By: AK Infinite
In Shakespeare’s Hamlet, Polonius advises, “Neither a borrower nor a lender be.”
Debt is often viewed as a strategic tool for growth and expansion. However, the intricacies and potential pitfalls of borrowing can sometimes lead companies down a precarious path.
In this podcast, Eric Neumann, a Fractional Chief Financial Officer at New Life CFO, shared his insights about the complexities of debt and the peril it can bring within the business environment.
In 2008, Eric was hired as the CFO of a company facing significant billboard and radio industry challenges due to declining revenues and an over-leveraged position (too much debt relative to profit). With a debt load of $325 million, they needed to renegotiate with their 63 lenders. Initial attempts at restructuring provided temporary relief, but by 2009, it was clear that further action was necessary as the company was on the brink of violating its loan covenants.
Loan covenants, designed to ensure the company’s ability to meet debt service payments, became a significant hurdle. Despite efforts to restructure debt and create financial cushions, the company’s forecast for 2009 showed they would miss their covenants, triggering a default by Spring. This situation forced difficult conversations with the board, which consisted mainly of equity investors unwilling to accept the grim reality of further investing capital to pay down the debt or risk losing their equity.
The company in question has 63 different financial institutions as its creditors, a mix of banks, hedge funds, mutual funds, and debt funds. This diversity of stakeholders, each with varying interests and expectations, created a complicated debt structure that included a 1) revolving credit line, 2) “first-lien debt” primarily held by banks, and 3) “second-lien debt” held mainly by hedge funds. Each group had its perspective on the company’s value and potential strategies for recovery, making consensus challenging.
High Debt
Since the 1992 publication of George Anders’ “Merchants of Debt – KKR and the Mortgaging of American Business,” which portrayed KKR’s equity team as villains for leveraging high levels of debt to boost equity returns, the narrative around leveraged buyouts (LBOs) and high-debt levels of any company has evolved. Despite initial criticism, many of the deals executed by KKR and other private equity firms, including those Eric was directly involved in, have proven successful. Examples include Safeway (equity backed by KKR), Hilton Hotels (equity backed by Blackstone Group), and Chancellor Broadcasting (equity backed by Hicks, Muse, Tate & Furst) of which Eric served as CFO. According to him, the key to this success is achieving consistent mid-to-high-single-digit revenue growth over several years while keeping expense growth much lower than revenue growth. The strategy of leveraging higher levels of debt has been adopted by many successful businesses over the past 30 years, contributing to key areas of economic growth and enabling impressive company turnarounds when managed effectively. The challenges or perils of high debt often stem more from the inherent risks of market cycles and competition than from the tactics employed by equity holders to secure returns.
The Role of Distressed Debt Funds
Many businesses turned to debt to fuel growth, especially in the recent era of low interest rates. However, the end of the zero-interest rate period brought new challenges. Distressed debt investment funds, specializing in acquiring troubled assets, were poised to capitalize on companies facing financial difficulties. These funds, adept at navigating complex financial situations, often buy debt at a discount to take control and restructure companies for eventual profit.
The Chapter 11 Process
As the company struggled to meet its financial targets, it became evident that it needed to undergo a Chapter 11 reorganization—a process to restructure debt and equity. This process, involving intricate negotiations and legal maneuvers, lasted several months. The goal was to reduce total debt to $135M and convert second-lien debt holders to equity holders. The original equity holders would lose their investment. Yet, a new equity investment was made by a distressed debt fund quietly watching the company for months, setting the stage for a potential turnaround.
“I’ve seen debt ruin companies or at least put them through a distracting reorganization (i.e., Chapter 11 Bankruptcy). The vast majority of bankruptcies, known as Chapter 11 or Chapter 7 (complete liquidation and closure of the company), are due to banks forcing the issue on the entrepreneur who has run afoul of agreed-upon performance targets.” shares Eric.
These reorganizations and liquidations are usually not initiated by the equity holders, who, by definition, must be patient through down cycles. When companies are faced with non-compliance on their debt covenants, it is due to two factors:
- Imperfect executive decisions. Hindsight is perfect; foresight and insight often aren’t.
- Markets/industries/companies go through cycles out of their control,
When those two factors combine, you can have a non-performing loan.
The Distressed Debt Funds’ Strategy
Distressed debt funds quietly bought up the company’s debt at a discount to gain control. These funds typically look for companies with significant distress but potential for recovery. Their strategy involved detailed due diligence, leveraging their expertise to restructure the debt and equity to the detriment of existing equity holders and eventually profit from the business’s turnaround.
The Road to Recovery
Post-bankruptcy, the company embarked on a strategic transformation. They invested in digital billboards, significantly increasing revenue from these assets. Additionally, they pivoted their radio business to include digital marketing services, helping local advertisers with online strategies alongside traditional radio advertising. This dual approach stabilized revenues and positioned the company for growth.
So, if you’re a business owner in a tight spot, you may ask, “What’s the better option then?” According to Eric, “Banks have a short-term perspective.” They are mandated by their own rules, standards, and traditions to get a “bad loan” off the books soon and take the write-off. The banks and their ecosystem don’t prevent distressed debt situations; they tend to fix their problem of a bad loan even at the risk of a company’s survival – a massive problem for the entrepreneur going through a down cycle.
On the other hand, equity investors often seek long-term success for businesses, and in many cases, they are willing to stay invested for extended periods to support recovery and growth during challenging times. In rare situations when equity forces a company’s bankruptcy, it’s primarily due to failed management or business models and market conditions that won’t improve.
Eric Neumann succinctly said, “The general belief is debt is far cheaper than equity – true. But when times are tough, debt will punch your lights out (figuratively), equity will still work with a transparent, transparent management team that operates a viable business.”
When debt is unavoidable, companies must enforce a carefully structured plan to manage the level and maintain transparency. While debt can be a powerful tool for business growth, it comes with significant risks. Despite the best of intentions, sometimes entrepreneurs need to catch up on their tips in debt. Still, a skilled CFO, brought on at the right stage in a company’s growth, can create detailed forecasts and strategies to help manage debt levels responsibly while mitigating risks.
For more information, you may visit New Life CFO’s website here: https://newlifecfo.com.
Disclaimer: This content is for informational purposes only and is not intended as financial advice, nor does it replace professional financial advice, investment advice, or any other type of advice. You should seek the advice of a qualified financial advisor or other professional before making any financial decisions.
Published By: Aize Perez
