One of the barriers facing energy companies seeking to restructure their balance sheets is the increasing specialization of their investors and financial institutions. Traditional banks only want to hold low-risk reserves-based loans (RBLs). Hedge funds and family offices have similarly narrow focuses. Examples include high yield secured notes, convertible bonds, preferred stock, and common stock with warrant coverage. These niche players do not want to own other types of assets – which may be required to effect a restructuring of a distressed company’s balance sheet.
When commodity prices fall, investments tend to lose their original risk and return characteristics. Companies may not have enough cash flow to service their debt. Borrowing base redeterminations can result in bank credit limits being slashed. Lower stock prices can leave convertible features out of the money.
Foreclosure on petroleum assets may sound like a great remedy, but it is tricky in practice. If a buyer existed, the asset’s prior owner likely would have sold it for cash. Is the investor really interested in taking title to the assets and paying someone to manage them?
In such cases, investors may be better off leaving the assets with their current owner and trying to swap the non-performing instrument for a different kind of security. Low-interest RBLs (that used to be secured twice over by reserves) may need to become high-interest bonds (with less security coverage). Debt that cannot be serviced may need to be converted into preferred or common stock.
Conversion scenarios can be made attractive by delivering new, conforming securities that have a greater value than their distressed predecessor. For example, a $10 million distressed note could be converted into $8 million of common stock and $7 million of preferred stock, with the preferred having the right to half of sales proceeds until $7 million is recovered by its holders. Assuming the common stock stabilizes or recovers, the investor should realize a premium on its original investment.
Nonetheless, some investors are unwilling to own alternative securities – at any price. Conventional banks are not in the business of holding high-yield, high-risk bonds. Debt arbitrage hedge funds want nothing to do with common equity, and so forth. No matter how economically attractive the conversion’s returns may be, the investor’s own specialization may render conversion unacceptable. It’s like serving up a perfect, juicy steak to a vegetarian. It doesn’t matter how good it is because they just won’t eat it.
If existing securities holders are unwilling to convert, the company then must search for replacement investors who can tolerate the risk and return characteristics of the new instrument(s). This compounds transactions costs, burdening an already struggling company with legal, due diligence, and other fees. It also consumes time, as the company’s personnel market the plan to new investors. Even if replacement investors can be found, they have to get comfortable with the underlying assets and business. The chance of restructuring the company declines, as this process adds an entirely new layer to the cashless conversion(s) – cash buyouts (usually at a discount) of existing security owners by the replacement investors.
New capitalizations are emerging in the wake of the 2014 oil crash, and companies should consider the potential inefficiencies of utilizing niche investors. The more a company’s investors are highly specialized, the harder for a company to restructure – should its circumstances change someday. These inefficiencies also indicate that opportunities may exist for “omnivore” investors. Funds that can comfortably move down the capital stack for a premium should be able to capture higher returns.
About the Gaille Energy Blog. The Gaille Energy Blog discusses innovative proposals in the field of energy law, with a new issue being posted each Friday at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).