 Introduction

o 439 firms with assets over $100M went declared bankruptcy from 1999 to 2002
 Some of them it was their 3rd time
 3 bankruptcies = “Chapter 33s” -> Chapter 11 x 3
 What is Distressed Debt?
o No universal definition
o You can judge based on credit rating
o BBB and above = investment grade
o BB and below = non-investment grade (“speculative grade”, “junk”)
o These ratings are limited because they do not say anything about the trading value of the
bond, and they lag behind major credit developments
o Martin Fridson Definition of Distressed Debt = “debt trading with a YTM of greater than
1000 basis points more than the comparable underlying treasury security”
 Relies on Efficient Market Hypothesis reflecting all available credit information
 Any debt security with a YTM over 10% of the appropriate underlying security is
distressed under this definition
o 1000 is not always the correct number, 487 bp above has been speculative before
o How we define distressed in this book:
 Equity is diminimus = stock trades at under $1 per share
 All or some portion of the unsecured debt will be trading at a market discount of
more than 40%
o You don’t really care about equity in distressed situations because it’s usually worthless
 Investing in Distressed Debt
o 4 Reasons Why Distressed Debt is Not Practical for Individual Investors
 1. Significant risk of loss
 2. Professional participants have significant information advantages
 3. Distressed securities market is illiquid (high transaction costs for individuals
investing on a modest scale)
 Even harder to earn desired return
 4. Size of average trading unit or block is so large that you cannot diversify your
portfolio unless you are mega wealthy
 This type of investment requires diversification
o If you are wealthy and want to invest in distressed debt, go through a professionally
managed vehicle like a hedge fund
o When a company restructures their balance sheet, investment opportunities arise
 This is a key aspect of investing in distressed situations
 The Distressed Debt Investment Opportunity
o Bankruptcies are a good thing for distressed investors
o Default is not just bankruptcies
 Default = bankruptcies, payment defaults, forced exchanges and other events
o There are tons of near distressed opportunities that never become “official” but manipulate
the share price causing opportunity
o Default Rate = # (or $) Defaults / $ Rated Debt Outstanding
 o Fallen Angel = an investment grade rated firm that becomes speculative grade
 Mostly BBB that fell to BB
 They usually fall, improve, and get back up to BBB
 When a firm is demoted to speculative, investment grade asset managers are
required to sell, pushing down the price to sell below fair value, magnifying losses
 “Technical Overselling” can lead to forced buying by BB-oriented managers
o Could represent an attractive time for non-investment grade
managers to buy, unless the firm does not recover and instead
becomes a dead angel
o Dead Angel = firm that fell from investment grade past speculative to default in one year
 Precursors to Default
o Determinants of Default Rate:
 1. Economic Performance
 Sustained periods of economic weakness are a cause of financial distress
 Low demand for goods and services, low units and/or price growth, lower
cash flow
 There is a correlation between default rates and industrial production
 2. Relative Quantity of Low-Rated Bonds
 Correlation between the amount of low-rated bonds (B or less) and future
defaults
 Lower rated bonds have a higher probability of default, so the relatively
greater the amount outstanding, the relatively greater the amount of
defaulted debt that should be expected
 View default rates as a relative frequency table indicating the probability of
default for that particular rating level
 C level is artificially higher because rating agencies demote companies going
into distressed situations from a mile away
o “Adverse selection”
 2 ways the quantity of low-rated bonds can increase
o 1. Downgrades
 Negative ratings outlooks indicate possibility of future
distress
o 2. New Issuances
 Periods of negative fund flows correlate with declines in
issuance volume
 Supply and demand, but demand determines supply here
 Money flows into funds, portfolio managers need to
put it in something, so investment bankers
manufacture new bonds by finding people who
need capital
 When fund flows decline, so does demand
 Essentially, if you want to forecast future periods of distress, look at trends
in new issuances and rating migrations
  3. Capital Markets Liquidity
 Correlation between default rates and the relative ability of speculative-
grade quality companies to access the capital markets
 Many times, companies default because they cannot make their interest
payments
o One way they go about fixing this is by refinancing their obligations
(securing new debt at a more favorable rate and using the proceeds
to eliminate the existing obligation)
o Sometimes, the markets will be unreceptive to distressed company
seeking additional capital, which, in-turn, causes them to default
 These firms (even though they are distressed) would normally be able to
raise these “emergency” funds, but for some reason the market is not
willing to invest in the high-yield securities these firms need to refinance
their obligations
 **Yield Spread: the difference between the yield or expected investment return on a given bond
and the yield for a similar-maturity U.S. Treasury Note**
o “Cost of Credit Risk” to an issuer
o “Fee Paid to Assume Credit Risk” for investor
o This spread is the required return demanded by investors over the risk-free return offered
by Treasury securities
 The equity markets also play a significant role, because sometimes
distressed companies raise funds through a stock issuance to make their
interest payments
 Market Conditions that Permit Superior Returns
o The market for distressed securities is less efficient than other markets
 This allows skilled investors to earn superior risk-adjusted returns
o Efficient Market Hypothesis (EMT): trading prices reflect all known and available
information, so no investor can consistently outperform the market
 Simply a hypothesis or a testable statistical assertion about the stock market
 Strong Form -> reflects all available information (disputed)
 Semi-Strong Form -> reflects all publicly available information (accepted)
 If a market is perfectly efficient, knowledge and skill are irrelevant
 If a market has inefficiencies, then superior investor can enjoy superior performance
 3 Key Assumptions of the EMT
 1. Equal Access to Information
o All investors have access to all available information
o There is so much media coverage and technology tracking abilities
built into the equities market that information is built into what you
see on the tickers
o Distressed markets do not have this type of attention
 Hundreds of small high-yield bond issuers that have no
analyst coverage
  Most distressed trades are conducted privately in the OTC
market, and prices are not disseminated to the public
 These high-yield issuers often have no equity and a small
number of debt holders, so there are no reporting
standards
o When a public company goes into Ch. 11, they discontinue SEC
reporting, so it is hard to make a current operating model for a
company in bankruptcy
o 2 Levels of Information Access in Distressed Debt Situations
 1. Restricted Non-Public Information
 Given to the bondholders of the distressed
company
 Operating data, management projections, etc.
