Creation Multiple for Distressed Businesses with Multiple Tranches of Debt at Different Prices
Hey all - I just joined a relval IG hedge fund out of college and trying to learn more about distressed securities. Say you have a company with $1000 of secured debt (term loan at 95c) and $3000 of unsecured debt (three tranches of bonds - $1000 due 2025 at 95c, $1500 due 2027 at 85c, $500 due 2031 at 60c) and $100 of cash. Assume $500 EBITDA.
How would you quote the creation value of buying the 2031 bonds at 60c - (1) using the SUMPRODUCT (three tranches * each price) or (2) total of the pari securities ($3000 of bonds) * bond you purchased's actual price?
In the above example:
- (1000 * 100% + (1000*95% + 1500*85% + 500*60%) - 100 cash)/500 = 6.9x creation
- (1000 * 100% + (1000+1500+500)*60% - 100 cash)/500 = 5.4x creation
Separately - what methods do distressed investors typically use to quantifiably measure when purchasing a bond at 40c vs. 50c vs. 60c vs. 70c vs. 80c makes sense or doesn't make sense? Let's ignore a distressed HF's prowess around trading quarters or ability to identify catalysts that the market isn't appreciating (which i know matter way more than some mathematical exercise). Say the distressed analyst started looking at the above cap structure when the 2031 bonds were at 70c (with a 6% coupon = 12% YTM) and the analyst has to come up with "I would buy this tranche at X price" to their PM.
What quantifiable analyses and metrics would the analyst run to inform which price they would enter at vs. sell at for the lower dollar price long bonds. Creation multiple (not just today but also in future 1-2 year forward period where potentially the 2025s bonds are getting refinanced with secured or priming debt) is one of them, hence my question on proper methodology. Utilizing yield / relative value metrics on a clearly challenged/distressed business where the long-end bonds start to yield over 15%+ (those 2031 bonds go to 60c = 15%, 50c = 18%) seems a little less relevant vs. more nuanced distressed analyses. Would appreciate any pointers here on how to evaluate entry and exit price targets on bonds trading significantly below par at distressed yields.
Lots to unpack here...
Your first question on creation multiple...the correct answer is your second example. If you purchase a pari security at 60 cents then you are effectively creating the business at that value as if applied to the entire tranche. From a practical, day to day perspective, I will show the price adjusted, market multiple through each tranche in my cap structure tables using your first example. The price of pari securities will converge (curve flattens), within a margin, once the issuer becomes distressed and a restructuring is priced in - i.e., a credit event has occurred, not just the business is stressed. The market is not pricing in real distress in your pricing example which is why you have the question between method 1 vs. 2. There is merit to looking at creation multiples but it is hardly the end all be all...have seen folks get blown up on "cheap create" theses so many times. You also need to have a view on the liquidity bridge of a company...for example, bonds at 40 cents may imply a 5x creation multiple and look "cheap", but if the company is running out of money you could easily see 2x of new money come in on a super priority basis and turn your 5x to 7x and your bond is now worth zero. But, cheap create!
It is hard to answer your second question of "how would an analyst decide to buy at X price, ignoring quarters and catalysts" because those can each be important legs of a thesis that will inform buy / sell decisions. Sidebar, I don't know any distressed hedge funds that are great at trading quarters; you're not going to be able to swing many stressed / distressed positions around, aside from on the margin, trading quarters.
