How to Value Distressed Debt – the Practical Guide to Distressed Investing

I was excited but anxious when I first joined the Special Situations Group at J.P. Morgan. It was 2008, at the height of the financial recession, and distressed investing sounded intense. To value distressed debt seemed arcane and complex. I knew financial modeling and I was hungry to learn, but what if I didn’t cut it for the job?

I felt the intensity when I took on my first project: value Chrysler’s distressed loans. I spent a year in investment banking prior to joining Special Situations, and I knew how to project financials and value a company. But how would I find out whether a distressed debt is cheap or expensive?

Chrysler became my crash course in distressed investing. Over the next 3 years, I valued distressed investments across industries – financial mortgages, automakers and suppliers, industrial manufacturing firms- and I honed the craft.

What I realized was, distressed investing is not difficult. It’s not arcane or complex. If you know the basics of financial modeling, you are not far away from joining a distressed hedge fund.

You just need to know how distressed debt valuation is done, and you are on your way.

Today, I’m going to break down the process of valuing distressed debt with an example. I’ll go through all major aspects of distressed valuation. By the end, you’ll know how to create a pitch to a distressed debt fund and ace your interviews.

Let’s get started.

Dan’s Petroleum

value-distressed-debt-1

Our distressed company in question is Dan’s Petroleum, our favorite fictitious energy company.

Dan was an ambitious kid growing up. He used to visit his dad at work after school, and the sight of his dad doing back-breaking work on the oilfield lit a fire within Dan. He respected his dad’s work ethic, but he didn’t want to graduate and work for the man till his dying days.

Dan was a risk-taker. He graduated during the oil boom and went straight to the bank to take out the loan. With good instincts and his dad’s experience, Dan successfully found a large oil reserve in the Permian Basin. He struck liquid gold, and his first fortune paved the path for Dan’s Petroleum.

Dan’s Petroleum enjoyed unprecedented growth over the next decade as part of America’s golden age. To accelerate the company’s growth, Dan borrowed more debt to build additional rigs and expand capacity. His business instincts kept paying off, and Dan was a king among oilmen. The extravagance of his mansion parties spread like wildfire among his social circles. His wife set up a logistics business just to handle delivery of champagnes and cigars to their residence.

Then the music stopped.

The price of oil had been pushed to unsustainable levels. America’s GDP growth began to turn, and energy demand by industrial manufacturers started to wane. Dan’s Petroleum’s revenues fell while fixed costs increased. The company’s high yield debt was downgraded to CCC, and now trading at just 60 cents on the dollar.

Sounds familiar? Many energy companies post the oil price decline in 2015 were in the same shoes.

You sympathize with Dan’s situation, but you are also an investor. You ask yourself: is 60 cents on the dollar too cheap? Would I make a good return if I buy the high yield debt?

Before we start, here’s the excel model for you to download and follow along:


Download Excel Model

OK, let’s get started. First, we look at Dan’s Petroleum’s financials. Here are the facts:

  • Current revenues are $1.0 billion and declining at 5% per year.
  • Selling, general and admin expenses are increasing at 10% per year.
  • EBITDA is $300 million but declining.
  • Current cash the balance sheet is $119 million.
  • There are $500 million of bank loans outstanding and $300 million of high yield debt.
  • The high yield debt is trading at 60 cents on the dollar, paying a 7% coupon and maturing in 5 years.
  • Dan’s Petroleum is still generating positive net margin and has cash on the balance sheet. Bankruptcy is not imminent.

To value the high yield debt, we need to think about the scenarios that could happen to Dan’s Petroleum. There are 3 main scenarios for this distressed company:

  • Upside Scenario: The weaker energy demand is just temporary. America’s growth comes back, and oil price recovers. Revenues turn back to positive growth in a couple years.
  • Base Scenario: Oil price continues to slide. Dan’s Petroleum’s revenues and EBITDA keep falling. The company runs into covenant issues with its lenders.
  • Downside Scenario: America enters a recession and oil price plummets. Dan sells his company’s assets in bankruptcy to pay back creditors.

Let’s analyze the high yield return for each scenario.

Upside Scenario

value-distressed-debt-2

In this scenario, the company gets back to its glory days in a couple years. Dan’s smiling again!