 2. Publicly Available Information
o In short, distressed situations have much less information relatively
available, and that contributes to the inefficiency of the distressed
debt market
 Rational Behavior
o EMT assumes investors act rationally
o Precondition for rational choice is free will
 Free Will: making purchase and sale decisions solely on the
investment merits
o If there is limited or no free will, there is coercion
 Coerced purchases and sales are inefficient because they
are not based on independent views of how to maximize
returns
o Sources of Coerced Sales
 Managers will sometimes make decisions not based on
portfolio performance maximization but on maintaining
certain performance benchmarks
 Banks that manage investment funds have to meet
benchmarks because outsiders and investors look at
these returns to gauge the health of the bank
 The two main benchmarks are:
o A low Nonperforming Asset Ratio
 Nonperforming Asset Ratio =
Generally Defaulted Assets / Total
Earning Assets
o Shared National Credit (SNC) Rating on
nationally syndicated bank loans
 Managers make may inefficient sales in order to
reach these benchmarks
 Sometimes eagerness to attain a return will cause
inefficient, non-return maximizing, rushed sales
  All sorts of managed funds do this, not just banks
o *Distressed securities often get pooled into high-yield instruments like CDOs*
o In short, holders of distressed securities may make sale decisions for
reasons other than investment merits, leading to inefficiencies in
the distressed debt market
 Low Transaction Costs
o The EMT assumes no (or very low) transaction costs
o If investor profit-maximizing behavior is the engine that drives
pricing to the precise point of efficiency, then costs cannot be so
high that they preclude an investor from engaging in transactions
that would make prices optimal
o There are 2 costs in buying securities
 1. Brokerage Commissions
 Fairly nominal
 2. Unwind Costs
 The bid/ask spread
 Bid is what the buyer offers, ask is what the seller is
demanding
 The bid/ask spread is wide for distressed because
they are risky, and buyers will purchase at a large
discount
 Investor needs the security to appreciate in value above the
amount of the purchase price and the additional costs in
order to make a capital gain
o In buying distressed securities, the transaction fee is still nominal
but bigger, but the unwind costs are very high
 Leads to infrequent trading, and thus, less information is
discounted into prices
o Essentially, the foundational elements of the EMT are not present in the distressed debt
market, and therefore the market is less efficient than other capital markets
o The key distressed investing is having information, and competing against a limited number
of players
 Conceptual Overview of Financial Distress and the Restructuring Process
o A = L + SE
 “The size of the boxes is never really known”
 GAAP balance sheet will always balance, but nobody would argue that the GAAP
presentation represents economic reality
o The difference between the GAAP approach and the market approach is for the market
approach you find the sizes of the liabilities and equity boxes through the trading values of a
firm’s securities
o EMT implies that the market “divines” (determines) the value of the assets, and then adjusts
the value of equity to fit it
o “Market Value of Assets Stretches”
 Think of it as SE = A – L
  If stock price increases to $10, and you have 20 shares issued, Equity Value
increases by $200, and therefore, the market value of the assets is “stretched” to
match
 In reality, the market values the assets, and prices equity accordingly, so we
are backing into the asset value which determined the equity value in the
first place
o A Conceptual Overview of Financial Distress
 **when you hear that a bond is trading at “50” or “20”, that means % of face value,
so $0.50 on the dollar and $0.20 on the dollar, trading at a discount**
 When a firm’s equity is trading at a significant value, it is generally assumed that the
firm’s liabilities should be valued at face (assuming normal interest rate
environment)
 The rationale is that since equity is junior to all debt, then if there was a risk
that the liabilities would not be paid, the equity value would be much lower
because equity holders get nothing
 So, why then does the market value liabilities below face even when equity is de
minimis positive?
 The stock price will never hit 0
 You would think that equity would have to be 0 before liability trades at a
discount, because if equity is at all positive, people think equity holders at
least have a small claim on the assets, right?
o Reality, no
o Liabilities can trade at a huge discount even with positive de
minimis equity
 Basically, equity value can decline and decline until a point where the
market values the liabilities below face value and trade at a discount, but it
will never hit 0
 This occurs for several reasons:
o EMT
 Stock prices go down when they are sold, or shorted
 There is a point (usually cents) where you won’t short to 0
because it’s not worth the transaction costs
 Also, these stocks still have “option value”, so they won’t hit
0
o Potential Lawsuits
 The equity investors might agree that the stock has no
fundamental value (i.e. value of assets is less than face
value of liabilities)
 They hold on (and keep the price at a few cents) because
they kind of expect some cash flow from legal settlement,
like mismanagement claims and such
o The Market Could Just be Wrong
 People might not understand the complexities
 Psychology and big egos could be getting in the way
 All we have been trying to say so far is that in distressed situations, the way the
market prices securities is very weird
 The price of one security does not imply the price of another security
 “Well if senior debt is trading at 50, wouldn’t that imply that the subs are
getting nothing??”
o Reality, the subs are trading at 20
 “Well, if the subs are trading at 20, would that imply the equity holders get
nothing??”
