We Have a Feasibility Problem

We're thankful this week for Judge Sonchi's decision last week in the Paragon Offshore bankruptcy cases. The decision was more than just a victory for the company's term loan lenders: it was a much-needed warning signal to the restructuring industry. 

First, a quick synopsis of the opinion. In short, Judge Sonchi sustained most, but not all, of the term lenders objections on the basis that the Debtors' (i) deployed unrealistic rig utilization and day rate assumptions and (ii) failed to take into consideration macro considerations that would affect the Debtors' eventual ability to refinance debt upon maturity in 2021 (if they didn't run out of cash before then). 

With respect to the former, the opinion underscores some dire trends (particularly provided correlations: rig supply up + price of oil down = dayrates down). Some highlights:

  • "E&P companies are currently seeking to drive excessive costs out of the supply chain and are working to sustain this reduced cost environment to avoid over-inflation and 'boom and bust principle' that has been seen in recent years and in the current cycle." (emphasis added)
  • "This 'vast oversupply' of rigs is creating a 'challenging commodity price environment' that is expected to last at least an additional 3.2 years...." (emphasis added)
  • "The oversupply of rigs is 'historical' even excluding newbuild rigs; and the only prior comparable downturn occurred in 1986, which had less of an overhang and did not have the additional newbuild overhang." (emphasis added)

Clearly, this is no bueno for revenue/EBITDA go-forward. Accordingly, an investment banker performing an analysis maybe ought to consider all publicly available resources to configure proper assumptions. Clearly, that didn't happen here and Judge Sonchi made it known. The term lenders' expert testified that, with respect to ongoing projected flat day rates, there wasn't "a single analyst that took a contrary view." But the Managing Director for the Debtors did. Curious.

Regarding the latter refinancing point, the Judge highlighted that "$110 billion of debt associated with severely strained oilfield services and drilling (OFS) companies will mature or expire over the next five years" - hitting RIGHT at the time Paragon would need to tap the capital markets. $110 BILLION. The Debtors' banker explained this massive number away by indicating that there is a $1 trillion E&P market and financing, therefore, would be available. The Judge demurred - calling the analysis "superficial" - and agreed with the term lenders' expert that (a) the market for "asset-based" lending for drilling companies generally is smaller and more specialized and (b) the historical capital used to support the market is no longer as prevalent as it was in previous cycles. Indeed, as this Bloomberg piece notes, fears about refinancing are starting to gain traction in the market.

Putting aside the specifics of this case, the decision is important for another reason: it highlights the importance of feasibility. Now, granted, the term lenders had to object for Sonchi to arrive at his conclusion in Paragon but there is an increasing likelihood of Judges scrutinizing feasibility. This Fox Business piece notes, "Some critics say bankruptcy judges too often focus on hammering out an agreement without paying enough attention to companies' chances of long-term survival." Will this continue?

Maybe we need Judges to be activists and save us from ourselves. Deals are being cut, sure, but are they for the right reasons? Are they cut to ensure the viability of the companies underneath capital structures or to uphold "castles in the air" theory and line the pockets of distressed investors? Hard to say: seemingly, these deals aren't doing them any favors either. Without greater transparency to the markets, it's hard to know.

Here's what we do know. In the last several years, there have been a number of repeat restructurings: American Apparel LLC. Global Geophysical Services LLC. Hercules Offshore Inc. Essar Steel Algoma Inc. Fresh and Easy. A&P. Sbarro LLC. Revel Casino. Catalyst Paper. Perhaps we all -- judges included -- ought to ask ourselves why that might be.