Equity Cushion
Hi,
if the Enterprise Value of a business deteriorates, is it always Equity (Value) that depletes first or does debt loose its value simultaneously?
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It’s both.
As the business deteriorates, the yield required on its debt to be properly paid for the risk of holding increases. Higher yield means the price of the paper falls.
I read a passage from a book where they said that e.g. 40% equity contribution in an lbo would serve as a cushion for investors as enterprise value would have to decline by more than 40% before their principal might be jeopardized.
Theoretically, that is correct. In practice, the debt will trade lower (yields will increase) as the company's financial health deteriorates. That being said, these are "paper losses" for the debt holders, and if it goes through a bankruptcy the debt could end up trading back at par if only the equity cushion is impaired.
In other words, this is largely a theoretical vs practical application. In general, creditors see having a large equity cushion as a credit positive, but the debt will also move even if the principal isn't technically impaired.
Thanks!
From a quant's/academic's perspective a lot of factors, like interest rates and volatility of the underlying business are also at play. Think of the debt as being short a put and the equity as being long a call at a certain strike price.
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