Distressed Investing in Energy: Strategies and Risks in a Nutshell

From a U.S. bankruptcy perspective, distressed debt investing is often based on two fundamental principles in the bankruptcy system: 1) a secured creditor is entitled to the value of its collateral in a given bankruptcy case (and subject to any court-imposed limitations, entitled to credit bid its debt in connection with a bankruptcy sale of such collateral) and 2) absent consent of senior classes, a plan of reorganization may not allocate any property to a junior class, on account of such junior interests or claims, unless senior classes receive or are allocated property equal to their allowed claims. On this basis, the distressed debt investor must determine where and how to enter the capital structure of a distressed company in order to realize its investment while balancing associated risks. Alternatively, distressed investors may approach a target company from outside the capital structure as a third-party purchaser pursuant to a pre- or post-bankruptcy process, which also involves unique issues and risks. Whether acting as a third-party bidder or "stalking horse" bidder in a bankruptcy sale, buying a debt position in the capital structure of an insolvent company, or simply navigating a long-time borrower's Chapter 11 case, the applicable field of play can be complex, risky and unforgiving.

Acquiring Senior Debt

Traditional capital providers (i.e., commercial banks) tend to be subject to greater constraints in restructuring transactions and dealing with non-performing loans due to regulatory oversight and risk management policies. As such, they are sometimes more inclined to exit non-performing loans when feasible. It is a common strategy for more nimble, non-traditional lenders to purchase distressed secured debt at a discount and utilize the debt and associated lien rights to negotiate a restructuring solution with the borrower and/or seek to credit bid the debt as a means to acquire the borrower's assets in bankruptcy. Notably, acquired debt remains subject to any pre-acquisition lender liability claims that may exist based on pre-sale, wrongful conduct of a departing lender. Claims such as breach of contract, fraud, tortious interference and excessive control/breach of fiduciary duty can result in the "equitable subordination" of the subject indebtedness to a class lower in priority than it otherwise would have held if necessary to remedy harm caused by the lender. Likewise, any collateral defects due to improperly perfected liens can create serious impediments to realizing value from the acquired indebtedness. Moreover, in upstream energy cases and cases involving significant project development trade-debt, inchoate statutory liens of vendors may exist under applicable state law even though such liens may not be reflected in the applicable real property records pertaining to the collateral. Depending on the timing of the vendor's services and the terms of the applicable state lien statute, statutory liens can incept (for purposes of determining lien priority) prior to the perfection of a lender's security interest and lien, and in such cases, the claim of the "senior" lender may actually be junior to inchoate statutory lien claims. Further, debt in syndicated facilities can become subject to borrower liability management strategies or transactions (i.e., uptier or dropdown transactions) effectuated by the borrower and a subset of participating lenders to disenfranchise and extract value from disfavored lenders.

Albeit rare, credit bid rights can also be limited by the bankruptcy court for "cause" in the name of fairness, to ensure competitive bidding or to prevent inequitable conduct. Accordingly, it is important to understand the risks associated with buying distressed debt, including the spectrum of potential outcomes that can be effected during a bankruptcy case.

Identifying the Fulcrum Security

Having a strong valuation thesis for a given target is critical, particularly when dealing with dynamic, insolvent companies. Bankruptcy strategies are often derived directly from value propositions relating to a lender's collateral and, as appropriate, enterprise value. The "fulcrum security" in a company's capital structure is the most senior class or tranche of debt (or in rare circumstances, equity) where expected recoveries based on available value is a fraction of the face or par value of the debt. That is to say, it is the most senior class of debt in the capital structure that will likely not be paid in full. Accordingly, as a practical matter, the fulcrum security is this class of debt that will bear the cost of the restructuring and may be in the best position to receive new equity in the reorganized company. If the senior secured debt is impaired, it will be in the best position to receive most reorganized equity; if the senior debt is to be paid in full but a mezzanine/junior lender in the value waterfall is impaired, it may be in the best position to receive the reorganized equity.

In upstream energy cases with producing properties, value is derived mostly from a company's oil and gas reserves, or more specifically, the expected cash flows to be derived from those reserves. The starting point for the value estimate is the reserve report, which details a petroleum engineer's estimates of the quantity and nature of hydrocarbons in the ground, how quickly they can be recovered, what percentage can be recovered and the estimated cost of recovery. It sets forth a quantity of estimated recoverable hydrocarbons over time, including different estimated reserve classifications, each having a different probability of recovery.¹ Generally, reserve categories (i.e., proved (1P), probable (2P) and possible (3P) reserves) and the expected cash flows to be derived are discounted based on the varying degrees of risk associated with each reserve classification, the required capital investment and the time value of money. The extent to which these reserves are discounted is largely dictated by the market. In renewable energy projects (i.e., wind and solar), there are no applicable reserves or reserve categories; however, there is variability in resources and probabilistic modeling is used to estimate, for example, how much wind and solar power will be available to produce energy during a given period. Probabilities in wind and solar (such as P50, P75 and P90 discount rates), based on long-term meteorological data and other measurements, are often used to model scenarios from a valuation perspective. These techniques – combined with traditional valuation methodologies – are often used to derive valuation theses for target companies and identify the likely fulcrum security in connection with a given restructuring scenario.