As with any good valuation analysis, we first need to forecast the company’s financials in this scenario. We build a 3-statement model forecast, and project revenues and EBITDA to return to growth in 2 years. From our model, we have the following projections:

upside-income

While the temporary downturn has hurt margins, the growth profile looks to be healthy again. Next, we check to see if the company would face a liquidity constraint during this downturn:

upside-cf

Great, looks like the company won’t run out of cash under this scenario. But what about any issues with the bank lenders? When banks lend to companies, the loan typically requires the company not to exceed certain financial ratios. These are “handcuffs” to make sure the company operates in a normal manner. The 2 most common covenants are:

  • Debt leverage covenant: The company’s total debt / EBITDA can’t exceed a certain limit in a year.
  • Interest coverage covenant: The company’s EBITDA / interest expense must meet a certain threshold in a year.

You can find a company’s covenants in its public SEC filings. Let’s take a look at Dan’s Petroleum’s debt leverage and interest coverage ratios to see how they compare to the covenants:

upside-cov

OK, no foreseeable covenant issues. Debt leverage gets somewhat close to the limit in Year 2, but there’s enough cushion.

We’ve determined that cash liquidity is healthy and covenant compliance is fine in the upside scenario. The company would keep running outside bankruptcy, and the high yield debt would mature in year 5.

Now we’ll calculate the return on the high yield debt. If we buy the high yield debt at 60 cents today, we would collect 7% coupon annually until we get paid back at par value, or 100%, in year 5, when the debt matures.

To calculate the high yield return, we use the rate() function in excel to calculate the yield to maturity:

upside-ytm

A 20% return would be a home-run. It consists of interest income from the 7% annual coupon, plus the capital appreciation of buying at 60 cents and getting paid off at 100%.

Next, let’s look at the base scenario.

Base Scenario

value-distressed-debt-5

What if oil prices keep sliding, and Dan’s Petroleum doesn’t recover?

In the base scenario, we forecast the company’s revenue growth to continue decline past year 2. We project that GDP growth remains anemic and oil demand continues to be sluggish. Dan’s Petroleum’s growth doesn’t recover until year 5. The company loses some operating leverage due to rising material cost, and Dan has to cut employee headcount to preserve some of the lost margins. Here’s our base scenario income statement forecast:

base-income

The picture is not pretty for year 3 when EBITDA turns negative.

Next, let’s look at the cash flows and liquidity situation:

base-cf

The company would still have positive cash flows until year 3. It would still have cash on hand to fund working capital and won’t have a liquidity constraint. That’s good news.

You now know the drill – we’ll then take a look at the company’s covenants. And this is the bad news:

base-cov

The company would break its debt leverage covenant by year 3! What happens now?

Breaking a covenant would put Dan’s Petroleum in “technical default” – the company is still paying interest to the lenders but has violated the loan agreement signed with the lenders. Dan needs to sit down with his bank to potentially renegotiate the covenants to get relief.

The lenders request Dan’s financial projections, and they see that there’s no stopping of EBITDA decline. Even if they provide Dan covenant relief, the company would still be in negative EBITDA territory after year 3.

This is bad for Dan. The lenders request Dan to sell the company and pay the loan back.

With no other choice, Dan’s Petroleum files for Chapter 11 bankruptcy and hires investment bankers to sell the company based on its enterprise value. In other words, as a multiple of its EBITDA.

Dan’s lenders also give the company a $100 million debtor-in-possession loan in bankruptcy, to fund the company’s operations and pay critical vendors.

The investment bankers shop the company around the global to find a buyer. Weeks go by, and finally, a European energy conglomerate, Alphacore Energy, expressed interested. Alphacore does its own forecast of Dan’s Petroleum and believes it can eventually get Dan’s Petroleum’s EBITDA back to $100 million. This is called the run-rate EBITDA.

Alphacore offers to pay 5.5x EV/EBITDA to purchase Dan’s Petroleum, using an average EV/EBITDA of peer oil businesses.

5.5x EV/EBITDA on $100 million run-rate EBITDA equates to $550 million enterprise value. Dan’s Petroleum also has $206 million of cash on the balance sheet at the end of year 2. There’s a total of $756 million of firm value to pay off the lenders.

base-fv

And here’s the “payment waterfall”: The $756 million firm value would pay off the $100 million debtor-in-possession loan first, and then the $500 million bank loan second.

After which there’s $156 million left to pay off the $300 million high yield debt. So the high yield debt holders get a 52 cents on the dollar recovery at the end of year 2.

