Covered 1L, Impaired 2L Thesis
Can someone explain the mechanics of how a covered 1L, impaired 2L thesis actually plays out?
Say the 1L is trading at 90 and the 2L at 80. Assume $100M of par 1L and $100M of par 2L. The business has $50M of EBITDA, and you believe it’s worth 3x. The 1L should be covered, but what are the steps to get to par?
Do you need to go through an LME, with the 2L equitized to reduce the debt load? Or am I making assumptions that don’t make sense?
Would appreciate any guidance here.
Following
Could play out in a million ways. The process of getting back par isnt a straight forward path.
Loans could trade up due to performance etc. company could refinance 1L, do an out of court or an in court rx.
The view of getting par is a thesis based on your credit analysis.
The company could do a million things theoretically which could all impact your ability to get par. This is why modern day distress and pull to par investing is tricky.
The term covered means it is widely believed (or you have a contrarian view) that the detachment point of the security is covered by underlying enterprise value or assets.
Hopefully that helps. Trying to be simplistic. Happy to expand
Thanks appreciate the response.
Maybe a different way to ask my question: Why is the 1L trading at a discount to par in the first place? Given traditional credit analysis, unless the 2L is a 0, then 1L should be at par. So is there a discount because the in-court/out of court rx could result in impairment on the 1L even if the 2L is not wiped out? Or is just a risk of new debt?
Understand it would be hard to be comprehensive but if you could give me a few buckets to think about that'd be helpful. Thanks again
It’s trading below par because somebody thinks somebody else will sell it at 88. People sell for all sorts of reasons, and sometimes there is no bid. If I’m a $20bn fund, have $10mn of a bond/loan position, and think for whatever reason that this credit will have some problem, then selling at 90/losing $1mn is inconsequential to the fund. These circumstances are a perfect example of Mr. Market: he brings me a bid every day, and I can choose to hit the bid or stay put. After liberation day, some securities traded down ~70pts, some people sold, some people waited a year and got refi’d at par.
Also need to factor in required return for risk. Its covered today at 67% LTV (100/150) and bonds in same sector with same detachment point may have higher coupon (ie. 1L need to be at discount such that YTM is sufficient). Similarly, even if covered it might pain in the ass to enforce and get your money back which can increase required yields
Or there might be binary risks with business etc where EV outcomes are binary
I think you're overcomplicating it but sticking to finance 101: the business is impaired to the point that a creditor has lost 50% of its principal, hence there is a materialized loss from risk that wasn't there/underweighted when both creditors originally underwrote the credit, hence the new risk profile of the company has to be re-adjusted affecting as well the price of the "safest" (ie 1L) instrument considering those are not isolated to the risk-return valuation methodology of any financial asset under the Sun. If you want to exit your position, you need to offer a proper return for the risk the new investor will undertake considering the new credit risk of the business (the IRR or YTM for bonds, but as it is more burocratic to change the terms of the indenture/credit agreement + $$ due to lawyers + no reason for the company to agree to pay a higher interest to increase the YTM, you will sell it at discount).
Besides, the longer the maturity, the higher the chance the business might again suffer some turmoil. They could miss a payment, or the collateral might lose market value, making full principal repayment less certain, etc., which will affect your IRR and hence the entry price other investors will find it acceptable considering the likelihood of such scenarios is higher, so you can't sell it at par / need to offer proper discount to incentivize entry. You can even get more fancy if your firm gathers lots of data and runs a bit more quanty things, they might say that across the database, the likelihood of a firm with such and such traits of repaying par is 60%, hence we need to factor that in a probabilty-weighted valuation of the instrument (or whatever your firm does), despite being somehow confident in getting par on this scenario, we will be willing to bid X price (below 100) to reflect our perceived risk considering the information we have as of today / or the scenarios which we expect will materialize in the following months or years
To answer what should happen to get to par, excluding supply and demand dynamics (e.g., lots of interest to get exposure to this business, hence lots of demand for the instrument, which might push the price beyond what would be rational), the company should remove the causes of the risk. But given the bias against the company due to their default or the new valuation levels, that would not be enough, so the company should probably go one step further and actually improve its risk profile beyond the scenario they had beforehand to remove any biases. To make my point across, imagine the company is currently mimicking the risk of a B+ rated company, when before it was believed to be A. Probably going back to A levels might not make investors comfortable to reach par, but imagine that Apple comes in and says they will guarantee the debt of this company on an irrevocable basis because they are their strategic suppliers or whatever. That's probably not only enough to get to par, but possibly to trade above par if the required YTM is lower (in line with Apple credit risk).
