Daily, it seems, we read reports of investment banks staffing up their restructuring groups in anticipation of that elusive next downturn.

But, while the need for restructuring professionals may up-tick in the not-too distant future, we believe that the skill sets that will really be in demand are those of specialists in distressed mergers and acquisitions. The combination of a less debtor- friendly bankruptcy process, complex capital structures levered to the nth degree, and a raft of industries already driven to consolidate, should cause many distressed companies to forgo reorganizations in favor of sales to industry players - or even strategic buyers willing to provide more appropriate capital structures – as their best hope of realizing value.

Certainly bankruptcy has become a less desirable refuge as a result of new requirements imposed by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. First, the changes reduce a debtor’s ability to fund a Chapter 11 proceeding by increasing the cash costs of bankruptcy and reducing the use of trade claims as a financing tool. Among other things: certain pre-petition vendor claims previously treated as unsecured are now defined as administrative - that is, payable in cash at 100 cents on the dollar at plan consummation; some vendors will be able to take advantage of enhanced reclamation rights; utilities will be due upfront deposits of cash or cash equivalents - a potentially big item for multi-location or heavy industry businesses; certain taxes have to be paid currently rather than deferred to consummation.

Additionally, the ambiguous burden placed on creditor committees with respect to communicating with non- committee member creditors has already cost debtors who have had to fund litigation over the form and extent of disclosure required as well as the communications methods themselves. Adding insult to injury, companies will shell out more for professional fees pre-bankruptcy as the amendments’ limits on a debtor’s exclusive right to file a plan, and mandate for swifter action on leases, demand that companies plan extensively before filing.

Second, the absolute limitation on exclusivity makes a debtor-promoted solution less achievable since creditors may prefer to wait out the exclusivity period to file their own plans. Also, to the extent there is greater information flow under the changes to the Bankruptcy Code from creditor committees to non-member creditors, more parties will have more data on the debtor and, hence, greater ability to value and ultimately bid for all or part of the estate. With the prospects of losing control of the company in Chapter 11 a real threat, executives of distressed companies may decide to push for a sale in lieu of, or in conjunction with, filing, rather than attempt to pursue a turnaround plan within the amended Code’s abbreviated exclusivity period.

Another factor favoring M&A solutions is the nature of the most recent liquidity wave, especially the rise of the now-ubiquitous second-lien loan. If nothing else, the complexity of capital structures further weakens a debtor’s ability to fund the bankruptcy. The question, for example, of who’s secured and who’s not suggests protracted fights of valuation early on, again making bankruptcy a more expensive and contentious process. Moreover, the rather extraordinary stretching of asset One of a series of opinion columns by bankruptcy industry participants values to justify recent credit extensions means that many companies will enter bankruptcy with no excess debt capacity. First-lien lenders, who typically stand ready to provide debtor-in-possession financing, will only do so if they prime second lien holders. But with more second-lien holders around to contest that priming, the DIP may not be easily forthcoming. Debtors pressured to raise cash (if nothing else to meet administrative claims and litigation driven by the Bankruptcy Code amendments) may be forced to sell assets piecemeal, potentially diminishing the overall value realized from the estate. Even if a debtor can finance its way through Chapter 11, in the face of extreme leverage and the short-term orientation of hedge funds who will be big players in future bankruptcies, creditors may be reluctant to restructure around their existing positions, pushing instead to be taken out through an outright sale. Indeed, the questionable security of some debt, particularly that where the use of “enterprise value” filled in collateral shortfalls, may also cause creditors, justifiably fearful that their security will be eroded in, and by, the bankruptcy process, to legislate for quick sales.

In many situations, business dynamics will favor M&A over reorganization as well. Already today, numerous industries are characterized by fundamentals which compel the absorption of weaker participants. Notwithstanding years of a healthy economy, pricing power has been non-existent in sectors such as automotive and auto parts, chemicals, textiles and packaging; coupled with rising energy and commodity costs and tough Asian competition, margins have suffered. Consolidation, at least, offers the hope that economies of scale will offset structural weaknesses. Industries facing contracting demand - such as homebuilding (and the related building supply and mortgage industries) and traditional media - are similarly geared to consolidate. As financial pressures build, the consolidation momentum will accelerate.

All this said, it is also important to understand that distressed M&A is its own unique beast, with a highly specialized set of protocols. Something as simple as choosing a winning bidder is more complicated in distressed situations when price must be traded off against ability to close. The marketing process - what is said, who is approached, and when and how - deviates substantially from that of healthy companies. And the context of the sale must be competently evaluated, since distressed businesses can be acquired in a variety of ways; the implications of choosing a Section 363 sale vs. an out-of-court acquisition, an asset vs. a stock purchase, for example, are meaningfully different.

Without question, companies that have begun to contemplate Chapter 11 must include in their planning clear-eyed comparisons of the value achievable in a Chapter 11 reorganization with that which could be realized in a sale (as well as the value-maximizing ways of achieving that sale). Those who fail to complete this exercise may find that, before they know it, the process will be making decisions for them, with unfortunate results for all involved.

