A Taxing Matter

Financial Distress

Williams, 2002

Short of cash

Should williams accept the BH-LB loan?

What are the terms of the loan?

• 900 million, maturity is 1 yr, might be less, interest at 5.8% quarterly
• Additional interest at maturity at 14% x principal
• Deferred setup fee = max*15%x principal, 15-21%x(RMT (rocky mountain transport) net sales price)

Rate of return to lenders

Assume RMT is not sold:

Solve for IRR, make NPV =o, solve for rho

rho=.078956

Turn rho, the quarterly rate, into an annual rate (1+rho)^4 =annual rate

What if RMT is sold?

Setup fee=(max, 135, 15-21% net sale price)

The loan grants to the lenders, an option on RMT equity, this is contingent on Williams defaulting on the loan agreement

Loan Covenants I:

• Security interest: collateralizing the loan, the RMT assets are the collateral, RMT is the borrower, its assets are the collateral. Why do lenders like to have security interest? Secured creditors get paid back first, they get the collateralized assets’ proceeds to get paid back everything they are owed before anyone else gets paid.

• “In default BH-LB get paid ahead of their claimants”
• Helps prevent managers from diverting funds elsewhere

• Liquidity Provision (protection from informational disadvantage)

• Williams must maintain minimum liquid assets of $600-750 million
• Early warning, violation triggers RMT sale, positions BH-LB well, before insolvency

Loan Covenants II:

• Coverage ratio restrictions: exhibit 1
• Board attendants right, lenders have the right to designate representatives attend meetings
• CFO of williams has to personally certify the solvency (make the individual personally liable)

• Is willials in worse shape than it looks?

Loan Covenants III:

• No stock redemptions. Why? It costs money (it’s the easiest way to take the money and run)
• Limits on CAPEX. Why? If the company is going under, you could take the money and make a super risky investments. This eliminates the incentives of taking risky investments that have the small chance of paying off very well
• Restrictions on intercompany loans. Why? If I can transfer money from a weak company to a stronger company where my position is more secure...why not… weak company could default, the money is harder for its creditors to cease.

• These address conflicts of interest between the lenders and firm managers and stockholders

Problems of Financial Information:

• Asymmetric Information

• Some contracting parties may have superior information. Other parties devise contractural provisions to mitigate their informational disadvantages

• Moral Hazard

• Interest of contracting parties may diverge, leading one party to act in ways that harm another. Agreements are structured to protect contracting parties against opportunistic actions by counterparties

How does the loan look from Lender’s View?

• If Williams defaults on the liquidity covenant RMT must be sold. Who would act as selling agent? Lehman Bros, and they’d earn a nice fee.
• Who would be a logical buyer? Berkshire Hathaway may be the only buyer at the fire sale. Other potential competitors do not have the funds
• So this deal looks pretty sweet from the lenders point of view

Why will Williams go for a deal that is so favorable to the lenders?

How much money does williams need?

• Exhibit 3
• Operating Cash flows:

• Were positive, started getting lower, started losing money

• Investment Cash flows:

• Start to sell assets and reduce capex from those assets

• Financing Cash flows

• Dividends cut
• Maturing debt exhibit 7

• $711 million short term that is maturing
• Some portion of long term debt is maturing

• Financing cash outflows are $1539 million
• Williams can tap their $700million credit line but this is not enough
• Williams cash needs are driven by maturing debt that can’t be financed by favorable terms

How did williams get into this mess? Bad investments, bad financing, bad luck?

• Bad investments?

• Core biz related to transportation of energy products continued to meet performance expectations
• Overinvestment in telecom?

• Bad financing?

• WCG financed by IPO plus heavy borrowing, much guaranteed by Williams. The after-tax loss on these guarantees was about $1000 million.
• Lots of debt is maturing at a time when Williams is suffering from a bad investment in telecom

Economic Effects of Financial Distress for Williams:

• Terms of credit are bad, borrowing is hard
• Do williams’ financial problems have any economic effects other than raising borrowing rates?
• Might not be able to take on positive NPV projects because they are so focused on the short term

• Williams energy trading biz needs credit to function properly. Lack of confidence in financial soundness can destroy this biz, otherwise expected to generate hundreds of millions in profit yearly.

• Rapid asset divestiture at fire sale prices resulting in economic losses

Costs of Financial Distress in General:

• How can financial distress cause loss of firm value?

• Customers lack faith in after sale service, demand falls
• New employees do not want to work for you because your company does not look attractive, they have to compensate for the financial distress risk
• Senior executives leave the company (you lose the best people first) and it is difficult to replace them
• Can’t raise funds for new initiatives, loss of growth opportunities
• Bankruptcy lawyers cost money
• Management time is focused on the financing emergency, not the core biz aspects

• Think beyond borrowing rates, these are more subtle^

What are William’s Alternatives:

• Accept the BH-LB loan
• Try to find a better loan (this will be hard to do) LB already has a close relationship, BH has a prior relationship with them as well.

• BHLB may be the least cost leaders because they have the deepest knowledge of Williams among financial institutions

• Sell stock

• Price is 2.95 a share, they have 500 million shares outstanding, to raise 900 million by selling stock, they’d have to sell 300 million shares, this would substantially dilute the existing shareholder position. Corporate control question. Who would buy up the shares?

• Accelerate asset sales

• But could you get good prices on sale of these assets?

• Filing for bankruptcy protection

• This is not good right now
• The current equity market cap is $1500 million

So what did they do? They took the loan

At first glance, the loan terms seem like highway robbery but then you access their position and understand that they are in a really bad position and need to take the loan since it is their best option