o Reality, equity trades de minimis
 Normally, market value fluctuations don’t affect GAAP format
 This goes for equity value fluctuations
 Since debt is a contractual obligation, and firms have to pay the full
amount of the claim by law
o SO, EVEN IF DEBT TRADES AT A DISCOUNT, THE FULL FACE VALUE
OF THE DEBT IS STILL OWED
o AND IN THIS CASE, WE SEE A NEGATIVE EQUITY VALUE
o “combines contractual reality with market reality”
 Fictional entity -> negative equity (unrealized loss)
 “Conceptual depiction of a firm in financial distress”
 o How Restructuring Attempts to “Fix” the Distress
 The basic problem illustrated above is that the firm’s financial value is now less than
the debt component of the capital structure
 2 obvious solutions:
 1. Asset value could be increased
o Not easy to do, otherwise management would have done it already
o Only a viable option if the firm has sufficient liquidity to make its
interest payments while they figure it out
 2. Reduce the amount of liabilities to reflect current asset value
o This is a restructuring
o Financial Restructuring: the process of transforming a firm’s capital
structure to better fit the current and/or future circumstances of
the firm
o In a restructuring, the valuation focuses on an independent
assessment of the firm’s assets
o Assets = Market Equity + Market Liabilities is not true
 We talked about how the balance is thrown off and
distressed securities are priced funny
 In finding a normal valuation, you use a discount rate, and
the discount rate is high because of the risk premium, and if
you are trying to find the value of the assets alone, typical
valuation methods thus should not be used
 Summary
 The value of assets is typically quite uncertain and often subjective
 Many say that EMT allows you to accurately assess the value of assets, but
EMT does not apply in distressed situations
 Big changes in equity value really don’t matter, it’s just when the market
value of the assets becomes less than the contractual amount of the debt
 You can either increase the value of the company or reduce the amount of
debt
 This book is about reducing the amount of debt (restructuring)
 Legal Overview of Distressed Debt Restructurings
o Distressed investors include the possible outcomes of a restructuring into their investment
calculus
 “You don’t buy a run-down home with the intention to fix it up without first
checking that zoning laws will allow you to fix it up”
o The basic concept of Rx = to “fit” the liability side of the balance sheet to the firm’s asset
value
o Infinite possible arrangement for this, but 2 ways that it can happen
 1. In Court
 Formal Ch. 11 reorganization
 Time consuming, expensive, risk of harming trade relationships
 The Bankruptcy Process
o 2 universal truths about bankruptcy
 1. It is hardly ever a surprise when firms file
 Distressed firms are easy to identify
 Plus, you can watch for them announcing they have
retained legal or financial advisory services
 2. Some or all of the original creditors will usually incur
some kind of financial loss
 Creditors fear substantial losses, and will thus sell
their distressed securities at a discount (the premise
of the whole book)
 Allows investors to find misvaluations or
accumulate strategically important stakes
 You just have to be looking ahead
o Some people think that you should buy everything at its minimum
 The minimum being the period just before the filing, but
this is not necessarily true because the market will reflect
the share price because firms going bankrupt are obvious
and because it is hard to buy the securities at this point
because the guy that holds them is thinking exactly what
you are thinking
 The key is not to necessarily buy at the “bottom” but to buy
at what is available for less than it is worth
 Most of the strategic investors are already in place well
before the bankruptcy filing
o Declaring Bankruptcy
 Legally, a bankruptcy case begins when an appropriate
petition is filed with a bankruptcy court
 The debtor’s petition is called a “voluntary petition”
 Sometimes 3 or more creditors can file a
“involuntary petition” to try and force a
bankruptcy, but the company usually just beats
them to it so that they control the process
 Management and creditors tend to prefer Ch. 11 to Ch. 7
 Sometimes individual creditors may be in favor of a
liquidation because they would recover
 Jurisdiction of Filing
 You want a place that has a history of expedited
processes
 Timing of Filing
 It is a function of the firm’s desire to wait and get
the best jurisdiction and move quickly to avoid
losing liquidity
  The company will always file before they make a
material breach of any of their agreements, because
that would mean the creditors could file an
involuntary petition
 They will file right before a big missed payment, and
this allows you to predict when a firm will file
 Date of filing is important, because any anything
incurred before that date is considered prepetition
and anything in incurred after is called postpetition,
and postpetition is always senior to prepetition
 Management keeps operations going after filing
 The entity is now called a “debtor in possession”
 Management’s fiduciary duty is owed to the
creditors now
 Management only has the authority to determine
day to day operations
o If they want to do something major (outside
the course of regular business) like sell a big
asset, they need the approval of the court
 Usually, an executive will resign around the time of
filing
o The creditors obviously want new
management in most cases
 Sometimes managers with distressed situation
experience are brought in, and they usually hire
consultants too
 Creditors can request an examiner review management’s
supervision
 Creditors can also, in some cases, appoint a trustee to
administer day to day operations instead of management
 When the company files, an Official Committee of
Unsecured Creditors is developed
 Appointed by the U.S. Trustee
 Supposed to consist of the 7 largest unsecured
creditors willing to serve
o The U.S. Trustee can pick ones other than
the largest 7, as long as it is representative
of the whole group of unsecured creditors
 There can be multiple when there is a complex
capital structure, but it’s usually just one
 The purpose of the committee is to help oversee
operations, and help formulate a plan of
reorganization or liquidation
  This committee can hire professionals at the
expense of the company
 Equity holders are legally entitled to participate in the
bankruptcy process, and can sometimes vote on
reorganization plans
 If there is considerable asset value to where the equity
holders might recover something, there may be an equity
committee that is formed
 The Goal: The Plan of Reorganization
o Plan of Reorganization: a legal document that comprehensively
discusses what will happen to the debtor, its assets, and all
constituent liabilities, including equity interests, upon the debtors
exit from bankruptcy
o Most important part is how the claims of the different providers of
capital are going to be “paid” (i.e. how much are they recovering,
how much equity did the creditors get, etc.)
o Disclosure Statement: an abbreviate version that allows creditors to
decide quickly if they support the plan or not
o The court must approve this plan
 You have 120 days after you file for bankruptcy to propose a plan
(Exclusivity Period)
o But they court extends this all the time
o The reason they have to is to encourage the debtor to move fast to
avoid eroding the value of the assets
 When Exclusivity Period has elapsed, creditors (or other parties) can
propose their own plans
 It prompts the debtor and the creditors to work together when the business
is deteriorating fast
 Sometimes the debtors and creditors agree on a plan before even filing
o “Prepackaged Ch. 11”
 If there is not agreement for a very long time (very drawn out Exclusivity
Period), it is called a “Freefall Ch. 11”
o Indicates a long and expensive reorganization process if they
couldn’t even agree after all this time
 Structure of the Reorganization Plan
o Two parts to the plan
 1. Identifies all the various claimants and assigns them to
classes for purposes of voting and priority
 Main separation including secured vs. unsecured
 If a creditor has a second lien, it could be
considered unsecured if the amount of the first
secured debt exceeds the value of the collateral
 2. Provides what each class will receive in the reorganization
  Most of the time, you group claimants based on
how similar their claims are
 But sometimes, you group them based on the type
of recovery they want
o A secured creditor looking for a control
stake might want common stock
o A bank might want cash
o Both of these are on similar (pari passu)
grounds, but want wildly different
recoveries
 Operating Under Ch. 11
o Once the process starts, there are 4 main objectives
 1. Stabilize operations for immediate liquidity
 Filing for bankruptcy gives you the advantage of
automatic stay
 Bankruptcy Code allows providers of DIP facilities to
be higher priority, and be secured by an existing
creditor’s collateral (priming)
 Now, to do this you have to show that the existing
creditor was adequately protected
o Most of the time, an existing secured
creditor will offer to be a DIP lender
 “Adequate Protection” is a tool the court can use to
let the business continue operations by selling
working capital, or to raise additional capital from a
DIP (allowing for priming)
 Ch. 11 allows you to get some more liquidity
because you no longer have to make full interest
payments
 Debtor may file a “Critical Vendor Motion” allowing
them to pay vendors that are essential for the
business if they want to continue on, even if they
are not the most senior claims
 You have to make sure your employees are happy
too, so you sometimes must re-write contracts
o Especially because management
compensation is usually stock based
o Key Employee Retention Program (KERP):
basically, a protected post-petition salary
package
 Post-petition, vendors will require cash payments,
no more trade credit
 Also, it will take you a long time to collect AR
  You also have to pay your employees on a current
basis as you continue to operate
 2. Develop a going-forward plan
 Happens after you stabilize operations
 Happens during the exclusivity period
 Management works with the committee of
unsecured creditors to avoid any problems
 You need court approval for big actions, and you
also need consent of creditors, so they all work as a
team usually to make it quick
 You can decide to sell assets, drop a business line,
reduce your labor force, close a factory, etc.
