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Business Dictionary

Corporate debt restructuring: what it is and how it works

The reasons that lead a company to become indebted are diverse; on the one hand debt contraction can occur as a result of a negative macroeconomic scenario that depresses its sales, or as a result of poorly designed and executed administrative and financial planning, or even structural changes that occur in a certain sector - no company is free of such risk. On the other hand, indebtedness does not have to be associated with bad scenarios: debt may be the best alternative when investment options for companies are profitable, with returns greater than the cost of debt, or when other financing alternatives become less attractive. 

However, when adverse situations occur, the debt burden of a company can lead to a trajectory of irreversible cash flow deterioration, so that the company is unable to meet its commitments to creditors. And that is when companies must think of a debt restructuring process as a way to get the financial breath needed to reverse such insolvency.

The corporate debt restructuring process is a service offered by Investment Banks, where action is taken to change the capital structures so that companies can survive, reconciling, on the one hand, the interests of debtors and, on the other hand, the interests of creditors, observing each current legislation and the aspects inherent to each transaction.

What is the purpose of a debt restructuring operation? 

Corporate debt restructuring is a very complex operation, which aims to change the financial environment of an indebted company by bringing the necessary cash flow so that the company can return to a state of profitability and solvency. Once the debt restructuring is done, the debtor company goes through a financial relief that enables the sustainable maintenance of its operations. On the creditors' side, debt restructuring has the fundamental role of promoting an increase in the chances of receiving their rights.

As in Mergers and Acquisitions, where investment banks can advise both acquiring and target companies, in debt restructuring processes they can advise both parties involved: creditors and debtors. A bank can only advise one side during the transaction, and some bankers usually specialize in a particular 'side' of the transaction and concentrate their services in this segment.

Investment banks should be able, when proposing debt restructuring with creditors, to demonstrate that reconfiguring the debt structure is the best way to achieve the objectives of both parties. Banks should treat creditors as possible partners in the debt restructuring process, as the new cash flow provided by the operation will bring gains for both parties. Investment banks, in advising the creditor party, will seek the best possible deal, which means the highest possible cash recovery or, in the case of a debt-for-equity swap, a higher percentage of equity.

How does the debt restructuring process take place?

A successful debt restructuring process must be able to reduce the total amount of debt the company bears, reduce or even suspend the interest rate charged and extend the payment period.

A common strategy for debt restructuring adopted by companies in difficulty is the exchange of debt for capital. In this method, called debt/equity swap (exchange debt/patrimony) creditors agree to receive a portion of the company in exchange for partial or total debt forgiveness. In the case of publicly traded companies, this operation implies an exchange of securities for shares.

Investment banks have a decisive role in the execution of the procedures of exchange of debt for capital, after all, a thorough evaluation work is necessary to determine the real value of the company, of the debt, and how the restructuring of debts will impact on the price of shares.

The exchange of debt for equity only occurs if creditors are convinced that it is worth giving up part of their rights to help capitalize the debtor company. In other words, to accept a stake in the debtor company, creditors need to glimpse the return to profitability of that company. In performing this task, investment banks need to figure out how to balance the needs of each group and find an arrangement that allows the company to survive, in addition to providing creditors with the income they are seeking.

What are the steps in the corporate debt restructuring process?

Like any complex process, debt restructuring must follow a well-designed course of action. Each transaction is different from the other, after all, it must deal with a diverse range of creditors, suppliers, financial and government institutions. Although operations are distinct, companies and investment banks usually follow certain steps.

Inventory of debt. First of all, it is necessary to investigate and analyze the origins of the financial problems the company is going through. At this early stage, investment banks, together with the company's financial managers, need to make an inventory of debt.

In this inventory, information such as: creditors' data; due dates of outstanding debits; values of debits; contractual interest and characteristics of each debt must be included. Only from the preparation of the inventory, gathering in an organized and clear manner all the debits of the company, will it be possible to continue the rest of the operation in a precise, clear and effective manner.

Renegotiation of debt. This is a key phase of the operation, where companies and their investment banks negotiate the new debt terms directly with creditors. Depending on the complexity of the transactions, trading rounds may take months to complete.

Investment banks need to help return debtor companies to their credibility with creditors. For this, it must be demonstrated that the new cash flow of the company, combined with a debt restructuring, will result in the payment of the restructured debt, meeting the deadlines and values established in the renegotiation.

