Amend and Extend or Amend and Pretend?

In the last 6 months, we've seen a number of "amend and extend" transactions. Typically they involve:

• The extension of the maturity of a term loan and/or revolver (typically for syndicated, non-investment grade loans). This is only for lenders who agree to the extension (i.e. some lenders may keep the original maturity).
• Increasing loan pricing for lenders who agree to extend (to reflect current market conditions and the higher credit risk of the borrower) and an amendment fee.
• Covenant relief for the borrower (reflecting operating performance below original the targets).

Why an Amend and Extend?

During normal economic times, a borrower would do a new syndication as the maturity date for an existing facility approaches. So why are we seeing amend and extend agreements rather than new facilities? Because many of these companies would have a hard time getting a new syndication done. The loan market is much more selective for high risk credits, and many of these companies have high leverage and weak cash flows.

Amend and Pretend?

It is clear why a borrower would want an amend and extend (despite the higher cost) - they get covenant relief and one or two more years to turn around the business and generate cash for debt repayment. But why are lenders agreeing to these transactions? Do they really

believe the borrowers will be able to repay the loans 2 years later, or are they just deferring the day of reckoning - the day when the borrower will need to do a major financial restructuring (or even a bankruptcy) and the lenders will have to write down the value of the loans? Is it an "amend and extend" or "amend and pretend" (that the loan will actually be repaid some day)?

How Xerox Fell

In How the Mighty Fall and Why Some Companies Never Give In, Jim Collins lists five stages of corporate decline. We used them to analyze Xerox in our last post. Collins uses behavioral terms to describe how companies falter, not financial measures.

We have a framework for analyzing troubled companies that complements Collins’ approach. It focuses more on financial measures than management behaviors. Ours is a tool for evaluating the symptoms, while Collins’ explains the cause of the disease.

Our Five Stages of Decline
Our financial framework for analyzing a company in decline has five stages.

• Stage 1: Prosperity. A company in this stage is thriving. Sales growth, profitability, and cash flows are all very strong. Liquidity is very high, and leverage is below average for the industry.
• Stage 2: Stability. In this stage, sales growth, profitability, and cash flows are strong. Liquidity is high, and leverage is about average for the industry.
• Stage 3: Difficulty. Sales growth, profitability, and cash flows are decreasing. Liquidity is low, and leverage is above average for the industry and increasing.
• Stage 4: Distress. Sales growth, profitability, and cash flows are negative. Liquidity is very low, and leverage is very high for the industry and increasing.
• Stage 5: Default. Companies in this stage have the same characteristics as Distress. But because they have missed a debt payment, they are in some form of financial reorganization or liquidation.

Xerox in Decline
Xerox is a good example of a company going through most of these stages. Let’s take a look at some key measures as Xerox goes from stability in 1999, to difficulty in 2000, and to distress in 2001.













Xerox’s operating profitability varies some through 1999, but it’s basically stable. In 2000, the trend is much worse, and margins contract in every quarter, ending in a loss – a clear case of difficulty. In 2001, profitability improves on the strength of radical cost cuts. But it remains low, and Xerox remains in difficulty.













Xerox’s debt is stable in 1999. But it increases sharply in 2000 to fund the decline in profits – a sign of difficulty. Although debt decreases in 2001, it shifts from 30% short-term at the beginning of 1999 to 60% by the end of 2001. That is a strong indicator of distress.














Liquidity shows a fall from adequate levels in 1999 (stability) to inadequate levels in 2000 (difficulty). By the end of 2001, it’s reached a dangerously low level (distress). Here we define liquidity position as cash and available committed credit lines less short-term debt and the current portion of long-term debt.

The Company Risk Cycle
We call these five stages the Company Risk Cycle. Comparing the trends in a company’s performance and finances to the Company Risk Cycle gives you a way to anticipate what could happen next. It gives you the early warning signs of credit problems.

Of course, decline is not every company’s destiny. Economic and industry cycles come and go, and companies get worse and better as they do. And companies in trouble on their own often solve their problems and turn around the way Xerox did.