Distressed Debt Hedge Funds

wildwestderivative:

WSO, what exactly do they mean when they say "fulcrum security"? The last security in the cap structure to get any value in a restructuring/liquidation scenario?

yes, so for example, if you think there are enough assets that only the common woudl get wiped out and some unsecured bonds would still be worth 100 cents on the dollar. so lets say you have some secured secured debt that is trading at 85 cents on the dollar and some unsecured debt that is trading at 10 cents on the dollar, but you run your analysis and see no way (even in a liquidation scenario, for example) that the senior secured debt would not get paid out at 100 cents, then you'd go long the senior secured paper since the unsecured/ junior debt is likley to convert to equity, not the senior secured.

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frgna:

I thought an illustration might illuminate things a little more. Anyone please feel free to chime in on this, I've been out of the restructuring advisory game for a bit now so my gears might be rusty.

Say Steinway Piano Co. had a cap structure of $500 mm sr secured debt, $250 mm unsecured subordinated debt, and then $250 mm of equity trading on Nasdaq (making these numbers up). Assume no cash for now. Prior to bankruptcy in the good old days when Pluto was still a planet and people bought awesome pianos, Steinway made $100 mm EBITDA and traded at 10x EBITDA. TEV = $1,000 mm. Equity = $1,000 - $500 - $250 = $250 mm.

Things go bad and they file and spend time in ch. 11 bankruptcy, shut down several plants, and scale back ops but there's still a good market for pianos so liquidation (ch. 7) makes no sense and the company can go on and make value, just not in as big a way and certainly not enough to pay its creditors in full. The restructuring plan filed with the Southern District of NY bankruptcy court lays out projected representative EBITDA at $65 mm, and we still assume 10x EBITDA. TEV = $650 mm.

Legally in the US under the doctrine of 'absolute priority' the sr secured would get paid in full, and the remaining $150 of value goes to pay the $250 claim of sub debt (60% recovery) and the old equity will get wiped out. Sub debt is the 'fulcrum' as they are not getting paid in full. In practice, old equity holders have some 'nuisance value' (this could be any other security beyond where value 'runs out' - consider a case where EV is so low that sr secured is impaired, then both sub and eq will have nuisance value) and will typically get paid out a little shred of the newco equity or maybe some out of the money warrants for their efforts. This is where you might see a contested valuation where equity committees form and put together (likely) trumped up valuations that provide value to the old equity (think high growth, high multiples, low WACCs, etc) and get experts on the stand to attest to said valuations - this is where the sub debts bankers get to have fun by ripping apart the equity committee's valuation methods.

Again in practice the lawyers and bankers for each security will work something out, which is when you see a consensual resolution. There are manners and important relationships at stake here after all (the restructuring advisory world is quite small).

For a new capital structure you need to figure out what debt the new company can hold. Assume the $65 million of EBITDA is valid and 5x debt/EBITDA leverage (you need to look at industry comps to see what leverage/metrics are appropriate for the rating you are targeting, as well as recent financings to assess the viability of raising the money - could also be many other things than debt/EBITDA that determine debt capacity, e.g. pension catchup requirements and other liabilities etc.), so $325 mm. You have $650 mm of TEV to distribute, half will be newco debt and half newco equity. Old senior debt receives $325 mm of value in the form of reinstated debt, and $175 mm in newco equity (100% recovery). Old sub debt receives the remaining $150 mm of newco equity (60% recovery).

Old equity technically should get nothing, but if they do it likely comes out of the fulcrum's hide and maybe other parties - this is why you still see equity trading above zero throughout the course of a restructuring. Restructuring advisors typically keep a 'tip study' which documents what out of the money securities in different cases get as 'tips' (i.e. nuisance payouts/non-absolute priority payments). In my experience it's usually pretty low but of course it varies case to case. There's no set rule despite some less sophisticated people (yes, even some HF investors) saying 'you get 5% of newco equity just for showing up, right?' Wrong...

Of course there are several other things that affect recoveries - DIP financing fees/repayment, advisor fees (esp. lawyers, and especially Sidley Austin...), changes in business prospects/tax treatments (see Smurfit Stone's black liquor tax credit for a very interesting one), position in the capital structure/org tree, intercompany claims, unencumbered assets, deficiency claims, management incentive plan packages, and on and on.

Summary: lay out the old claims, figure out the new value, find the fulcrum, figure out the new cap structure, apply to old claims, and calc recoveries.

