Interview Question: What Are The Characteristics of a Distressed Company?
Much of the work you'll be doing as an analyst or associate in restructuring investment banking is creating profiles and screens. These are small one-to-three page reports that give an overview of a company that the analyst or associate believes is likely to face a restructuring event in the future.
Future is the operative word because almost everything in restructuring involves a rather long lead time.
It is incredibly rare that a large company will enter into a truly distressed state without having either a) having been approached by RX bankers before or b) having had discussions internally about restructuring possibilities.
So understanding what makes a company distressed and likely in need of restructuring sometime in the future is one of the most critical skills to build (and one to be aware of in interviews).
While in Restructuring Interviews we go over many different aspects of what a distressed company will look like - along with giving examples of profiles and screens - let's cover the three most important things to think about.
Liquidity is likely (hopefully!) a term you're familiar with. But ask yourself, what does liquidity actually mean? Chances are the answer you give will not be the convention used in restructuring.
In restructuring our definition of liquidity is as follows:
- + Amount available on the revolver
- - Letters of credit outstanding
- - Restricted cash
Liquidity in this sense really means, "how much cash do we have that can we can use for operations (assuming negative FCF) or to use in order to pay off creditors in order to reconfigure our capital structure".
Liquidity can be thought of as providing: a runway (in which a company can continue to operate even with negative FCF) and optionality in terms of what can be done to the capital structure with the cash on hand.
In a capitalization table (usually just called a cap table) you'll have a listing of all the pieces of the capital structure along with their critical features including their maturity.
Debt maturity walls refer to time periods when at least one major piece of the capital structure comes due and must be rolled over (re-financed) or simply paid off.
Large chunks of debt coming due is often the impetus for a restructuring event. The debtor can no longer live off of their liquidity (cash and revolver draws). They now must actually go and raise new money and if no one is willing to give them more debt to pay off their old debt then they'll be faced with needing to either restructure out-of-court or in-court (Chapter 11).
In your profiles and screens you'll always create a graphic - in Excel - showing when maturity walls are coming due to illustrate when this event is likely to take place.
It's important to remember that a company that appears tremendously unhealthy can exist as a zombie corporation for years on end if they have no debt coming due (and have sufficient liquidity to draw on).
A common term you'll hear in your day-to-day role is when a "restructuring event" will occur. Maturity walls coming due represent a potential restructuring event.
Debt Trading Levels
You'll almost always discuss where debt is trading (even if it's a private company, since large private company debt will usually be syndicated and trade on the secondary market, of course). In particular, you'll look to at least one area of the secured part of the capital structure (normally revolvers or term loans) and the lowest parts of the unsecured part of the capital structure (excluding mezz debt).
If you have secured debt trading in the low-90s, but unsecured debt trading in the 60s, for example, this is a signal that the market is pricing in a restructuring event where the secured debt is, well, secure (properly collateralized or covered) while the unsecured debt is likely to be heavily impaired (get only a modest amount of recovery in the event of a Chapter 11).
Conversely, if you have secured and unsecured debt trading in the 50s-70s that may signal the market doesn't anticipate an out-of-court restructuring is possible (since the company is too far gone and secured debtors are unlikely to want to roll the dice on some kind of debt or debt-for-equity exchange). Instead, it's likely going to be a Chapter 11 in which even the secured debt is impaired (meaning unsecured debt will almost certainly receive nothing).
On the other hand, if you have a company will large leverage ratios, lots of debt coming due, but yet secured and unsecured debt are trading in the 90s then the company is viewed as probably being able to roll their debt over. The market just doesn't seem that concerned and isn't forecasting any kind of restructuring being needed.
Debt trading levels can not tell you everything, but they can give you a directional sense of what restructuring outcomes the market is "pricing in".
For debt trading levels you'll almost always use MarkIt or occasionally you'll turn to Bloomberg. Almost all debt will trade on the secondary market if the placement is large enough (occasionally you'll see some revolvers that don't, however).
Determining whether a company is likely to be in a distressed position is a nuanced, holistic process. It's invariably a judgement call.
However, if there's limited liquidity, debt maturity walls coming due, and debt prices trading down it's almost inevitable the company will be facing a restructuring event.
If you'd like to learn more about what distressed companies look like, how restructuring occurs in the real world, or are looking to crush your restructuring interview make sure to check out Restructuring Interviews.
One final note, never in an interview say the equity trading down is indicative of a company in distress and needing restructuring.
While that is often (in fact, almost always) true, what we care about in restructuring is the capital structure and that involves debt or debt-like instruments.
The fact that equity trades down has no direct bearing on the capacity of the firm to continue operations. The COVID-19 events of 2020 are proving this to be true as companies that are down 50% are able to go out and raise billions in new debt; many at shockingly low yields.