AUSTIN—It might go against the adage, but companies fighting for survival in the oil and gas sector during this downturn might want to change courses midstream—or, rather, upstream. E&Ps in bankruptcy need a game plan to get back in business; and those still in business but in financial distress need a game plan to avoid filing.

The winning strategy is restructuring, according to Mark Carmain, managing director at Petrie Partners, and Anthony Caluori, managing director at Rothschild Inc., who presented their thoughts on restructuring at the recent Energy Capital Conference presented by Oil and Gas Investor. The two firms have forged a debt-advisory alliance to help energy companies through the restructuring process.

A substantial re-equitization of the sector is required, and that’s going to come “through the courts, or through consolidation as some of the companies and assets switch hands into the better-capitalized players who have access to the capital markets at competitive rates,” Carmain told the audience.

While some upstream players might hesitate to change course, the market is already “gravitating toward higher-quality, more sizeable entities ... rewarding those it sees as having the equity capital base and access to capital to survive the downturn,” Carmain said. He also noted that investors are favoring large-cap companies, capitalizing them at higher market value-adjusted multiples of 12x-13x EBITDA.

Due to low commodity prices, there is a lot of restructuring to do. Petrie Partners and Rothschild have endorsed a variety of restructuring measures, starting with a tactic from 2014. Back then, a lot of “healthyor then-healthier companies pursued amendments or debt waivers and an extension of their company’s relief period,” according to Caluori. He added that the same is a viable strategy to pursue today, and that although these opportunities remain, “the scarcity of capital as it pertains to asset sales” presents an obstacle.

Currently, about $19 billion worth of liabilities are covered by the 52 companies that filed for bankruptcy from January 2015 to mid-March 2016, Carmain said. About 85% of the liabilities are covered by the top 10 companies on the accompanying graphic—but that $19 billion represents only “10% of E&P high yield outstanding.”

Of the 52 companies, 13 have gone in with a pre-package filing, which supports restructuring. The remaining 39 did not—most likely from a lack of consensus with lenders, not from a lack of effort, Carmain said. Pre-packaged filings spend three to nine months in bankruptcy, while it could take anywhere from six to18 months for the alternative with no pre-arranged plan.

Roughly 80% of the small-cap upstream companies Petrie Partners follows have debt trading below 80%; this hinders the execution of merger transactions because change of control adds debt at 101% of par and complicates the de-levering process, Carmain said. In the past, companies seeking to reduce debt could sell assets into the market to meaningfully de-lever and improve credit ratios. But now, potential sellers are hesitating and evaluating whether broader restructuring is preferable, considering “a divestiture actually may be a leveraging transaction if I sell a cash flowing asset in a low commodity price environment,” Carmain said.

Other transaction alternatives involve buyers purchasing assets from overleveraged companies through “the bankruptcy process, where they can transact free and clear of any liens,” protecting both the buyer and seller.

Debt exchanges are high on the list of restructuring methods—when they are available. According to Caluori, they are both “defensive from an issuer’s perspective or a bit opportunistic to extend one’s runway and create incremental liquidity” by reducing debt and consequently debt service. Although debt-for-debt exchanges can extinguish debt and extend liquidity runways, Caluori suggested they could be less prevalent in the near-term, “given the recent rise in high-yield securities.”

Many debt exchanges use a “carrot-and-stick approach” that incentivizes one party to trade a considerable amount of its principal through the exchange of securities in order to “move up the priority waterfall … layering the position they were in previously,” Caluori said.

An example of a successful exchange can be found with California Resources Corp., which has completed an oversubscribed debt-to-debt exchange. Caluori pointed out that the company was aided by the fact that “they were previously investment-grade, [and] they had significant liquidity access to their then-unsecured revolver.”

In terms of exchange offers, there’s been a marked shift from “targeted, privately negotiated transactions with large institutional investors” to a wide offering to all qualified institutional buyers and accredited investors, creating more value for issuers, Caluori said. He said that action potentially stems from management’s growing concerns with class action lawsuits and litigation risks.

Another emerging trend involves companies that are “fully drawing their revolving credit facilities in advance of upcoming spring borrowing base redeterminations.” This is a defensive tactic that “they’re being advised to do” in part to maintain sufficient liquidity should they ultimately enter bankruptcy, according to Caluori.

Both speakers cautioned that “if issuers are overly aggressive in their exchange offers, those deals can lose momentum early on, which is hard to recover from” and can result in failed transactions.

Annie Gallay can be reached at agallay@hartenergy.com.