Investors Fume as Banks “Extend and Pretend”
July 16, 2009
As they attempt to recover from excessive losses, banks are finding it easier to buttress struggling companies they’ve underwritten deals for rather than allowing those companies to pursue other options, options that could benefit investors but result in further bank losses. This has created tension between the banks and investors, which some market participants say could boil over and result in lawsuits.
Some investors say banks are propping up underperforming companies—mainly small and midsized companies—with refinanced or new debt and not allowing these borrowers to pursue, for example, acquisitions or capital infusions from private equity sponsors, which could improve recoveries for junior lenders. While this situation has been causing tension since the onset of the recession, investors are becoming increasingly vocal about it, sources said.
“We are going to call this phase the ‘extend and pretend’ phase in our economy,” said Bryan Marsal, co-founder of Alvarez & Marsal, a law firm specializing in bankruptcy and restructurings. This, he said, is when “you extend a company’s maturity—because it is going to default—and you pretend that business will come back or that leverage is going to come back.” Both banks and companies are trying to buy time rater than deal with the leverage, said Marsal, who was hired in September as the CEO of Lehman Brothers Holdings.
As of July 6, the number of issuers that have amended debt this year stood at 206, according to Standard & Poor’s Leveraged Commentary and Data. That’s 58 more than all of the amendments executed last year. Moreover, as of July 13, the year-to-date global volume for working capital loans was $109.5 billion, the highest year-to-date volume on record and a 12% increase over the same period last year, according to independent data provider Dealogic. Working capital loans provide cash to cover a company’s operating expenses, such as employee benefits, rent and electricity costs.
With the level of “amending and pretending” increasing, investors have taken it upon themselves to try and change the situation. Some are becoming vocal because they bought a company’s debt prior to the recession and would like to recover as much as they can when the debt matures. Others are motivated because they bought a company’s debt on the secondary and would like to see it improve.
Corporate Zombies
One investor said he knew of several companies that were undercapitalized, overlevered or operating without sufficient liquidity that had received offers from buyout firms or competitors, but their lenders denied them the opportunity to pursue these options. “Ultimately, rather than take a write down, the bank reloaded the term loan with $2 million more in order to keep a crappy borrower afloat,” he said. “People talk about the zombie banks, but it’s really the zombie borrowers, who are stuck in a bad situation, where they are overlevered and they can’t access new outside capital. They are just treading water while they hope that their bank allows for some sort of solution to be put into place. If you were thrown in the ocean, you could probably tread water for a long time, but sooner or later it becomes more difficult to keep your head above water.”
One example, the investor said, happened with a company that was sold for approximately $112 million three years ago, receiving almost half of that from a bank. The deal underperformed “right out of the box.” The company, he said, posted $1 million in cash flows last year, and will likely post less this year. The bank, meanwhile, has liquidated assets, converting some of that to cash, but that has done little to help the company find a buyer or to fix its capital structure. “You can go without a meal for a day to loose some pounds, but starvation is not a winning business plan. That’s what’s going on out there. That’s why it’s so destructive—when you hear situations where the bank is lending more money to a [company in dire straits] in order to keep it afloat.”
Neal Schweitzer, an independent observer of the leveraged loan market, added, “The good news is that banks have typically managed troubled loans to companies with prospective or current debt service problems in order to manage through a troublesome and uncertain economic environment. The bad news is that how they manage exposures is subject to some dispute among analysts. Whether it’s an orderly liquidation, a workout, or avoidance of bad debt classification depends in large part on the character of the agent lender’s management.”
Banks, in their defense, are facing tremendous regulatory pressure to perform, so they are reluctant to let go of a deal and take another write off. Prior to the recession, banks didn’t have to worry about propping up a bad company because they weren’t taking the hits they are now. Some market participants said banks are doing all that they can to help companies restructure. They are, after all, not legally bound to look out for the junior creditors. “We see deals all the time where banks are willing to let the company rearrange,” said a partner at an international law firm. “We’ve even seen litigation where a group of institutional lenders is trying to make the bank continue funding a company.”
The No Solvency Zone
The tension between investors and banks is just that: Tension. But while investors may not have hired any law firms to draft up the lawsuits yet, the chatter around the subject is intensifying, said Chris Molen, a senior partner at Paul Hastings.
One possible legal avenue that has been discussed is the “zone of insolvency.” This requires a company that knows it’s insolvent or knows it could become insolvent to look out for the needs of not only the equity holders, but the creditors too, which it is legally responsible to do. Debt holders have been considering legal action that would extend the “zone of insolvency” to banks, reasoning that a bank would know before junior creditors if a company was at risk of becoming insolvent. However, such cases could be dead ends because it’s difficult to prove how much the bank knows, sources said.
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