Wednesday, September 19, 2012

Arcapita's ambitious plan to exit bankruptcy

I didn't expect to find much in the "Debtors' motion for an order..authorizing debtors to implement global settlement of senior management claims" (pdf), but it included details about how Arcapita is planning to exit bankruptcy.  The filing details what the company describes as "a long-term business plan designed to effectuate, among other things, an expeditious exit from bankruptcy" aided by a previously approved incentive plan with employees that Arcapita states has "stabilized their operations and avoided the flight of the Arcapita Group’s best employees who have most, if not all, of the institutional knowledge required to effectively manage the Debtors’ interests in Arcapita Group investments and portfolio companies."

The earlier plan allowed terminated employees (and current employees if they remained with the company through November) to settle the amounts they owed Arcapita from an incentive plan that allowed them to co-invest with Arcapita in portfolio companies. 

The incentive was provided by an affiliate of Arcapita loaning them money (through a qard loan) to invest in Arcapita's deals.  The loans were repaid in 5 equal payments of 15% of the loan amount from a portion of their annual incentive payments.  If they remained with Arcapita for 5 years, the remaining 25% of the loan was forgiven.  The earlier plan allowed employees (with the exception of senior management) to have the amount they owed forgiven in exchange for returning their share of the investments in portfolio companies corresponding to the amount they still owed Arcapita. 

The current request is to allow the senior management (6 individuals in total) to participate in the same type of plan, except to make it dependent on different conditions.  Currently these 6 people owe Arcapita $7.5 million, while the 'fair value mark' of the shares they are offering in return is just $4.0 million (although Arcapita claims that "the aggregate value of the shares which may be returned to Arcapita via the Senior Management Global Settlement would actually exceed the related aggregate [incentive plan] obligations."). 

Although Arcapita believes these shares are worth more than the debts being forgiven, the management has also offered to waive their claims against Arcapita for bonuses from 2011, although it is unclear why bonuses to management should be owed for a year when the company was in dire financial straits (and potentially insolvent according to KPMG's mid-level valuations of its assets).  The motion argues that litigation over these claims would be difficult since they would occur in foreign jurisdictions, and would be challenged by the senior management would not be enforceable since the funds are owed to a subsidiary of Arcapita that is not involved in the bankruptcy proceedings. 

The motion further argues:
In addition, the historical treatment of the [incentive plan] also undercuts any argument that the obligations thereunder should be enforced now.  The Arcapita Group historically did not pursue departing or terminated Employees in respect of their [incentive plan] exposure.  Employees may argue that the Arcapita Group’s failure historically to enforce these obligations supports their treatment as an incentive plan, not an obligation which needs to be satisfied.
More important for those who are interested in how Arcapita could exit bankruptcy, the condition for senior management's proposed plan to become effective is: 1) the case is forced into liquidation of the company before December 15, 2012 in either the US (under Chapter 7) or in the Cayman Islands; or, 2) the filing of a reorganization plan by December 15, 2012.  A reorganization plan that would qualify would:
either (1) a standalone chapter 11 plan whereby the current entities emerge from chapter 11 in a substantially similar organization (the “Standalone Plan”) or (2) a chapter 11 plan (the “Toggle Plan”) that provides for both (a) a restructuring plan premised on the Debtors’ raising new equity capital from investors (the “New Money Plan”) and (b) a Standalone Plan.  If a Toggle Plan is filed, it will “toggle” from a New Money Plan to a Standalone Plan if a minimum of $500 million of new equity is not in escrow prior to plan confirmation.  If at least $500 million of new equity is raised and in escrow by December 15, 2012, a New Money Plan can be filed as an Eligible Plan, satisfying the Plan Milestone.
From this, it appears that Arcapita believes it can either liquidate sufficient assets to meet their obligations (or convince those creditors to take a haircut), or raise $500 million in new equity (and presumably also get creditors to agree to extend their debt or otherwise restructure it. 

Arcapita says that the incentive plans are about 46% underwater (the valuation of the shares are about 54% of the debts incurred--the book value of those assets).  It would seem likely that senior management holds either a representative slice of Arcapita's portfolio (at the worst).  The latest values of Arcapita's investments was September 30, 2011, so the figures are a bit dated, but the reported value of the company's investments was $2.35 billion (total assets of $3.57 billion). 

Through the last annual report from June 30, 2011, the $2.46 billion in investments had been marked down (through cumulative fair value changes) by just $90 million (3.7%).  The vast majority (>99%) of the investments are accounted for as Level 3 assets, which are based not on market prices but on unobservable inputs "e.g., valuation methodology using EV/EBITDA multiples or discounted cash flows."  There was an additional $17.2 million in fair value adjustments in the three months to September 30th (4.3% cumulative loss recognized on the balance sheet). 

This is probably a reasonable way to value investments in private equity because they tend to be held for many years and are not liquid (the 'private' part of 'private equity').  But using the 46% fair value-to-original value discount that a mid-point valuation established for the senior management's coinvestments through the investment program values the firm's investments at $1.326 billion (compared to the value from 9/30/2011 of $2.365 billion). 

Adjusting the equity reported on 9/30/2011 by the difference ($1.039 billion) left Arcapita technically insolvent at today's investment valuations, with negative net equity of ($6.5 million).  For Arcapita to attract new equity capital, it will need to find new investors who view the mid-point valuation from KPMG as undervaluing the assets Arcapita holds and, likely, also be willing to assume that Arcapita's creditors will agree to 'extend-and-pretend' while it monetizes its assets. 

Management clearly believes it can convince investors that both will hold true, and can convince them in the next 3 months.  Only time will tell. 


alternative investments said...

Interesting - the issue in all of these "extend and pretend" cases is how long must the creditors "extend" for?

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