Being Made Whole in Bankruptcy

In our discussions in our Managing Corporate Turnarounds class during our financial restructuring session, I got to thinking about what it would take to be made whole in a bankruptcy scenario. While the hard math will tell you that it is impossible in the short term (EV = 80, Net Debt = 100), I began to think back to the PIK and using a high yield to restore value in the future. So my question became this: If I hold the debt of an insolvent company, what can I negotiate to help me restore value? The most obvious solution is to renegotiate the terms of my debt which will probably result in me taking a haircut (discount) on the principal or face value of my debt. However, we’ve acknowledged that in scenarios where people become riskier, obviously the company’s related securities should bear a higher return. So my question then evolved to: If I have to take a discount of X percent, what additional spread Y would I have to earn in order to be made whole in N years. It turns out:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N

However, this assumes that you can break even with (or more accurately, catch up to) where your security would have been if the company had not defaulted to begin with. After playing with these numbers, however, it was quite clear that even with a small discount (say 20% discount), the spread Y had to be astronomically (unreasonably) higher in order to have any chance of being made whole relative to the standard debt, so I thought it would be unrealistic not to include a factor which accounts for the value lost:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N + Value Lost

In trying to understand what these numbers mean, I looked at Value Lost / FV as a proxy for the default rate of this type of security in distress which is obviously closely tied to the actual economic circumstances of the company. In the graph, it is reflected by the distance between the Standard Debt curve and the PIK (Realistic) curve.

Also, Y can probably be determined by looking at the spread between similar bonds with different credit ratings (dropping from BBB to C for instance).

X is reflective of the economic scenario (so if EV was 80 and Net Debt was 100, X would be 20%). It is also reflective of the negotiations, as well as considering a discount in order to liquidate the current assets of the company.

Another problem is also that once a company switches from PIK to cash sweep, its risk profile drops and it stops earning high yields, dropping the return on capital and therefore making it impossible to “catch up”. Also, a bank which was happy to finance your debt will not be interested in converting neither into a mezzanine structure better suited for hedge funds nor into equity.

This model is similar to the VC model of predicting the failure rate using the discount rate except in reverse. It is also similar to the interest rate parity (IRP) model and boot strapping by using compounding to determine where you would have / should have been otherwise as a benchmark for where you are going.

I guess the real lesson is that bankruptcy is really expensive and that being made whole in this scenario is difficult, regardless of the financial engineering and patience, although these two factors can be used to ease the pain.