Using the rate() function in excel, we calculate the yield to maturity for the base scenario. The yield to return is 5.2%, which includes 7% annual interest but is partially offset by the capital loss of buying at 60 cents and getting a payoff of 52 cents.

base-ytm

It’s not a great return, but still worth our consideration.

But it could be worse for Dan. Let’s look at the downside scenario.

Downside Scenario

value-distressed-debt-6

In the downside scenario, the outlook for oil has gotten bleak during the Chapter 11 bankruptcy. The investment bankers shopped the company around and received no offers. America enters a deep recession, and oil prices were plummeting. The company can’t be sold based on EV/EBITDA because no one has a good handle on estimating the run-rate EBITDA.

With no other choice, Dan converts the bankruptcy process from Chapter 11 to Chapter 7. This is asset liquidation. Dan has to sell the company’s assets one by one at a discount to pay back the lenders.

In this scenario, we calculate the discounted value of the company’s accounts receivable, inventories, plants and equipment, and intangible assets. The $206 million of cash can be recovered at 100%. But the other assets might not worth their face value.

The accounts receivable should mostly be recoverable. Dan sells them to a financing institution for 80% of the face value.

The inventories are mostly barrels of oil, but with the plummeting oil price, Dan sells them at 70% of the face value.

Plants and equipment are mostly rigs, office buildings, and old furniture. Not a lot of buyers out there. Another oil company sees the opportunity and buys them at 60% of face value.

The intangible asset is mostly Dan Petroleum’s brand. But who would use this name again, after Dan wasted away his fortune on mansion parties? This brand is now worthless.

Adding up the recovered asset values, we get $717 million to pay off creditors with:

downside-asset

The money would pay off the $100 million debtor-in-possession loans and then the $500 million bank loan. After which there’s $117 million of value left for the $300 million high yield debt. The recovery rate would be 39%.

Using the rate() function to calculate yield to maturity, we get a -6.6% loss on our high yield debt in an asset liquidation scenario.

downside-ytm

Weighted Return

value-distressed-debt-4

Investing comes down to taking a calculated risk, and it’s no different here. We think about how likely is each scenario going to happen, and assign each a probability.

After carefully thinking about the current economic condition, where oil price is headed, and Dan’s Petroleum’s prospects, we conclude that the downside scenario won’t likely happen. Let’s assign it a 10% probability.

What’s more likely to happen is the gradual recovery of oil price. It could recover quickly in 1 – 2 years or take a bit longer in 3 – 4 years. So we assign an equal probability to the upside and base scenarios.

weighted

We arrive at a weighted average return of 10.7% on our high yield debt if we bought at 60 cents on the dollar today. Not bad at all!

We discuss our analysis with the investment team, and they agree with our thought process. The 10.7% return just meets the fund’s return objective of 10%. We execute on this investment and buys the high yield debt at 60 cents.

Conclusion

Congratulations, we just make our first distressed investment.

Distressed investing can seem complex, but we just walked through the core process of valuing distressed debt. There’s more nuance to the bankruptcy process and additional claims, but we just covered all key steps of how a distressed investment is made. If you’ve walked through this case, you can now make a convincing pitch to a distressed debt fund.

Let me know if you have any questions – leave a comment or question below and I’ll get right back to you.

Takeaways

    • Valuing distressed debt requires knowing the basics of financial modeling and coming up with scenarios for the distressed company.
    • The 3 typical scenarios to a distressed business are:
      • Full recovery outside bankruptcy
      • Sale of business based on its enterprise value in Chapter 11 bankruptcy
      • Asset liquidation in Chapter 11
    • Look at the company’s cash flows – would the company run into a liquidity constraint?
    • Compare its debt leverage and interest coverage ratios to its financial covenants.
    • Analyze the recovery value of the distressed debt.
  • Calculate the yield to maturity for each scenario and weight them based on their probabilities of likelihood.

Join the discussion 16 Comments

  • Ronak Negandhi says:

    Need a very good knowledge on the industry in which the company is operating. Very well explained!

  • Kevin says:

    Very nicely explained and love the There Will Be Blood tie in.

    Can you please explain why you use a yield to maturity vs an IRR which funds typically look at?

    In a real life scenario would funds look at a weighted average return or a base case return to progress an investment decision?

    Thanks!

    • Thanks Kevin. DDL did a hell of a job in that movie.