Trouble Ahead: The Challenges of Post-Default Second Lien Loans

While the timing of the next credit downturn is anybody’s guess, one thing is certain: the increased prevalence of second lien debt will inject an unusual degree of contentiousness and confusion in the restructurings and bankruptcies fueled by the inevitable market slump. The explosion in the second lien loan market, from issuance of $0.5 billion in 2002 to $12 billion in 2004 and nearly $9 billion through the first six months of 2005, has produced a huge new creditor class with its own idiosyncratic lending practices, players, and intercreditor relationships. As these loans begin to encounter distress, early indications are that the post-default outcome for second lien holders is playing out in ways not fully appreciated when the loans were initiated. Moreover, it is becoming apparent that the second lien loan recovery experience will vary widely, with savvy, proactive holders generally faring better than passive lenders. Among the elements affecting the recovery experience are the following:

1. Collateral value. Historically, a secured loan was simply a senior bank facility, fully and exclusively secured by a conservative collateral pool. With the advent of the second lien loan, not only was the concept of a competing claim on a given pool established, but the definition of acceptable collateral was stretched to cover all of a company’s residual assets – the more frenzied the issuance of second lien securities, the more creative the design of their underlying collateral pool and the more abbreviated the lender effort to validate asset quality. Not surprisingly, as defaults begin to arise, the values of many of these marginal assets are proving to be at levels well below those expected at loan origination.

   With implications for all parties to a restructuring, the valuation of second lien loan collateral will undoubtedly spur hotly contested disputes regarding process, methodology and results. “Tranche jumping” alliances between senior and unsecured lenders, mutually interested in depressing the second lien loan’s collateral valuation, may become common. In defense, second lien holders will have to become early, active participants in the restructuring process, fully prepared to deal with issues such as how to secure a voice in the selection of valuation methodology or whether it makes sense to accept a greater unsecured position if it allows the domination of the unsecured class.

   Debtors, meanwhile, will find that second lien loan asset claims increase the difficulty of the bankruptcy process. Potential impacts range from challenges in obtaining DIP financing because the second lien has tapped out available collateral, to problems effectuating a plan due to insufficient cash to repay second lien lenders with super-priority claims covering the post-bankruptcy diminution of their collateral value.
   
   

2. Intercreditor negotiations. The concept of the “silent second”, where a second lien holder dutifully follows the lead of the first when trouble arises, is a linchpin of many intercreditor agreements. In typical agreements, the first lien lenders acquire substantial power in the event of borrower distress. Post-default, for example, they can wipe out junior liens by choosing to foreclose on a meager collateral pool; in a bankruptcy situation, they can bring in a DIP lender who reduces, or even wipes out, the second lien lenders’ equity in the collateral pool.

   But in the wake of some actual second lien loan restructurings, the notion of the silent second appears to be evaporating. First, when default becomes a reality, the glaring divergence of first and second lien interests has driven second lien holders to fight for their rights, even those they’d previously relinquished. Second, it is becoming abundantly clear that typical intercreditor agreements inadequately address the highly technical and specialized aspects of bankruptcy. The interplay of these developments is strongly influencing the ultimate recoveries of second lien lenders and of other stakeholders as well. For example, second lien lenders’ waiving of bankruptcy rights for the benefit of the first lien lender, a key tenet of many intercreditor agreements, has been held by some courts to be unenforceable. That aside, given the scantiness of collateral coverage, second lien holders are aggressively using the legal system to improve their recovery outcomes post-default, pushing for in or out-of court action to prevent further dissipation of their collateral value or using their ability to hold up a senior lender-proposed asset sale to extract some pound of flesh, even though the value of that collateral didn’t support their claim to such proceeds.

   Further complicating intercreditor relations is the rampant claims trading among credit classes. The concept that you might know who sat above, below, or next to you in a credit, facilitating negotiations in difficult times, will be mere myth in many of these second lien situations. Even within the second lien class itself, trading may produce some unpleasant surprises. Second lien lenders may arrive at a default only to discover their compatriot holders also own big chunks of the senior secured loan and, by the way, their strategy for maximizing recovery just might mean sacrificing a little on their second lien position for the sake of improving their first lien recovery.
   
   

3. The participants. Hedge funds have dominated the demand side of the second lien loan market in recent years. Some of them are highly experienced distressed players, likely to take full advantage of their rights vis-?is senior and subordinate claims. Others, though, have little experience with troubled credits, let alone the bankruptcy arena. Inevitably, the aggressiveness of the experienced players, and/or the confusion of the novices, in concert with the pure novelty of dealing with second lien credits, is likely to have a substantial [negative] impact on the pace and conduct of restructurings.

   While the story of the second lien loan recovery experience is yet to be fully written, it is clear that there are complications arising from such loans in distress which justify before-the-fact analysis by the lenders themselves, as well as competing claims holders, borrowers and interested professionals. The smarter of these will work now to develop their post- default strategies, for if anything was learned from the credit meltdowns of the early nineties and 2001- 02, the day of reckoning for second lien loans may, in fact, be just around the corner.