But to be more specific, in a true distressed situation I would build a recommendation around 1) recovery price, 2) form of consideration, and 3) timing / other administrative matters. Recovery price is equal to the value equivalent I expect to receive on my security; a security trading at 50 cents that I think is worth 70 is a good start and may be a compelling enough reason to do more work. Form of consideration is how your recovery value is paid to you. In a restructuring, you can get three things in exchange for your claim: 1) cash, 2) takeback debt, or 3) reorganized equity and it will often be a package with multiple pieces, particularly so the lower in the capital structure you are or complicated the situation. To get a sense for where this shakes out you need to run a pro forma restructuring model and get a sense for what exit capital structure will be built around your reorganized enterprise value and more importantly how the market will price each new security. Cash is easy, it is worth 100 cents. Maybe a bit less if you take a PV approach. Takeback debt will have its own coupon, maturity, and par value and you will price it with a relative value approach. If the professionals have done their job and not overlevered the company out of the gate this security should trade at par, but quite often it will not. For example, say you are long a bond at 50 cents due to recover 55 cents in the plan of reorganization via a mix of 25 cents in cash and 30 cents in takeback debt with a 10% coupon and five year maturity. The creation price of your takeback debt is 83 cents (50 - 25 = 25 / 30 = 83.33) with a 15% YTM. If the company will have high leverage, continued cash burn, or some other negative credit aspect post-restructuring the package may actually be efficiently priced at 50 cents because the market thinks the credit risk is worth a 15% YTM, not 10% YTM which would value the instrument at par. This gets even more nuanced once you factor in reorganized equity. Lets add on to the above example and say that, everything else remaining equal (cash and debt considerations) the bond will on paper recover 70 cents with the remaining 15 cents coming in the form of new, reorganized equity in the company. This is easy to value because at 50 cents, less cash and the value of the takeback debt you are creating the new equity for free. This may be the market saying the equity is worthless and the company is a chapter 22 candidate, but you may consider it to be an attractive investment opportunity because 1) you are getting 50% of your basis out via cash (25 cents on 50 cent purchase), 2) a 15% YTM may be an attractive on a relative value basis; takeback debt typically features strong, creditor friendly covenants with incentive to refinance early, plus, at the implied 83 cent creation price you will earn a 12% current yield (10% / 83) and can benefit from price appreciation, and 3) you effectively have a free, embeded equity option (although it may be illiquid and valued at a discount for a reason). Timing and other administrative aspects are also important...how long you expect a restructuring or process to last can impact your IRR and also erode total return as the longer things take to play out the more at risk your credit is from value leakage, most often to advisors and other constituents. I also care about whether my security is secured vs. unsecured, new money dynamics, potential creditor on creditor violence dynamics, who the true fulcrum is, ability to build a meaningful position, and ability to be "at the table" and on the steering committee / ad hoc group. Just to highlight a few of those...say you have a reorganized EV worth 250 against 200 secured debt and 400 unsecured debt. The secured debt recovers 100 cents and unsecured debt recovers 12.5 cents...the fulcrum security in the true classic sense is the unsecured debt because that is where value breaks, but I would argue the secured debt is the true fulcrum as that class will almost definitely walk away with the controlling equity stake in the business and in fact will likely try to "cram down" the unsecured class with a marginal recovery. If there is no liquidity in a situation and you cannot build a position then it is almost definitely a waste of time to work on because it is not executable. The price you see on bloomberg may not actually be the price you can buy bonds at, and in fact may not be close at all, so you need to have flexibility and a range of prices at which you care to be involved. This relates to your point above where you have three bonds of different sizes all trading at different prices but still within the same tranche; your distressed hedge fund might be buying across all three bonds depending on where the liquidity is and view them all as effectively one position with a weighted basis. You might need to pay up and buy more of the highest priced bond if that is all that is available and you need more bonds to build a controlling position within the tranche.
Frankly, I find the math to be the easy part and I think most others would agree. I certainly don't think I've made money in distressed by having the most correct valuation model. I have definitely lost money in distressed by getting too nuanced in my restructuring models and missing the forest for the trees - i.e., it is and always will be a terrible company. You ask about how to quantify the trade...there are things you can do like the above, but a lot of it comes down to qualitative, game theory-based aspects which you can't really quantify.
All of the above assumes that the company is already in a restructuring and the market has priced securities on a recovery value basis. The reality is that the market will continue pricing securities of a stressed issuer on a relative value basis until it becomes a foregone conclusion a restructuring will take place. From that perspective it does make sense to keep your relative value hat on when devising trading strategies. For example, you might have a bond trading at a 15% YTM with a price that you think is below the ultimate recovery value, but that bond could continue trading lower to 18% or 20% if, for example, the issuer did something like an amend & extend with senior lenders that kicks the can down the road without actually solving the problem. And then, the next thing you know a window to get a comprehensive restructuring done is missed, the business continues to deteriorate and now your EV is worth substantially less and recovery values are down across the capital structure. So you really do need to have a catalyst in mind, in my opinion. Having said all that, I think that each shop probably approaches your questions in similar but different ways. I know some distressed guys that couldn't care the slightest above relative value.
