Restructuring and insolvency - Ominous silence

Advisers have reported a massive increase in the need for restructuring-related advice. "It used to be 10% or less, it makes up an estimated 50% or more of the current workload," states Dr Julian Lemor of SJ Berwin. Others agree that the demand is increasing and many expect it to peak in the next two to three months. "The big wave of private equity-related restructuring work is still ahead of us," warns Philipp von Braunschweig, of Pollath + Partners, adding: "The fact that it's not quite there yet is because reports are written quarterly. Many firms made their covenants, but this often included some creative applications of accounting rules in Q4 2008. We expect large numbers of breaches in April, after the covenant tests for the first quarter of 2009."

"Some firms have been waiting for the last possible moment," states one lawyer, with another agreeing that private equity firms are dragging their feet, when getting advice now would be best in the long run. The reluctance to get timely advice might be caused by the opacity in the credit markets and the wider economy, but is also grounded in legislation, both recent and outstanding. "While many know they have to restructure, the new German insolvency law actually makes players postpone decisions, as it gives them a wider timeframe to act, which lends itself to a procrastinate attitude at the moment," says Guido Krueger of Beiten Burkhardt. His colleague Heinrich Meyer points out sector sensitivities: "There is a pervading sense of nervousness from those that have invested in the automotive space especially."

Players have to identify the potential problems before they can do any restructuring. Sometimes issues are down to deflated multiples corresponding to EBIT struggling to meet debt repayments, while other times it is an industry-specific problem. "Activity we see right now centres on identifying the problems on a case-by-case basis, and formulating a plan on how to address them," states Lemor.

Assessing options

With the global economy heading for recession, Germany is hit especially hard in its hefty automotive sector, which, with the near-cessation of cashflows in some suppliers, starts to look weaker. But the ship-building, chemicals and IT sectors have their own woes. Overall, legal advisers agree that companies financed with debt of 9-11x EBIDTA will struggle to meet the repayment in the cooldown.

Some approaches to relieving struggling portfolio companies could be: debt-for-equity swaps; entering insolvency; equity cure; asset sale; renegotiating of covenants with fee increases. One of the most pressing questions is which of these are likely to be enforced (see also Jefferies 2009 Survey, page 16). Advisers agree that insolvency is by far the least desirable option and only used as a last resort. However, filing for insolvency is mandatory in the event of illiquidity - German law allows for three weeks to cure the situation, otherwise the management commits a criminal act if it does not file for insolvency. Lawyers report that advice for management teams has increased significantly to explore issues of personal liability.

"Entering insolvency actually endangers restructuring of the company," warns Meyer. "It may be possible to sell off parts of the business, but this is not desirable due to the depressed prices and is likely to destroy a lot of value." There are ways to keep the company going in insolvency, but advisers agree that they are cumbersome. "You would have to work out a restructuring plan and present this to the court. There are so many burdens connected to it that not going into insolvency is by far the best way to do a restructuring," says Krueger.

Advisers expect private equity firms to make use of a mix of the other available options. Debt-to-equity swaps could, for example, tackle the problem of over-indebtedness, which needs to be addressed to prevent insolvency. Some say the equity-driven covenants of the past lend themselves well to debt-to-equity swaps, and expect this measure to increase on a massive scale in the next two to three months.

However, in German law, owning a certain portion of the equity gives voting rights - which need to be exercised. Law firms now negotiate with new shareholders. "We see lawyers moving towards becoming more mediator-like between the different parties, and overall, law firms are moving away from a confrontational approach towards a more inclusive, solutions-focused approach. At the top end, law firms are gaining more influence, as we have seen with the Schaeffler takeover of Continental," explains Lemor.

Operative restructuring is another cost-saving measure that has been mentioned, but some lawyers caution that many German companies felt that they had already been restructured and were thus operating at maximum efficiency. "These companies are often already very lean operations and have sold their assets in the last few years to be more competitive. In fact, they are so lean now that many are concerned they don't have enough fat to last them through a hard spell," explains Meyer.

Pyrrhic victories

When it comes to renegotiations of the covenants (which, according to the Jefferies study, is by far the most expected measure) the solution may not be quite as straightforward as many firms hope. The terms of the loans, which have been typically widely syndicated, necessitate bringing ten or fifteen financing partners to the negotiating table. This complexity is further exacerbated by the time pressure of the looming insolvency threat and the banks' own illiquidity. Many of the financing partners, such as RBS, Commerzbank or Fortis, now have the government as shareholders and have tightened their lending practice and risk assessment. "In many cases, these lenders can only provide sums of about EUR10m - everything beyond that has to be approved by their board of directors, which creates a massive bottleneck," states Krueger.

Many champion the use of equity cures, but at the time of writing, advisers agreed that it is too early to take these into consideration as valid solutions to the problem. As the German government has decided to establish "bad banks," advisers express hopes that this measure will take some of the pressure off the industry. "We see banks willing to waive part of the loan in return for equity injections," says von Braunschweig. "However, equity cures cannot be a long-term measure. So private equity firms can do this for one quarter, but cannot prop up portfolio companies like that over a twelve-month period if the company does not recover in the short term. Curing one quarter might not make any difference."

German law reform has now made it possibly to place a holiday on over-indebtedness to stabilise companies in these extraordinary economic storms. The law states that this holiday can be enacted when the management can reasonably expect the situation to be cured within 12 months. This opens up more problems than it resolves. The German business code requires management to act as "commercially prudent businessmen," and thus advisers don't expect the new rules to be used with any meaningful frequency. "Even faced with this provision, exactly which forecast should management use for their projections?" asks von Braunschweig.

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• Topics
• Restructuring
• DACH