In a nut shell, you need buyer for your piece of paper who thinks it’s worth par. If buyer think there’s risk to that, then it won’t be par. Nowadays unsecured trade at much closer yield to secured than before because of the LME shenanigans that 1L is not really 1L.
I can take a stab, BUT please feel free to correct me if I don’t have the right mentality.
I think everyone else in the thread did a wonderful job describing how to actually position your approach to the situation (what the 1L and 2L prices may indicate and how supply and demand factor in to actually driving difference in returns demanded by a potential buyer).
Zooming out then, if we take your case as given, the mental steps I’d take to discern how to go about an investment in the cap stack here is as follows:
1) Value the business: pure gramm-dodd exercise of finding the fundamental value of business and building an opinion on their drivers. Simply put, let’s imagine you did that and got to a valuation range of 2.5x - 3.5x EBITDA - and we will stick with 3x. In accordance with this you’d build a simple operating model going forward to see how liquidity evolves and whether the current company can deal with its maturities as is.
2) Now layer on capital structure and correlate structure: let’s say that the 1L and 2L sig at the opco level. It’s immediately clear to us that according to OUR own fundamental valuation of the business, the 1L is undervalued and the 2L is overvalued in a frictionless setting. But this assumes that a filing is going to happen, both are equal in temporal seniority, and the coupons are similar (I have seen times when clipping the coupon on an extremely high yielding tranche leads to a strong return despite returning less than cost-basis, but this depends on liquidity!).
3) Consider how the capital structure may change: this is where the analytical sauce is. We already know how far off the business is from filing and how likely that is. So we have one case where the business enters chapter 11 (an easy way to back of the envelope check returns is assume 5% TEV admin expenses and find recoveries). If our valuation of the business is equal to the plan value, the 1L will be covered and 2L will recover 35 cents. Don’t forget too that difference in consideration drives returns profile - just because the 2L gets stuck with “on paper” 35 cent recovery means nothing if distressed investors bidding 2L up actually perceive the recapitalized business to be worth 4.5x, stick the 1L w take back debt and some cash to appease them and abscond w all of the equity, creating the biz at 3x and earning an “immediate” 100% return on multiple expansion alone as the company gets valued post-confirmation at 4.5x on the basis of strong capital structure (immediate is a strong word, but consider this to be a less effort intensive multiple re-rate over a shorter period of time, like 1 year?). But out of court solutions offer companies more than just a filing alternative - learn about the sponsor, the holders/crossholder, dynamics, credit doc permissibility, and any other macro/biz/sector trends that will inform how advisors approach the cap stack. Maybe it’s a maturity issue with the 1L - this could be amended with an increased coupon, tighter docs, and some fees (assuming liquidity is enough to incentivize this). Maybe it’s fundamentally an overleveraged business combined with an impending maturity - this could be dealt with a more comprehensive recap through doc permissibility (do you have a requisite majority in an ad hoc group?). Could be without amending docs - so a double dip new financing or a drop down to unlock incremental capital to deleverage slightly and capture some discount while pushing our maturity profile. Or, if you have majority could be an exchange or an uptier. Think through various cases for where the cap stack may go and different recovery profiles under them, when layered onto a business’ operations and you view on EBITDA + biz quality to info your valuation and assess which tranche has good risk return.
Basically in your case, it’s wild to consider a business valued at 3x with 1L trading at 90 and 2L trading at 80; there is likely lots of optionality baked into the 2L price (so long as your value is close to the market). This may signal that the 2L matures early so it will need to be amended (in real world the 1L tends to have a springer, but we can live in the fantasy). Or the 2L has tighter docs that will need to get dealt with ahead of the 1L maturity because the 1L majority group wants to effectuate an LME and cannot without a waiver from the 2L. Or, maybe the your value of the business is just different from the market - maybe you expect some customer to churn off or some secular decline to hit this biz harder than market expectation. So, all this to say, without maturity profile and liquidity (operating view of simply EBITDA and static liquidity today = unrestricted cash + available revolver draw - outstanding revolver) it’s tough form an accurate view.
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