 You should also work with creditors to stop them
from proposing radical things like a liquidation
 3. Determine the legitimate claims on the business and their
priorities
 Assets and liabilities change drastically in distressed
situations
 When you file, you actually have to look backwards
in time for a second
 The court is skeptical of any big payments to
creditors right before filing (90 days to a year)
because they think you might have been treating
them more preferably
 Voidable Preferences: a class of transactions
involving payments or other transfers (like grants of
liens) in payment of debts immediately prior to
filing
o Any payment of this kind within the
lookback period must be returned, and the
creditor has to join the others in seeking
recovery
o Increase assets
 Fraudulent Conveyance: a general tort claim about
a particular transaction in which the debtor paid
more than the fair value of the asset purchased
o These are rarely litigated, because most of
the time these transactions come with
fairness opinions (“fraudulent conveyance
insurance”)
o If this succeeds, the asset is returned, and
your payment is returned
o Increase assets
  You can reject any executory contracts when you
file
o Usually, these are unexpired leases, where
the debtor no longer needs this space, so
they can terminate the lease and move out
and not be contractually bound to pay rent
o Decrease liabilities
 4. If a reorganization, create an allocate a new capital
structure
 Develop a valuation
 2 valuation analyses
o 1. Liquidation Analysis
 Used to perform the “Best Interests
Test”
 No creditor should receive less in a
reorganization than they would in a
liquidation
o 2. Going-Concern Enterprise Valuation
 Valuation is a negotiation
 Usually done through DCF or cash
flow multiple
 Important because it determines
who gets what and how much in
the reorganized business
 If you have $300 valuation, you
don’t have enough to pay the $500
secured claims, so unsecured gets
nothing
 If you have $700 valuation, secured
is paid in full and unsecured gets
something
 Unsecured creditors might be unhappy with a low
valuation and may propose their own valuation for
the court to accept or reject
o Unsecured creditors seek higher valuations
o Secured creditors see this threat (they
might lose some of their recovery if the
court sides with the unsecured) and may
offer the unsecured 10% of their recovery
from their own pockets to gain their
support
 Your valuation could be really wrong
o You could say “we are worth only $300, so
you $500 creditors get all we have”
 o But in reality, you could sell for $1000, and
you would get a $700 “windfall profit”
 Voting on and Confirming the Plan
o The reorganization process involves
negotiations between parties of varying
bargaining leverage
o The debtor and its financial advisor develop
a disclosure statement that must be
approved by the court detailing the
reorganization plan and valuation
o This all happens before filing in a
prepackaged bankruptcy
o Not everybody votes
 If you would fully recover, it is
assumed that you accept
 If you would get nothing, it is
assumed that you would reject
 Only claimants that would recover
but not in full would vote
themselves
o For a class to accept a plan, need 50% in
number of claims and 2/3 in value to
approve
 and that’s based off of those
participating, not actual class size
o once tallied, you have the Confirmation
Hearing
o the court looks at a variety of factors to
make sure the plan is fair
 There are 4 tests that they use to test general
fairness
o 1. Best Interests of Creditor Test
 If someone votes no, the
proponents of the plan must show
that the claimant voting no would
recover more under the
reorganization than they would in a
liquidation
o 2. Good Faith Test
 The plan has to be proposed in
good faith
 Undefined, a mechanism for people
to object for a broad reason
 Rarely used as an objection
 o 3. Feasibility Test
 Court will only confirm if the plan is
good enough so as to avoid future
reorganizations or liquidations
 Any single creditor can raise a
challenge, this part is the most
heated
 There are tons of reason why a plan
could be argued as not feasible
o 4. Consent or Cram-Down
 Cram-Down: plan of reorganization
in imposed on an impaired class
that voted to reject the plan
 To cram down on a class, at least
one impaired class must have voted
yes
 You have to provide a minimum
recovery to rejecting parties in a
cram-down
 During the confirmation hearing, all parties realize
their maximum points of leverage
 Leverage is usually used to “recut the deal” to give
more value to the obstructing class
 Junior classes that are recovering nothing might be
very difficult and argue every possible thing
 The longer it takes to approve things, the lower the
rate of return for investors, so usually senior classes
will “bribe” junior classes not to fight
 2. Out of Court
 Voluntary agreement between firm and some creditors (not all)
 Preferred option when feasible
 The Financial Effects of an Out of Court Restructuring
o The firm and its most significant financial creditors either:
 Negotiate a change in the terms of existing obligations
 Not plausible if the face value of the debt greatly
exceeds the market value of the assets
 Complete a voluntary exchange of financial interests
 A trade where the original bond is exchanged for
new consideration that could include a combination
of a bond with a reduced principal amount, some
type of equity security, and/or cash
 Usually wipes out the old equity holders
