Euroweek high yield report: restructuring

Euroweek high yield report, July 2011

Asia’s high yield markets have been remarkably resilient in recent years. Through the global financial crisis, when one might have expected numerous restructurings, there were comparatively few required. But when they do happen – and more will inevitably do so – it’s worth looking at what has worked and failed in previous situations.

In October 2008, the Taiwan-owned, China-based and Singapore-listed steel maker FerroChina said it was unable to service its huge debts and was stopping production. It had about RMB706 million of working capital loans that had come due which it could not repay, and was also unsure it could repay total loans of RMB4.52 billion. The failure realised many of the worst fears of offshore investors who had put money into Chinese businesses: just how far would they be down the pecking order in the event of a default? They were about to find out: offshore bondholders, with limited rights to onshore assets, were excluded from the onshore restructuring and forced to take considerable losses. “Ferro China was perhaps the first deal where offshore noteholders were made painfully aware of how subordinated they are vis-à-vis onshore lenders, even if the government gets involved and makes efforts to help the company to survive,” says Florian Schmidt at ING.

It would not be the last. Asia Aluminum was the biggest aluminium extrusion group in the region, a Hong Kong-listed company with major manufacturing facilities in Zhaoqing, China selling chiefly to the domestic market. In the good times, it issued US$450 million of senior notes, listing them on Singapore Exchange; then issued US$535 million of payment in kind (PIK) notes, again in Singapore, to fund a leveraged buyout.

Swiftly running into trouble during the financial crisis, it tried and failed in early 2009 to buy back its senior notes and PIK notes at a fraction of their face value – 27.5 cents per dollar for the bonds and 13.5 cents per dollar for the PIK notes. As PRC legal actions began against it from onshore creditors, the group defaulted on both sets of notes, and became insolvent in February 2009 with a total onshore and offshore debt of US$1.79 billion.

Once again, it ended badly off offshore creditors. All the equity in the company’s PRC operating assets was sold to a management buyout consortium for US$475 million. Onshore creditor and Hong Kong lender obligations were assumed by the consortium, meaning that in theory they didn’t lose a cent; senior note holders got 19.2 cents on the dollar, and PIK noteholders less than a cent (a 0.6% expected recovery). “In Asia Aluminum, the company could and should have been a going concern, but the sponsor simply was not willing to engage in a constructive manner,” Schmidt says.

A better outcome came with the restructuring of Titan Petrochemicals, a Hong Kong-headquartered provider of oil logistics and marine services in Asia and in particular China which ran into trouble on the back of rising oil prices, poor performance, the volatility of freight rates and new requirements from the International Maritime Organization on the carriage of oil. Seeing its liquidity situation deteriorating, Titan appointed ING to restructure the company’s debt and capital structure, in particular US$315.4 million worth of 8.5% guaranteed senior notes, due 2012. This was not, technically, a default, more an announcement that trouble was ahead.

First an open-market repurchase of Titan’s bonds in early 2009 reduced outstanding debt; then an exchange offer was made. For every $1,000 of existing notes, noteholders were offered $376 in convertible notes, $68 in new PIK notes and a cash payment of $206, with an early tender premium of an extra $32.50. In July 2010, the company announced a 66.43% acceptance rate.

“In Titan Petrochemicals, the company did not wait for a default, and the chairman sold equity and vessels in order to get investors on board for a debt restructuring,” Schmidt says. “Titan saw it coming and engaged banks early to say: this is our situation. The dealer managers [ING and Goldman Sachs] reached out to investors and explained that the debt will have to be restructured; we encouraged them to appoint their own legal counsel and steering committee.”

This, he would conclude, was a key step. “Once you’ve got a steering committee together, then you are able to negotiate and take note of the preferences they have.” In the case of Titan, investors wanted an element of cash; the company sold all its ships to meet coupon payments and sold equity to create cash for those investors. Some asked for a convertible element in order to create an upside in the equity price if the company survived, and that was arranged too. “It was the first consensual restructuring of a widely-held Chinese high yield bond,” Schmidt says. “The lesson from all this is: one, the sponsor has to be willing to pay and to engage investors; two, once the sponsor has done this, you have to engage investors early.”

Matt Sheridan, a partner at Sidley & Austin who worked on the Titan restructuring, reached similar conclusions. “One complication was identifying the investor base and getting them organized to express what they wanted so we could try and negotiate a deal,” he says.

“You figure out who the big investors are, encourage them to form a group and start talking so that when you launch a deal, you’ve got a high chance of success. Then the rest of the investors see that, and come in too.”

Generally, another vital part of the restructuring process is to understand what investors are likely to accept from a settlement. “You’ve got a number of available currencies to help you with these things, and it’s different in every circumstance,” Sheridan says. “You’ve got to figure out what you have available to you, what is your investor base, and what are they interested in.”

