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 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.

(Opinions expressed are those of the author or authors, not of Dow Jones Newsletters.)

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