  Pick an arbitrary number of shares, and pick some
amount of debt you want post reorganization and
build it around that
 Sometimes there is no debt in the post
reorganization capital structure
o Equitization
o The value of the stock jumps because there
is no debt, so all asset claims fall to equity
holders
o Great for firms not generating cash flow
that cannot handle interest payments
o No debt makes it easy to borrow in the
future
o Key limitation of an out of court process -> the interest if a claimant
not participating in the restructuring cannot be changed
o Voluntary bondholders can do whatever they want to their own
claims, but cannot reduce the claims of others
 But they can manipulate the % stakes of non-participative
equity holders
o Instead of eliminating the claims of equity holders, they could just
buy the bonds back at a discount using cash
 Total debt claims $700
 Trading at 42
 Use the $200 cash on hand
 Buy back $475 in face amount of debt
 The Out of Court Restructuring Process
o Begins with a negotiation ultimately leading to an agreement which
is thereafter implemented (only agreed upon by the key
participants)
o Parties involved
 If the debt is a bank loan, the bank negotiates
 If the debt is a small group of lenders, they all negotiate
 If the debt is a large syndication, there is an agent that
negotiates
 If the debt is bonds, a small group of significant
bondholders form an informal bondholder committee to
negotiate
 Technically, from a legal standpoint, there is an
indenture trustee for the bondholders, but they can
only act on behalf of a certain specified % of
bondholders
 So, in order for the indenture trustee to act, the
bond holders must independently organize (through
this informal committee) before the trustee acts
 The trustee is usually a bank
 Unless it is a payment default, then the trustee acts
on its own
 Indenture trustees are not proactive
 Usually the biggest bondholder organizes the other
big bondholders to form the committee
 There are no rules in forming the committee
 This process of forming the committee and getting
the trustee to act is called “self-appointment”
 The committee has to represent a significant
portion of the total bondholders though
 Usually the committee has to own at least 25% of
the bonds for management to take them seriously
 The committee will debate the best options, some
might believe in the firm’s eventual success and
push for an equity stake, others might say the only
worthwhile asset is cash and that they should
liquidate
 The committee members interact directly with
management, and can negotiate to hire counsel for
the committee on the company’s dime
 The Bondholder Committee has no legal authority
to bind either members or nonmembers
 The job of the committee is to receive confidential
documents to analyze and find a solution that
maximizes the value of the bondholders’ claims
 The “best” solution often depends on the credibility
of the committee’s counsel
 The nonmembers usually just trust that the
committee members know what they are doing and
are going to get them a good deal because they are
working on their behalf
 Strategic Considerations in Participating on the
Bondholder Committee
o Why would a specific bondholder become a
member?
 There’s no compensation by the
way…
o 2 big decisions you must consider
 1. If you want to participate, you
need to accumulate a significant
quantity of the bonds
 2. Requires the investor to accept
and review material nonpublic
 information about the debtor
(confidentiality agreement)
o Committee member s become “restricted”
when they get information about the
debtor, reducing their ability to trade but
helping them in finding the best solution
 You could just have your advisors
look at it if you don’t want to be
restricted yet
o The amount of detail in the information
determines how long you get restricted for
o If you want to trade your securities, you
have to make the buyer aware that you
have insider information (because then they
will say “yikes”)
o To make absolutely sure that the
counterparty knows that you have insider
information, you make the counterparty
execute a “big boy letter”
 Big Boy Letter: contains two
features, acknowledgement that
they are aware that the seller
possesses nonpublic information,
and a waiver of claims
o Basically, if you want to influence the
restructuring process, you limit yourself in
terms of trading your securities
 Beginning the Process
o Out of court processes require voluntary participation of creditors
o They always begin with a negotiation
o If it is bank debt, the company’s CFO usually contacts the bank
representative, because they bank can force a default by
accelerating maturities
 Bank debt restructurings can only be accomplished through
negotiation
o If it is bond debt, all sorts of things can happen
 Usually, if the company is public, bankers will watch the
trends in their securities and solicit them
 The company might deny, but once everyone is saying “you
are doomed” they will retain council
o Once the company decides to retain council and form a strategy,
they have 2 options
 1. Invite creditors to form a bondholder committee
  Advisor identifies the largest holders, and requests
them to form a committee
 The company provides funds for the committee’s
advisors
 2. Propose a restructuring without prior consultation
 Can only be done in the context of public bonds
through a tender or exchange offer
o Tender Offer: bonds are trading at 42, we
will buy them at 25
o Why would anyone do that?
