Editor: Would you describe your background in corporate finance?
Thompson: Prior to joining Proskauer in August 2008, I was the general counsel at Jefferies Finance, the lending arm for Jefferies and Co., an investment bank based in New York. I am a partner in Proskauer's Finance Group. My areas of concentration are primarily complex financing and capital restructuring transactions, with a particular focus in the areas of debt exchanges, debt buybacks, workouts and restructuring, acquisition financings, leveraged recapitalizations, mezzanine investments and debtor-in-possession financings. As the market has moved away from new issuances, my practice has transitioned back to out-of-court workouts and restructurings and insolvencies. As a part of meeting client goals of deleveraging companies in out-of-court restructurings, I developed a specialty in debt buybacks and debt exchanges and cancellation of indebtedness transactions.
Editor: Why has the subject of debt buybacks become so appealing to companies and private equity firms?
Thompson: Notwithstanding that many companies have robust businesses and persistent demand for their goods and services, the financial crisis has revealed that many of these companies have incurred excessive leverage. These companies are looking down the barrel of near-term cash crunches and oftentimes defaults. Many of these companies also face a grim environment for refinancing their debt when it reaches its stated final maturity. Debt buybacks are one mechanism to permit certain parties, either the borrower itself, the private equity sponsor who originally invested in the transaction or third parties, to acquire debt which is trading at a significant discount to the face value of the instrument. Investing in this portion of the capital structure, on a relative basis, can be attractive to certain investors. For example, if a bank loan worth $100 is trading at $60, a party looking at potentially cancelling the debt could buy that $100 worth of debt at $60, cancel it, and thereby reduce the company's leverage by the face amount. Alternatively, if the party consummating the buyback holds the debt to maturity, the return on the investment may be very attractive on a stand-alone basis without the benefits of cancelling the debt. If cancelling the debt is part of the transaction, the equity holders in the borrower and the other creditors to the borrower also reap the benefits of a deleveraging debtor without the debtor using scarce cash resources to repay the debt at par (as opposed to the discounted purchase price).
Editor: What measure in the recent economic stimulus package makes it attractive for companies to buy back their debt at a discount?
Thompson: The recent stimulus package included incentives relating to the treatment of cancellation of indebtedness income (i.e., COD income). As a general matter, a corporate borrower whose debt is cancelled is subject immediately to income tax at ordinary corporate rates based on the face amount of the debt that is cancelled. The reforms now allow a borrower to elect to participate in a COD income tax holiday until 2014 for debt which is cancelled in 2009 and 2010. In the five subsequent years (i.e., after 2014), the borrower will be required to ratably pay the COD income tax liability. Given the current depth and likely duration of the financial crisis, the stimulus package has implemented a reasonable and prudent set of incentives for borrowers to pursue transactions which will result in the cancellation of debt. Of course, with respect to debt buybacks, you can have a debt buyback transaction that is separate from cancelling debt. A standalone transaction to buy discounted bank debt may be attractive in and of itself, but the stimulus package provides the critical tax reform to encourage the parties to a buyback transaction to take it one step further and consider cancelling the debt. The borrower does not suffer the immediate cost of being able to pay the COD income tax liability and is able to ride out the economic cycle over the next five to ten years.
Editor: Why is this particularly appealing to private equity firms?
Thompson: We can break that question into two parts. First, there is the set of existing private equity firms who own portfolio companies that are looking hard at ways to restructure the balance sheets of their over-leveraged portfolio companies. Private equity investors are trying to use both debt buybacks and/or debt exchanges to reengineer the balance sheets of existing portfolio companies in order to minimize the likelihood of a default or other adverse development under the existing credit documentation. The ability to execute a debt buyback and cancel the debt is very attractive for existing private equity investors to the extent that the debt is trading at a heavy discount, the COD income tax liability is manageable and the private equity investor can retain significant equity ownership going forward.
