"Distressed Debt Restructuring." Distressed analysis is performed with similar principles used in credit analysis. Qualitative analysis is as important as quantitative. We need to understand the problems that are putting pressure on the credit. We need to be honest about whether they can be fixed. And we need to be able to apply an acceptable restructuring plan that addresses the financial and operating risks, the liquidity or lack thereof, and the entity's cash flow generating ability. The problems that a company might have can occur on many levels. Some are easier to address than others. First and foremost, is the industry as a whole facing a challenge. Such as, bricks and mortar retail versus online retail, or is the problem company specific. Industry risks can be tied to the economic cycle, such as housing starts or commodities prices. They can also be secular in nature, such as the change in the way movies and entertainment are now watched, or how shopping is done. On the company side, we can look at the way a company operates. Are the problems with revenues or revenue growth, cost management, or problems with investment, either poorly planned, unanticipated, or runaway in nature. Lastly, we'd wanna know, does management have a plan, or are they a part of the problem as well? When a company is not performing well, breaking covenants or nearing default, nothing is easy. However, certain problems can be sorted out more quickly than others. Cost cutting, which can be tied to the business cycle is usually the first to be targeted. Next, managerial issues such as working capital or CapEx are addressed. Of course, in some cases, management has little control over working capital if the business is very inventory intensive. However, working capital is an area of immediate gain if it can be addressed as well as capital investment whether it can be scaled back to maintenance levels. Lastly, addressing revenue growth can be the most challenging task as it often takes the longest to resolve or turnaround if at all possible. Overall, we need to know, is there a sustainable business plan a reason for the company to exist. Once we have an idea what is going on with the company or the industry, the borrower and lenders will need to understand what options are on the table. First and foremost, is their borrowing capacity under existing facilities, this would most likely be in the form of a revolver. Revolvers often have borrowing based calculations, so there may be room under a revolver on paper, but in actuality, the company's already at the limit. In this case, we would have to look at additional debt capacity using the current or predicted cash flows. In some cases, depending on the nature of the company, and the cash flows, an asset backed lender could be brought in to assess additional capacity. This would require restructuring the existing debt as well, as asset backed lenders tend to demand super senior status. Additional equity would increase the debt capacity as well, and allow for breathing room, but it is not always possible in a public company with a battered stock. Private investments in public companies are more common these days, however. If these options are not available and the creditors feel that their capital is seriously at risk, a sale of the company would be considered. If the secular issues are such that the business as a whole has little value going forward, then the company would be broken up and sold for its asset values.

In terms of desirability, the debt restructuring options are considered first as that represents the best chance at maintaining a going concern. Debt might be forgiven a restructuring, particularly in a form of bankruptcy. It might also be restructured in the form of extending maturity, adjusting the interest rate, or swapping the cash interest for payment in kind. The existing creditors might also be given equity in the company. This is done as a way to pave the way for additional borrowings often by private debt investors, but occasionally by banks in the current facilities. The senior lenders already have a claim on the assets, so for those claims to be relinquished and to make room for new lenders, the senior lenders are sometimes offered equity. This might not be appealing to senior lenders who want out of the business as they would rather cash out the assets and recoup their capital before new lenders are brought in. Much depends on the business and the industry. If the creditors demand the immediate sale of the assets as collateral, and the business is still viable, a fire sale is conducted where the company is valued at a discount to hurry the sale along. Proceeds from the sale would go first to paying back or paying down existing debt. If the business is not viable, the company will be liquidated and sold which is of course the worst scenario with the most collateral damage to other stakeholders. The second way out of a distressed situation is by additional borrowing. In context, this option would be considered before a sale or liquidation of the company. Borrowing additional funds available under revolver is the simplest way to access more capital, but usually that is not available due to the limits on the facility as previously discussed. A debt capacity study would look at the total acceptable leverage of the company according to a particular metric. The metric is chosen based on a value driver that is acceptable to the market as well as the overall cap, if looking at total leverage or the minimum if looking at, for example, cashflow. Debt-to-EBITDA is the most widely used metric, and the cap on that metric is based on the market's appetite for leverage as well as the comparables in the industry. Almost everything in lending comes back to debt-to-EBITDA. However, lenders are not blind to the shortcomings of EBITDA as a cashflow proxy. As a result, other cashflow based metrics are used to set and monitor leverage, such as the Debt Service Coverage Ratio or DSCR. The DSCR can be defined in many ways. Since this is a coverage ratio, we are looking at a minimum acceptable level of cashflow as opposed to a maximum as in the case of debt-to-EBITDA. That minimum is based typically on a particular type of industry or company. A lower DSCR is more flexible and a higher DSCR is obviously more restrictive.

