March Madness
Auditors may not give some companies a clean bill of health, setting some on the path to bankruptcy
By Aleksandrs Rozens February 23, 2009
The nation's bankruptcy judges may be busier with new cases in March, with a pickup in activity likely coming just as many companies file annual reports that reveal details about their fiscal health.
For public companies, the 10-K reports are filed with the Securities and Exchange Commission, while private companies prepare reports which offer details about their financial health for their bank lenders.
In both cases, auditors are required to offer their perspective on the companies' health in what is known as a going-concern opinion. Companies whose auditors question their financial health could end up breaching covenants with lenders and this, in turn, could put them on the path to bankruptcy.
"It is clearly an issue that is looming larger [than in previous years]. Was it always a potential issue? Yes. Today it is more of an issue," says Jeff Werbalowsky, co-chief executive of Houlihan Lokey.
"There will be an upswing in March [bankruptcy filings]," says Greg Milmoe, a partner at Skadden, Arps, Slate, Meagher & Flom and co-head of the firm's bankruptcy practice. "This will shake out a lot of companies that are close to the edge. Some will go over the edge."
If the pace of bankruptcies kicks up to livelier levels in March it would follow an already active month. In February, some high-profile corporate bankruptcies included Foamex International, BearingPoint, Trump Entertainment and Charter Communications.
Companies that have a market cap of $700 million or more have 60 days to file their 10-Ks and those with a market cap of $75 million to $700 million have 90 days after the fiscal year.
Some of the companies whose auditors raise doubts could get waivers from lenders, allowing them a lifeline. But, that lifeline may be temporary because borrowing costs have rocketed higher amid the credit crisis and a company may not be able to keep up with higher borrowing costs associated with a new loan.
Meanwhile, those businesses owned by private equity companies could get much-needed money to keep themselves alive. But not all private equity companies are willing--or able--to put more money into a portfolio business.
"PE funds are limited as to what they can put into a single investment," says Milmoe.
For example, a PE company may find that one of its businesses needs $100 million. The PE fund managers may be willing and able to back the business, but guidelines in the fund may prevent them from investing more than 20% of the fund in any single company.
One such investment company is Cerberus Capital Management, which has troubled automaker Chrysler in its portfolio.
In December, Cerberus said its investment concentrations generally do not exceed 5% of assets under management. The company's Chrysler investment was initially about 7.5% of its assets under management, making the stake in the auto company the single largest investment that Cerberus has ever made. Late last year, Cerberus had $27 billion worth of assets under management, excluding the $13 billion capital managed for co-investors in Chrysler, GMAC and other investments.
Jeff Robinson, a partner at audit firm Grant Thornton, points out that questions about a company's ability to continue as a going concern do not always lead to bankruptcy, but they can propel a business into a court-supervised restructuring if the questions prompt lenders, vendors and customers to pull away from the business.
Last week, Grant Thornton's corporate advisory and restructuring group said in a statement that it is possible that a number of publicly-traded companies in the auto industry could receive a "going concern opinion" from auditors.
Robinson noted that the going concern issue impacts not just public companies but affects private businesses. Bank covenants, he says, often require that a company submit audited financial statements 90 days or so after the close of a company's fiscal year. So, companies typically submit them in the period between mid-February and the end of March.
He says that "in the economy we are in today, the going concern assumption is questioned more frequently. Projections for businesses are very difficult to determine."
In addition to autos, industries where auditors may question a company's future viability include any business involved with consumer goods, as well as housing and real estate--both commercial and residential.
So how bad can it get? Martin Fridson of Fridson Investment Advisors believes that default rates could hit around 15% in coming months. "A 15% to 16% default rate. I think that is a realistic expectation in light of current economic forecasts."
A warning flag raised by auditors could not come at a worse time for many companies that need to refinance their debt. According to a report recently published by Moody's, about $190 billion of speculative-grade corporate bonds and loans will mature between 2009 and 2011. Some $100 billion of this is in the form of credit facilities, while $90 billion is in the form of corporate bonds.
"Market liquidity has declined significantly, limiting access for issuers seeking to refinance their debt," Moody's analysts noted in the report, which warned that defaults in the high-yield market will rise to a 16.4% rate by as soon as November. "As the global recession deepens, profitability and operating cash flow are deteriorating for many companies ... this will result in an increase in covenant violations, defaults and balance sheet restructurings."
The rise in defaults as well as a decline in willing lenders likely will result in distressed exchanges, says Jim Schneider of Morgan Joseph, who specializes in advising companies on distressed exchanges. Schneider expects these to rise dramatically amid the economic slowdown (see related story). Also, recent legislation included in the government's stimulus bill may spur more of these debt-for-debt exchanges.
Specifically, Schneider says the new law allows companies that do debt-for-debt exchanges to put off, or defer, tax payments for five years. The tax payments would then have to be recognized in years six through 10. "We are talking to a lot of companies, both troubled and healthy, about exchange offers," he says.
(c) 2009 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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Jeffrey Werbalowsky
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