The main objectives of the negotiation should be to reduce the amount of debt, reduce or temporarily suspend the interest rate of the debt and extend the term of payment of debts. It is understood that these measures will bring the necessary cash flow so that the company can begin to reverse the deficit picture.

Principle of priority. Defining which debts should be paid first and in which order of priority payments should be placed is an important question that cannot be neglected. Most experts argue that the payment of debts should start with those creditors who represent a larger volume of debt. This recommendation cannot always be met, after all, each operation involves different profiles of creditors.

It is important to prioritise payments so that the discharge of debts does not cannibalize the working capital that will allow the company to operate normally. That is why investment banks and their specialized restructuring teams gain such importance in the process, analyzing values and designing the best strategies.

Communication, trust and transparency. During the debt restructuring process, creditors need to be constantly informed about the company's situation, intentions and actions. Firms and investment banks contracted to act in the process need to explain, throughout the negotiation rounds, their total interest in solving the problems of outstanding debts.

It is necessary to treat the creditor as a potential partner to avoid him becoming a litigant in pursuit of his rights, which can result in exhaustive and costly legal proceedings for both parties involved.

No matter how solid and meticulously planned the agreements are, there are always several possibilities of breaching the agreement. In these cases, creditors must be informed in advance. A prompt response to creditors is also necessary, with new dates or amounts in the event of unforeseen events, thus renewing the partnerships already consolidated. 

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Business Dictionary

What are debentures?

Debentures are medium to long-term fixed-income securities issued by companies in order to finance their projects. While only financial institutions may issue CDBs, LCIs, among others, the debentures are issued by non-financial institutions that are registered with the Brazilian Securities Commission (CVM). The issuance process is usually coordinated and structured by an investment bank or other financial institutions.

Imagine a company wants to open a new line of business. For that, it needs available funds. It can arrange these funds through equity, bank loan, stock issue or debenture issue.

The company's objective is to make this line of business created through the funds raised by the issuance of debentures profitable, so as to pay the principal and the interest of those who buy these papers.

The redemption of a debenture can be made on the due date or in advance. In the latter case, the debenture holder must trade it on the secondary market.

The interest payment can be semiannual or annual, depending on the trading conditions. The maturity of these assets is at least two years, and may reach more than ten years. 

One way to invest in debentures is through an investment bank or financial institution that structures and trades these assets, generally available to both institutional and retail investors.

Classification of debentures

There are some ways to classify debentures. Let us clarify these classifications below.

  1. As far as convertibility is concerned

Convertible debentures: can be exchanged for shares of the issuing company. This type of debenture presents less risk than other debentures, because if the company does not have cash to pay its commitments accumulated with debentures, the creditor may become a shareholder of the company.

Exchangeable debentures: can also be exchanged for shares. The difference is that in the case of exchangeable shares, the shares may not belong to the company issuing the debentures itself.

Simple or non-convertible debentures: cannot be exchanged for shares. Therefore, the risk of these papers is greater.

  1. As for the incentive

Debentures encouraged: receive income tax exemption. These debentures may be issued only by companies in the infrastructure sector. The government gives this type of incentive so that projects aimed at expanding the country's infrastructure network are more viable.

Common Debentures: do not receive income tax exemption. The incidence of Income Tax is regressive, that is, the longer you keep the paper, the less tax is charged. For example, if you stay up to six months with the paper, the tax on your profitability will be 22.5%, already if you stay more than two years with it, the tax on your profitability will be 15%.

  1. As for income

The most common forms of income from debentures are as follows:

Debenture prefixed: the investor receives a defined interest rate at the time of purchase of the paper.

Post-fixed DebentureThe paper yield follows a pre-established indicator, such as SELIC or CDI. In this case, there is no way of knowing beforehand what the effective yield will be, as it will follow the variations of the indicator.

Hybrid DebentureIn this case, there is a prefixed and a post-fixed component. Generally, the fixed component is a specific interest rate (7%, for example), while the post-fixed component is an indicator of inflation, such as IPCA or IGP-M.

  1. As for the guarantee

There are four types of debenture guarantees to make your risks smaller. These are them:

Actual warrantywhen there are assets (whether of the company itself or of a third party) that are given as security through pledge, guarantee, mortgage or anti-chresis. As long as the securities are not redeemed, the assets given as collateral cannot be traded.

