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Chapter 11: Bankruptcy restructuring
In the last video we talked about the scenario where a company, for whatever reason, it just couldn't pay it's debt holders. So let's say these are debt holders right here. This is the debt, or the liabilities. It couldn't pay it's debt holders. It went into bankruptcy, and it was determined that these assets that it had right here, that it made no sense operating them as a company. And then the bankruptcy court essentially just decided to liquidate it. And we learned that the debt holders were actually more senior to the equity holders. And they get paid first. And if there wasn't enough money to pay all of the debt holders, then the equity holders got nothing. And that was called a Chapter 7. We're just focusing on the corporate world right now. Maybe we'll do personal soon. So that's Chapter 7 liquidation. That was the last video. And in that case, and I think that's what most people associate when you say that a company has gone bankrupt. That it'll just disappear. That people just say, OK, these assets don't make any sense. They can't pay these guys. We're just going to take these into possession by the courts and then just liquidate the assets. But that raises kind of an obvious question of, well, what if these assets are worth something? What if I sell a socks website, and socks have gotten even more popular. And the only problem is I just can't pay all of the interest that I owe on the debt. Right? Maybe, for whatever reason, I took out a really crazy loan that was variable rate. Or for some reason, I have to pay back some loans because I messed-- and I'll talk more about covenants and things like that. Covenants are pretty much a bunch of rules that the debt holders say, look, you're good, but if any of these x, y, or z things happen, we can take you into bankruptcy. And we could force you into bankruptcy. So maybe because of that, I'm in bankruptcy. But it's determined that these assets, right here, are actually worth more as an operating entity than they are if you were to liquidate them. A good example might be, I don't know, a car company. Right? Let's actually take this example as a car company, because it's very salient to our, at least it was-- I've heard a lot less about the auto bailouts, but it was very salient at the end of last year. So let's say that these are car factories and land and whatever else. And if we're the debt holders, and let's say it goes into bankruptcy. Let's say this is generating cash. And I'll teach you in a future video how do you see what is the cash being generated by the assets. And then you have to subtract out the cash that has to be used to pay the debt holders, because you're paying interest, and then what's left over for equity. And I'll show you how to do that on an income statement. But let's say this is generating a lot of cash. Right? It's generating a good bit of cash, but let's say, these guys eat up interest. Right? So some of the cash will go to the debt holders as interest. And let's say, for whatever reason, either interest rates went up, or they had a bad quarter or a bad year, and they just didn't generate enough cash, let's say they couldn't pay off one of the debt holders. And that debt holder says, hey, you couldn't pay my interest payment, or you couldn't pay the principal payment. I'm taking you into bankruptcy. Right? I'm taking you into bankruptcy. So it goes into bankruptcy. And in this situation, immediately we realize it makes no sense to shutter this asset. If we were just to shut down the factory and lay off the employees, we're going to get nothing for these assets. Because the land is in a part of the country where'd there's no obvious buyer for the land. An empty car factory is pretty much useless, especially when the other people in the industry are in no mood to buy the factories from you. So everyone decides that it's in their best interests to keep this thing running. So what happens is that the debtor stays in possession of the assets. So you can kind of view the debtor as the equity holders and the management of the company. So they stay in possession of the assets. And actually what happens is-- because these guys didn't have enough cash to pay off their debt holders-- what happens is that they take on a new loan, called a debtor-in-possession loan. And this new loan is the most senior loan. It's called DIP financing. It's actually a great business, although it's become scarce recently. It's a great business because you're at the top of the stack. You're more senior than even the senior guys. And it's called DIP financing. Debtor-in-possession financing. And what this provides is a company with some kind of cushion cash so that it can keep operating, so it can keep the lights on. So it's essentially a debt. It's just a very senior type of debt. And it happens once a company has entered bankruptcy. Right? And this bankruptcy that we're going to talk about is Chapter 11. Chapter 11 restructuring. And in Chapter 11 restructuring, you keep operating the company. You might do some things on the left-hand side of the equation. You might want to sell off some of the assets and all of that, but we won't go into that. Most of what you do is you rearrange this side of the balance sheet. And this is why, you probably-- every airline has, some of them, have gone into bankruptcy multiple times, but they still exist. It's not like when you go into bankruptcy the company just disappears. The assets will persist and all of this gets reorganized on this side. A lot of times when someone goes into Chapter 11 and then they come out of it and they go back into it, they call that Chapter 22, and then Chapter 33. I think you get the idea. So anyway, what happens in Chapter 11? So the assets-- essentially it becomes kind of the bankruptcy court takes over, and they hire some investments. They'll get the debtor-in-possession financing so that the company has some cash to operate, pay the bills, and pay the employees and whatever else. The company keeps operating as it always would so it can pay its suppliers and operate as a regular business. And then all of these guys hire a bunch of lawyers. And they start negotiating with each other. And essentially there will be a bank associated with the bankruptcy court whose whole job-- and it's all part of a negotiation-- is to value this. And it's often, maybe this debtor right here, he'll hire one bank. This debtor will hire one bank. Maybe the management will hire another bank. And everyone's going to come up with bankruptcy plans. But bankruptcy plans are usually of one or more varieties. It's essentially just saying, well, we need to value these assets, right? We're not selling it. So we're not just going to get cash. We're going to hire some bankers. And we'll do a lot of videos on that in the future. And they're just going to say-- based on the prospects of this company, how fast it's growing or how fast it's not growing, or how much cash it's generating in a year-- they're going to assign a