Depends, some mezz deals put the holder of the mezz piece in the first position to take over the asset if they want. So theres some considerable modeling that goes on there.

If its a striaght B position than its as simple as SK says, all you need to think about is "hey, what is the probability of me making my money back on this one?"

It also depends on why you are buying the subordinate piece, do you want to buy off the 1st position holder then take over the asset? Lots of reasons why you would buy it and lots of ways to model. If you just want to buy subordinate pieces and hope you get paid off more often then not its pretty simple stuff.

 
Best Response

I would qualify SK's comment by saying that his math is correct if the B piece is impaired and can take title to the asset. Then it is effectively an automatic path to the equity so, as with all equity, the value of the position is the unlevered asset value less the debt with priority over the equity. However, as SHB suggests, if the B piece is "money good" then the value is just the NPV of contractual cash flows (or conversely the return is just the yield to maturity). SHB--I think when SK states "first position" debt he is not referring to the first-loss piece, but the senior/1st mortgage.

In summary, the approach to analyzing discounted subordinated debt is typically to underwrite returns under various scenarios. The two most obvious scenarios are (1) what happens if I get paid off at par? and (2) what happens if the sponsor surrenders the asset and I have to foreclose and/or cure the senior debt?

Note that with debt, the exercise is often less about "valuation" and more about adequacy of returns for a level of risk, and the math is less about discounting future cash flows and more about quantifying risks: what is my last-dollar basis relative to current value? to peak value? to replacement cost? What's my debt yield (NOI / last-dollar basis)? What's my coverage ratio? What's the refi gap if I have to take possession of the property and cure the senior?

 
re-ib-ny:

I would qualify SK's comment by saying that his math is correct if the B piece is impaired and can take title to the asset. Then it is effectively an automatic path to the equity so, as with all equity, the value of the position is the unlevered asset value less the debt with priority over the equity. However, as SHB suggests, if the B piece is "money good" then the value is just the NPV of contractual cash flows (or conversely the return is just the yield to maturity). SHB--I think when SK states "first position" debt he is not referring to the first-loss piece, but the senior/1st mortgage.

In summary, the approach to analyzing discounted subordinated debt is typically to underwrite returns under various scenarios. The two most obvious scenarios are (1) what happens if I get paid off at par? and (2) what happens if the sponsor surrenders the asset and I have to foreclose and/or cure the senior debt?

Note that with debt, the exercise is often less about "valuation" and more about adequacy of returns for a level of risk, and the math is less about discounting future cash flows and more about quantifying risks: what is my last-dollar basis relative to current value? to peak value? to replacement cost? What's my debt yield (NOI / last-dollar basis)? What's my coverage ratio? What's the refi gap if I have to take possession of the property and cure the senior?

Many thanks for your insightful inputs. As you suggested, for debt pieces that can potentially convert into equity positions, it is often more appropriate to analyze them with scenario analysis rather than a sensitivity analysis. Also since we are talking about distressed debt here sometimes it is necessary to consider legal uncertainty and their impacts on the scenario analysis, e.g. what if the legal or political process denies you the right to foreclose or take title of the assets. What are your options then re either continued litigations or attempting to reach some sort of private settlements with the debtor. This is especially the case with many emerging market debt situations but also arises in certain U.S jurisdictions sometimes in light of political/popular opposition or rulings from activist/"liberal" judges. Sometimes those in power just don't sympathize with "vulture" investors who bought their positions at a discount as much as they do with originating lenders. These are much harder to quantify and incorporate into models thou. Just something that the investors need to bear in mind.
Too late for second-guessing Too late to go back to sleep.
 

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