Floating warrantyThere are no specific assets given as collateral. The guarantee are unspecified company assets. In case of bankruptcy, debenture holders have preference in the list of creditors.

Unsecured guaranteeIn this case, the debenture holder has no preference in the list of creditors in case of bankruptcy. In other words, there is no specific guarantee.

Subordinate guaranteeHere, the investor has preference only over the shareholders of the company.

The main advantage of debentures is that their return is usually higher than other fixed income papers because their risk is higher, since they are issued by private companies that usually want to expand their business (open a new factory, develop a new product, etc.).

One disadvantage of debentures is that for you to redeem these papers in advance, you must trade them in the secondary market. It is often difficult to find buyers of debentures in this market, which can make your liquidity very restricted.

Another disadvantage is that the risk is higher in relation to other fixed income papers. This is because debentures are not covered by the FGC (Credit Guarantee Fund, which guarantees the recovery of deposits and credits in financial institutions). Therefore, it is necessary to investigate whether the company is solid, whether it can afford its commitments.

Companies can use certain guarantees to give their debentures credibility and reduce their risks. For example, a transmission company may use consumer receipts as collateral to show that it is able to honor its commitments.

Difference between debentures and shares

Debentures and shares are quite different assets. Although both are issued by companies, the debenture is a company debt that has defined term and interest, while the share is a part of the company's capital, and both its profitability and term of application are not defined. Therefore, whoever invests in stock becomes a partner of the company, while whoever invests in debenture becomes its creditor.

Conclusion

For those looking to diversify their portfolio, debentures are a great option. If you are familiar with the company's case and know it will honor its commitments, buying some of its debentures can be a smart choice. Since these assets carry greater risk, it is not recommended that you invest all your money in them.

You must choose the debentures that are most compatible with your profile. You must pay attention to the redemption period, the risk and the return on the asset. Once this is done, the chances of you making the wrong investment are very small.

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Business Dictionary

Understand what are Real Estate Receivables Certificates (CRI)

CRIs are fixed-income securities issued by various securitization institutions, which serve to raise funds to finance real estate market transactions. They were created in 1997 to provide liquidity to this market.

They are long-term investment roles. The terms of the securities usually range from 2 to 10 years and can be up to 15 years. Another feature is that they cannot be redeemed in advance - but can be sold on the secondary market.

How do they originate?

Suppose a construction company sells a certain real estate development (condominium, house, among others) in the plant to its buyers. This construction company then hires a securitization company, which in turn issues bonds to investors. These bonds are precisely the CRIs. The CRIs buyers, in turn, earn a certain return on the amount invested in a certain period of time, whether at the maturity of the investment or periodically.

In this way, the CRI investor finances the real estate market by anticipating the credits that will be received by the sector. This provides liquidity to the market.

How are they structured?

There are three forms of CRIs profitability:

(i) Fixed remunerationThe investor already knows from the beginning the interest rate he will receive. There is no uncertainty about the profitability of the paper;

(ii) Post-fixed remunerationAn indicator is used as a reference for remuneration (CDI, SELIC, etc). In this case, there is uncertainty as to profitability, as it will follow the behaviour over time of the indicator in which the paper was fixed;

(iii) Inflation-indexed remuneration: you receive a pre-fixed interest rate plus a post-fixed rate linked to some inflation index (usually IPCA or IGP-M).

Advantages of CRI

Unlike other long-term investments, such as Treasury Direct and CDBs, these securities are not subject to Income Tax and Financial Operations Tax (IOF) for individuals. In other words, the rate known at the time of the investment is already the net rate of return. Thus, their profitability is generally higher than other more traditional fixed-income securities, such as government bonds.

Another advantage of the IRB is that there is no minimum value to apply to these papers. With only one thousand reais it is already possible to invest in CRIs.

Disadvantages of CRI

CRIs are not covered by the Credit Guarantee Fund (FGC), which guarantees the recovery of deposits and credits in financial institutions.

In addition, its terms are longer than other private fixed-income papers and its liquidity is limited, since its sale and purchase operations on the secondary market are not as expressive.

Therefore, CRIs generally have higher liquidity and credit risk than other more conservative investments, such as CBDs, LCI and LCA. Therefore, you should check the rating that CRI papers receive from rating agencies.

