Remember 1984? Terrible clothes, big hair, westernwear on dimestore cowboys? That was also the last time Chapter 11 filings were lower than they are right now. I’d heard some grumbling, but Lynn LoPucki sent me the data from his remarkable Bankruptcy Research Database (BRD). Amazing. (The numbers are in the continuation.)
With record sales of junk bonds, these companies are not deleveraged and somehow better able to withstand economic shocks. So what’s going on? I have three theories, but I could be overlooking something.
1) Bankruptcy law is well-settled, so businesses now do private, non-bankruptcy bankruptcies in which everyone gets slightly better than their likely Ch 11 payouts.
2) A few hedge funds are controlling all the action, calling the reorganization shots privately and making credible threats that there will be no DIP financing, which makes bankruptcy look very unattractive to a debtor who is in the clutches of the funds.
3) Companies are refinancing and refinancing, until they eat up all their assets–a strategy that keeps them out of bankruptcy for now, but that will promote more crashes in the future.
Other ideas?
From LoPucki’s BRD:
Year filed Frequency Percentage
1980 3 0.41
1981 5 0.69
1982 13 1.78
1983 7 0.96
1984 6 0.82
1985 8 1.1
1986 10 1.37
1987 8 1.1
1988 12 1.65
1989 16 2.19
1990 30 4.12
1991 40 5.49
1992 32 4.39
1993 25 3.43
1994 11 1.51
1995 20 2.74
1996 15 2.06
1997 17 2.33
1998 31 4.25
1999 44 6.04
2000 79 10.84
2001 97 13.31
2002 81 11.11
2003 57 7.82
2004 30 4.12
2005 25 3.43
2006 7 0.96 (through July 31)
Total 729
Comments
6 responses to “No Big Chapter 11s”
Professor, I think your points one and three have some merit, but I don’t see any evidence of point 2. I think there have simply been significant systemic changes that account for the drop in chapter 11 filings. First, there is more money to invest out there: (1) the economy has been doing nicely for an extended period of time; (2) there is an enormous amount of investment capital looking for deals, especially in private equity groups and hedge funds; (3) the second lien market has exploded, growing from $5 billion to $20 billion in the last few years. That means that existing money is more patient, and there is often fresh investment money ready to take over. I don’t know if this means greater crashes later — many of these investors demand greater efficiency and prodcutivity, and are looking to resell their investment at a handsome profit. They also often combine troubled company acquisitions with other investments, hopefully producing something better. The second big change is a new, less forgiving chapter 11, which discourages filings. As you noted, players are more experienced now and like to reach negotiated resolutions outside of bankruptcy if possible. This is especially so on the investment side, rather than the the asset acquisition side, where a 363 sale is still in demand.Lou
Sounds like you’re right on, Elizabeth (from today’s ABI headlines, http://www.abiworld.org):
A poll released by the Turnaround Management Association (TMA) on Thursday found that turnaround professionals are working differently given the unprecedented liquidity in the marketplace, the change in the bankruptcy law and the drop in companies seeking chapter 11 protection, Portfolio Media reported yesterday. More than 200 companies that specialize in turnaround, financial advisory and consulting services responded to the TMA 2006 Trend Watch Poll. Only 17 percent of respondents said that 50 percent or more of their work was done in court, which was down from 31 percent in 2005. Instead, the survey found that financial restructurings are increasingly handled out of the courtroom, with 41 percent of respondents spending half or more of their time that way, representing an increase from 28 percent in 2005. The poll found that an upward trend in engagements, staff size, and firm acquisition and consolidation activity in the past year suggests that the turnaround industry is retooling for a surge in restructuring, which is anticipated to happen by the end of 2007.
Professor,
Your underlying unanswered questions are “How can these overleveraged companies withstand economic shocks?” and “Why aren’t troubled companies filing bankruptcy like they used to?”
I think the answer is the 401(k) and the service economy, respectively.
I suspect that the “Junk Bond” industry and availability of credit is fueled by increased numbers of average people who sock their money into mutual funds and 401(k)’s. The average person did not “invest” in 1984, but the rise of the 401(k) and increasing vulnerability of Social Security have nearly forced wage-earners to invest in a market already saturated with prudent investors.