 Because someone will accept, and
that means less cash for your
eventual recovery…
 They usually still have a very information talk with
the significant creditors to test the water before
proposing
 Just saves time and hassle of forming bondholder
committee
 Happens when all of the economic value of the firm
is going to bondholders anyway
o Sometimes, although rarely, the bondholders can initiate the
restructuring negotiation
 This is rare because the creditor has no bargaining power
unless there is a breach, and management just won’t take
their call
 The only party with legal power against the company is the
indenture trustee
 All they can do pretty much is ask management questions or
say that they would be willing to sell the company their
securities at a discount
 Management will talk if they are talking to the most
significant shareholder, because they could be the “boss”
down the road
 Implementing the Restructuring
o It depends on the type of debt involved
o Bank Loan -> easy implementation, you just amend the loan
agreement
 Just need majority consent for small changes
 But, for big changes like maturity extension reduction in
principal or amortization rate, reduction in interest rate, or
change in collateral requires 100% consent
o Bonds -> easy, just negotiate with the bondholder committee
 Not quite though, because of the Holdout Problem
 Feasibility: The Holdout Problem
o Out of court exchanges are hard because of voluntary participation
o The Holdout Problem: those not participating in the exchange may
be better off than those that do, but if too many hold out, all will
be worse off
o In game theory, this is called the Prisoner’s Dilemma
o This could force the firm to file Ch. 11, and all bankruptcy does is
add costs that ideally could have been avoided
o The more holdouts, the less effective the restructuring will be
o 2 approaches to handling this
 1. “Moral Coercion”
 Threat or ability to apply economic leverage at
some point in the future
 The guys that do this type of thing are very few in
number, and so they do not want to piss each other
off
 Probability of future contact makes everyone play
nice (ideally)
 Sometimes distressed investors will go against their
best interests with an eye on future deals
 2. Coercive Structural Devices
 Applicable to situations involving exchange offers to
bondholders
 The most common tactic is to “strip” the covenant
protections of nontendering bonds
o Exchange offer includes a provision that
tendering bonds will be deemed to have
voted to authorize an amendment to the
indenture of the original bonds, which
effectively deletes all protective covenants
o Therefore, holdouts will have pretty
unattractive bonds
 Second tactic is to combine the exchange offer with
a solicitation of support for a prepackaged Ch. 11
filing
o Makes the holdouts go “crap, they are
serious” because they already drafted their
filing
o And, if they do follow through with Ch. 11
(i.e. the holdouts continue to hold out),
they save a ton of administrative and filing
costs
 Third tactic is a structural feature in all exchange
offers (but not all cash tender offers) that requires a
 high minimum tender participation rate
requirement
o Provision states that no tendered bonds will
be accepted for exchange unless at least
90% of all bonds tender
o Basically, guarantees that if the deal goes
through, the distress will have been
resolved
o The group of holdouts is small, so only a
small group gets the benefits of not
participating
o There will always be a few idiots who don’t
even know this is going on, so part of the
allowed 10% is to accommodate the
“innocent” holdouts
o Pressures all creditors to participate
because if not enough do, they are all hurt
o If you have several levels of debt, the problem is so complex that it
often makes a voluntary exchange impossible
 Summary: out of court restructurings are simpler, yet only done 10% of the
time, because these can only be done when effective and feasible
o Effective -> the restructuring would resolve the distress
Feasible -> the probability that you will be able to minimize
holdouts given the number of creditors involved
 Chapter 5 – Overview of the Valuation Process
o Capital structure must, in the long run, bear some relation to asset value
o Asset value determines capital structure, not the other way around
o In distress, asset box shrinks, and debt and equity boxes must be chopped to conform
o Bonds trade at prices
 If you want to know whether to buy or sell, you have to value the debt box and
come up with your own price and compare
o Cash Flow Based Valuation
 DCF is time consuming, and based on future assumptions
 Distressed investors use a simpler method, the Cash Flow Multiple Method
 EBITDA used as a proxy for cash flow
 “EBITDA Multiple Approach” MOST WIDELY USED METHOD
 DCF Method is more theoretically correct, but it is time consuming
 Distressed companies often operate under losses, and get tax refunds
 “Net Operating Loss (NOL) Carryforwards”
 Important source of cash flow
 You use this method because making operating projections in a DCF is very hard and
time consuming, and the data for this method is easy to obtain and the math is
more simple
  Σ[CF * (1 + g)n * 1/(1 + DCR)n]/CF
 This formula produces a cash flow multiple that you apply to LTM cash flow to get
an enterprise valuation
 DCR is high for distressed companies, and your multiple will most likely be between
4x and 8x
o Comparable Company Analysis (for EV)
 You can get EV by multiplying a firm’s EBITDA by an appropriate multiplier
 You just have to find the right multiplier
 No exact way to do this
 Gather the right universe of comparables
o Liquidation Valuations
 Sometimes businesses simply cannot generate sufficient “value added” to justify
their existence as a going concern, and the best use of the assets is to be sold in a
liquidation
 Estimate the selling price of the firm’s assets
 Little information on this
o There is a correlation between disinterest and likelihood of misvaluations
 Chapter 6 – Leverage and The Concepts of Credit Support and Capacity
o Last chapter was about finding the size of the asset box
o This chapter is about determining the size and structure of the debt box
o Credit Risk: the probability that the contractual payment terms of a loan or bond are
breached
 Chance that principal and interest are not paid when due
 Function of 3 Parameters
 Leverage, Priority, Time
o Credit Support: the source of the funds used to repay debt
 Classified as Collateral or Cash Flow
 A lot of times cash flows are too small, to volatile, or there are too many other
creditors, so lenders wont loan to that business
 They might consider it if certain assets are pledged as collateral
 Collateral can be pledged against a specific asset or they could take out a broad lien
against all of the company’s assets
 Sometimes loans have “borrowing bases” that define how much credit will be
extended relative to available collateral (like AR or inventory)
 Collateral should always be sufficient to repay the creditor regardless of what
happens to the borrower
o Credit Capacity: how much debt can be supported by a firm’s operating cash flows alone
 Relative to credit risk, like if you have a 50% confidence level it means there has
been more debt loaned
 Shows that more debt = more risk
 Applies to collateral, you have to pay attention to how soon and for what % of
market value and asset could be liquidated (“advance rate”)
 There is no generally accepted way to gauge credit capacity based on cash flow as
support
 If a business has volatile cash flows, lender a lower multiple of EBITDA and vice
versa
 Commonly, you measure debt capacity by:
 1. Debt Repayment Ability
o The most stringent measure
o Banks use this
o Is the borrower able to repay the loan from internally generated
cash flow?