Hope that is helpful! Let me know if you have any questions and feel free to PM.

frgna

LOL at Sidley Austin. I actually know quite a few attorneys there, didn't realize that they are more expensive than other restructuring lawyers. Have you read Distressed Investing by Martin Whitman of Third Avenue? It is a good book that covers all aspects of the distressed investing and reorganization process within the U.S legal framework.

Seeing that how the restructuring process takes place is completely dependent on the laws in the jurisdiction where it takes place, I wish I could find a book that deals with distressed investing in Asia, and Mainland China in particular.

frgna:

I thought an illustration might illuminate things a little more. Anyone please feel free to chime in on this, I've been out of the restructuring advisory game for a bit now so my gears might be rusty.

Say Steinway Piano Co. had a cap structure of $500 mm sr secured debt, $250 mm unsecured subordinated debt, and then $250 mm of equity trading on Nasdaq (making these numbers up). Assume no cash for now. Prior to bankruptcy in the good old days when Pluto was still a planet and people bought awesome pianos, Steinway made $100 mm EBITDA and traded at 10x EBITDA. TEV = $1,000 mm. Equity = $1,000 - $500 - $250 = $250 mm.

Things go bad and they file and spend time in ch. 11 bankruptcy, shut down several plants, and scale back ops but there's still a good market for pianos so liquidation (ch. 7) makes no sense and the company can go on and make value, just not in as big a way and certainly not enough to pay its creditors in full. The restructuring plan filed with the Southern District of NY bankruptcy court lays out projected representative EBITDA at $65 mm, and we still assume 10x EBITDA. TEV = $650 mm.

Legally in the US under the doctrine of 'absolute priority' the sr secured would get paid in full, and the remaining $150 of value goes to pay the $250 claim of sub debt (60% recovery) and the old equity will get wiped out. Sub debt is the 'fulcrum' as they are not getting paid in full. In practice, old equity holders have some 'nuisance value' (this could be any other security beyond where value 'runs out' - consider a case where EV is so low that sr secured is impaired, then both sub and eq will have nuisance value) and will typically get paid out a little shred of the newco equity or maybe some out of the money warrants for their efforts. This is where you might see a contested valuation where equity committees form and put together (likely) trumped up valuations that provide value to the old equity (think high growth, high multiples, low WACCs, etc) and get experts on the stand to attest to said valuations - this is where the sub debts bankers get to have fun by ripping apart the equity committee's valuation methods.

Again in practice the lawyers and bankers for each security will work something out, which is when you see a consensual resolution. There are manners and important relationships at stake here after all (the restructuring advisory world is quite small).

For a new capital structure you need to figure out what debt the new company can hold. Assume the $65 million of EBITDA is valid and 5x debt/EBITDA leverage (you need to look at industry comps to see what leverage/metrics are appropriate for the rating you are targeting, as well as recent financings to assess the viability of raising the money - could also be many other things than debt/EBITDA that determine debt capacity, e.g. pension catchup requirements and other liabilities etc.), so $325 mm. You have $650 mm of TEV to distribute, half will be newco debt and half newco equity. Old senior debt receives $325 mm of value in the form of reinstated debt, and $175 mm in newco equity (100% recovery). Old sub debt receives the remaining $150 mm of newco equity (60% recovery).

Old equity technically should get nothing, but if they do it likely comes out of the fulcrum's hide and maybe other parties - this is why you still see equity trading above zero throughout the course of a restructuring. Restructuring advisors typically keep a 'tip study' which documents what out of the money securities in different cases get as 'tips' (i.e. nuisance payouts/non-absolute priority payments). In my experience it's usually pretty low but of course it varies case to case. There's no set rule despite some less sophisticated people (yes, even some HF investors) saying 'you get 5% of newco equity just for showing up, right?' Wrong...

Of course there are several other things that affect recoveries - DIP financing fees/repayment, advisor fees (esp. lawyers, and especially Sidley Austin...), changes in business prospects/tax treatments (see Smurfit Stone's black liquor tax credit for a very interesting one), position in the capital structure/org tree, intercompany claims, unencumbered assets, deficiency claims, management incentive plan packages, and on and on.

Summary: lay out the old claims, figure out the new value, find the fulcrum, figure out the new cap structure, apply to old claims, and calc recoveries.

Hope that is helpful! Let me know if you have any questions and feel free to PM.

frgna

Great synopsis. I've long held an interest in leaning more about restructuring and your description was excellent. Thanks for sharing! If I had any SBs left, I'd give you one.