Sheridan worked, for example, on the restructuring of Davomas, an Indonesian cocoa exporter that was unable to meet the interest due on $238 million of guaranteed senior secured notes. In that restructuring, Sheridan says, “creditors only wanted cash. They were willing to take a haircut but didn’t want equity or convertibles.” And it’s worth recalling that an unwillingness to take a particular asset may not represent obstinacy on the part of an investor, as the terms of its own mandate. “Some investors can’t take equity. It’s not just that they won’t, they legally can’t, in some cases.”

In the Davomas case, the company launched a consent solicitation to try to get at least 75% of holders, in terms of principal amount, to exclude holders in burdensome jurisdictions from further solicitations – a method of trying to move forward without being held by back slow-moving objections – and got 96.41% consent. Then it launched an exchange offer for $119 million of variable rate guaranteed secured notes, due 2014, backed by strong credit enhancements such as a cash water fall structure ensuring interest payments, and the appointment of KPMG to enforce financial discipline. Davomas got a 98.35% success ratio.

In Indonesia generally, Schmidt says, “It’s entirely a question of what the judges are doing: are they leaning towards onshore or offshore, are they issuer friendly or creditor friendly, or are they neutral?” ING worked on the Davomas restructuring, which was considered largely successful, but it arguably should not have happened in the first place. Schmidt says it came about because “one small onshore holder was able to initiate bankruptcy against the company even though the issuing entity is domiciled in Singapore. In Singapore he would have been told: talk to your trustee.”

Other lawyers have their own techniques and starting points. “The key thing with any restructuring is a full analysis of the cashflow situation of the group,” says Joseph Tse, partner at Allen & Overy. “From a lawyer’s perspective, you need to look at the group structure and identify the structural subordination issues. It’s all very well for cash to be generated onshore by an operating company, but if there is a big cash trap in China whereby you can’t get the cash out, that’s not going to help foreign creditors who are typically holding debts incurred by the offshore holding companies. They are, technically, structurally subordinated.”

Are there more restructurings ahead? Asia has looked comparatively strong over the last few years. But privately, many bankers, lawyers and issuers are looking at some of the deals coming out of China now with mounting alarm. “Several of them,” says one, “are restructurings waiting to happen.” Another adds: “you don’t have to be particularly cynical to see some of these falling into restructuring in the future.”

“There’s a real peril with some of these Chinese real estate issuers,” one issuer says. “If you are buying a bond for a Chinese real estate company you must be taking equity risk. There’s going to be a bad event there: there are constant issuers coming out with no track record and no banks are lending into that market. My feeling is there is going to be a big differentiation between those issuers, and those that have a more sane view of the credit markets.”

Tse says: “Every market has its cycles. At the moment we are in a boom cycle where a lot of high yield gets done, but come the next downturn I’m sure some of these will go through a restructuring.” He thinks this is particularly likely in markets and industries which are more cyclical – which is unfortunate, since the mainstay of Asian high yield issuance, Chinese real estate, is about as cyclical as it gets.

When it happens, familiar issues of structural subordination and competing interests will arise again. “You will see the same issues arise if some of the current high yield issuers go through a restructuring in the future,” Tse says. “That’s something investors and advisors will have to put their heads together on, to try to find a solution and improve their position.” On top of that, Asian recovery rates tend to be lower than global rates for all of the circumstances discussed above: lack of insolvency regimes, lack of creditor-friendly regulatory and legal environments, and a straightforward unwillingness to pay. One banker says that, as a rule of thumb, if recovery rates are 30 to 40% in the US, they are more like 10 to 15% in Indonesia and close to zero in China.

In some ways, it’s a surprise it hasn’t happened already. “We’ve seen this cycle before, when many of the real estate players who are now issuing high yield bonds went through their restructuring just before the financial crisis, when the Chinese government was trying to cool down the property market,” says Tse. “In a way, the financial crisis in the west saved them, because in response to that the Chinese government relaxed its credit tightening policy and allowed banks to lend to these companies,” or allowed them to complete IPOs.

To avoid defaults, highly leveraged companies need to revise their balance sheet. On top of that, more companies are seeking consent to amend covenant terms on bank debt and other debt securities in order to stop covenant breaches happening. The role of private equity and mezzanine debt, to strengthen the balance sheet, should also be evaluated. For the very highly leveraged, they may have to consider heavily discounted tender or exchange offers in order to restructure. Whatever the method, it’s far better to fix problems before they get anywhere near a courtroom. “In Indonesia and China, really the restructuring should start before a default happens,” says Schmidt, “and before somebody takes you to court.”