Simplified Distressed Debt Recovery Analysis

Distressed Debt Investing requires a lot of assumptions. Every investor can look at a certain situation and come up with radically different conclusions based on seemingly minuscule differences in EBITDA and exit multiples. When I do an analysis of a credit, I run a number of different models to come up with recoveries. These models will be industry specific sometimes and other times will be very general.

Assets are valued differently in a bankruptcy court depending on who is doing the valuation. If you have time, read through some old dockets where Financial Advisers (creditor or debtor) give testimony on how the valuation of the enterprise was determined. In reality, it is determined in a fashion to approximate the recovery (what type, how much, etc) that the hiring parties want the financial advisers to come up with: If the unsecured committee wants the post-reorg equity, their financial advisor will argue to the court that the enterprise in question is worth a lot and can support a fair amount of debt. In that way, senior secured lenders are reinstated or paid back from an exit facility and the unsecured class retains the equity and captures the levered upside.

As stressed in previous posts: It's all about incentives. Know the incentives, and you are on your way.

As analysts we need to do our own valuation of the assets/enterprise, no matter how granular. I have had cases where my Excel file had 40 or 50 tabs and others when there is one tab with a simple recovery grid. It all depends on the situation at hand.

For those that do not know, let me explain the simple recovery grid. This is where you have multiples on the vertical axis, and EBITDA or cash flow on the horizontal axis. It looks something like this:

All things being equal, the above chart tells me how much the enterprise is worth. From here, I can walk through the waterfall, and get to a point where I can back into what the recovery on a particular bond. For example, if there was $2.0B of debt outstanding in the above case, the recovery on the debt would be:

Now, admittedly this is a simplified analysis. What is important though is that if this bond were trading in the market at say 77, you could zero in on what the market is expecting for both EBITDA and multiples. In the above example, if your EBITDA forecast was coming in at $185M, you would be a SELLER of these bonds unless you believed multiples were going to increase above 7.0x which is a hard-sell in a lot of bankruptcy cases.

Without blatantly posting one of my "go-to" models on the interweb, I thought I would walk readers through the next few steps in the process; or better yet, vet this process out a little bit.

First, you need your EBITDA forecast. This can be a range like above. That being said, the range I have above ($185M-$300M) is laughable. If you really understood a business, you should be able to approximate run-rate EBITDA in a much tighter range. This is where your work on market share, pricing dynamics, wage inflation, demographic trends, cost controls, etc come into play. You will spend a lot of your time working on this, and maybe at the same time finding ways that the company could be more profitable in the future, especially if you are in a control position. This is where talking to competitors, suppliers, distrubutors is essential. Why does XYZ turn its inventory 2x faster than our ABC bankrupt company? Why has SG&A always been 50 bps higher than the industry average? Etc.

From here, you are going to need a range of comps. I can confidently say I have read more proxies and bankruptcy valuation reports from financial advisors than most. Everyone has their own method: Adjusted EBITDA, EBIT before stock option expense, OCF less Capex, etc all times some multiple that can be construed by selectively pulling together certain comps. Do you want a high valuation? Well then remove all capex heavy companies from the industry and call our bankrupt company "asset-lite". Magic sometimes happens when applying multiples. Unfortunately, you have to play the game and throw up some multiples to at least see where market assumptions are. Even if you do not use the final product from your analysis, you will have another valuation tool in your tool bet.

So you have your multiples, your EBITDA forecast, and thus your Enterprise Value. From here you add ancillary assets whether that be cash generated during the bankruptcy process, patents, trademarks, land, etc. You now need to guesstimate what kind of capital structure this pig will have when it emerges. What are other companies in the industry levered? What do the economics of the business (stickiness, low capex, high asset turnover) allow for leverage? Let's say you are confident this company should be 3x levered. How much will that be senior bank debt? How about bonds?

From here, you then work out what the interest expense would be for said enterprise given an oscillating scale of more bank debt or more bonds. Generally speaking, EBITDA less capex less interest expense has to be moderately positive for a bankruptcy judge to approve a plan/projections otherwise the debtor faces the risk of Chapter 22. Let's say that after you have determined 3x leverage works, where 2x turns of it will be bank debt, and the remaing 1.0x turns unsecured bonds.

You then work your waterfall. Do not forget taxes, post-petition interest that may be accruing, professional fees (use 3-5% of debt outstanding), rejected lease administrative claims, critical vendors, 20day AP, etc. All of these are admin expenses and generally need to be paid out in cash before a plan can be approved. This is what an exit facility is sometimes used for. Let's say all of those expense equated to 1x turn of EBITDA and that 1x turn will be financed with an exit facility. So of your 3.0x turn enterpise, 1.0x has been used up for admin.

With the remaining available leverage, the new bank debt and bonds will be used to either pay down pre-petition bank debt lenders or provide capital to the business (generally with the help of a rights offering etc). If you were a pre-petition bank debt holder you can now determine how much of your recovery will be in senior bank debt and how much in sub bonds.

After the 3.0x leverage threshold in our example has been extinguished, the rest of the value would accrue to equity. How much is this equity worth? Well you have to do a DCF of sorts. Work the post-petition cash flows with the new capital structure, and your projections for capex and working capital. After you get your FCF, apply a discount rate (make it nice and HUGE to ensure a large margin of safety - think 25%), and value your equity.

At this point, you should have a good sense of who is getting what in the re-org. You will also be able to determine what percentage of your recovery is cash, new bank debt, new bonds, or new equity (again with the help of a potential rights offering). Run a number of scenarios, and apply probabilities to each, to come up with a weighted average recovery.

If this recovery is materially higher from where your preferred debt instrument (or equity even in the case of PPC) is trading, you may have yourself a distressed debt winner. Rinse. Repeat.


Azeem 9/09/2009  

Although your go-to models should certainly not be shared, it would be interesting to see a short form model, or some kind of quick mock up, if you have one, just to see how you do things; I've been on restructuring deals in the past, so while the analysis is similar, I think the mechanics nuances are a little different, and it would be cool to see them in a model (and obviously illustrative for all those who have no restructuring/distressed experience)

If not, completely understandable. Thanks for writing! Always refreshing to read your informative posts!

Sami 9/09/2009  

great post.

A question: how do you get to the leverage level. the 3x is assuming an industry peer but don't ch 11 companies can sustain less leverage than peers?

I assume you go through this analysis before the proposal as the proposal has the recoveries outlined?

Kevin Rogers 9/09/2009  

Excellent outline to the process. One point assumed, but feel readers should be reminded of, is the importance of knowing the debt priorties (secured vs unsecured, guarantees etc)as it impacts priority of recovery. I believe Hunter has pointed this out in the past.
Sami's point is one that drives everyone "mad" as there is no "science" governing how much leverage; it is a negotiation amoungst different creditor classes, though needs to be tied to your valuation work. In my experience "industry peers" leverage can help you as either comp or starting point for leverage. One item to remember is the a restructed company needs an implied equity cushion under the new debt structure. The fact the the company filed bankruptcy may suggest a riskier business profile than peers and therfor need a larger equity cushion than peers(hense lower leverage).

Anonymous,  9/10/2009  

On valuing the equity in the reorg, wouldnt a much easier and feasible way be to take the enterprise value, less the new total debt amount in the BK company at emergence from BK (using the pro forma cap structure), and simply divide that equity amount by shares out?


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.