Second, there is the set of private equity sponsors who are looking to structure debt buyback transactions to effect a potential consensual change of control away from the existing private equity firm and to use the debt buyback transaction as a way to reengineer the balance sheet of the underlying portfolio company. This type of transaction is quite complicated to execute; however, we are working with a number of private equity clients to design, structure and execute these deals. The existing private equity firm is an active participant in these deals and is incentivized to minimize their losses (or realize their gains) through this consensual exit strategy based on agreed to valuations and related matters.
As an overview, considering the amount of new or existing money which is available to invest in distressed or discounted debt instruments and/or to invest in regular private equity transactions, there is a significant pool of money available to get these deals done. Bottom line, that is the good news. The tax relief in the stimulus package has been critical to ramping up the cancellation of indebtedness transactions. We view debt buybacks as a creative and helpful way for the markets to go through the process of deleveraging.
Editor: In former times, loan covenants would foreclose a company's early retirement of debt. Why is this not the case today?
Thompson: In considering a debt buyback and cancellation of indebtedness transaction, a very close review of the existing credit documents is required. There will be some credit documents which are so restrictive that they will, directly or indirectly, block the consummation of the transaction. In other credit documents there may be sufficient flexibility, depending on obtaining certain levels of consent from lenders, to make the transaction viable. Often the level of consent will be limited to majority lenders and those lenders whose debt is being cancelled. That is not an outright prohibition on cancellation of indebtedness, but it does provide for a threshold level of consent to consummate the transaction.
Editor: When private equity buyers repurchase debt of their portfolio companies to the extent that it provides them with a majority block, do the minority debt holders have any legal recourse so long as there are no debt covenants that prevent this?
Thompson: It's a transaction-specific problem. To the extent that existing debt of a borrower is being cancelled, and the consideration for that transaction arises from sources other than the credit parties themselves, the existing remaining lenders obtain the benefits of a deleveraged credit, i.e., the total amount of debt on the company has been reduced by the amount of debt that has been cancelled, the company's fixed-charge ratio has been improved, and the existing investors will commonly have avoided the types of losses associated with a default or an insolvency event. Most minority remaining investors should see their investment gain in value, so, as a general matter, we view most debt buyback transactions as beneficial to minority holders of debt.
Editor: What is the position of the debt after its repurchase vis-à-vis the other debt holders?
Thompson: The answer turns on the particular transaction: in particular, a critical question is which entity is acquiring the debt? For instance, in the UK under proposed credit agreement language promulgated by the LMA, if the borrower or its related parties buys back debt, one of the options contemplated by the LMA is for the newly acquired debt to be subordinated to the other debt holders and for certain voting rights to be modified or waived. To answer the question adequately requires a close study of the relevant credit documentation and the contemplated transaction.
Editor: Why is a debt buyback a better transaction than a simple cancellation of debt?
Thompson: A unilateral cancellation of indebtedness by existing debt holders is, from a practical and credit documentation perspective, difficult to execute, especially where the existing debt holders are widely dispersed in a broadly syndicated transaction. By way of contract, if it is a "new money" debt buyback transaction (i.e., where a party unrelated to the existing credit parties is providing the consideration for the debt buyback, as opposed to cash from the credit parties), structuring the deal in compliance with the existing credit documentation will often be less complex.
Editor: Do you expect to see debt buybacks as an ongoing trend as part of the deleveraging of companies both in the U.S. and abroad?
Thompson: We view debt buybacks as an ongoing and viable way for companies to restructure their balance sheets; to the extent that refinancings of existing credit facilities will be very difficult to execute over the next two or more years, debt buybacks and debt exchanges will become more common. The volume of bank debt that is required to be refinanced over the next two years is extraordinary, and the current capacity of the debt markets to refinance that debt is not apparent.
Editor: What does this auger for economic growth?
Thompson: A continued period of austerity - austerity in the use of free cash flow, austerity in deploying cash for investments and austerity in the management of expenses.
Published March 31, 2009.
