A few days ago I was seemingly caught flat-footed as Paragon Offshore's (OTCQX:PGNPF) management presented a restructuring agreement with their banks and bondholders that surprisingly would leave the majority of the equity intact for the time being and moreover provide an immediate and very substantial cash payout to the company's bondholders.
I went through the restructuring agreement in detail in my last article and arrived at the conclusion that management had more or less missed out on the chance to much better position the company for the protracted downturn the industry is currency experiencing as more than half a billion dollars in potentially much needed cash would be advanced to bondholders and banks should the bankruptcy court approve the restructuring agreement leaving the company with a very tight available liquidity balance of just around $130 mln which does not look appropriate for the size of the company and the current and projected future industry conditions.
Moreover the company will continue to carry a very substantial debtload of more than $1.5 bln going forward and credit covenants are going to revert back into place already in Q1/2018.
After all the restructuring agreement would buy the company roughly two more years at current market conditions until management would have to come back to ask its creditors for another set of concessions - pretty much in line with many of their equally weak peers like for example Pacific Drilling (NYSE:PACD), Ocean Rig (NASDAQ:ORIG), Seadrill (NYSE:SDRL) and Hercules Offshore (NASDAQ:HERO).
While my assessment of the restructuring agreement has been already pretty negative I initially overlooked a very material issue - thanks to user "borncynical" for providing some valuable insights on this topic, so let's take a closer look now:
The press release announcing the restructuring agreement stated that:
Paragon Offshore plc ("Paragon" or the "company") today announced that it has entered into a Plan Support Agreement (the "PSA") with an ad hoc committee representing approximately 77% in the aggregate of holders of Paragon's 6.75% senior unsecured notes maturing July 2022 and 7.25% senior unsecured notes maturing August 2024 (together, the "Bondholders") to support a restructuring of Paragon's balance sheet. Furthermore, a group comprising approximately 89% of the amounts outstanding ("Revolver Lenders") under Paragon's Senior Secured Revolving Credit Agreement (the "Revolving Credit Agreement") has also signed the PSA in support of the company's restructuring efforts. (...)
The release continues:
(..) The PSA anticipates that the company's term loan will not be impacted by the Chapter 11 process and that the term loan will remain in place under its original terms."
So the restructuring agreement has been negotiated with both a majority of the bondholders and revolver lenders but entirely left the term loan lenders out of the discussion.
As this decision obviously has been made deliberately we have to assume that the parties subject to the restructuring agreement believe their case might be strong enough to prevail in bankruptcy court regardless of potential objections by the term loan holders.
Most likely this would be mainly based on the concessions made by the revolver lenders that agreed to convert their claims into a term loan and significantly extend the maturity date. Furthermore some temporary covenant relief will be provided. On the other hand the revolver lenders will pocket an immediate $165 mln down payment and will be entitled to a higher interest rate compared to the existing term loan lenders. The actions laid out in the restructuring plan would result in both term loans being pari passu at the top of the company's capital structure with roughly equal amounts outstanding.
Not surprisingly the term loan holders quickly moved to object the deal as reported by law360.com:
Paragon Offshore PLC ran into opposition to its strategy for a quick trip through Chapter 11 when term lenders, owed some $650 million, said on Wednesday they were not on board with the offshore oil and gas developer's plans to offload $1 billion in debt.
During Paragon's first-day hearing in Wilmington, attorneys for Cortland Capital Market Services LLC, the proposed successor agent for the debtor's senior secured term loan facility, said the term lenders have not only been excluded from restructuring talks, but do not back the Chapter 11 plan support agreement the company brought to court when it filed Feb. 14.
"We don't want the court to be under any illusions we're on a smooth path to confirmation," lenders' attorney Scott D. Talmadge of Kaye Scholer LLP told U.S. Bankruptcy Judge Christopher S. Sontchi. "We don't think the plan works and we will be contesting the plan vigorously in this case."
It's now up to the bankruptcy court to weigh the arguments and either approve the restructuring agreement in its current form or ordering all parties back to the negotiating table to hammer out a more comprehensive agreement that also provides some benefits to the term loan lenders.
Frankly speaking I can't envision the deal to be approved in its current form given the deliberate exclusion of the term loan lenders from any potential benefits.
