In Good Times and in Bad

The U.S. economy has been on a tear in recent years, so one can be forgiven for thinking that restructuring teams across Wall Street have been sitting by idly, waiting for the inevitable bankruptcy wave. That's not how it works, of course, and surely isn't the case within Goldman Sachs' U.S. restructuring group, headed jointly by James Sprayregen and Dhruv Narain. Mergers & Acquisitions' sister publication IDD recently had the opportunity to chat at length with the highly regarded co-heads. The following is an abridged version of that conversation.

M&A: Can you talk about how you have positioned the restructuring practice at Goldman?

NARAIN: Companywide, our philosophy is that there is an intersection between financing, principaling and advisory. They are really the three legs of the stool. Where we can add the most value to our clients is actually if we can combine those things.

The advisory and the financing sides intersect quite a bit, although not in the traditional sense. Our focus is advising companies that still have some options open to them, not necessarily those where Chapter 11 is a very strong or distinct possibility sometime in the relatively near future. Maybe the company has run into trouble for a variety of reasons, or the industry has hit a downdraft. In good times, the spread and the access to capital for good and bad companies narrows. You can finance a much worse-off company down the credit spectrum. In bad cycles, the opposite is true and people sometimes throw the baby out with bathwater. So, even the decent companies see their access to capital dry up. Or, if it does not dry up, the cost of capital increases dramatically. These companies may still have several options and so it's really a question of optimizing those options.

M&A: Goldman as a firm has had success moving into the middle-market arena. Do you see substantial opportunity there on the restructuring side?

NARAIN: For the most part, the companies that get into distress are not the Fortune 100 or Fortune 1000 companies. While Goldman Sachs is not abandoning the universe of companies we've traditionally banked, we want to add another layer. And the firm has been aggressive in trying to cover a lot more companies that traditionally would be considered mid-market, [defined by Goldman as] those with anything from a $1 billion to $5 billion market cap. And so there are a lot more people at Goldman now who have relationships with and cover those companies.

M&A: Can you offer an outlook on the business cycle?

NARAIN: It is my personal opinion that the housing and subprime situations will have a much bigger impact on the economy over the coming weeks and months. I think subprime will have a big impact from a credit perspective because this is really the first real-world test of the structured financing products. People are questioning whether triple-A securities were really triple-A securities or whether triple-B securities were really triple-B securities. There is a lot of uncertainty in people's minds as to exactly how these things are going to play out and how this tranching is going to work. The whole premise of taking these assets and doing structured financing against them was a great concept when everything was working. Now that the subprime market has been so deeply impacted, people are looking into all the other structured financings and wondering if they are going to work. That has driven default scenarios higher, and the cost of these vehicles is up quite a bit.

I believe that the housing market will have a broad economic impact as it is going to put pressure on consumer spending and confidence. Therefore, the sectors related to consumer discretionary spending are going to take some hits. There is likely going to be a big disparity between the multinational companies that are not as tied to the U.S. consumer and get a much greater percentage of their earnings from outside of the U.S. versus companies that are reliant on the U.S. consumer. Consumer spending won't fall off a cliff unless unemployment goes up significantly, but I think it may be severely impacted.

SPRAYREGEN: I'm a little bearish on being bearish. The U.S. consumer has proved incredibly adept at continuing to spend when everyone predicts they won't be able to. The good news is that our restructuring business is built to work in any economic environment. In the healthy environment we have been doing all sorts of rescue financings and exit financings of the historical entities that are still on their way through Chapter 11. To the extent there's a wave [of bankruptcies], we are ready to help on those situations, too. In the year-and-a-half I've been at Goldman Sachs, it's been about the most robust [economic] environment you can have, and we've been very busy on several different types of client situations.

M&A: Is there a common theme to companies that come to you?

SPRAYREGEN: No, clients come to us for advice and financing in all different types of situations. It could be a liquidity issue, it could be a covenant issue, it could be a maturity issue or it could be some exogenous issue, like fallout from the impact of (Sarbanes-Oxley) and being unable to file financial statements. That may drive a covenant issue in a company that is otherwise fundamentally healthy, and because of that involuntarily comes into our world. Common denominators are some sort of business problem that isn't a regular business problem. That is why we refer to our practice as not just helping companies in bankruptcy, distress, or even stress, but also those in "pre-stress" situations.