value to it. So let's say that this guy up here, he hires a banker. And this banker says-- Let's say this was originally the same situation. This was $10 million. Let's say that the liabilities were $6 million. And that the original equity was $4 million. Right? And let's say these bankers evaluate the business. They make detailed models. They take it in the context of the current macro environment. And they say, you know what? I think this company is actually only worth $5 million. And given that it's worth $5 million, and we think that it can sustain-- it's only worth $5 million and there's no way that it can pay interest on $6 million of debt. Right? It doesn't have enough cash to generate $6 million of debt. We think it can afford $2 million of debt. Right? So what will happen is, the new company-- And this is just a plan. And then once you have a plan, then everyone has to vote on it, and there are things called cram downs-- and we''l do that in more detail-- but the plan will say, you know what? The assets are worth $5 million. I thought I was using the square tool. Undo. This plan might say, you know, those assets are worth $5 million. And the company can only handle $2 million of debt, not $6 million of debt. So now, it can only handle $2 million of debt, and then there will be $3 million left of equity. Right? And I'll call this the new equity. Because sometimes this can get confusing. So let's just say for a second-- and I want you to think about it-- what is everyone's incentive? This guy up here, his incentive is to value the company as lowly as possible, right? Because then he gets more of the company. I think that'll be clear to you in a second. This guy's incentive is to say, no, this company is worth a lot. So all of you guys are going to get paid back and then I get what's left over. And you're probably asking, what do you get paid back for not liquidating it? And the answer is the new shares of the company. So what happens is that this stock-- let's say this plan gets passed. This plan right here. In this situation, these guys up here were the most senior, right? Let's say there was $2 million of senior debt up here. Let me write that in a different color. There's $2 million of senior debt up here. So what they'll do is they'll actually get $2 million of the new debt. They're most senior. And then all of these other $4 million, who are more junior-- let me see if I can color it in. I know it's hard to read-- these other $4 million guys, instead of getting any kind of cash or any kind of debt securities for having been owed this money, they'll get the new stock. So they'll get $3 million of new stock. Let me see if I can draw that in. So this $3 million of new equity will go to these guys. And this unsecured guy down here, he's not going to get as much equity. He'll be impaired a little bit. And the old equity guys, the stock's going to go to 0. They're not going to get anything. So the old shareholders of the company are wiped out. They go to 0. And essentially, the debt holders become the new shareholders of the company. You'll often see when a company goes into bankruptcy but it's getting reorganized, you'll often see some people start to buy up this debt or these bonds, right here, because they want to be the new equity holders. When this company emerges from bankruptcy-- let's say that this is how it emerges from bankruptcy-- they want to be these guys, the new equity holders. Because usually when you value it, you want to undervalue it a little bit. I know I've overdrawn this picture a little bit too much. But the debt guys, especially the senior debt guys, they want to be safe. They want to say, you know what? We've already been hurt by this company. They're already not paying our debt. We want to assign as low a possible value to the company as possible-- in this case $5 million-- so that we make sure. Hopefully the company ends up being worth $10 million again, in which case these guys right here make out like bandits, right? If the company was really worth $10 million but the bankruptcy court values it at $5 million, these guys get all of the shares of the company. These guys get wiped out, even though the company really was worth something. So let's say the company emerges from bankruptcy like this, but it actually turns out there were $10 million. Then let's say a year later the company starts doing well again. And let's say that someone could value the company again at $10 million. Now it only has $2 million of debt. And now you have $8 million worth of equity. So these guys-- maybe they were owed $2 or $3 million before, and they got $3 million of the new equity, they might have made out like bandits. Because now all of a sudden, that equity could be worth a lot. That's not always the case. But that's the view from the debt holders' point of view. The equity holders, you can imagine, they don't want to be left with nothing. They'll hire their own bankers. And their bankers, they'll probably submit a plan that says, no, no, no, no. This company is worth at least $8 million. So up here $8 million. And we think it can handle $4 million of debt. So they'd want a scenario like this, where they think the company's worth $8 million. It can handle $4 million worth of debt. And so it has $4 million worth of equity. And of course, the first $6 million of the value-- so the $4 million of debt, and then $2 million of the equity will go to the debt holders, right? Because they were owed $6 million to begin with. And then what's left over, which is essentially-- so this is $2 million of equity, and then you'd have $2 million of equity here-- this $2 million of new equity, right? This is the new shares of the company will be given to the old shareholders of the company. So that's what the shareholders want. I know this gets a little confusing, but it all ends up being valuing the assets as you emerge from bankruptcy. You say, you know, it's generating cash, it's worth something. And then you pay people off according to seniority. And first you pay them off. You say, OK, I still owe you some money. But this company can't support $6 million of debt. It can now support $2 million. And whatever's left, people are paid with actually shares-- new shares-- of the company. Not the old shares. So the old shares will go to 0. So you can imagine a world where GM goes bankrupt. Right now, the shares of GM go to 0. GM old goes to 0. But the assets keep operating, and that's why some people are a little bit misleading in this whole automotive bankruptcy debate. They're kind of using scare tactics to say, oh, if GM goes bankrupt, then these assets are just going to disappear. No, they'll just keep operating. If it makes sense to operate them, they'll keep operating. The only people who will lose big are the old equity holders. And then some of the unsecured, the more junior levels of debt, will probably lose some money. But if the assets are worth operating, they'll continue to operate. And if the people, if it makes sense to have them employed, they'll keep working. See you in the next video.