Punch Taverns, which announced its latest restructuring plan in February, has perhaps the mother of all zombie balance sheets. It is a profitable company weighed down by an excessively over-levered capital structure. The pub company reported pre-tax profits of £52.4 million on revenues of £492 million in 2012. But it owes £2.4 billion in debt. Ever since the board at Punch Taverns announced the completion of its capital structure review last October and confirmed that a restructuring proposal would be forthcoming, a group of hedge funds have been building their positions in the debt and equity. Five funds Glenview Capital, Octavian, Luxor Capital, Alchemy and Avenue Capital now hold over 50% of the issued share capital and most of the subordinated debt in Punch B. As in the recent Seat Pagine case, those funds have used this clout to influence terms of the restructuring to the detriment of the senior bondholders. It is a good example (and a very large one) of the increasing muscle of subordinated bondholders particularly those that have a significant equity stake as well in the restructuring of zombie companies. The debt pile is held in two securitization vehicles: the £1.48 billion Punch Taverns Finance (Punch A) and £914 million Punch Taverns Finance B (Punch B). When Euromoney examined the situation at Punch in detail in March 2011, sources emphasized that the much-discussed threat by the firm to default on its then-£2.7 billion of debt was simply a scare tactic to prepare the bondholders for what lay ahead. This will be a classic contentious situation. All this talk about walking away from the pubs is just softening up the bondholders for a really bad deal, one industry veteran told us at the time. That really bad deal is now here. On February 7 Punch Taverns announced its proposal: the paydown of Punch B junior debt at a material discount to par and a five-year extension on the senior debt with covenant amendments and deferred amortization. This is not what a traditional restructuring which would be driven by the senior bondholders should look like. Given that many of the subordinated debt holders will have bought in at a significant discount, the loss if any that they crystallise on the deal could be minimal. They will also receive £93 million in cash (ahead of the seniors) and new notes worth £56 million, reducing the debt in Punch B by £229 million. The company is proposing to buy the Class B1 and B2 notes back at 65 and 63 they currently trade at 66. The terms of the deal see cash payment to the junior noteholders ahead of the seniors who will see their final maturity extended to 2019 and their covenant protection eroded although they will benefit from a cash sweep. This is unlikely to go down well. Senior bondholders will reject this proposal, says one source familiar with the negotiations. They are not going to give up on their covenant protection and extending for five years is simply a five-year free option to the company. The majority of the senior debt is held by a group of large institutional investors understood to include Aviva, Kames Capital (formerly Aegon), M&G, Legal & General, BlackRock and Standard Life. The senior bondholders have formed a bondholder committee under the ABI and are being advised by Rothschild. The extension will be particularly painful for the Punch A Class M tranche, which has a very low cash coupon, something that will be very painful to bear for a further five years. The tranche is held by a UK bank. Punch Taverns, which is being advised by Blackstone and Goldman Sachs, has now embarked on a charm offensive to try and win the seniors round. These proposals already have the support of a significant group of stakeholders, says Stephen Billingham, executive chairman of Punch Taverns. The board is mindful that support is also required from a large number of other stakeholders and the board is keen to engage with all stakeholders and commence implementation of the restructuring proposals without delay. Gearing for a fight That is the last thing that the seniors want and they wont go down without a fight. The battle lines are not clear cut, however, as several senior bondholders are known to hold positions in other parts of the capital structure. The classic contentious situation is therefore now in play and seniors will likely push for at least a coupon uplift in return for the extension or some kind of debt for equity swap. We think that the class As in both Punch A and B have a good case for getting the targeted new Weighted Average Life (WAL) back to the current schedule rather than suffering from an extension, reckons James Martin, credit analyst at Barclays. In its statement the firm dismissed equity dilution, saying The provision of new equity was discussed at length with a majority of the Group's shareholders who only indicated support for the proposal set out in this announcement. It also dismissed the idea of a pre-pack administration for the securitization vehicles. The juniors are very well protected by the liquidity facility, the source points out. If the equity holders insist on no dilution then you cant do a debt for equity swap. Billingham hopes to implement the deal without delay but he is likely to be disappointed. The Punch Taverns restructuring is not called the next Eurotunnel for nothing.