What is a Rights Offering? How Rights Offerings are Used in Chapter 11
Let’s imagine that you’re working at a distressed debt hedge fund. You’ve been following a company that’s been in distress for a while and it has a pretty simple capital structure. Let’s say that it’s comprised of a few tranches of secured debt and a tranche of unsecured notes.
Now let’s imagine this company is in the oil and gas space and it’s 2016-18. After years of intensive investments funded through debt issuance, the company has ended up in a place of distress given the suppressed price of oil. Ironically, the suppressed price of oil is largely caused by all of this company’s competitors - who all are remarkably similar - desperately trying to stay afloat (along with OPEC keeping production high so as to squeeze out all these overlevered American upstarts).
As a smart analyst, you look at this situation and say to yourself, “This company would be phenomenal if only the price of oil were higher, or if this company could delever significantly.” You say this to yourself with complete confidence even though when you were previously looking at a distressed natural gas company someone kept on mentioning strip pricing and you thought they were referring to steaks.
Anyway, let’s say the unsecured notes are trading at sixty cents on the dollar and through your brilliant analysis - or your general predisposition toward conformity - you think they’re perfectly pricing in the recovery value if the debtor were to file Chapter 11.
Given this scenario, would it ever make sense to recommend a building up a position in the unsecured notes?
The answer is potentially yes. Not only because as an impaired class in this simplistic scenario some post-reorg equity will make up at least part of your recovery – and you said you’d love to own the equity, because you think the company would do great if it could be delvered – but also because you can potentially buy even more of the post-reorg equity via a rights offering, at a steep discount, while making sure the company doesn’t emerge nearly as levered as it was beforehand.
One thing I haven’t written much about – because it’s entirely outside the bounds of what you would ever be asked in an interview – is the way in which pre-petition creditors can participate in giving the debtor new money while in Chapter 11 in exchange for some pretty enticing securities.
However, when you’re in a distressed-oriented seat – and looking at buying debt in a company you think is likely going to have to file – you won’t always be buying with the intention of then sitting on your hands and waiting to see what your recovery will be.
If you’re in the secured part of the capital structure, you may be looking to participate in the DIP facility. If you’re further down the capital structure, you may be looking to participate in a rights offering or even, depending on your fund’s appetite and ability, backstop the rights offering.
Both of these ways of committing more capital to the debtor allow a fund to potentially enhance their overall returns (although both will lead you to being even more closely wedded to the debtor – especially when it comes to participating in a rights offering).
Note: Just to be clear, rights offerings don’t happen in every Chapter 11. Generally, rights offerings will occur in the larger and thornier cases, and you’ll frequently see distressed funds in the mix like SVP, Contrarian, etc. (although sometimes you have other odd players suddenly step in – like in the case of Chesapeake where you initially had Franklin Resources come in to backstop the rights offering).
Note: As we’ll get into, not every class of debt will be able to participate in a rights offering. Normally it’ll be some lower parts of the capital structure (e.g., second-lien, senior unsecured, or sometimes common equity holders) that will be allowed to participate. However, depending on the capital structure, and who the holders are, you can see first-lien holders being allowed to participate as well.
Note: By far the most notable rights offering of the past few years was Hertz at over $1.6b with nearly $800m reserved for the backstop. Yet another reason why Hertz was such a bizarre case is that this massive rights offering was for prepetition common equity (although nearly all non-institutional equity holders couldn't participate due to security regulations surrounding needing to be accredited, so these non-accredited holders took the alternative warrant package for their recovery value). The divergent treatment of equity by Hertz is an entire saga in and of itself.
Note: The preamble above is somewhat tongue-in-cheek, because from 2016-18 many distressed funds got burnt on oil and gas rights offerings (which is largely a reflection of O&G making up the majority of the restructurings taking place during that time).
On This Page
You can use the links below to go to specific sections of this page. As usual, I’ve written far too much on this (so hopefully you find this helpful!). Keep in mind that none of this will come up in restructuring interviews except maybe if you’re lateraling in.
Simply put, a rights offering allows a company to raise new money from existing creditors – or occasionally pre-petition equity holders - through the issuance of post-reorganization equity or debt that is normally issued at a steep discount.