Difference between CRI and LCI

It is important not to confuse CRI with LCI (Letra de Crédito Imobiliário). LCI is also a fixed income security that finances the real estate market and has IR exemption. But while LCIs are issued by banks (and therefore covered by the FGC), CRIs are issued by securitization companies and have no such guarantee. In addition, the redemption terms of CRIs are generally longer than those of LCIs.

In short, if you want a long-term, profitable investment and are sure you will keep the investment until maturity, CRIs are a great alternative in diversifying your portfolio.

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Business Dictionary

What types of Mergers & Acquisitions (M&A)?

As we have seen before, mergers and acquisitions can vary greatly in their objectives and synergies. This is why some main types of M&A can be classified. They are:

M&A horizontal

A horizontal merger or acquisition occurs when two competing companies, selling the same type of product, merge, or one acquires the other. This type of business increases the market share and the combined value of the companies involved in the process, thus increasing their ability to compete against other competitors. Horizontal M&As operations can increase the company's revenue by offering a range of new products to its customers.

As competition is extremely high between companies operating in the same market, the synergies and potential market share gains are extremely high for the merging firms.

If a company wants to expand the sale of its product to a geographical area that it is unfamiliar with, an alternative may be to merge with another company that sells the same product in that area, because that company knows the local specificities, has easy distribution and sales of the product in that region and customers are familiar with it.

Companies involved in horizontal mergers benefit from economies of scale, which characterise a situation where the increase in production reduces unit production costs.

An example of a horizontal merger was the agreement signed between Sadia and Perdigão to form Brasil Foods (BRF) in 2009. Both companies were active in the refrigerated food sector, so their merger constituted a horizontal merger.

Vertical M&A

A vertical merger or acquisition occurs when two companies in the same production chain, but at different stages of the same chain, merge, or one acquires the other. This type of business increases product quality control, improves the exchange of information along the production chain, exploits synergies between companies, and decreases the friction caused by negotiation. Therefore, vertical mergers make the production process more efficient or cost-effective.

Vertical M&As reduce the risks associated with the supply of goods and services along the production chain. Companies that emerge can switch to a single production schedule so that there is never a shortage of inputs for production.

There are two types of vertical integration. Forward integrations refer to integrations that go towards the final sale of the product to the customer, already backward integration refer to integrations that go towards the supply base.

The vertical merger or acquisition can also be extended beyond suppliers to include customers. For example, in the entertainment and fast food industries it is common practice for fast food and beverage manufacturers to integrate into establishments such as fast food cinemas and restaurants, so that only their specific brand of food or beverage is offered for sale in those establishments.

An example of vertical merger occurred in 2015 when Swedish furniture manufacturer Ikea bought 38,000 hectares of forest in the Baltic states. Since wood is one of the most important inputs for furniture production, Ikea's acquisition of these forests helped the company form its own forest management network, so this represented backward integration.

Conglomerate

Conglomerate mergers occur when merging companies operate in different sectors and industries. Conglomerate mergers are good for diluting the risk of the enterprise among several areas.

Some care should be taken with the formation of conglomerates. The first care is for the conglomerate not to act in an area in which its management team has no familiarity and technical capacity to act in that area, thus decreasing the efficiency of the conglomerate. Other precautions should be, for example, that the company does not get lost in other sectors that are not its main business sector or that there is no culture shock among the employees of the merging companies.

There are two types of conglomerates: pure and mixed.

A pure conglomerate consists of companies that are totally distinct and operate in markets without any intersection.

A mixed conglomerate consists of companies that are looking to expand their production lines in the same market.

An example of a conglomerate occurred with the acquisition of American Broadcasting Company (ABC) by Walt Disney Company in 1996. While Walt Disney is an entertainment company, ABC is a television broadcasting company, so this acquisition was considered a conglomerate.

Other types of M&A

The three types of M&A mentioned are the main ones, but there are still two other types of mergers and acquisitions less common. One is market-extension M&A, which occurs when two companies selling the same product in different markets merge, or one acquires the other. Another is product-extension M&A, which occurs when two companies that sell different products in the same market merge, or one acquires the other.