Buying Assets From Distressed Sellers

Buying assets outside of bankruptcy court from distressed sellers involves a relatively high degree of risk and must be approached with caution. Generally, the U.S. Bankruptcy Code and fraudulent transfer law dictates that a debtor may not dispose of his property with either the intent or the effect of placing it beyond the reach of his creditors. A transfer of property by the debtor for "less than reasonably equivalent value" while the debtor is insolvent – or that renders the debtor insolvent – is deemed a fraudulent transfer and may be avoidable under the Bankruptcy Code. Although the value of the property is to be determined at the time of the transfer in issue, such determination is usually performed by the court with the benefit of hindsight and is often based upon a battle of valuation experts. Accordingly, it is virtually impossible to eliminate litigation risk in connection with such an out-of-court transaction. Although it can be beneficial to obtain fair value opinions, ensuring a robust, value-maximizing marketing process may be the best available protection. Even so, value can almost always be questioned with the benefit of hindsight.

Buying Assets Out of Bankruptcy

Unlike out-of-court sales, the vast majority of bankruptcy sales are conducted under Bankruptcy Code Section 363(f), which provides for sales of estate assets "free and clear" of interests in such assets. Further, bankruptcy sales are subject to express findings of reasonably equivalent value and good faith under the terms of the court order approving such sales. Bankruptcy trustees and debtors in Chapter 11 cases conduct asset sales regularly under Bankruptcy Code Section 363. Sales in the ordinary course of business may be conducted without notice, a hearing or court approval, and sales outside the ordinary course of business may be conducted after notice and court approval. One critical point with respect to free and clear sales is that the Bankruptcy Code does not operate to cure defects in title. The Bankruptcy Code does not create or define the nature or extent of rights in property – such rights and interests are established by applicable non-bankruptcy law. Accordingly, except as it relates to the free and clear attributes of a sale order, a bankruptcy sale will not vest a buyer with any greater title than that which the debtor originally owned.

Although "private" sales to specific buyers are sought from time to time, most Chapter 11 sales are conducted subject to higher and better bids through an auction process to support value maximization. Such a process and the associated sale/bid procedures are established pursuant to a court-approved procedures order.² The bid procedures order typically dictates the procedures for the assumption and assignment of contracts, the approval of bid protections (e.g., a break-up fee and/or expense reimbursement) to any stalking horse bidder, key dates and deadlines associated with the bid/sale process, the required deposit and financial information from potential bidders, and other required information that must be submitted by a party in order to become a qualified bidder and to access the debtor's data room.³ The order typically provides for limited diligence, limited seller representations and warranties and the approval of any stalking horse bidder.

Debtors often seek to identify a party willing to serve as the stalking horse purchaser in advance of any auction. A stalking horse establishes a minimum acceptable offer that other bidders must prevail against in order to become the winning bidder. The stalking horse bidder binds itself to the terms of a purchase and sale agreement on the timeline set forth in the procedures order, and in exchange, it is awarded an agreed break-up fee (typically between 3 percent and 5 percent of the purchase price) and an expense reimbursement to protect the stalking horse in the event it is ultimately outbid at an auction. The break-up fee and expense reimbursement are built into the process economics and establish a minimum overbid requirement that must be satisfied in order for the sale to proceed to auction. The existence of a stalking horse bidder often helps to facilitate interest from third parties and competitive bidding.

Notes

¹ See e.g., Tye C. Hancock et. al., "Litigating Value in Oil and Gas Bankruptcy Cases," The Journal of Corporate Renewal, July/August 2012 (discussing reserve classifications, reserve risk and discounting methodologies).

² Neither the Bankruptcy Code nor the Federal Rules of Bankruptcy Procedure address bid procedures. Bankruptcy Rule 6004 addresses the giving of notice to interested parties and the conduct of the hearing, but it does not address orders establishing bid procedures. Accordingly, the practices around bid procedures are largely creatures of busy courts and advisors.

³ The applicable asset purchase agreement often provides that the form of proposed bid procedures and sale order are subject to the (reasonable) approval of the stalking horse bidder.