While you can certainly have either debt or equity issued as part of a rights offering, the most common form of rights offering in the Chapter 11 context involves post-reorganization equity, so we’ll focus in on that. However, for reference a debt rights offering will have similar characteristics to an equity rights offering (e.g., it’ll be offered to a limited number of classes, have a backstop party that gets some kind of backstop fee, and will involve some kind of discount that’s baked into the debt offering to incentivize participation).
Alright, it's probably easiest to just set the stage with a simplified and stylized rights offering example. Let’s say that a company is currently in Chapter 11 and their restructuring plan has come up with an equity plan value of $500m (what the equity value is based off the total valuation determined).
The company goes to one or two junior and impaired tranche of debt and basically says, “Sorry about this whole, uh, going bankrupt thing. Deeply unfortunate, isn’t it? Anyway, the reality is we took on too much debt before, but in our proposed restructuring plan, as you know, we envision coming out with a very modest amount of debt. We’re going to be the envy of all our competitors with how little debt we have! But we do need to raise cash somehow to make this debt-lite plan work, so we’re prepared to make you a deal. We’ll let you purchase a big chunk of our post-reorg equity. While our equity pre-filing wasn’t great to own since we, uh, went bankrupt, that was really a reflection of how debt-laden we were. But now, through our brilliant maneuvering of the restructuring process, we’re confident our post-reorg equity will more truly reflect how great our business is. Since we figure you may be skeptical, we’re prepared to let you purchase $100m of our post-reorg equity at a 30% discount to the plan equity value! As a junior creditor we’re giving you the ability to participate in this – meaning you can take your pro-rata share of post-reorg equity – but if you don’t want it, no worries. We have a bunch of very savvy distressed debt hedge funds like Anchorage, Monarch, and Diameter backstopping this – meaning they’ll fund not only what we’ve allocated to them, but everything that you and your fellow creditors don’t want.”
So, basically what’s happening here is that the post-reorg equity value is $500m, and we’re allowing these junior tranches of debt to purchase $100m of it at a 30% discount. So, it’s effectively like these junior creditors are buying equity as if the plan equity plan value were $350m, not $500m. Further, for the $100m put in by these junior holders they’ll end up controlling 28.6% of the total post-reorg equity.
Therefore, if the plan equity value itself is low – or even if it’s just accurate – suddenly these junior classes have the potential to make a sizeable return if they participate in this rights offering (which they have the right to, but not the obligation). Of course, from the debtor’s perspective this is all great – they raise cash based on issuing post-reorg equity not debt. And it’s not like the debtor’s current management cares much about issuing post-reorg equity – they’ll be given a non-dilutive chunk of the post-reorg equity as part of a management incentive plan (MIP) anyway. The debtor’s management almost invariably just wants the least debt in the post-reorg capital structure as possible.
Note: We’ll get a bit more into the debtor and creditor incentivizes at play for a rights offering later on.
Anyway, as discussed above, in order to ensure the debtor can do a relatively large equity rights offering and maximize participation – and thus bring in significant new money to the debtor without adding any additional leverage – post-reorg equity is usually offered at a steep discount to the equity plan value that’s been agreed upon within Chapter 11.
Generally, the discount offered is somewhere between 20-40%. However, you can have some rights offerings that offer no discount, and some that offer even higher discounts.
For example, one of the more notable rights offerings – because it was large and resulted in the only litigation around rights offerings that reached the circuit-court level – involved Peabody Energy. Peabody was looking to raise $750m through an equity rights offering at a 45% discount to plan value, and an additional $750m raised through a private placement of preferred stock at a 35% discount to plan value.
Notably, one of the characteristics of a rights offering in the Chapter 11 context is that participation in it is usually confined to one or two classes of debt. So, for example, in the case of Peabody it was just the senior unsecured and second-lien noteholders who could participate in the rights offering.
Note: Each holder within a class that is allowed to participate in a rights offering has the opportunity, but not the obligation, to purchase a pro-rata share of the new security being offered (e.g., post-reorg equity).
Note: I don’t want to muddy the waters here too much, but the reason why Peabody’s rights offering was litigated and reached the circuit-level is because a small minority of unsecureds didn’t have the same ability to participate as others in the same class (because of the structure of the rights offering, which essentially gave preferential treatment to the unsecureds who participated in the private placement and backstopped both the private placement and rights offering). Basically, the Court ruled that you can treat certain creditors within the same class more favorably if those creditors shouldered significant risks outside the context of their claim (e.g., by providing new commitments to the debtor).