Moreover the agreement would provide a major payout to junior unsecured creditors (the bondholders) from funds effectively provided by amounts just drawn very recently by the company under its senior secured revolving credit agreement. Unless the revolver lenders are also owning a major amount of the company's outstanding bonds this agreement does not make much sense as you would usually expect a senior secured lender to object any payment made to junior unsecured creditors just like the term loan holders did recently.
In order to reach a comprehensive solution revolver lenders and bondholders will most likely have to make some concessions to the term loan holders. Perhaps the agreed $165 mln down payment will be split evenly among both loan holders and the interest rate for the term loan might get adjusted upwards to the level of the former revolver. Also I wouldn't rule out cuts to the suggested bondholder compensation while I expect the equityholders stake to remain largely untouched.
But most likely the loan lenders will have to sort this out amongst themselves as their claims look almost identical in size, collateral and maturity date and should be entitled to similar benefits in a restructuring agreement.
The worst case at least for Paragon Offshore's bond- and shareholders would be a failure to reach a solution with the court subsequently deciding to dismiss the submitted plan of reorganization effectively forcing the company to enter into protracted ordinary bankruptcy proceedings which could keep Paragon Offshore in that state for years to come. Under this scenario any compensation for shareholders or even bondholders would be hard to envision.
As all parties involved into the company's restructuring know about the risks associated with being unable to resolve the current objections I don't expect the worst case scenario outlined above to come into play. However it remains one of many potential outcomes.
After some initial excitement about the unexpected outcome caused the shares to explode by more than 300% investors have meanwhile started to digest the obvious risks associated with the restructuring agreement. Reports about the term loan holders objecting to the deal clearly didn't help things either and as a consequence the shares have already given back a good chunk of the initial move.
Remember also that despite a still miniscule market capitalization of roughly $30 mln the shares aren't exactly cheap from an enterprise value perspective given the large debt load that will remain on the company's balance sheet. For example, fellow shallow water driller Hercules Offshore came out of bankruptcy last year being in a net cash position. While contrary to Paragon Offshore the company currently remains a sizeable consumer of cash Hercules Offshore has not only retained its positive net cash balance but also has two potential catalysts ahead this year as a brand new custom-specification jackup rig will be added to its fleet which is projected to commence a multi-year high margin contract with Maersk Oil later this year. Moreover the company has recently decided to explore strategic alternatives. At current share prices the company is actually trading at a negative enterprise value compared to Paragon Offshore's roughly $1.3 bln.
Make no mistake here, from an operational standpoint Hercules Offshore is an even weaker player than Paragon Offshore and the company is actually a fraction of Paragon's size. But both companies are mainly shallow water drillers owning mostly outdated rigs with very little residual value. Even the backlog looks comparable with Hercules' being at roughly $0.7 bln vs. Paragon's about $1 bln.
Given the giant valuation gap, the potential upcoming major catalysts at Hercules Offshore and the fact, that the company has already successfully restructured its debt obligations, investors looking to cast their line into the abysses of the offshore drilling industry should give Hercules Offshore a try instead of chasing Paragon with the decision of the bankruptcy court still in limbo at this point.
Not surprisingly the term loan lenders objected to the restructuring agreement in recent bankruptcy court hearings after previously being explicitly excluded from the negotiations.
It will be up to the bankruptcy court to weigh the arguments of both sides and issue a respective judgment. Potential remedies and outcomes include a wide range of possibilities including the risk of seeing the company's plan of reorganization being dismissed entirely. All parties subject to the current restructuring agreement might have to offer material concessions to the objecting term loan holders in order to ultimately get the plan of reorganization approved.
Even if current equityholders will be able to retain their 65% ownership of the company stipulated in the current restructuring agreement Paragon Offshore's shares are not a bargain when compared to its closest peer, Hercules Offshore, or even companies with superior asset and liquidity profiles like Atwood Oceanics (NYSE:ATW).
Should the bankruptcy court approve the restructuring agreement largely unchanged or at least with the equityholders 65% stake remaining unchallenged I would expect the shares to have another field day. Longer term the share price will depend on the progression of oil prices and industry conditions. Suffice to say current data points available give little reason for optimism at this point.
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