Hope that is helpful.
Tranches are diff maturities even if pari. So wouldn’t #1 make more sense? They also trade differently. I’m not a distressed guy but have thought of creation multiple as effectively exposure of last dollar through where you are creating your security. Hi would tenor and hold duration play in here.
I don't think #1 is correct because the price you pay for a bond is your creation price of the tranche regardless of where it sits in the maturity wall, it is not a "weighted" multiple. The nuance here is how things trade when the credit is performing vs. distressed. Taking the #1 example, if I purchased the 2025 bond at 95 cents I am effectively betting these bonds will be refinanced / solved and so I am paying a premium vs. the 2031 bond at 60 cents; the creation multiple is less relevant here because I am not maximizing my trade for recovery value. If a credit event were to occur prior to the 2025 maturity and the credit became distressed then the prices of all bonds in the tranche would converge to their recovery value - the curve flattens and creation multiple is more relevant. One might short the 2025s and go long the 2031s to express this view. If I were "stuck" in the 2025 bonds at 95 cents in this case, then my creation multiple is still the tranche value x 95 cents.
The 2025 bonds trade better in this example because they have what is called "temporal seniority" vs. other bonds in the tranche. Temporal seniority is provided by their earlier maturity date vs. the rest of the bonds; effectively, these bonds have cash flow priority ahead of other bonds in the tranche, so long as the credit is performing, because they have an earlier contractual maturity date. If the first example were a live situation and the credit was stressed, the company would primarily be negotiating with 2025 bondholders, not the others (so long as they continued paying interest to the 2027s and 2031s). However, the 2025 bonds are still pari with the others so if negotiations fell apart and the probability of an in court restructuring increased the price of those bonds would fall. For a real example, this is what happened with CommScope's 2025 bonds recently.
Duration can also create interesting trading dynamics. Lets say the 2027 bond has a 10% coupon and the 2031 bond has a 5% coupon. At prices of 85 and 60 cents, respectively, this would create YTMs of 15% and 13% for each. This is interesting because the 2031 bond would be trading at a tighter YTM than the 2027 bond which seems inconsistent with what this credits curve should look like; one might argue that the 2031 bond should be trading closer to a 17.5% or 20% YTM. In this case, you might find the market "pays up" on a yield basis for the 2031 bond because the 60 cent purchase price is attractive relative to where ultimate recovery value might be. If this bond were priced between 17.5% - 20% the dollar price would be between 41 and 47 cents, a level at which even the most bearish analyst on the credit may argue a silly level of downside protection exists and to sell the bond at that level would be providing free money to the buyer. So, the bond hangs out at 60 cents despite offering a lower yield than the middle of the curve. This exists just given the way bond math works.
Voluptates nulla exercitationem beatae enim ut nisi sed. Ipsum doloremque voluptatem voluptas aut iste sed voluptate. Atque debitis nesciunt in maiores nihil et culpa. Dolores voluptates blanditiis eveniet quos culpa. Et voluptatem dolor a perferendis vel iure. Facilis tempora odio et fugit optio nesciunt dolores tempore. Fugiat eveniet officia non est.
Ut perspiciatis iusto odit nostrum voluptatibus. Veniam labore aspernatur eos consectetur quia unde cumque qui. Laudantium voluptates deserunt iusto omnis ipsam omnis.
Eveniet in molestias perferendis. Repellendus aliquid et iusto. Eum sed qui qui quia neque iusto. Ducimus laboriosam impedit qui sit natus rerum exercitationem. Id veniam expedita tenetur tenetur. Porro unde ipsum ut adipisci ipsa minus placeat.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...