To see DSCR in use for debt capacity analysis, we start with EBITDA, and then we work toward a free cash flow calculation. Immediately, we can see that the free cash flow in this example is 55% of the total EBITDA, that's a stark difference. Next, we would apply a DSCR ratio, and again, this would come from precedent deals in the market or from the bank's acceptable minimum ratio, which in this example is 1.3x. This means that the cashflow must be 1.3 times any debt service. In this example, that gives us 423. The 550 divided by the 1.3. Now, let's assume that there is a 5% annual interest rate and a 5% annual amortization of principle for a total of 10% debt service. Dividing the 423 by the 10% gives us a 4,231 of maximum debt. When we apply this to EBITDA, because as we've said, everything comes back to the debt-to-EBITDA ratio, we would get an implied debt-to-EBITDA ratio of 4.2x. And that would help us determine whether our DSCR is actually in line with where the market is on overall leverage. The DSCR is often used as a governor of cashflow as well, meaning that it is applied to forecast cash flows to restrict or limit cash available to be used in the analysis. We will see that in our next example. In this example of debt capacity, we will be using the forecast cash flows and then applying a debt service coverage ratio to them to limit the amount of cash used in the analysis. This does two things. First of all, it provides a cushion to the lender, in case the forecast does not come to fruition, so it's essentially like taking a haircut. Secondly, it rightly assumes that all the cash that's being generated in the model cannot be used for debt, which is generally the case. We would then take a net present value calculation of the five-year cash flows at the after-tax interest rate on the debt. We then assume that after the interest is taken out, all of the remaining cashflow is used to pay down the debt over the term, which in this case is five years. At the end of the five-year loan, all of the cashflow has been applied and the balance of the loan is zero. The important number to consider is whether the loan amount established based on the NPV is going to be enough to get the company through the distressed situation. Having looked at the restructuring of the current debt and adding potentially additional debt, we can now look at how a company might be sold in a distressed setting. This is not unlike the process for selling an undistressed company. Namely, we will look at where the comparables are trading or have sold in the market, and then apply those multiples of earnings to the targets to find an implied value. Typically, this is done on a forward basis. It can on occasion be applied to an LTM basis, particularly if we're looking at the precedent transactions. It goes without saying that any valuation should include multiple methodologies and a DCF would also be considered in most cases. In our case study coming up shortly, we will be focusing on the comparables approach as our case company sits in an industry with a robust comp set that makes that approach more applicable. However, a DCF would typically be done as a backup to determine what the residual equity value would be after the debt has been paid off. The last option for restructuring is the sale of the assets also known as liquidation value. It is also a kind of valuation in that we have a book value of assets on the balance sheet, and we need to determine what we could sell the assets for. Here, we would apply a recovery rate based on the type of assets. Current assets are generally worth more as they're closer to converting to cash. Property plan equipment is not as valuable as current assets, but it can have significant value if there is a real estate component. Equity investments, long-term investments, or even joint ventures can also hold value and will be considered for sale, generally, before getting to a liquidation. Whatever the asset recovery is, it will be applied to the outstanding debt according to the creditors' place in the capital structure. Not only senior versus junior, but who has a priority lien claim on the assets. First lien creditors will be paid first, and sometimes there are multiple first lien creditors, as in the case of a revolver and a term loan, A or B. Followed by second claim or second lien lenders, followed by junior or subordinated lenders.

Now that we've gone over the tools needed for distressed company analysis, we will apply these concepts to our case in point, which is Verso Corp. In the next section, I will introduce the case and the supporting materials, and there's also a debrief to the case that will follow.