Note: Generally, participation in the rights offering happens concurrently with soliciting votes on the overall restructuring plan (as obviously the new cash raised through a rights offering is integral to making the overall plan feasible).
While there’s a lot of nuance I’ll glaze over here, from the debtor’s perspective there are two main benefits to doing a rights offering.
First, obviously one of the primary goals of a Chapter 11 is right sizing the balance sheet, which invariably means reducing down the debt load of the company. So, doing an equity rights offering has the obvious benefit of bringing cash in the door – to fund restructuring plan distributions and costs associated with emergence from bankruptcy – while ensuring that the post-reorganized debtor isn’t too bogged down in newly issued debt.
However, one issue that gums up the works of many Chapter 11 processes are valuation fights. If you think back to basic waterfall interview questions, in those questions we’re assigning a value to the company and that then informs the recovery of each class of debt.
If you’re the debtor, you obviously want a low valuation as this ensures you emerge with a very lightweight capital structure. Likewise, if you’re a senior creditor in the capital structure, you want there to be a low valuation (one that gets you full a recovery, but that gives very little to all the creditors who are junior to you). However, if you’re more junior in the capital structure and are not getting a full recovery with a proposed plan, you may want to put up a fight and argue that the company is worth more so, as a consequence, your recovery should be worth more.
So, the second benefit of doing a rights offering, from the debtor’s perspective, is that it can help build consensus among the more contentious junior groups in the capital structure. Basically, the debtor can go to the junior creditors who are not getting full recovery and say, “Hey, we know you think the valuation of the company being used in the plan is too low. But what if we did a rights offering, and that way you can participate in all the upside post-reorganization? If the valuation is really too low, like you think it is, then the equity should benefit substantially upon emergence from Chapter 11! And, just to make this even more enticing for you, we’ll even give you a hefty discount to the current plan valuation. So instead of feeling jilted by the low valuation, you get to take advantage of an even lower valuation than the valuation that you already think is too low!”
Note: In the restructuring guides (the “bonus questions” report) I talk a lot about how to think about the equity of a distressed company in terms of asymmetric value. This is a somewhat similar kind of framework for thinking about post-reorg equity.
Thinking through rights offerings from the creditor’s perspective can be taken in innumerable directions, and this post is already much longer than I wanted it to be, so I’m going to just quickly touch on the basics.
From the perspective of the creditors who are participating in the rights offerings, they get the benefit of buying the post-reorg equity of a company that has a slimmed down capital structure at a deep discount.
Further, if a creditor participates in the backstop – which basically means they’ll buy up whatever post-reorg equity other creditors decide not to – they also get a backstop commitment fee (usually around 8-10% of the total rights amount). This fee usually is paid in the form of post-reorg equity as well.
From the perspectives of the creditors who are not participating in the rights offering – so, for example, those in other classes who are not allowed to participate – they also benefit from the fact that the company is bringing in cash while not needing to take on new debt. In other words, they benefit from the capital structure being kept slim too.
While I’ve tried to gradually build up concepts without complicating things too much, it’s probably easier to just run through a more detailed example.
So, let’s imagine we have a company that’s currently in the Chapter 11 process. The restructuring plan devised calls for the post-reorganized equity to be divvied up, pre-dilution, as follows: 80% to prepetition unsecured noteholders, 15% to prepetition preferred equity holders, and 5% to prepetition common equity holders.
Note: It’s quite rare for prepetition preferred and common equity holders to get any post-reorg equity, but I’m just trying to flesh out our example a bit here. Also, given the strangeness of the 2020-21 restructuring landscape, we actually saw quite a few deals where prepetition equity did get some post-reorg equity.
Now let’s say that restructuring plan has come up with an equity value of $800m. As part of the plan, a rights offering will take place in which $300m will be raised at a 32.5% discount to plan value.
According to this plan, we’ll say that unsecured holders can participate in up to 50% of the rights amount and prepetition common equity holders can participate in up to 5%. Finally, the backstop party – which will be made up of existing creditors – will be allocated 45% of the rights amount.
Note: Keep in mind that virtually every rights offering has a backstop party, and the purpose of the backstop party in this example is to buy up both their allocation and whatever the prepetition unsecured and common equity holders don’t.
