Hey - I have seen the concept of "value break" analysis tossed around when looking into restructuring. Does anyone have a technical example of this (i.e., with numbers / quick math), or a good explanation of this? I have an interview tomorrow and would greatly appreciate any guidance. I have exhausted Google, the guides, etc.
Many thanks
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Let's say a company in distress or in bankruptcy has 500mm of debt, split up between 300mm secured and 200mm junior debt. Now let's say the enterprise value of the company is 250mm. That means value breaks at the secured debt, since they have claim on the first 300mm of EV, but the company is only worth 250mm of EV. In a strict priority waterfall, secured would recover 83% (250/300), and everyone else would recover 0%.
Thank you - very helpful.
Now, if we layer in multiples / EBITDA assumptions into your analysis:
Debt Structure: * Secured - $300 * Junior - $200
Assumptions * EV / EBITDA Multiple - 15.0x * EBITDA - $50
Enterprise Value: Equity + Debt - Cash * Implied EV = 15 * $50 = $750 * equity value = $750 - $500 + Cash * Assuming Cash = 0, that would imply Equity Value of $250mm
Now, to identify value break:
* In this scenario, would you use the given (or "base") multiple of 15.0x to imply an EV, then calculate the value break from there? * EV = $25 * 15.0x = $375 * Value Breaks at Junior, as Secured has claim to first $300 of value, then Junior to next $75. As such, Secured recovers 100% and Junior recovers 37.5%
* EV = $50 * 8.0x = $400 * Value Breaks at Junior, as Secured has claim to first $300 of value, then Junior to next $100. As such, Secured recovers 100% and Junior recovers 50%
Are these analyses correct?
Thank you!
Yep, both of those are correct.
Wouldn't one technically see a drop in EBITDA, whereby you first make the necessary adjustments (but also see the obvious lack of performance due to the environmental circumstances) and also use the lower end of the multiples spectrum?
Minor correction to your equity formula... EV = Equity + Debt - Cash, so Equity = EV - Debt + Cash. Doesn't impact your numbers since you assumed cash = 0 though.
One other point to consider - while technically your math is all correct, in real world restructuring transactions, each group of security holders will form a group that will have its own legal and financial advisers. Each group will argue for a valuation that leaves that class of securities unimpaired (i.e. the senior lenders will argue there is barely enough value to pay them back, while the equityholders will argue there is plenty of long-term value in the business and they should only have to take a small haircut on their position). The various groups should eventually reach a consensus on a valuation range (sometimes this gets litigated in front of a judge if they can't come to an agreement), and the point in the capital structure at which the "value breaks" is called the fulcrum security. The holders of the fulcrum security may end up getting some recovery in a mix of cash and equity (or just equity), and while theoretically everyone below that point in the capstructure should get 0, in practice everyone may agree to throw a bone to the more impaired classes to make the process move along faster (as restructurings can be very expensive and time consuming).
For example, I was involved in a recent transaction where the second lien debt was the fulcrum security; the first lien ("1L") lenders got repaid in full, the 2L holders ended up receiving a mix of secured notes in the post-restructuring company and 85% of the new equity, and the unsecured noteholders (who in theory should have gotten 0) ended up with 12.5% of the new equity. The equityholders themselves (who definitely should have gotten 0 since they were so far out of the money at this point) got 2.5% of the new equity + a bunch of way out of the money options worth up to another 30% of the company (but only if the stock price effectively doubled after restructuring). By structuring it this way, the entire bankruptcy was resolved in 6 months (whereas it could have taken 2+ years given this was a $5bn company), and from the perspective of the 2L holders they gave up 15% of the equity in exchange for more protection (since they got a mix of debt and equity). Also, everybody wins when restructurings move along quickly this way, since a few months in bankruptcy can cost $100mm+ due to hundreds of advisers being involved representing multiple parties.
This is extremely helpful - thanks for your input. I like how you incorporated your experience to further your example.
Since you said you had an interview:
One of the most common restructuring questions is "how much would the equity be trading at?" when they're out of the money i.e. value breaks in a creditor class more senior to the equity holders in the capital structure. In theory, the equity should be trading at 0 because there's no value left for them, but in actuality, the equity will still be trading at a few dollars/cents (depending on the situation) because they'll sometimes receive an equity tip once the bankruptcy is resolved - ala @NuckFut's example above.
This idea is known as option value, i.e. the equity is a call option on the value of the firm. Hence, when asked the above question, answer: "the equity will be trading at a very steep discount, anywhere from ~2%-10% of pre-bankruptcy value, due to the option value that equity holders will receive a tip once the bankruptcy is settled. Therefore, equity will almost always be trading above 0 even when it's technically out of the money."
The option value isn't just from the possibility of an equity tip. Since equity has unlimited upside, there's always a chance that the firm turns around and equity is worth a lot, so the equity will still trade at low prices to reflect this. Debt, on the other hand, is capped at face value, so option value is there to a much lesser extent. That said, out of the money debt still has some option value, it just isn't' infinite.
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