Distressed publicly traded credit - case study help needed!

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Hey guys,

Appreciate if you could help with the below:
I've got a case study to give a recommendation on the publicly traded credit. As the company is in distress - they now trade way below par. How should I approach it?

  1. Is there right or wrong answer? E.g. if leverage falls below 10x then too risky investment. Or is it purely a situation where you need to make your own call?
  2. How to compute IRR?
  3. Should I build 3 statement model?
  4. Should I do LBO/DCF valuations (or that's not relevant for credit)?
  5. What slides should I include in the presentation?

Any tips would be super highly appreciated!

Thanks in advance!

Comments (34)

 
Jul 15, 2020 - 11:03am

I'm just parroting what I've heard from seniors at my bank about the distressed market. Hopefully someone can swoop in with a steel chair and explain where I got it wrong.

It looks like they want you to model the company's debt schedules and answer two key questions.

  1. does the firm have ample liquidity to refi or service its debt at maturity. I've seen credit research where they just build out to excess cash flow, so Im up in the air on whether you need all 3 statements. the LBO and DCF don't seem so helpful on face value since your employer wouldn't be taking an equity position in the firm.

  2. if the firm can't repay, Will the creditors get out and what may happen in the event of a restructuring. if the secured notes are trading in the 80s then there's probably some coverage but I'd do a liquidation analysis to see how your fund would do if the opportunity blows up.

I'm excited to see how other people swing on this question. Hopefully someone like me going through the process in the near future can grab a few tips.

 
Jul 15, 2020 - 12:59pm

I'd look at the comment right below mine.

the way the analysis was explained to me (again, I'm an intern and my word is the farthest thing from law) was that you multiply the values of assets on the balance sheet by some value between 0 and 1 based on the 'quality' of the assets. cash liquidates 1:1 and intangible assets like trademarks being closer to zero. receivables and inventories require some more serious info about the credit worthiness of the receivables and the demand for inventories. once you have the liquidation value of all assets you start distributing them down the capital structure until there are no more assets. If you're a creditor getting 30% of face value in liquidation, that's ok if you paid .20 for the debt.

 
Most Helpful
  • Investment Analyst in HF - Event
Jul 15, 2020 - 12:43pm

Work at a distressed fund and have interned at one as well. My thoughts -

There's no right or wrong answer per se. They just want to see how you think of the opportunity and what your analysis suggests. Just because it's at 25 doesn't mean you should buy. Maybe the assets are crap and you don't want to touch the biz, maybe it's still a bit expensive at current multiples, etc. Or maybe you're right, the assets might be good and the multiple looks good, outlook is decent and covid presents a buying opportunity?

1) You want to figure out what's going one with the company - story, why in trouble, what's the outlook, etc. What is the industry, what are the assets, is this a co you want to own or just move on? What's going on with rest of the cap structure?
2) After you do 1, you will have a better idea to look at certain tranches i.e. maybe just the secureds or if you think the recoveries look good on the unsecureds then maybe that - what does the waterfall look like?
3) what's the creation multiple on the biz - if assets are good, would you be comfortable owning at that multiple, what sort of returns would that generate?
4) What are the risks to your thesis? Is there a catalyst? What's the catalyst for the upside and downside?

I don't know what sort of detailed presentation the fund you're interviewing at wants but you don't need to build a 3 statement model / DCF / LBO. Give historical financials briefly for the important items - revenues, EBIT, EBITDA, interest, etc. for a couple of years, What do the cash flows look like? UFCF and LFCF? What does the debt waterfall look like if this thing blows up (liquidation)? What about at some creation multiple that you would be comfortable with? Main question is - If the assets are good, what price would I be comfortable buying at

Slides I would include - brief overview of biz and industry, what's the story now, historical financials, valuation, risks and catalysts, recommendation

 
  • Analyst 3+ in IB-M&A
Jul 17, 2020 - 8:35am

I have management projection for Revenue and EBITDA (pre IFRS16 as lease heavy) - should I create downside case from that?
Also Management has fiven FCF pre tax and interest - but I cannot replicate it at all ( I don;t know if they project higher capex and lease expenses or negative WC) - therefore not sure how i can build a downside case from that. I was thinking just creating my own FCF projection with my own NWC, capex and lease expense projections and then building downside from there. Do you think that would work?

