Default rates and bankruptcy filings hit historic lows in 2007. Until last summer’s credit crunch, the availability of financing on very favorable terms allowed companies facing a liquidity problem or a potential default to borrow their way out of trouble. With the lending window now all but shuttered, more and more businesses will find themselves forced to reach out to their creditors to restructure.

Professionals active in the field generally agree that the next wave of restructurings will be very different than the last. A recurrent theme is that workouts and bankruptcies will be more contentious and more complex—and therefore more costly—than in the past. Some go even further and argue that a fundamental shift in restructuring dynamics has quietly taken place over the last few years, leading certain investors to complain that Chapter 11 is no longer about fixing companies.

Restructurings are shaped, to a large extent, by the credit cycle that gave rise to them as well as constraints imposed by bankruptcy laws. As both the lending market and the Bankruptcy Code have undergone significant changes since the last downturn, it is safe to predict that these changes will affect how the restructuring game is played. Given the low number of recent large corporate bankruptcies, however, the impact of these changes has yet to be fully observed.

New Players
In the old days, when a company needed covenant relief, it would speak to its bank agent, who would herd the lenders in the syndicate and, after some negotiation, deliver the requested amendment or waiver. The company knew who its lenders were and, in most cases, they were prepared to work with the company to address its problems. Things could get trickier if the company also had bond debt. But even in that case, the company could, with the banks’ support, file for bankruptcy, obtain post-petition financing permitting the company to continue to operate, and threaten to cram down a plan of reorganization on the bondholders. While this picture oversimplifies the complexities of the process, borrowers could usually rely on a degree of cooperation from their senior lenders in times of need, at a price to be negotiated.

One of the defining features of the last credit cycle was the rise of hedge funds and other non-institutional lenders, which have effectively stepped into the shoes of banks and other financial institutions as primary investors in corporate loans. In addition, while a company may know who its lenders are at the outset, it may be difficult to determine who holds the debt once the company becomes distressed. If the company needs to negotiate with its creditors, it may not readily know who to speak to or who represents a majority of the debt. In many cases, the company may discover that substantially all of its debt is now held by distressed funds, which have raised billions of dollars in anticipation of the tide of investment opportunities that the next downturn is expected to bring. Even after a lender group coalesces and negotiations commence, dramatic shifts in holdings and, as a consequence, negotiating positions may occur.

People tend to talk about distressed funds as a monolithic group. However, their interests in any given workout may be far from uniform or predictable. For example, different funds have different investment strategies. Certain funds have a trading mentality, with a shorter-term investment horizon that may be at odds with the operational turnaround of a business. Other funds adopt loan-to-own strategies, which tend to be consistent with a longer, more traditional reorganization process, but may be incompatible with the wishes of management or other creditor groups. Further complicating the analysis, investors often accumulate positions in multiple layers of debt and may have bought the same debt at substantially different prices. Compared to the last downturn, workouts and bankruptcies will likely involve a greater number of players with potentially more varied and less predictable interests. As a result, it may become more challenging for companies to find common ground within and among their creditor constituencies.

More troubling is the potential impact of credit default swaps and other derivatives on creditor motivations. For example, a creditor who holds a credit default swap may actually be better off by pushing a troubled company into bankruptcy. Because derivative transactions are not publicly disclosed, creditors’ real economic interests may be impossible to determine. Certain commentators believe that the growth of the derivatives market has increased the systemic risk of default and bankruptcy. Others dispute this contention, remarking that for every investor who benefits from a company’s default, another loses, thereby creating countervailing incentives to rescue troubled companies. To date, there is no evidence, other than perhaps anecdotal, that derivatives are affecting restructuring dynamics in a meaningful way. By separating economic risk from ownership, however, derivative transactions raise interesting policy issues as to whether and the extent to which investors should be required to disclose those transactions.

More Leverage
The proliferation of new financing sources gave rise to more leveraged—and in many cases more complex—capital structures as lenders aggressively competed for business from private equity sponsors and companies. In particular, many borrowers have taken advantage of the leveraged loan market, including second-lien loans, to recapitalize.