o Bank debt is good because the amortization of principal reduces
credit risk over time
o Assuming Stable Cash Flows:
 The higher the leverage, the longer it takes to repay
o Assuming Volatile Cash Flows:
 It’s very dangerous for lenders if they make a loan to a
cyclical business in an upswing
 EBITDA volatility can lower a firm’s debt repayment capacity
 The greater the expected volatility in cash flow, the more
difficult it is to asses a borrower’s debt capacity
 2. Asset Coverage
o Looking at ability to repay from internal cash flows is not the only
important thing
 For an unsecured creditor, maybe it is
 For a secured creditor, they also want to check and see that
the collateral asset value is always greater than the debt
they provided
o Bottom line lending criteria is that asset value is greater than debt
value
o Asset Coverage is not in terms of collateral, because collateral is
assets that are put aside, we are talking about overall assets here
o Capital structure is driven by asset value
 If asset value falls below nominal debt value, market
reduces the value of debt to where the boxes fit again
 If you catch it before the adjustment, you could short the
debt and make a profit
 3. Ability to Refinance
o Investors want their loans repaid on time with interest
o If you cannot pay what is due at maturity, you must refinance the
debt, and take on new debt using the new cash to repay the old
debt
 If it’s a bank loan, the bank may just renew with you,
because you make your payments
 If it’s a bond, it must be repaid in full at maturity
  If you cannot, you need to do additional capital
raising even if you have been performing well
 The potential need for additional capital raising highlights
the importance of maintaining asset value because people
will not lend to a business with insufficient asset value
 And you can forget about raising equity of lenders
are skeptical
 4. Interest Expense Coverage (Liquidity)
o If the interest on aggregate debt exceeds EBITDA, the company will
probably default
o You can have an interest payment default even with sufficient asset
coverage, it’s just that those assets must not be generating much
cash flow
o Also, if the interest payments are too high, the company might
forego necessary capital investment, reducing the potential for
higher cash flows
o Most of the time, nobody will lend to you if they think you won’t
make the interest payments, even if there is plenty of collateral
because the administrative hassle and time delay is not worth it, but
there are always some who are willing to risk it
 These are the 4 ways/rules lenders follow in assessing capacity of a debtor
o Lawyers and investment bankers get crazy with the rules, and develop instruments that
violate these 4 principles because they have potential for high reward
 1. Exchangeable Preferred Stock
 This is a way to add “debt” when there is insufficient asset coverage
 Technically not true debt because defaulting on preferred dividends does
not have the same consequences as defaulting on interest
 You issue these if you are highly levered
 2. Convertible Bonds
 You can convert the face amount of the bond into a specified number of
common shares
 The strike price (“conversion premium”) is usually 18-25% above the stock
price at the time of issuance
 If the stock price declines, these securities do not convert, and are called
“busted converts”
 3. Discount Notes and Payment-in-Kind Notes
 If the primary constraint a company faces is interest expense coverage
ability, the primary technique to avoid this is to design securities that allow
the payment of cash interest to be deferred
 The interest still shows up on the income statement, but you don’t pay
anything until maturity
 It is assumed that the company would grow to a point where they could
refinance the notes at maturity through additional capital raising
 Chapter 7 – Capital Structures and the Allocation and Management of Credit Risk
o Every investment, with the exception of U.S. Treasury Bills, involves credit risk
o Consider a capital structure as a risk continuum
 Risk is a function of leverage and priority
 Capital structures allocate risk
 EMT -> as risk increases, return must increase
 The title of a security is meaningless, and everything is situation specific
 You look at a security’s obligation relative to the other obligations in the
capital structure
 Lenders limit what a borrower can do using covenants
 The primary method by which credit risk is allocated within a capital structure is
through the use of prioritization mechanisms
 Priority controls the order of payments
 These priorities determine the application of the Absolute Priority Rule
 The law assumes all debt is equal, pari passu, pro rata
o These are ways you can “override” this assumption
 4 Way to Determine Priority:
o 1. Grants of Collateral
 Collateral is a source of credit support
 Granted through a Security Agreement
 Secured lender is first in line to collect the proceeds of the
collateral
 Secured lenders with claims to certain pledged assets
collect before secured lenders that have a broad lien on all
assets
o 2. Contractual Provisions
 It is impossible for one bond to attempt to assert its
seniority over other claims
 Subordination: an express legal provision in the indenture
 You cannot have a provision saying “I am the most senior”
 The law assumes all liabilities of a firm are equal unless the
holders of those liabilities agree to reduce the priority of
their claim
 Most debt indentures subordinate themselves to only other
debt, not trade claims
 Assign every recovery pro rata
 Then, adjust for subordination
 Trade claims are not altered, but you take away
from all subordinated debt and add to the things
they have been expressly subordinated to
o 3. Maturity Structure
 Mostly looking at bonds
 Longer the bond term, more volatility in prices and interest
rates
 Longer maturity = higher interest rate
  Senior claimants never want junior debt maturing before
their claims because they don’t want to erode credit risk
 A lower seniority bond might be better if they mature faster
 If you mature faster, you get paid off with any remaining
liquidity, if you mature older, all of the cash has been used
to pay everyone else already
o 4. Corporate Structure
 Most firms operate through multientity structures
 A nonoperating holding company owns a variety of
operating and nonoperating subsidiary corporations
 You do this for a variety of operating and tax reasons
 It allows you to structure your debt as well
 Ex). Holding Company has a loan, and asset is Sub 1 stock
 Sub1 has a loan, and asset is Sub 2 stock
 Sub2 has no loan, and asset is cash
 Makes Sub 2 appear to have no debt
 Structural Subordination: the claims closest to the assets
have the highest priority
 Results from rules in the Bankruptcy Code
 In a liquidation, by law, value flows up in accordance with
stock ownership
o Again, the law assumes that all debt is pro rata, pari passu, equal,
unless there are provisions saying otherwise, or unless there is
structural subordination
o One other “override” to the assumption of equality of debt claims is
a guaranty
 Guaranty: a contractual promise to pay the obligation of
another
 A guaranty cannot single handedly make a piece of debt
more senior than something else, it can only make it pari
passu to the obligations of the guarantor
o Nonrecourse: the opposite of a guarantee, states that if the loan is
defaulted, lender has no right to recover from certain persons
 You can foreclose on the house, but you can’t go after the
personal belongings of the owner if the house is not enough
to cover
 How Capital Structures Manage Credit Risk
o As previously discussed, capital structures allocate credit risk
through the technique of credit layering
o But, if the borrower has the power to change the capital structure,
even a secured lender is still at risk
o The borrower can do some crazy things like make new guarantees
or basically tell everyone they are all secured by the same thing and
such
o So, you basically need a way to manage credit risk in an ongoing
fashion
o This is done through covenants
 Covenant: a detailed contractual provision contained in
lending documents or bond indentures
