Bankruptcy Isn’t What It Used to Be#

Back in the day, bankruptcy usually meant “game over” for a company, like in Monopoly. Operations stopped, everything was sold off. But things have changed. Now, for many companies, bankruptcy has become just another business strategy.

This shift is one of four key reasons why we’re seeing such a big increase in bankruptcies right now. While some folks might peddle doom-and-gloom stories, these other three reasons are genuinely concerning and explain why business leaders might not take bankruptcy as seriously as they used to.

According to data from Standard & Poor’s, corporate bankruptcies among the major companies they track were up over 200% in the first half of 2023. High-profile names like WeWork, Vice Media, and Bed Bath & Beyond all went under. The reasons are usually a mix:

• Poor management
• Changing consumer preferences
• High interest rates
• Bad market conditions

Here’s the weird part: even though these companies went bankrupt, Vice is still making videos, you can still rent an office from WeWork, and Bed Bath & Beyond is still selling stuff (maybe overpriced laundry hampers!). This shows that bankruptcy isn’t always the end.

Let’s dive into the four reasons behind this bankruptcy boom.

What is Private Equity?#

Private Equity is a broad term for investing money into companies that aren’t publicly listed on a stock exchange.

• Venture Capitalists, who invest in early startups, are a type of Private Equity.
• Those deals you see on Shark Tank? Yep, Private Equity.
• Even if you give a family member a few thousand bucks for their Etsy store in exchange for a cut of future profits, you’re technically a Private Equity investor (feel free to update your LinkedIn!).

The Real Money: Leveraged Buyouts (LBOs)#

Where the big action is, though, is with buyout funds. These firms raise billions from places like college endowments, retirement funds, and wealthy investors. They use this money to buy entire companies.

Their stated strategy is that their smart people with business experience can improve the companies they buy, cutting costs and boosting sales.

But, as someone named Benjamin might say, the real investment strategy is getting absolutely jacked to the tits on debt that they don’t have to take responsibility for.

How a Leveraged Buyout Works:#

Let’s break it down with an example:

1. You’re a Private Equity partner with $1 billion to invest.
2. Find a company: You find a promising company that needs your business skills (let’s call it Play Things R Us).
3. Buy the company: You use your $1 billion to buy Play Things R Us. You are now the owner.
4. Install new leadership: You hire a new CEO you trust to follow your instructions.
5. Take out massive debt (on the company’s behalf): The CEO’s first job is to get a huge loan from a bank or investors using Play Things R Us as collateral. If the company is profitable and valued at $1 billion, it might be able to borrow around **$700 million**.
6. Decide what to do with the borrowed money: You, as the owner, tell the CEO what to do with that $700 million.
   • Option 1 (Traditional): Reinvest it in the business (advertising, new locations, online capacity).
   • Option 2 (The LBO Play): Have the company pay that $700 million out to you, the Private Equity firm/owner.
7. Repeat: If you chose Option 2, you can then use that $700 million (which was borrowed by the company you just bought) to go buy another company and do it all over again.

This is a leveraged buyout. Private Equity investors try to make it sound complicated to justify big fees, but it’s similar to a Real Estate investor using cash-out refinancing to buy another rental property.

The Key Differences from Real Estate:#

There are two big differences:

1. Instead of buying real estate, they buy entire companies.
2. Crucially, unlike a mortgage: If the money borrowed by Play Things R Us can’t be paid back, the Private Equity firm is NOT responsible for that debt.

For a Private Equity investor, this makes telling the appointed CEOs to take out as much debt as possible a great strategy.

• If you can turn the businesses around, you can 4x or 5x your investment very quickly.
• Even if the businesses get crushed by the debt, you often only lose 20% to 30% of your investor money.

Because this strategy offered high returns while effectively managing the risk for the PE firm, thousands of well-known companies were bought using LBOs when interest rates were low.

Now, rates on prime commercial debt have tripled. Companies saddled with trillions of dollars of this LBO debt often can’t make their payments, leading to bankruptcies. While this hurts lenders and employees, for the Private Equity firms that set it up, it can be an amazing profit opportunity because, believe it or not, they can use the bankruptcy process to make even more money.

Small Businesses Are Big Business#

Operating a small business is always risky, but the type of companies going bankrupt might surprise you.

• The Small Business Association of America (SBA) defines a small business by revenue (ranging from $1 million to over$40 million) and employment (100 to over 1,500 employees). So, some “small” businesses are actually quite large.
• According to the US Census Bureau, these companies provide jobs to nearly half of all working Americans.
• Compare this to big companies like Bed Bath & Beyond, Amazon, WeWork, and Walmart, which collectively employ only 23% of Americans.

While each individual small business bankruptcy has less impact than a major one, collectively they are much larger and more important to the overall economy and workforce.

