Fulcrum security distressed investing blog

This article is the first in a series of articles examining key legal decisions during last bankruptcy cycle. The purpose is to synthesize the voluminous array of legal analysis and opinions on these rulings and develop essential take aways for distressed investors. While distressed investors rely heavily on the advice and counsel of their FAs and attorneys, in the final analysis the PM must execute his strategy and be accountable for the results. Therefore, it is important to survey the legal landscape and be aware of some of the pitfalls distressed investors face.

Given the enormous growth in the leveraged loan market, particularly the 2nd lien loan market, many of the rulings in the last bankruptcy cycle were related to secured creditors. The focus of this article is on decisions impacting control distressed investments more commonly referred to as loan-to-own. In late and early as the markets began a precipitous decline, credit, including traditional third party DIP financing from commercial banks, dried up. They were getting margin calls on the total return swaps, redemptions from investors and suffering significant mark-to-market losses.

For those players with sufficient dry powder and locked up capital, being the DIP provider gave them the most strategic position in the capital structure, and very often the DIP was the fulcrum security. With traditional DIP lenders on the sidelines, first lien lenders seized the opportunity to roll-up their pre-petition debt into post-petition debt.

Such actions are generally frowned upon by the courts because pre-petition debt effectively becomes cross-collateralized with post-petition assets. Those creditors who were left behind by the roll-up DIP objected to these loans on the basis that the rules and procedures of bankruptcy did not allow for members of the same class to leap frog them and obtain better recoveries and terms.

Nevertheless, with no viable alternative the courts approved many of these loans, although frequently they amended some of the more egregious terms after some trial-and-error. Roll-up DIPs effectively became de facto bridge loans to a credit bid. In February , the debtors filed for Chapter 11 after defaulting on their loan agreements.

The bid procedures required cash funding and specifically precluded the lenders from credit bidding. Nevertheless, the debtor successfully painted the banks as the villain. The Lenders would receive any cash generated by a higher bid at the auction. In October , the bankruptcy court issued an order refusing to bar the lenders from credit bidding. Additionally, the plan paid the noteholders full cash value of their claims while precluding them from credit bidding on the assets.

The PALCO and Philadelphia Newspapers rulings have established that in the context of a plan of reorganization credit bidding is not a right at least in the 3rd and 5th Circuits. This is significant in that the 3rd Circuit governs Delaware where many large corporate bankruptcies are overseen. However, the issue of the right to credit bid in a sale outside of a plan was not addressed. The court remanded back to the bankruptcy court the issue of whether secured creditors were receiving the Indubitable Equivalent and that the plan met the Fair and Equitable test.

What these rulings demonstrate is that secured creditors have lost some strategic ground in being able exercise influence and take possession of the collateral through the right to credit bid. Funds employing a loan-to-own strategy should weigh carefully how these decisions may impact the timing and manner of deployment of capital in a distressed investment.

Had the secured creditors been the DIP lenders in these situations, they would have been able to exert far more influence in determining the outcome. It is likely that during the next cycle banks will again be reeling from mark-to-market losses in their trading and CMBS books and will again not be able to deploy DIP capital as was the case in the cycle. The early part of the cycle will be ripe with opportunities for those funds with dry powder to effectuate control through a third party or roll-up DIP loan.

While the spectrum has enormous value, the large capital expenditures required to launch satellites and fund the cash burn until they are operational, has forced two major players DBSD and Terrestar, majority-owned by Harbinger Management, to seek bankruptcy protection. When appointed, these neutral parties are given a mandate by the bankruptcy courts to examine and investigate a wide range of claims and issues, and their reports have the potential to drive plan negotiations and settlements.

They also come at a cost. The estate neutral would be selected by the U. Trustee and approved by the court in a similar manner to chapter 11 trustees. The ABI Commission contemplated that the estate neutral would be appointed more frequently, and for a broader range of reasons, than an examiner.

For example, the estate neutral could be appointed to further negotiations when parties are at an impasse. This is in contrast to other parties, including the debtor, who have potentially diverging interests and may be motivated purely by self-interest. The ABI Commission determined that an estate neutral could therefore serve a useful role in facilitating dispute resolutions and reducing information asymmetries.

Statutory Committees One of the major changes in bankruptcy practice since the enactment of the Bankruptcy Code has been the increase in secured debt. In fact, oftentimes the fulcrum security is a secured debt instrument and unsecured creditors are out of the money.