Also they have several debt instruments - given the interest rate, maturities etc i created debt schedule - to compute interest rate schedule. But it seems wrong - the company is in distress - they might restructure debt, etc. Should I read all OMs on those debts and try to analyse all covenants and predict what they can and cannot do? Seems a little intense for a case study...

Also still have no idea whether I would recommend to buy or sell this debt - all depends if they get new liquidity now. The company also operates in hospitality/aviation industry - hard to predict how that industry will behave as the most impacted by Covid...

 
  • Investment Analyst in HF - Event
Jul 17, 2020 - 9:25am

You can project whatever you want, but the first point is to understand the biz / industry and see what you think of it. If it is actually in distress, do you think it will survive for the next few months? If not, what's the point of projecting numbers for next few years? Just use the numbers in front of you for now I would say. In that case it's just a recovery type situation. You know liquidity levels now and you also can come up with a creation multiple. That's all you need for you to ask is now a good time to get into this biz? Show projections when you lay out financials but don't waste a lot of time on it. It's important to understand the longer term outlook if you think the biz has good assets and can come out of distress. In both cases, it's important to understand how and why the biz got into the situation it is in

Cap structure layout doesn't have to be detailed. Layout the cap structure and then do a simple waterfall to see recoveries as of now. Either with your liquidity (cash + RCF + other stuff) numbers or see what's the creation multiple but basically Q is at what price would you be comfortable buying at if at all it seems interesting What do the downsides look as well? What could it trade down to? For example, I had a case where the biz was valued at 7x and the senior notes were trading at ~85, but I said I would be more comfortable owning at 4x where notes would be trading considerably lower (and thought that would be a better entry point). I just had to justify my answer, which I did using my research on the biz / industry. Another case where I identified that biz had enough liq to pay off front end maturities and not the back dated notes, but front end notes were trading ~60c. Did my research and identified the notes they would pay off first (why waterfall is important) Don't need to make it super complicated for yourself and for your interviewer. Simplicity is key.

With the cap structure layout you should note what's issued at opco / holdco, what's the seniority (1L, 2L, unsecureds), etc. so you know in case of a waterfall who gets paid first, etc. I wouldn't say you need to go through docs to identify covenants but if there are any reports then see if you can find anything obvious

You kind of have a start. You know the biz is in a difficult industry and don't know the recovery on the industry. You're definitely not going to pay a high multiple to buy this biz. What would you be comfortable buying at? I keep repeating it, but that is all you want to answer. Happy to answer any follow ups

 
Jul 19, 2020 - 5:02am

Sorry to hijack but you're clearly knowledgeable about the space. Quick basic question - when dealing with lease obligations (eg rent payments for a retail chain), do you capitalize them and then rank super senior (/ pari?) to any outstanding debt, or is there a more nuanced process?

In addition, how does lease rejection factor into this? Do you usually scour indentures for lease rejection rights? Or is there a different quick-and-dirty treatment?

For simplicity, say you have a business EV = 1000, senior secured = 800, capitalized lease obligations = 500. is recovery on senior secured 62.5 (= (1000 - 500) / 800)), 76.9 (= 1000 / (500 + 800)), or does it depend on language in indenture?

Array
 
Jul 19, 2020 - 5:14am

I think it really depends, but in my experience so far, I have seen lease payments to be junior to all of existing debt tranches unless specified in the inter creditor agreement. If no seniority of lease is specified, then consider it junior most (but above equity)

There's a reason why when firms go bankrupt, they can lobby to the court to reject some of their Unfavorable leases. Never heard any such treatment meted out to debt tranches (ie they'll be restructured or amended but won't be rejected).