So why isn’t there more panic? Because of the second reason bankruptcies are booming: it’s overdue.

The Hangover from Easy Money#

In 2021 and 2022, company bankruptcies actually fell to an all-time low. This happened despite incredibly challenging market conditions. How?

• Government programs: Like the Paycheck Protection Program (PPP) loans.
• Rock-bottom interest rates: Made it easy for companies to borrow money to cover expenses and stay open.

Without these conditions, many of these companies would have failed long ago. They were essentially “Zombie Companies,” kept alive by cheap money.

Now, those loans need to be paid back, and the interest payments are much higher. Small business loans often have adjustable rates, meaning the interest payment can change anytime based on market rates. (This is unlike fixed-rate mortgages common in the US thanks to Fannie Mae and Freddy Mac, though adjustable rates are common in other countries and are hurting budgets there too). American companies aren’t so lucky with their debt.

The Coming Debt Cliff#

According to investment rating agency Moody’s:

• $1.87 trillion of corporate debt considered “junk quality” is expiring between 2024 and 2028.
• This is a 27% jump from the $1.47 trillion recorded in last year’s study (for 2023 to 2027).

It’s important to note:

• Moody’s does not track PPP loans.
• This figure also doesn’t include the $953 billion in additional PPP loans given to companies for wages.
• According to public records compiled by CBS, $757 billion of those PPP loans were forgiven. Businesses may be off the hook for repayment, but they also can’t rely on that kind of funding anymore.

Most of this “junk debt” is held by the small companies where nearly half of working Americans are employed. As this debt comes due, more companies simply don’t have the cash to make the payments, forcing them into bankruptcy. That’s a serious problem for employees.

The Two Types of Corporate Bankruptcy#

Think of them as the convenience store duo:

1. Chapter 7 Bankruptcy: This is the old-fashioned, Monopoly-style “game over”.

   • Operations stop.
   • The company’s assets are liquidated (sold off).
   • The money goes to stakeholders in a specific order of priority, determined by the US bankruptcy code.

   The Bankruptcy “Waterfall” (Payment Order)#

   Until everyone higher on the list is paid in full, no one lower gets a cent.

   • 1st: Secured Creditors: Usually banks with loans backed by specific assets like property or equipment.
   • 2nd: Priority Creditors: Includes things like clients who held money with the company on account, or employees (for wages owed).
   • 3rd: Unsecured Debt Holders: Creditors without specific collateral backing their loans.
   • Last: Shareholders: If any money is left (rare). If there are different classes of shares (like at Berkshire Hathaway or Meta), non-voting preferred shareholders get paid before common shareholders.

   The Exception: Executive Pay Here’s where the infuriating part comes in. Companies regularly pay their CEOs and top executives millions to stay and guide the company through the liquidation process. Why? Because if senior management sticks around and helps, a lot more value can often be recovered for all stakeholders.

   Imagine you’re the CEO of a pharmaceutical company you bankrupted. You can’t just flip off the lights and hand the keys to an auctioneer. Things like ongoing medical research labs only have value to potential buyers if they can be properly transferred.

   It’s a ruthless corporate world; those executives want to know what’s in it for them. A bankrupt company might not even be able to pay their regular salary (since employees are only second in line). But because they can help others higher on the list get their money back, a deal might be struck: a large, one-time payment to stay until everything is done. Without this, CEOs would often quit and look for a new job immediately.

   The most infamous example was Enron. This huge bankruptcy was caused by the fraudulent actions of the very executives who were going to be paid millions to oversee the company’s collapse. After Enron, Congress passed legislation to stop companies from paying “retention bonuses” to executives during bankruptcy.

   However, according to Robert Jackson, an associate professor at Columbia Law School, they left a loophole: executives can be paid performance-based incentives for doing a “good job” with the bankruptcy they caused. This is just different enough from a retention bonus to technically be legal.

2. Chapter 11 Bankruptcy: This loophole is even more important for this second type. Chapter 11 allows the company to keep operating under a court-appointed administrator who works with the existing executives.

   • The goal is to rearrange finances and operations to pay back as much debt as possible.
   • They try to maintain the good parts of the business that still make money.

   This is why Vice is still making videos even though it’s in Chapter 11 – that’s a revenue center they want to preserve to help pay off creditors.

   Chapter 11 bankruptcies are booming because now is a perfect time to renegotiate debt. Lenders often prefer to get something (via a Chapter 11 plan) rather than nothing (via a Chapter 7 liquidation). Plus, lenders want to avoid panic in the market. Companies also aren’t keen on raising new money at today’s high interest rates, so even if their credit rating gets hit by a Chapter 11, it might not change their plans much.

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So, that’s the story behind the bankruptcy boom. It’s complicated, and it shows that “how money works” is rarely simple or fair.

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