Conclusion

In order not to lose its market share, the company must always be updated on the conditions of the sector it is in and act in order to offer the best products and services to its customers. In this sense, mergers and acquisitions are ways to improve the company's production conditions, whether through a drop in production costs, an increase in revenue or by winning new customers.

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Business Dictionary

Corporate takeovers: What are they and what are their types

A takeover is the general term used to refer to an acquisition of control of one company by another, with or without the acquiescence of the target company in question, through the purchase of most (or all) of the shares listed on the stock exchange.

If the takeover is successful, all operations of the acquired company, as well as its shares and debts, become the responsibility of the acquiring company.

The aim of takeover is to take advantage of companies' synergies in order to increase their market share or achieve economies of scale that reduce their costs and therefore increase their profits.

Generally, takeovers are materialized through money, but also stocks and debts can be used in trading.

Types of takeover

Takeover friendly. A friendly takeover occurs when the board of directors of both companies - target and acquirer - negotiate and approve the offer, so that the transaction is beneficial to both parties.

The buyer contacts the management of the target company, talks about its intentions and makes an offer. If the management accepts the offer, it then advises its shareholders to accept it. If they accept, the friendly takeover takes place.

The negotiation takes place through a takeover bid, in which the acquiring company commits to buy a large volume of shares of the target company, with specific date and value. The shares, in this case, are usually traded at a value above the market value, to facilitate the operation and expedite its outcome.

Example: In 2018, the pharmacy chain CVS Health Corporation acquired health insurer Aetna in a friendly takeover for $69 billion.

Hostile takeover. It occurs when a company seeks to acquire another one without the consent of that company, that is, without the board of directors of the target company having an interest in the business.

In this case, the acquiring company may use a roll of tactics to ensure that the target company loses control of its assets.

Example: The case of the purchase of the drug producer Genzyme Corporation by the pharmaceutical company Sanofi-Aventis can be cited. After an unsuccessful attempt at a friendly takeover, Sanofi-Aventis went directly to Genzyme shareholders, paid a high price for its shares, and eventually acquired this company.

Strategies used in hostile takeover

The most common strategies used by the acquiring company to take control of the target company are the following:

Tender offer: The acquiring company makes an offer to buy a large part of the shares of the target company at a value higher than the market value, to convince its shareholders to sell their shares to the acquirer.

Proxy fight: In this case, the acquiring company tries to persuade the majority of the shareholders of the target company to accept the change of directors, replacing directors who are against the takeover with takeover-friendly directors.

Hostile takeover defenses

In a hostile takeover, the target company, because it does not want to suffer the acquisition, will try to avoid it in every possible way.

One way to avoid hostile takeover is through the poison pills, which consist of clauses in the shareholders' agreement that oblige them to propose a takeover bid that makes them buy all the company's shares if they acquire a certain percentage of shares (for example, 35%).

Another strategy used by the target company is the kamikaze defense, which consists in making itself less attractive, either by increasing its debts, selling its best assets or acquiring assets that the acquirer does not like.

The golden parachute, another defense strategy, is an agreement in which the company's executives have the right to leave the company with enormous compensation if there is any change in the company's corporate control. This deters shareholders from accepting takeover.

Takeover reverse. A reverse takeover occurs when a privately held company buys a publicly held company. In this way, a privately held company becomes a publicly held company when it buys an already listed company.

The main reason to take over is for the acquiring company to be publicly listed without going through an IPO, since this process is costly and long.

Example: In 1989, the privately held Carnival Corporation & plc, which provides cruise travel, acquired Holland America Line, another cruise company, but it was publicly traded.

Takeover backflip. It occurs when the acquiring company becomes a subsidiary of the target company, hence the origin of the term "backflip". The main reason to do this type of takeover is to take advantage of the fame and strong brand that the acquired company has.

Backflip takeovers usually occur when a large, well-known company is out of resources and a less well-known company is financially sound. The lesser known company then acquires the better known one and becomes a subsidiary of it.

Example: Acquisition of Continental Airlines by Texas Air Corporation in 1982. Since Continental Airlines was much better known than Texas Air Corporation, it is last preferred to keep the name of the latter.

Conclusion

In the world of M&A, takeovers refer to acquisitions and also include hostiles. As already discussed here, they are very important to make the economy dynamic, allowing those companies seeking expansion to take control of those with inefficiencies and to bring greater margins to the new united company.