Array
 
  • Analyst 3+ in IB-M&A
Jul 19, 2020 - 7:33am

I also read a little on the topic and leases have 0% recovery in liquidation, as the assets are not owned by company. Also in bankruptcy (depending on agreements) believe the lessor will just call back his equipment etc. to stop any losses. Also there must be some clauses in the lease contracts about premature termination...

 
Jul 23, 2020 - 1:30am

In Lev fin, not distressed, but can give insight offline to slide layout, how to layout certain slides (strengths / weaknesses aka risks / mitigants), company at a glance, capital structure, etc.

maybe even thrown you a decent template for cap structure, etc. i can also provide an excel pipeline of deals to filter for comps, altho if distressed, this could be company specific.
And I can definitely see if there are certain documents, including legal docs (credit agreement, 10K), ratings reports, etc. that you are overlooking, to download, and possibly use.

 
Jul 24, 2020 - 4:28am

I would lay it out as follows:
1) Simple intro to the company - what they do and geographic exposure.

2) Recent issues and why the name is stressed - given this is a retail name my guess is margins are falling (due to online pressures and escalating leases) which pressures FCF.

3) Lay out some valuation comps - EV/EBITDA(R) etc to see where players in the industry trade.

4) Capital structure - include lease obligations and any pension obligations. Show the creation multiple based on MV of debt....this ties back into slide 3 and comps

5) Org chart showing where all the debt sits (holdco vs opco)...should be in the IM.

6) Debt maturity profile....when do they need to refinance next and will that be a catalyst.

7) Summary financials - just keep it simple and do Revenue down to EBITDA and cash flow statement from EBITDA down to FCF. Add some credit metrics (ND/EBITDAR, FFO/net debt, RCF/net debt).

8) Estimate the sustainable level of debt for the business. What do you think is the sustainable level of CADS (cash available for debt service) this business can generate and back out the level of gross debt. So if you think CADS is $100 and cost of debt for non-stressed peers is 5%, the company could operate with 100/5% or $2bn of gross debt. If existing debt is $4bn then you know they need to haircut debt by 50%.

9) A simple recovery analysis to quantify downside....typically sr. unsecured recovery is in 20-40% levels.

10) A summary with thoughts on outcomes. "Bonds trade at 70 today and we think recovery is 40 in a restructuring. Upside is company pulls through and bonds get repaid at par (100) so price today (70) is implying a 50%/50% chance of each outcome." Then talk about your thoughts on likely outcomes.

 
  • Analyst 3+ in HF - Event
Jul 27, 2020 - 9:07am

He is essentially assuming a certain interest coverage ratio and backing into the amount of new debt that would yield his ratio with a certain cost of debt. In this case, his coverage is 1.0x ($100mn CADS / ($2bn gross debt * 5% cost of debt). This is no different than assuming a target leverage ratio and arriving at new debt that way.

Yes, you want to look at non-stressed comparables for a sense of where leverage / cost of debt should be, but you also want to create a capital structure that gives the Company flexibility and room to breath. Most businesses that emerge from bankruptcy are still "stressed" in a sense, especially if an operational turnaround is part of the equation. In the above 1.0x example, I would likely conclude that there needs to be less debt as this ratio is not strong enough. CADS is really just a more detailed EBITDA - Capex calculation, so if your starting ratio is 1.0x for interest coverage then the risk is that as EBITDA declines you will need to cut back on capex in order to meet your interest obligations. This creates a viscous cycle where you need to continually cut capex in order to make your interest, but you also cannot really grow yourself out of the problem because of the capex you're cutting. So, I tend to prefer businesses with at least a 1.5x (2.0x+ preferable) CADS ratio or a restructuring plan that can get them there.

 
Jul 27, 2020 - 12:50am
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