The final piece of the puzzle we need here is the backstop premium, which is the commitment fee paid to the backstop party for being willing to backstop the entire rights offering. We’ll say this is 9% of the total rights amount and that it will be paid in post-reorg equity. Further, we’ll say that this backstop premium does not dilute the newly issued post-reorg equity.
Note: While the backstop premium can vary, recently it’s been common to see between 8-10%.
Alright, so now let’s take a look at the equity splits. These equity splits show what groups own what percent of the post-reorg company when it’s all said and done.
What we’re showing in the “Pre-Dilution” column is what the pre-dilution post-reorg equity split looks like based off of the aforementioned restructuring plan. Then in the “Rights Offering” column we’re showing how those pre-dilution values get watered down as a result of the $300m rights offering. Finally, in the “Backstop Premium” column we’re showing how the backstop premium impacts the equity splits (keep in mind we said the backstop premium doesn’t dilute the new equity issued).
Note: There are other ways in which a plan can introduce even more dilution. For example, via having a management incentive plan or warrants that ultimately get exercised. Further, you can have some nuance over who of the pre-dilution post-reorg holders get diluted and by how much.
Note: We’re assuming here that everyone takes their pro-rata share of the rights offering.
So, basically what’s going on here is that we’re telling the unsecured and common equity holders that they can buy $300m worth of post-reorg equity at a 32.5% discount to the $800m plan value. Therefore, they’re effectively buying at a $540m valuation. In the end, when we include the backstop premium, this leads to 60.6% of the post-reorg equity going to those who participated in the rights offering.
All of this may seem like a lot of dilution! But while this example is on the higher side, you can definitely have situations where dilution is at or above these levels when you have a rights offerings and a management incentive plan (MIP).
For example, in a recent deal Carlson Travel had their senior secured notes getting 100% of the post-reorg equity in their restructuring plan. But after accounting for the rights offering, MIP, and a few other things that gets down to just over 11% of post-reorg equity. However, those senior secured notes can participate in the rights offering if they want thus getting themselves back to a higher percent of the total post-reorg equity (just like in our example above).
Another thing you may be thinking is that it seems quite lucrative to be a backstop party. Not only does that involve you getting a steep discount on buying post-reorg equity, but you also get a pretty large fee for providing the backstop.
This is a source of occasional controversy and consternation in-court, because if you assume that the post-reorg company does well the returns can be incredibly impressive. However, providing the discount and large backstop fee is a result of the i) temporary illiquidity of the post-reorg equity and ii) uncertainty of if the company will really perform well after getting out of Chapter 11.
To bring this all home, many distressed investors – including potentially our hypothetical analyst in the preamble – have been burned by participating in the rights offerings of oil and gas companies. It’s true that - especially when you provide the backstop - on paper things initially look great. However, when oil continues to go lower, the debtor goes out raising more debt for more exploration, etc. equity value can quickly collapse below where it was when you bought in.
More recently, we’ve seen many retailers who went through Chapter 11 in 2020 provide large discounts and high backstop fees in their rights offerings. At time zero, things looked great for the funds who participated. However, today many are underwater.
But, of course, not everyone participating in rights offerings gets burned (that’s why they’re popular!). The rights offering done last year by Chesapeake Energy – with a heavy discount to plan value and a 10% backstop premium – has provided some absolutely eye watering returns (the judge should’ve allowed for a new rights offering based on a higher equity plan value, but that’s what you get when dealing with courts in Texas not Delaware).
Well, there you have it. Because every rights offering needs to be viewed in the context of the debtor and their overall restructuring plan, every rights offering is somewhat of a unique situation to analyze. In fact, there are a lot of caveats I should have included in this post, but I’ve really tried to simplify things down for you while also not glazing over too much of the nuance.
Ultimately, rights offerings are an incredibly valuable tool in the toolbox of debtors. Not only because they allow the debtor to raise cash without taking on additional debt, but also because they can be used by the debtor to not so subtly coerce creditors into coming to an agreement (or, perhaps better said, coerce enough creditors such that a plan can get approved).
Just to reiterate – as I know many reading this post will be gearing up for restructuring interviews – none of this is something that would ever come up in an interview context. So definitely focus your time on classic restructuring interview questions and knowing what restructuring investment banking generally is. However, as you look up various deals that have happened over the past few years, you’ll probably notice that many will talk about a rights offering taking place – so now you have an idea of what that means and how they roughly work!