Capital Structure Analysis Questions
How do people decide what is attractive in the cap structure? Obviously, you can run expected values of each security, but don't you have to discount it further based on placement in the cap structure. Or are people just running different recovery value scenarios based on probabilities, and finding value that way. Still feel that there should be further discounting comparing lets say an unsecured bond vs. a first lien. You can't just make decisions based on expected value? Appreciate any insights.
What you're describing would certainly work, I'm sure.
Typically, credit investors will calculate LTVs for each tranche of debt from a "detachment" standpoint. For example, we'll take a stance on how much the Company is worth ($1bn), then we'll know that the $100mm revolver represents a 10% LTV at yielding 5.5%. Then the $200mm first lien term loan represents a 30% LTV yielding 6%, then the $200mm 2L represents a 50% loan to value yielding 8%, then the $300mm unsecured bonds represent an 80% LTV yielding 10%.
What this layout will demonstrate is an upward sloping line between risk (LTV) and return (yield). At that point, you're left with two ways to move forward, the first being the most common:
1) Your shop has a cost of capital of 10%+, which means that you're only able to play in the unsecureds in this example. Or your shop is CLO focused and can only buy the term loans. Or there isn't sufficient trading volume in 3 of the 4 tranches of debt, so you're stuck with the bonds. Or your shop is IG only and only invests in 1L risk. So there isn't really all that much analysis.
2) Because of the dynamics described in #1 ^, irregularities come out of the capital structure, where the 2Ls might trade at only a 0.25% yield discount to the unsecureds, but at a 30% LTV discount. Or, comparable Company B has a 2L at the same LTV but that yields more.
Two other dynamics in evaluating the "attractiveness" of a capital structure:
1) Maturity -- depending on your fund structure, some might prefer a higher yielding near-term maturity (with a low MOIC), or some might be more MOIC driven and look at the later maturities.
2) "Doc risk" -- credit documents of certain securities in the capital structure may be more or less prone to the Company being able to screw you over.
Obviously much more than I've written, but getting you pointed towards how credit analysis works.
wow thanks for writing all this up - it makes sense and you explained it very well. Would you learn this stuff in restructuring banking ?
no, you learn this on a desk
In this example, you are saying LTV represents risk. But can't you have two different tranches with the same LTV (is value represented as enterprise value?) but placed in different parts of the capital structure. So it wouldn't be apples to apples when comparing the return / yield?
Let's say EV is 100.
Revolver 10 mm LTV 10% yielding 4%
Loan 20 mm LTV 20% yield 6%
Unsecured 20 mm LTV 20% yielding 8%
Equity 50 mm
Under your methodology, you would go with the unsecured but idk maybe I am obtuse but something seems off.
Right, not how this works, good clarification. In your example, the unsecureds would have an LTV of 50%, not 20%. LTV math in this context is synonymous with "detachment point", where we'd look at *cumulative* debt senior to us in the debt stack (i.e. for the unsecureds to receive any value in a restructuring, we'd need to believe the revolver and loan recover at par).
Very kind. I came from a coverage bank but work at a credit shop, so had to do some "learning on my feet". Lots of former restructuring bankers in my group.
Thank you for explaining. I’m bookmarking this :)
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