distressed situation in a way that benefits equity holders? What are some potential solutions?
Carroll: Yes, there are often creative solutions. For example, if a company in financial distress is proactive, it may be able to approach its lenders and restructure its debt. In cases where equity holders are willing to infuse some cash to ensure the company survives, we’ve worked with them as they persuaded their lenders to sell them their own debt at a discounted rate or reduce the principal amount. In some cases, the lenders will agree to accept a small percentage of equity in exchange for a debt reduction.
I’ve also seen underperforming retail stores negotiate with their landlord to reduce their rent substantially. In one recent situation, our client’s landlord agreed to eliminate fixed rent in exchange for a percentage of sales. This also benefited the landlord, because they were unable to re-rent the space.
Owsley: Because individual situations have unique features, solutions frequently need to be bespoke as well. In constructing a solution, it is critical to remember that old equity constituencies have a couple of real advantages: option value and control value.
In volatile industries (oil and gas), one way to maximize option value is through bargaining for additional time. It is certainly possible to envision a scenario in which there is a reversal of fortune and old equity is able to reap the benefits from upside trends. Conversely, a way to minimize old equity recoveries can be to accede to creditor demands for an immediate equitization of the balance sheet at a cyclical low point and dilute it to the point of meaninglessness.
Control value is equally important, and it ultimately rests with the board. Creditors—and many restructuring advisors—insist on a “mark to market” of the balance sheet that is great for the creditors and horrible for old equity. If there is to be a meaningful old equity recovery, the board needs to drive the restructuring process in a way that benefits old equity. If a board wants to work on behalf of old equity, it needs to engage financial and legal advisors that will develop and implement such solutions. Far too often, boards engage advisors that shortchange old equity simply because it is the most expedient thing to do. It doesn’t have to be that way.