 Lenders make decisions based on the current profile of a
borrower, and covenants protect against future changes
 Lenders want protection, borrowers want flexibility
 Worse credit rating = more extensive covenants
 Lenders compete by relaxing covenants
 Most investment grade companies can get loans with no
covenants
o There are 3 sources of credit risk
 Leverage, Priority, Time
 Covenants try to manage each of these risk sources
 Leverage Covenants
 Leverage is basically the amount of debt relative to
available credit support
 These basically prevent a borrower from getting
more debt piled on and increasing risk of default
 Limits debt to a specified multiple of EBITDA
 May also specify an interest coverage ratio that
must be maintained
 Breaching does not mean the lender can accelerate,
but if you breach, you cannot borrow any more,
which is a death sentence for a poorly operating
company
 Priority Covenants
 Limit the erosion of credit support before the loan
in question is repaid
 You try to ensure your priority through these, and
“override” the par passu assumption
 2 main types
o 1. Restricted Payment Provisions
 Designed to limit a firm from
distributing its assets to third
parties to the detriment of the
creditor
 But again, borrowers need some
flexibility to function
 These provisions are negotiated to
balance the needs to the borrower
and the lender
  These provisions identify anyone
who could erode credit support,
which are called leeches, and
separate them from third parties
that are value adding, like
employees and vendors to whom
distributions of assets are necessary
for operations
 Leech: any party to which the
borrower gives money or other
assets that could weaken the
lender’s recovery in an immediate
liquidation
 Allows you to create “restricted
subsidiaries” and “unrestricted
subsidiaries”, where the
unrestricted is treated as a third
party, and the borrower cannot
deal with them, but they are free to
make unrestricted choices
 Unrestricted subsidiaries are
potential leeches
 They are not a part of the credit
support
 The most common way these
provisions operate is by preventing
any principal payments to junior
debt prior to maturity, and at
maturity, they require the junior
debt to be repaid using proceeds
from a junior debt or equity
issuance
 Reduces the risk of asset erosion
o 2. Negative Pledge Clauses
 The major advantage of having
collateral is that it gives the secured
borrower first priority over any
proceeds from the sale or
liquidation of the pledged asset
 If you have nothing but unsecured
creditors, it is assumed that all of
your assets are generally available
to all unsecured creditors as credit
support
  Sometimes, your rating may
decline, and you can only get
people to lend if they are secured,
so if you raise secured debt, the
position of the unsecured creditors
is compromised
 So, to prevent you from bringing on
a secured creditor, the unsecured
creditors will enact negative pledge
clauses
 NPC means that if the borrower
secures a new creditor, the
unsecured creditors must also be
beneficiaries of that asset pledge
 Blocking: when a secured bank loan exercises its
right to prevent interest payments to more junior
claimants because their payment has not been
made
o Means that the unsecured creditors do not
get paid, and allows them to accelerate
maturity
 So, any lender that blocks is basically saying that
they are ok with a Ch. 11
 Time Covenants (Temporal)
 4 basic provisions to protect against the uncertainty
that comes with time
 1. Performance Covenants
o Sometimes loans are made with cash flow
being the main credit support
o Lenders expect that cash flows will improve
form their current levels when the loan is
made
o Usually limited to bank lending situations
o These covenants require you to meet
certain operating performance milestones
o The previous covenants have all been
restrictive, these are based on performance
o The lenders are giving management a
chance to execute its business plan
 2. Put Rights
o Interim milestones when lenders can decide
whether or not they want to remain in the
deal
 o If they don’t want to remain, the borrower
must repay
o All sorts of ways these can be structured
 Remarketing Feature: an agent
remarkets the bonds at a current
interest rate (appropriate to bring
them to trade at par) and makes a
tender offer
 ^ a way to get out if you want
 Forced Call in a Downgrade
o State that if the rating of the instrument
falls below investment grade, the issuer will
offer to repay in full
o Happen in fallen angel situations
 Performance Linked Pricing Provisions
o These automatically adjust interest rates in
the event of a credit deterioration
o Not technically a covenant
o No default if breached, just an adjustment
is triggered
o Basically, says that if interest coverage
ratios fall, the basis points over LIBOR
increase
o These don’t protect against credit support
deterioration, but at least provide
additional compensation to offset the risk
o Increases the value of the loan
o Summary
 A subordinated note at an operating company level or with a maturity in the near
future may be more valuable than a senior bond elsewhere in the same capital
structure
 The title of a security really doesn’t mean much
 Capital structures allocate risk through credit layering
 Caters to investors with different risk profiles
 This allocation of risk can be misleading if the borrower has the power to change its
risk profile
 Covenants manage this
 Causes of Financial Distress and the Restructuring Implications
o Until now, we viewed distress simply as the asset box being smaller than the debt box
o Indicators of Financial Distress
 3 Methods to Screen for Likely Distress
 1. Debt Ratings
o Moody’s, S&P, Duff & Phelps, Fitch
o Most prominent and easily accessed
 o Bond price is heavily correlated with rating
o Ratings are trusted because those agencies get nonpublic
information from the companies they rate
o Credit rating changes your cost of debt, so management wants to
paint a pretty picture for the ratings agencies
o Not all bonds are rated
 Not Rated (NR) Bonds
o You have to request a rating, usually because you want to decrease
your cost of debt
o You pay a lump sum, then an annual fee for continued rating
o Investment grade firms usually get both Moody’s and S&P
 Non-investment grade firms typically only get one rating
 An NR is better than a low rating, so they avoid a second if it
will be lower
 They explain it away, claiming unnecessary cost
o Ratings are the best estimate of the probability of default
 They measure how likely they are to miss a principal or
interest payment
 Ratings don’t consider the value of a security in terms of
collateral or potential post-petition interest
o Ratings are slow to adapt to new occurrences that affect credit
worthiness
 They give a “Rating Under Review” notice very promptly as
a warning
 Usually says whether it ill have positive or negative
implications
 2. Predictive Models
o Prof. Edward Altman
 Leading researcher in distressed debt and bankruptcy
 1968 -> Z-Score Model
 1993 -> updated to Zeta Model to account for changes
introduced by the Bankruptcy Act of 1978
 Designed for manufacturing companies

Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5

X1 = working capital/total assets

X2 = retained earnings/total assets
X3 = earnings before interest and taxes (EBIT)/total assets
X4 = market value of equity/book value of total liabilities
X5 = sales/total assets.
Z-scores of <1.81 have been shown as highly predictive of a bankruptcy as
long as two years in advance
Z-scores of >3 are generally indicative of reasonable credit stability.

 Widely tested and used

 Each variable has an intuitive connection to credit metrics
 Working Capital/Total Assets tests Liquidity
 RE/Total Assets tests cumulative earnings power and
dividend policy (long profitable firms have better dividends)
 EBIT/Total Assets tests cash flow generation (heavily
weighted variable)
 Sales/Total Assets is weighted the most because if a firm
can generate above averages sales per dollar of investment
in assets, it has a credit advantage
 This model predicts bankruptcies
o No use in determining potential for recoveries