RX Interview Question: Structural Subordination
Say we have a HoldCo with $0 in assets and $200 in liabilities ($100 senior debt and $100 junior debt). In addition, that parent has an OpCo with $200 in assets and $200 in liabilities ($100 senior debt and $100 junior debt). The OpCo also has an upstream guarantee for the HoldCo's debt.
What would the debt waterfall look like? Do both of the HoldCo's debt obligations get paid off, or do the senior debt obligations from HoldCo and OpCo get paid off?
Assuming that the senior Holdco notes have a senior guarantee, the Opco and Holdco senior notes would be paid off at par with both junior notes receiving $0.
Opco Assets: $200 minus
Opco Senior Notes and Holdco Senior notes Guarantee: $200
=$0 recovery for the junior debt pieces.
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This is wrong. Dont reply if you don't know the answer. The purpose of the question is literally to test understanding of structural subordination so that might give you a hint that just paying off "senior" debt first is the wrong answer. Order of priority is 1 senior opco debt, 2 junior opco debt, 3 senior holdco debt, then 4 junior holdco debt. Also a guarantee is a weaker claim than a lien.
To expand a bit you also need to consider secured versus unsecured since senior and junior really are incomplete descriptions. If the junior opco debt is unsecured, in bankruptcy it would be pari to all other unsecured claims including the guarantees from the holdco debt unless there is some intercreditor agreement stating the contrary. However, presumably the junior opco debt holders aren't going to allow the holdco debt holders to split proceeds and would demand either a secured claim (2nd lien) or an intercreditor with the holdco debt stating that the opco debt gets priority payment.
You made a mistake and referred to junior opco debt as 2. And 4.
Obviously it's going to come down to the specific debt documents, but a guarantee claim is not by nature subordinated to a direct claim on the company's assets; there is such a thing as a secured guarantee and a subordinated lien. The phrasing seems to apply that all of this debt is unsecured, so there is no lien against the company's assets, just a general claim. A senior guarantee>a junior claim. Many bankruptcy cases where a senior guarantee is getting paid before a subordinated note because each guarantor is jointly and severably liable.
Not sure why this is getting MS'd. The guarantee of holdcos debt by opco is removing the effects of structure. That said, if there are some holdco assets like some residual cash, you could get holdco debt recovering above opco.
Also, more for the benefit of the thread (judging by your other answers, seems like you know this) while it doesn't matter for this problem, would still advise drawing out the balance sheet and taking the intermediate step of allocating pro rata before accounting for subordination. It'll matter if your interviewer decides to change opco/holdco assets or debt sizes.
bump
Maybe wrong here but if the guarantee assumes that the guaranteed liabilities become senior unsecured claims - wouldn't that mean both holdco senior and junior debt get treated equally in receiving value from the opco? Their seniority refers to the order of payment from the issuer, not from the guarantor. So wouldn't the breakdown be holdco senior, opco senior, and opco junior all take pro rata shares from the senior unsecured pool of claims, and then the junior debt come after?
I think for this type of question, it's okay to ask for a little bit more information. The term "junior" isn't enough to answer the question. It implies some level of subordination, but the question is what exactly is everything subordinated to. Moreover, as the question is worded, there's no reason to think that the guarantee of HoldCo's debt by OpCo is subordinated to anything. I also would advise drawing the structure out on a piece of paper with a mini-balance sheet for each entity: Here is how I would answer this question:
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See my reply to his comment. I think he's right and with the numbers in the question, my analysis doesn't matter. That said, put the model into excel for yourself and play with the numbers, you'll see that if you change some of the claim sizes, its not so simple. So people could be MSing his approach to the problem or just not understand it themselves
Questions are as much about thought process as answers. His thought process was not nearly as well thought out as motley's and he may have even made some simplistic assumptions (I would not assume a guarantee is on a senior basis as a starting assumption)
Seems like some misinformation here. I agree with most that you should ask clarification questions. Here are the various permutations of possible correct answers
1) Senior Debt: Could be a 1L or unsecured
2) Junior Debt: Could be a 2L or have an intercreditor agreement that subordinates its to the unsecured senior debt
3) Guarantee: Unsecured or secured by a 1L
In all the instances above, the former seems like a more reasonable assumption in the absence of a clarification. If thats the case then the OpCo debt is likely to recover in full and the HoldCo debt is likely to recover nothing
The later of the above produces a more complicated answer
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