      On YTM to IRR – the textbook answer is that YTM assumes the reinvestment of received coupon, while IRR does not. In practice, it comes down to what measure your fund uses. Senior loan funds are typically buy-and-hold types. Their approach is similar to private equity, which is to look at the long-term value of the business. These funds typically use IRR as the measure. Funds that trade high yield however, use YTM or YTW (yield-to-worst), because most performing high yield debt is quoted in YTM/YTW. They look to compare apples to apples when looking at a distressed high yield.

      In a real life scenario, there can be more scenarios than just these three mentioned. For example, the fulcrum security holders (the piece of the capital structure that will get only partial recovery) could negotiate with the senior lenders and shareholders to restructure the debt and convert to equity. This could be a consensual process or a litigated one. Depending on the process, different valuation multiples are used. It’s a challenge to assign an exact probability to each scenario. However, that’s what the investment team does when it discusses each scenario and think about likelihood. Therefore the decision is based on probability weighted, whether the probability is explicitly built into the model or implicitly assumed by the investment team / decision maker.

      Kelvin

  • Jay says:

    Thank you for the concise and clear explanation on this topic. If I want to invest across the capital structure in this company, do I just need to extend this analysis to calculate the YTM based on the recovery prospect of the different tranches?

    • That’s correct Jay. The most interesting tranche will always be the “fulcrum”, which is the most senior debt tranche that doesn’t get fully covered by the enterprise or asset value.

      This is the tranche that will be partially converted to equity. Depending on how the company performs post-bankruptcy, the fulcrum holders can generate significant returns by buying the fulcrum before a restructuring and become equity holders through a debt-to-equity conversion in bankruptcy.

      The most senior bank loan is usually less interesting because it’s fully covered by the assets and enterprise value. It’ll most likely get paid in full. The very junior tranches like convertibles and preferred equity are also not very interesting, because they’ll likely be wiped out in bankruptcy and just get a token piece of equity as a small incentive to go along with the bankruptcy process.

    • Nelia says:

      Woman….you drew me in. You write so well….keep it up…and I think what ever is next, it’ll be fabulous – because you are soati230;.be&u#8ful and amazing and kind and full of life! xoxo

  • Mr Funk says:

    Curious about this real life scenario 1. Company goes private, funded by 600mm term loan and 250mm senior notes 2. Equity of company now owned by a private equity company and a pension plan 3. The senior notes are very distressed, trading at about 60, coupon is 11%, mature at the end of 2019 Here what my question, in the 10-k, the company disclosed that the PE company has bought 100mm of the 250mm senior notes Does this mean anything? Like the bonds are not as distressed as they seem? I can give the company info if you are interested

  • Great scenario Mr. Funk, and nice pick-up of the PE purchase in the 10-K.

    By buying the senior notes, the PE fund continues to invest further into the company. Why does the PE fund buy the senior notes and not the equity?

    Again, let’s think through the scenarios. There are two scenarios: the company avoids bankruptcy or files for Chapter 11.

    If the company avoids bankruptcy, the senior notes eventually return to par value (100). The PE fund makes 100/60-1 = 66% return on the capital appreciation. This excludes the 11% coupon each year.

    The more interesting scenario is if the company files for Chapter 11. In this case, the senior notes would be the “fulcrum security” and get converted to equity. The PE fund would get more equity by converting the senior notes through a bankruptcy.

    Buying the senior notes is logical for the PE fund in the bankruptcy scenario for 3 reasons:

    1) The PE fund has a vote in two different tranches in bankruptcy – senior notes and equity.
    2) The senior notes have collateral and get recovery before the equity.
    3) Investing in the equity would be “pari-pasu” to the pension’s stake, whereas investing in the senior notes and then get converted to equity is more attractive.

    The PE fund made an inherent assumption in buying the senior notes. It assumed that the company’s enterprise value in bankruptcy is more than 600 million, which fully covers the term loan. Therefore the senior notes would be the “fulcrum security” and get partially converted to equity.

  • […] when oil price tumbles from $100 to $30, it can be Chapter 11 sentencing for an over-levered driller. Debt is a double-edge […]

  • Alex Ks says:

    Excellent guide. Really doesn’t get much better than that! Thanks so much!

  • Franklin says:

    Does the maturity of debt matter in the repayment process? Also what about payments to for general administrative expenses and salaries?

  • GG says:

    Thank you for the article, very helpful indeed. What happens with the trade payables? Shouldn’t we include them in the waterfall for the liquidation scenario?

    Thanks

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