Nevertheless, after considering other proposals, the ABI Commission ultimately concluded that the mandatory appointment of a committee of unsecured creditors in all cases with some exceptions for smaller cases should be retained.

The Report recommends that a list of this information be filed with the bankruptcy court in connection with any motion filed under sections , , , or of the Bankruptcy Code or any chapter 11 plan filed within 60 days after the petition date. This would essentially require almost all chapter 11 debtors to file such a list on or shortly after the petition date. Parties-in-interest would be able to request copies of the documents included in the VIP.

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Secured creditors come before unsecured creditors who, in turn, come before stockholders. Senior creditors get paid in full before their juniors get anything. Why is this the case? That rule requires that senior creditors be paid in full before junior claims get anything. If a class of claimants is only being partially paid, then no one else is entitled to receive the stock i.

So the partially-in-the-money group of claims has a presumptive right to the stock of the reorganized debtor. A fulcrum is a lever. A partially-in-the-money group of claims has leverage over a bankruptcy plan because they are often the only class of claims that has a vote that matters. To get ahead of the curve and address the increasingly growing concerns amongst their lenders and shareholders, the management team has retained an RX bank for its advisory services as a preventive risk measure.

In this specific case, the fulcrum security is the senior unsecured notes as it signifies the point in which the cumulative capital structure lines up with the enterprise value of the firm. Theoretically, since the enterprise value breaks halfway through the senior unsecured notes tranche, the remaining bottom-half of the senior unsecured notes, the subordinated debt, and common shareholders should be ascribed to no recovery value.

If LightingCo had timed the acquisition a few months later when the severity of the coronavirus became more well-known, the acquisition likely could have been terminated with no or minimal break-up fees due to the presence of a material adverse change MAC. This means that LightingCo would be incapable of compensating even half the most senior creditor class i. Worst-Case, Liquidation Scenarios Oftentimes, the distressed company will be severely impaired to the point that it is in the best interests of all claim holders that the business be liquidated under a Chapter 7 bankruptcy.

This is seen in Example B, which represents an example of a failed LBO in which an otherwise well-performing company took on too large of a debt burden, which was exacerbated by the additional debt raised to fund an add-on acquisition. Hence, the focus in private equity investing is on pursuing companies with recurring, predictable free cash flows in non-cyclical industries. In these worst-case scenarios, such as Example B, the fulcrum security would be within the senior secured bank debt and the senior unsecured notes and subordinated debt should trade close to zero.

Assigning Value to the Fulcrum Security: Distressed Debt Valuation While this should go without saying, accurately locating the fulcrum security is a very challenging task in practice. The perceived valuation of the distressed company deviates widely across different RX bankers, distressed investors, and creditors due to its subjective nature.

For our purposes, we used an arbitrary industry multiple that was adjusted downward to reflect the distressed state. Until , the implied valuation of WidgetCo was always greater than the debt it has held unchanged for the past four years , based on the industry-derived multiple. However, this took a turn for the worse in as the valuation multiple had a drastic reduction to 3. Similar to the case of LightingCo, WidgetCo was also negatively impacted by COVID and the debt on its balance sheet soon became a concern, as the face value of its debt surpassed its enterprise value.

Thus, despite the moderate or above-average leverage multiple, WidgetCo is still considered distressed under our definition for these exercises. If the RX investment banking analyst or distressed analyst thinks that WidgetCo is worth 3. In that case, the senior unsecured notes and bank debt will both trade at par and would anticipate full recoveries. To calculate the pricing of the fulcrum security: At a 3. Since the value breaks at the lowest debt tranche i. Pricing the Fulcrum Debt: Illustrative Example D In our 2nd scenario for WidgetCo, the only adjustment we will make is that the industry comparables are more impaired and thereby leads to WidgetCo being valued at a multiple of 2.

Under this lower valuation assumption, the fulcrum security becomes the senior unsecured notes, as opposed to the subordinated notes. To reiterate a point made earlier, the fulcrum security being higher in the capital structure means that fewer claim holders receive full recovery. And so, the higher the fulcrum security is located, the more concerned the lower creditor s and equity owners should be. This ties back to how the fulcrum security is not meaningful in financially stable companies — hence, it is not tracked for non-distressed companies.

Below, we can see the same financial performance and capital structure was used as Example D, and the only variable that was adjusted upward is the valuation multiple from 2. Since this time around the industry multiple being used to value WidgetCo is 6.