Although second-lien debt appears to have become a standard component of leveraged capital structures, there remains much uncertainty about the leverage and recovery prospects of second-lien lenders in a distressed scenario. Complex intercreditor agreements between first- and second-lien lenders create new opportunities for disputes on a wide range of issues yet to be settled by courts, including second-lien lenders’ right to block a priming debtor-in-possession (DIP) financing or a sale of collateral in bankruptcy (so-called section 363 sales). In addition, even if second-lien lenders are significantly undersecured, as is likely in many cases, their nominally secured status nonetheless will afford them a greater ability to influence the Chapter 11 process than unsecured creditors. This is not good news for unsecured creditors, whose traditional role and relevance effectively may be usurped by second-lien lenders.

More problematic is the impact of second-lien financings on the ability of companies to obtain DIP financing. In order to fix their business and reorganize in bankruptcy, a large company will typically need time and significant financing; by contrast, selling the company in bankruptcy will usually be faster and require less financing. If substantially all of a company’s assets are already pledged, secured lenders may refuse to provide a large DIP facility, even if they are oversecured, out of fear that it will impair their recovery. This, in turn, will increase secured creditors’ leverage over debtors and limit debtors’ options in bankruptcy.

As a general matter, more layers of debt means more people fighting for the same pie and accordingly more voices demanding to be heard in the restructuring process. If there is substantial overlap among the various creditor groups, consensus may be easier to achieve; otherwise, there will likely be more intercreditor disputes, which may translate into fewer consensual out-of-court workouts, more uncertainty and delay, and higher costs. However, as these disputes are resolved by parties or courts over time, the uncertainty about the outcome of these disputes—and the corresponding appetite of investors to fight over them—will likely decrease.

Amendments to Bankruptcy Code
The overall effect of the 2005 amendments to the Bankruptcy Code is to shift leverage from debtors to creditors. Major changes effected by the amendments include greater restrictions on debtors’ freedom of action such as the new 18-month limit on debtors’ exclusive right to file a plan of reorganization and increased demands on debtors’ liquidity resulting from greater protection for trade creditors, utilities and landlords.

Many restructuring experts predict that these changes will result in more section 363 sales than in the last downturn. With less time and liquidity with which to restructure, more debtors may be forced to sell or liquidate their businesses, some of which may be attractive targets for private equity buyers. These and other constraints imposed on debtors by the Bankruptcy Code may encourage more companies to try to restructure out-of-court.

It is too early to tell which of these predictions, if any, will materialize. In practice, what will make sense in any given case will depend on the value of the business, the nature of the problems faced by the debtor and a variety of other case-specific factors.

Covenant-Lite
With the increasing leverage in the last credit cycle, came declining covenant protection. To remain competitive in an extraordinarily liquid market, lenders made “covenant-lite” loans (which contain few restrictions on the borrower) and borrowers issued “PIK toggle” notes (which give the borrower the option to pay interest in cash or new notes).

These features severely impair the ability of lenders to force a change of course if the borrower’s financial performance begins to deteriorate. In addition, the absence of financial covenants deprives lenders of an early warning system to detect problems. By the time a default occurs, there may be little enterprise value left to repay the loan.

For borrowers, relaxed lending terms allow them to focus on their business without being distracted by creditor demands. But it is important for borrowers to use this breathing room wisely and to address any liquidity or other financial problems early. If a company waits until it runs out of money, it will have limited options and may be forced to file for bankruptcy. On the other hand, by addressing problems early, the company may be able to explore alternatives to a formal restructuring.

The first step that many troubled companies often take too late is consulting with restructuring professionals. When legal and financial advisers are involved sufficiently early, they can assist companies and private equity sponsors on a wide range of critical issues and decisions, including getting a handle on the cash needs of a business, developing a viable operational and/or financial restructuring plan, exploring strategic transactions or assessing the advisability of infusing capital in the business.

Conclusion
Recent developments in the lending market combined with the 2005 amendments to the Bankruptcy Code will no doubt have an impact on restructuring dynamics, and although the nature and extent of these changes remain unclear, it seems likely that achieving a successful restructuring will be an increasingly contentious challenge. One thing is certain: In the future as in the past, restructurings will continue to be about enterprise value—how to reconcile different views on value and how best to preserve that value.

By My Chi To, a partner in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the Debevoise & Plimpton Winter 2008 Private Equity Report. Additionally it appeared in the May 2008 issue of Mergers & Acquisitions, the Dealmaker's Journal.