Sometimes, hopeful shareholders think along the following lines:
My stock has fallen so much, that it might well be an acquisition target. I can't sell now, at heavy losses, because I could wake up tomorrow and see the company be acquired at a huge premium to these distressed levels.
It's easy to see why shareholders in the energy space might think this way. With crude and natural gas down heavily, the space is laden with companies that show 90%+ drops from their former highs. Two such examples would be Chesapeake Energy (NYSE:CHK) and Ultra Petroleum (NYSE:UPL). Beyond thinking that since they have fallen so much they must potentially be "cheap," shareholders can also fall prey to the reasoning that this would be a good way for larger companies to acquire reserves (and ongoing production).
In this article, unfortunately, I am going to explain a simple reason why such hopes are unrealistic. The simple reason is debt.
It's not just that considering debt and equity, the companies haven't fallen "that much" (in Enterprise Value terms). It's much worse. The problem here is that the debt trades at a fraction of its face value.
For instance, consider CHK. You can find its debt trading for 25 cents on the dollar, as is the case with the following 2021 bond, for a yield of 44.75%:
Or UPL, where this 2018 bond trades for ~10 cents on the dollar:
When debt gets this distressed, someone actually wanting to acquire CHK or UPL no longer needs to buy the whole company through acquiring its equity. The whole company becomes much cheaper through buying its distressed debt, perhaps together with a sliver of an upcoming obligation, and then forcing bankruptcy as soon as possible if needed be.
Moreover, buying the company's shares entails not only just paying for the equity, but also making good on the entire debt load - or else it would be the debtholders getting the company, and not the equity buyer.
This means that acquisitions of distressed energy companies are highly unlikely to happen under the present environment, with the debt of those same companies trading for such fractions of their face value.
Moreover, it also means that even a public shareholder has no rationale for staying in the company's shares. Someone holding CHK, for instance, would do much better to sell the shares and buy the bond I pictured before. After all, in the event of bankruptcy, it's likely that the debt would still receive a measure of recovery. And even if the company managed to stay out of bankruptcy, the bond would get equity-like returns, both from capital appreciation (the bond would have to be made good at 100 cents on the dollar), and the fact that the 6.125% coupon on a 25% of par bond yields a current yield of a full 24.5%/year for as long as the company pays those coupons (or a full 122.5% return on the original investment from coupons alone if the company pays all coupons until maturity).
Said another way, for the equity to be worth anything above $0, said bond has to provide a return of 422.5%. And this while providing a measure of safety in the event of bankruptcy - where the shares will be wiped out.
For acquisitions, there are just three more things one needs to add:
- First, acquirers can pick and choose the best assets before the company even files bankruptcy. After all, distressed as they are, these companies will sell assets at any price just to keep current on their liabilities.
- Second, a potential acquirer would have to be sure that there are covenants in place, making it impossible for the company to issue senior (or secured) debt, lowering the existing debt down the seniority structure and making recovery to it (and access to assets in bankruptcy) much less certain. The potential acquirer would also need to be sure of covenants impeding sales of assets without creditors' approval.
- Third, a potential acquirer, in the absence of those covenants, could himself offer to finance the company using senior (or secured) debt with appropriate asset-protection covenants, with the hope of either getting high returns for such debt, or getting the assets on the cheap.
It should be said that smart financiers and acquirers have long used all of these methods. For instance, Eddie Lampert acquired a controlling stake in Kmart through acquiring its debt during bankruptcy. And Warren Buffett financed Williams Companies (NYSE:WMB) through secured debt together with a high coupon and warrants back in the middle of the 2002 crash.
Finally, I should also add that having distressed debt is, in itself, a barrier to further financing. So, if a company already has distressed debt, it's less likely to get further financing on reasonable terms. The reason is simple: If someone wanted to lend money to the distressed company, why would it lend it new money on reasonable terms when it could buy older debt at a 40% yield? This means that any new debt a distressed company needs to issue has to necessarily be issued on harsh terms, including senior/secured status, high coupons and dilutive securities.
I can draw several conclusions from this exercise:
- Acquisitions will not save shareholders of distressed energy companies.
- Any acquirer would rather buy the debt or finance the company under harsh terms including using secured status to pick and choose the assets they want.
- Furthermore, even for public shareholders, it no longer makes sense to hold the shares, when they can replace those shares with debt at such distressed levels. Holding distressed debt can provide equity-like returns on the upside and less risk on the downside if the company files bankruptcy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.