Assessing Credit Risk in a Changing Market

By Mohsin Y. Meghji and Doug Greer

Assessing credit risk and potential bankruptcy risk in the energy industry has never been more important.  Many energy companies face excess capacity, high gas prices, and excessive debt levels.  In response, the industry has undergone more than two years of extensive restructuring efforts designed to cut costs, shed non-core or risky assets, and reduce leverage.  However, while these efforts are necessary, they may not be enough in some cases.  Lack of liquidity coupled with maturing near-term debt obligations could precipitate more bankruptcies in the industry.  So, what determines whether a company will become insolvent, and what is the effect of bankruptcy on the various constituents involved (management, lenders, trade creditors)?

Evaluating long-term bankruptcy risk is similar to a general credit analysis.
Key financial ratios such as interest coverage, leverage, and liquidity should be examined.  Trends in the company cash conversion cycle such as increasing days receivable outstanding or stretching of days payable outstanding are indicators of potential trouble.  Beyond the obvious, one should consider the long term prospects for the company and the industry recovery.

In the near term, liquidity is the key in evaluating bankruptcy risk.  It is not sufficient to focus on asset and liability amounts – one must evaluate the timing of maturing obligations and determine whether liquidity is sufficient to address them. If not, consider the prospects for refinancing or extending maturities.
There are various options for doing so, including the issuance of equity,  high yield bonds, or bank debt and using the proceeds to pay down maturing obligations.  Notwithstanding several notable exceptions, the energy industry was repeatedly successful in tapping the capital markets to refinance and extend maturities over the past year.

A successful refinancing is dependent on both company specific and financial market conditions.  Company specific issues include mix of assets and geographies, the attractiveness of  contracts, and the qualifications of management.  What are the prospects for business recovery and does the management team tell a compelling story?  Investors are far more likely to believe such a story if the key elements of a turnaround (e.g. cost reductions, divestitures of non-core assets) are clearly articulated and management has a demonstrated track record of success.

Financial market conditions, such as recent funds flows to institutional loan portfolios, could impact the success of a refinancing.  According to S&P Leveraged Commentary and Data group, institutional loan investors received $21 billion of net cash inflows in the second half of 2003, fueling their appetite and the competition for new issues.  One should also consider investors' desire for portfolio diversification and their existing exposure to the company.

What other factors could have a negative impact on liquidity?  Watch out for the downward liquidity spiral that precipitated several of the high profile bankruptcies in the industry.  For example, a credit rating downgrade could trigger increased collateral requirements or a tightening of trade credit from nervous vendors.  This reduction in liquidity could drive further downgrades, causing further collateral requirements, and so on.

For investors assessing credit risk, they must also estimate the amount and timing of their recovery in the event of bankruptcy.  The bankruptcy process can take years as court approval is required for key decisions and creditors can object at every turn.  All of the options to maximize recovery must be fully vetted, and the interests of multiple constituencies must be addressed.

To estimate the ultimate recovery to a specific creditor class, one must determine the expected value of the estate as well as the creditor position in the capital structure.  The expected value of the estate (i.e. the size of the ‘pie') depends on the ultimate form of reorganization, whether liquidation, a sale of the business, a standalone reorganization, or some combination thereof. One position in the capital structure and the nature of their collateral (if any) determines how much of the asset value they get (i.e. how large a slice of the ‘pie').  For example, structural seniority and proximity to the operating entities are critical factors in evaluating a security in a complex capital structure.  An unsecured bond issued by a subsidiary / operating company is likely to get paid in full before any cash can flow upstream to pay a bond issued by the parent / holding company.  When holding company bonds are secured by the equity in the operating subsidiaries, the key question is therefore how much residual equity remains after satisfying all obligations of the operating company.

Evaluating credit and bankruptcy risk is a complex task, and the energy industry is more complex than most.  However, by considering the factors outlined above and performing careful analysis, one can estimate the prospects for a company or a specific security within a reasonable margin of error.

Mo Meghji is a Principal of Loughlin Meghji + Company, a boutique restructuring, crisis management and financial advisory firm with offices in New York and Cleveland.  Doug Greer is a Director at LM+Co.  They can be reached at (212) 340-8420.  www.lmco-ny.com