Locating the fulcrum security

Hi Everyone,

I'm trying to understand how to find the fulcrum security for a distressed company and unsure where it is. I'm doing this for a PE distressed debt fund that wants to take ownership of the firm after bankruptcy.

I understand the more senior debt holders get paid in full and the next tranche after that would get equity but what is considered a asset that is given to senior debt holders? I thought maybe it was all the assets of the firms but then the equity would be meaningless because the company would not be a going concern. If the company is a going to remain in operation what do the senior debt holders actually get that wouldn't destroy the firm?

or am I taking the complete wrong approach to figure out the fulcrum security?

Thanks!

btw, been lurking here for months and this is my first post so be nice and sorry if I put this in the wrong section/tag or anything.

Region

Comments (3)

 
Best Response
Aug 29, 2012 - 10:11am

You come with questions that are not really easy to answer without a detailed example... So let's start by defining what the fulcrum security is. It's essentially the most senior security that will be impaired (not receive a full recovery), thus likely ending up with the most equity in the restructured firm. It is also important to note that many times the fulcrum security holders will significant leverage over the approval of the debtor's restructuring plan, allowing for cram-downs, etc. This is beyond the scope of your question.

Let's take this simple example. Company X has taken on too much debt and needs to be restructured. The debt totals $100 and is broken down as follows: $50 bank loan, $25 senior secured notes, and $25 subordinated notes. We decided that the new company is worth only $70 and the new capital structure will consist of $60 debt and $10 equity. The idea here is that we have now only $70 to distribute to the creditors. To keep things very very simple, we can say that that the bank loan will receive $50 (full recovery) of the $60 of available debt. There is now $20 left for distribution ($70 - $50). This entire amount will go to the senior secured notes because they are owed $25 and there is only $20 left for distribution. Thus, the senior notes receive $20 back, $10 in debt and $10 in equity. There is nothing left for the subordinated notes.

In this overly-simplistic example the senior notes are the fulcrum security, and have come out of this situation controlling all of the equity. There are many moving parts in a restructuring and in many cases a senior class may give up something to a lower class in order to get a deal done. Point is, to identify the fulcrum security you would want to (1) value to value the company, (2) figure out its new capital structure, which is typically done by a few simple debt capacity calculations, and (3) using the waterfall methodology above, apply it to all creditors. It will be clear which is the fulcrum at this point.

Hope that was helpful... Again, keep in mind this was a simplified example of a very complex process.

 
Aug 29, 2012 - 10:39am

oR3DL1N3o:
You come with questions that are not really easy to answer without a detailed example... So let's start by defining what the fulcrum security is. It's essentially the most senior security that will be impaired (not receive a full recovery), thus likely ending up with the most equity in the restructured firm. It is also important to note that many times the fulcrum security holders will significant leverage over the approval of the debtor's restructuring plan, allowing for cram-downs, etc. This is beyond the scope of your question.

Let's take this simple example. Company X has taken on too much debt and needs to be restructured. The debt totals $100 and is broken down as follows: $50 bank loan, $25 senior secured notes, and $25 subordinated notes. We decided that the new company is worth only $70 and the new capital structure will consist of $60 debt and $10 equity. The idea here is that we have now only $70 to distribute to the creditors. To keep things very very simple, we can say that that the bank loan will receive $50 (full recovery) of the $60 of available debt. There is now $20 left for distribution ($70 - $50). This entire amount will go to the senior secured notes because they are owed $25 and there is only $20 left for distribution. Thus, the senior notes receive $20 back, $10 in debt and $10 in equity. There is nothing left for the subordinated notes.

In this overly-simplistic example the senior notes are the fulcrum security, and have come out of this situation controlling all of the equity. There are many moving parts in a restructuring and in many cases a senior class may give up something to a lower class in order to get a deal done. Point is, to identify the fulcrum security you would want to (1) value to value the company, (2) figure out its new capital structure, which is typically done by a few simple debt capacity calculations, and (3) using the waterfall methodology above, apply it to all creditors. It will be clear which is the fulcrum at this point.

Hope that was helpful... Again, keep in mind this was a simplified example of a very complex process.

great answer - SB

 
Aug 29, 2012 - 10:22am
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