I'm testifying in a Federal Court on a Case involving a Fulcrum Security. What is that?
Distressed Private Debt Strategy to gain Equity Control
Being in distressed Private Equity means you are constantly bumping into the absolute priority rule of debt, which outlines which stakeholders get priority during the liquidation of a companies assets. Senior creditors, with first or blanket liens on assets, will be top of the list should the company enter into a chapter 7 position.
Creditors this high up the stack are likely to lend against a collateral position that secures their loan, justifying a lower interest rate as it’s believe the principal is well protected.
Creditors further down the stack, such as a junior secured, unsecured or mezz lenders may or may not be so lucky in times of liquidation. The historical rates of principal recovery is outlined in the following exhibit (hint: it’s not good)...
Depending on the market value of those assets during liquidation, at some point, one of the creditors in the stack will only receive partial payment with the rest below them receiving nothing. This point in the repayment waterfall is called the “value break” and represents the most senior tier in the credit stack that is likely to be converted into equity; aka the “fulcrum security”.
The creditor who finds themselves in the fulcrum security position are now in charge of leading the turnaround & restructuring efforts; a skillset that likely don’t have internally. Enter distressed PE Firms who can take that burden off this particular creditors shoulders whose head is likely spinning at this point all while accruing expensive legal fees. Moving this burden to someone else, does come at a cost of course - an extra % discount from par value. Keep in mind that the restructuring effort, especially in a balance sheet turnaround, needs to take debt off the balance sheet & the fulcrum security accomplished that by moving debt —> equity.
A distressed PE firm needs to locate which tier would be the fulcrum security but should know that they are on the wrong side of negotiating table - the holder of the fulcrum security has the power & control should it be converted into equity. What a distressed PE firm is willing to pay for to earn that control over the turnaround process will determine the size of the par level discount, if any.
So that leads me back to the title of this article - I’m involved (in an advisory role on behalf of the distressed PE Firm) in a case involving a bankrupt auto parts company, where the equity is getting wiped out and a private lender who has found themselves in a position as both senior lender and only getting 45% of principal repaid back after conducting a liquidation analysis. I’ll be speaking, on behalf of the distressed PE fund, on the difficulties of maximizing ongoing value of the company both during & after the sale of the fulcrum security is complete.
Let’s go through some math (slightly adjusted to keep the companies financials private of course) to bring the story together & help you understand…
How to locate the Fulcrum Security
Negotiation on valuation to find out what the Distressed PE will be buying (from the senior creditor)
EXAMPLE
This 25 year old auto parts company became distressed through the COVID lockdowns of 2020 driven by declines in auto sales, difficulty finding workers and an overlevered balance sheet to help with plant modernization. The companies simplified debt stack was as follows…
Senior Secured Debt —> $55 Million
Junior Secured Debt —> $15 Million
Unsecured Trade Debt —> $8.5 Million
A 32% drop in EBITDA caused the company to be out of compliance with it’s Fixed Charged Coverage Ratios. After we ran through cash flow forecasts & 2022 budgets, the senior creditor didn’t see a clear path to covenant compliance, thus forcing a foreclosure on the assets. Keep in mind that projections to senior creditors don’t include any turnaround efforts, they are more “as is” projections.
So where is the fulcrum security? We like to test it against…
Liquidation Value of Assets —> $25 Million (auction value for assets)
Enterprise Value of Ongoing Concern —> $75 Million (or 3x normalize EBITDA)
The probability of this company surviving & continuing to meet loan covenants, we felt was low due to the nature of their market so the weighted value was set at $40M, hence making the senior secured debt the fulcrum ($40M < $55M).
So how do we price it for the senior secured to sell to the distressed PE?
If we continue to assume a 3x normalized EBITDA for valuation sake, which is based on what “like” auto parts companies have sold for over the past 3-5 years & apply a weighting that favors a liquidation event, then the senior secured will get 72 cents on the dollar ($40M/ $55M).
What the Fulcrum Security holder will argue in order to increase 72 cents valuation…
Changing probability assumptions of liquidation vs. ongoing concern -> more towards ongoing than a liquidation event
What is normalized EBITDA? -> COVID impacts are temporary so 2019 is reasonable to look at
What the Distressed PE will argue to reduced the 72 cents valuation (this is what I’ll be testifying to)…
Valuation based on new post COVID world & not 2019 normalized earnings -> more work from home, people’s patterns have changed permanently
Embellish the cost & difficulty of a turnaround much more than what they internally believe -> no pricing power, slow paying customers, further CAPEX to keep up with rapidly changing market
It’s likely that the debt will be priced below 72 cents as the senior creditor made the mistake to initially foreclose on the assets, showing their hand & making it known that increasing the valuation of the company >$55M won’t be easy as auto parts are a very cyclical industry will just a few customers to sell to.
The takeaway here is that distressed PE firms are out there hunting for situations like these to finds that tier in the capital structure that could take equity control via the fulcrum security. They want to analyze their actions to get an edge on the negotiations to pay as little as possible for the right to convert to equity. After agreeing to a price, execute on a well thought out turnaround plan that allows them to dramatically increase the value of the equity, earning a generous profit in the process. I look forward to passing along more updates in the future on the progress of this case.