When to Refer Your Borrower to a Debt Restructuring Firm

Article Provided By Daniel Wheeler, senior counsel at Buchalter Nemer

Sometimes both bankers and lawyers can achieve the best result on a problem loan by looking outside their respective skill sets and bringing in an outside debt restructuring firm. A good restructuring firm working with a suitable borrower can frequently help the borrower improve their balance sheet and cash flow, restore the borrower to compliance with debt covenants and keep the loan as a performing asset in the bank’s portfolio.

The downside of calling a default and pursuing collection remedies is well known. If loan covenants have been violated and the borrower is in payment default, the business’ assets may be already deteriorating in value, the accounts receivable may be harder to collect, and equipment and inventory usually will have to be sold at liquidation prices. Enforcement costs are borne by the bank and there is an immediate hit to bank's capital and earnings when recovery falls short of the outstanding loan amount. In addition, there are the opportunity costs of a lost banking relationship. Whether the business is liquidated or leaves the bank as a result of refinancing, that business usually never comes back to the bank. Both that business and the potential referrals that business may have brought to the bank are usually lost forever.

Debt restructuring, when done correctly and for a suitable client, avoids these problems. John Seeley, Managing Director of Acrius Capital, a San Francisco company that provides financing and debt restructuring services for distressed companies, says that his approach “is to restore a company’s financial health so they can once again be a solid borrower in the bank’s portfolio.” According to Seeley, “we do this by working with the trade creditors and subordinated debt holders to decrease the debt service to an amount that can be paid by the company’s cash flow.” In most cases, the restructuring fees are paid by the borrower, so there is no cost to the bank.

A debt restructuring firm is generally compensated on a success fee basis, which means they have an incentive not to take on unsuitable projects. The compensation varies, with some firms taking a flat fee, while others are paid a percentage of the savings achieved by negotiating payment plans or permanent reductions on outstanding credit balances. Most firms do not charge by the hour for telephone calls, emails and faxes that go back and forth to their clients’ creditors. The time-consuming task of dealing with creditors is taken off the shoulders of management, which allows the company to focus on rebuilding its business.

A good candidate for debt restructuring is a business that has the cash flow to service a reduced debt load (including trade debt) approximately equal to the bank’s loan. “Our typical client has a total debt load that is 1.5 to 3 times their asset base,” says Seeley. “For those companies that have the cash flow for a debt restructuring program, their debt could be reduced to less than half of its original amount, including all debt restructuring fees.”

An important element in the success of any debt restructuring is early intervention. Bankers

need to review their clients’ financial statements quarterly, if not monthly to detect signs of trouble. For example, if the cash flow statement suggests that the company is maintaining cash flow through asset sales and stretching out accounts payable and other liabilities instead of from profit generation, this is probably a red flag suggesting that intervention is necessary even if loan covenants have not yet been breached.

The restructuring firm’s main job is to help a company prioritize its debts and then negotiate a settlement with the company’s creditors. Some trade creditors or subordinated lenders may not be critical to the business’ survival. Other creditors may be sole source providers of goods or services necessary for the business to function. A bank referring its borrower to a debt restructuring firm should insist on priority treatment in the restructuring process, as is appropriate for the bank’s position as the largest lender and first priority secured position.

Part of the restructuring strategy may involve takeout financing. Most restructuring firms maintain relationships with non-traditional lenders with whom they can broker an appropriate facility once the company’s overall debt load has been reduced. Because these takeout lenders generally do not offer deposit or treasury management services, the referring bank can usually keep those relationships.

In summary, debt restructuring can be a way to maximize the value of a business and thus the recovery on a bank’s problem loan. Instead of the bank and its customer being adversaries, the bank can be instrumental in bringing in a valuable team member for its borrower and all parties can work together constructively.

Daniel Wheeler is senior counsel at Buchalter Nemer and specializes in representing independent banks. He can be reached at 415-227-3530 or dwheeler@buchalter.com.