Distressed Debt - Moyer

I would take a look at the following in deciding which tranche to invest in. Though I do say, in reality it is also a function of your firm/funds return targets as well. A credit fund that is targeting 9-10% IRR is unlikely to invest in the 1st lien tranche given returns wont meet the target. But for the sake of this, lets assume your fund is agnostic 

1) Think about the overall LTV through to the 2nd lien. If the company (and over the cycle, including comps) EV trades at ~8x, you may feel less inclined to invest in the 2nd lien at 6x given the margin of safety and equity collateralization remains slim. Thus, your chance of recovery is threatened. 2nd lien debt is also cov-lite (as is 1st lien these days) so the only chance of enforcement is if there is an event of default due to non-payment or some other breach. At this point, the capital structure may be significantly above >6x NLR, meaning it will be difficult to get your money back. If the business EV trades at ~12-15x EBITDA, than you have much more overcollateralization and thus, have higher margin of safety at the 6x attachment point. Perhaps under this scenario, you can justify investing in the 2nd lien tranche given the equity cushion/protection and ofcourse, the higher return. 

2) Overall credit quality and stability over the cycle, in addition to cash flow coverage. This applies generally, and is all about making sure there is enough FCF to cover debt servicing requirements (i.e. cash interest) through to the 2nd lien. This is not just about financial and CF analysis but also the qualitative dynamics, including the overall base level of earnings and what underpins this. Is it a cyclical sector (where you have seen earnings move drastically over the cycle) or perhaps a sector with competition and overall commoditization? or is it stable with some demonstration of stable margins (showing pricing power and cost control) and earnings/CF generation. If it is the latter, you can probably get comfortable with being in the 2nd lien at 6x. You wouldn't want to be if it isn't. The other important of FCF generation and earnings growth is it helps with deleveraging. You don't want to be in a credit deal for 5 years and be at 6x at the end of it, because it makes refinancing (and exit) significantly more difficult. 

Unfortunately, in optimistic environments like today, bankers can sell 2nd lien at even higher attachment points for cyclical businesses because there is so much liquidity 

3) Comparison of similar 1st/2nd lien deals in the market / traded, and where these trades from a yield and leverage perspective vs. the proposed 1st/2nd lien structure and pricing you have stated. If for example, 1st lien is trading at L+450bps but 2nd lien is L+1000bps for a similar deal, than you may find the 1st lien more attractive and the 2nd lien not. So it is to an extent a function of relative value 

I don't think there is per say a 'breakpoint' where you can put in some input and expect an output. Both unfortunately and fortunately, credit investing (much like most investing) is an art as much it is a science, but with the application of such frameworks.