Chapter 23. The Restructuring & Special Situations Special

Distressed Debt, Turnarounds, DIP Finance & Creditor Dynamics

When Capital Structures Break

Restructuring sits at the intersection of law, finance, and negotiation. This chapter covers what happens when capital structures break: from early warning signs through formal insolvency, from debtor-in-possession financing through plan confirmation. Written for bankers who need to understand both sides of the table. The distress trigger: Liquidity crisis, EBITDA decline, covenant breach, or external shock The restructuring process: Out-of-court (workout, exchange offer), in-court (Chapter 11, schemes, administrations) The core dynamic: Every creditor class tries to minimize its loss; every solution leaves someone unhappy The advisor's role: Navigate law, model recovery, and negotiate the waterfall

Zone of Insolvency

When does a company become insolvent? When do directors' duties shift? When should advisors get called? Balance Sheet Test Liabilities exceed assets at fair value. Company has negative equity. Easy to calculate, hard to defend in court (fair value is contested). Cash Flow Test Unable to pay debts as they fall due. The practical insolvency: no cash, can't meet payroll or debt service. Most triggers restructuring. Zone of Insolvency The grey area where company is nearing insolvency but not technically insolvent yet.

Directors' duties shift from shareholders to creditors. In US: "deepening insolvency" concept; in UK: wrongful trading liability begins here. Red Flag: Timing Directors who hide distress or continue risky business in the zone of insolvency face personal liability. Once insolvency is probable, duty shifts, the board cannot favour equity holders at creditors' expense.

The Absolute Priority Rule

In restructuring, seniority matters absolutely. The waterfall is the law of the land. Super-priority (Admin claims, DIP): Paid first, rarely challenged Senior secured (First lien): Secured lender recovers from collateral (typically 60 to 80% recovery) Senior unsecured (Bond, trade): Unsecured creditors (typically 40 to 60% recovery) Subordinated: Junior debt (typically 20 to 40% recovery) Mezzanine: Hybrids, preferred equity (typically 0 to 20% recovery) Common equity: Gets nothing unless fully above-water (rare) Fulcrum Security The layer where value runs out.

Everything senior is paid in full. Everything junior gets scraps. The fulcrum holder has maximum leverage, they negotiate the plan. Example: Capital Structure Waterfall Enterprise value: $500M. Senior secured claims: $400M (paid in full). Senior unsecured claims: $200M (only $100M available = 50% recovery). Subordinated claims: $150M (gets $0 = 0% recovery). Equity: worthless. Fulcrum is senior unsecured.