M&A: Who are you hearing from?

SPRAYREGEN: We are hearing mostly from companies that have trouble or may have trouble somehow related to consumer spending. For the last 18-24 months people have been predicting the start of this new [restructuring] boom in the next 18-24 months and it just keeps getting pushed out. I personally do not believe the business cycle has ended. But like I said, we're not built to be here only for a difficult economic environment. We take the economy as we find it.

NARAIN: The real proof will come in January when companies report holiday sales. That's when we'll get a sense of what really is happening in the economy. But you've started to see the first signs of some of the trouble.

M&A: Can you talk about the impact of the new bankruptcy law?

SPRAYREGEN: The amendments done in October 2005, putatively to tighten up consumer bankruptcy laws, also included a section on business bankruptcy that significantly changed the law in this area, too. I think at the end of the day it hasn't been a large driver in whether a company files or doesn't. By far the bigger drivers have been the robustness of the economy, combined with the availability of rescue and out-of-court financing.

NARAIN: The biggest change that we haven't talked about is that the exclusivity is now limited to 18 months. My own view is that that's the biggest practical impact, especially for the more complicated bankruptcies.

SPRAYREGEN: It's an interesting provision. In my opinion, there was a misperception that companies were lollygagging around in the bankruptcy court, but in my experience, no company really wants to be there, and they try to get out as quickly as possible. First of all, about 90% of bankruptcies are done in a year-ish timeframe. So the 18 months doesn't apply to most cases. For the big ones that can't get done in less than 18 months, the fact that there's no more exclusivity changes the negotiation dynamics, but it doesn't make it happen any quicker. In fact, it could make the situation worse if competing plans are filed. More importantly, it may deter people from negotiating between, say, 13 to 18 months. They may figure, "Why do we have to make a deal? I'll let the 18 months run and I'll file my own plan."

NARAIN: While on the margin I think the changes will have a small impact, I don't think they are going to significantly impact the way people think about bankruptcy. More companies aren't going to be liquidated or get sold as a result of the new law. I think it's going to be very case-specific as to what's the best outcome for that company and its related parties.

SPRAYREGEN: I think the bigger impact comes from the robustness of the out-of-court financing markets. The market has gotten much more efficient outside of court in its willingness to lend to troubled companies. So, by the time a company now gets to court it's been able to access the capital markets very significantly outside of court, therefore leaving less of its balance sheet available to be used for DIP financing. This means that DIP financing could be tougher or even not available for some of these companies. Or, it may be only available to fund a fairly quick sale through the process, as opposed to a two-year bankruptcy because there just isn't enough un-liened value to support new debt.

M&A: Do the companies coming to you now have more leverage on their balance sheet?

NARAIN: It depends. Companies can be highly levered to begin with, or they can become highly levered because their Ebitda has gone down. The people who have the ability and desire to push for a sale most are the secured creditors because they're the first ones to get paid off. When Ebitda dips down, secured first-lien leverage as a multiple of Ebitda is much greater—so these are the debt holders who become most concerned. The people who are further down the credit chain tend not to push as hard. They want the company to swing for the fences because that gives them the highest likelihood of getting paid. They don't want to erode [the value of the estate] and sell off crown jewels to pay off the senior secured creditors.

SPRAYREGEN: A lot of times the first and second liens in the old days would have all been one lien. There may not have been a different amount of leverage but now it has been priced for different risk appetites. [At] other times, the second lien allowed you to get more leverage than maybe you could have gotten on the first lien.

NARAIN: The important point is that just because a company has second lien doesn't mean, by definition, that it's more levered than a company that has first lien and bonds.

M&A: How did you get into the restructuring field?

NARAIN: I find it intellectually stimulating because in order to be good at this job, one has to be able to be a lot of things—a strategy consultant, an investment banker and sometimes even a bankruptcy lawyer. There is clearly a strategic element to whatever we do. If a business is in trouble, we need to find out why it's in trouble. Maybe it's just one aspect, or maybe it's something pervasive to the entire company. Obviously, all of the investment banking skills are required in order to value the business.

SPRAYREGEN: I call it the last bastion of the generalist. We have our restructuring expertise but we're not industry-specific, so whatever comes into our space we tend to learn a huge amount about the industry. That keeps it really interesting.