Lou Salazar’s post is correct – the credit market is hot. From a supply/demand perspective there is a supply of credit that (for now) will keep pace with demand. So companies can, as you correctly note, borrow their way out of bankruptcy (for now).
But as to why the Chapter 11 system isn’t used as much even when it otherwise ought to be, I think the answer is that we are a different kind of business now.
Think also of how since 1984 we moved away from manufacturing economy to an economy that just moves money around. The “service” economy creates businesses that may not be able to use bankruptcy to reoganize like a traditional industrial business.
But what do I really know about 1984? I was a 14 year-old high-school freshman listening to Van Halen tapes.
From my perspective the relative strength of the economy and the strong new issue calendar have kept the default rates low and therefore fewer bankruptcies. There are some notable exceptions, such as the automotive space, where the Big 3 domestic OEMs and their first, second and third tier suppliers are under tremendous pressures to cut cost and improve product offerings. But most of the rest of the high yield universe is doing fairly well. While interest rates are up, spreads have tightened considerably in the last few years (the difference between the risk free treasury rate and premium lenders charge for a particular loan – bank debt or bond). So it is not as expensive, relatively speaking, for below investment grade companies to borrow money as it was three or four years ago. This is supply driven as there is a lot of money in the high yield market with most of the liquidity being supplied by hedge funds. Fund flows into high yield mutual funds have been basically flat since January 2005. This supports Elizabeth’s last point that companies are able to borrow more cheaply against assets. When we see a tightening in the credit markets there will be more defaults.
Responding to her first point, sophisticated investors certainly are aware of the costs and uncertainties of bankruptcies and can calculate the benefit of an out-of-court restructuring versus returns for in-court reorganizations. But the appropriate reorganization solution depends on what’s ailing a company. Reducing costs such as labor, pension obligations and unfavorable contracts can rarely be done effectively out of court. I would not reach the same conclusion as her first point.
In my experience there is plenty of money available for DIP loans and if anything, pricing on DIP loans have gotten cheaper over the past few years. There may be cases in the smaller size of the middle market where hedge funds have bought up the senior secured debt and threaten to fight a DIP order so a debtor cannot access the DIP market. But generally DIP loans are easy to get and many hedge funds, in addition to commercial banks and institutional investors participate in this market.
My view is that aside from a few industries (automotive, airlines) the economy is strong enough with corporate profits near all-time highs for the weaker companies to survive in the short run. There is also plenty of availability in the credit markets to keep pricing relatively low. There are so few decent opportunistic distressed situations right now that hedge funds are starting to look to make a quick buck via consent fees for companies that have missed deadlines for filing financials.
I only recently learned of this blog site, so my comment is untimely. Still, here it is:
I overheard two lawyer friends not so long ago bemoaning the fact that restructuring deals — even those that planned on bankruptcy as part of the deal — were being done by nonlawyers, and that the lawyers were only called in to paper the done deal. Wonder what that says about what’s going on.
I also have heard that hedge funds are using second lien financing as an acquisition mechanism. Wonder what that says about what’s going on.
Although this discussion has been quiet for a few months, it still appears to be timely. I would just like to echo the earlier readers’ comments adding a slight macroeconomic take on Professor Warren’s suggestion number 3.
Global liquidity has been at an all time high over the last 5 years driven by historically low target interest rates set by the Bank of Japan and the Fed. This liquidity glut has allowed banks to earn a sufficient spread at lower lending rates (at the earliest stages of the liquidity pyramid). This basically means that banks could underwrite the same amount of “risk” for a lower cost throughout the risk spectrum.
While this provided the liquidity needed to boost the Japanese and domestic economies, it also likely allowed companies to refinance at lower interest rates as banks and borrowers (including private equity and hedge fund buyers) looked to put the capital needed “to work” in order to continue generating fees. It seems that this could explain the historically low bankruptcy rates as other financing sources became more attractive to otherwise distressed borrowers as an alternative to entering a court-dictated restructuring process. If you add in the fact that we have been in an expansionary cycle in the economy during this same period, this should help to explain the historically low number of bankruptcies.
It will be interesting to see if default rates and bankruptcies begin to rise as the BoJ and Fed continue tightening – and banks start to tighten their standards back to rational/historical levels.