CAIA Chapter 22

Question 1

What is a fulcrum security and how might it facilitate a PE fund strategy?

Answer 1

• the security in a distressed company’s capital structure that is most likely to be converted into equity during a bankruptcy reorganization
• by acquiring fulcrum securities, PE funds can position themselves to gain control of the company during reorganization, enabling them to implement operational improvements or asset sales

Question 2

How does an increase in covenant-lite loans affect default rates and loss magnitude?

Answer 2

Effect on Default Rates: covenant-lite loans lack traditional financial covenants, reducing the early warning signs for lenders and delaying corrective actions, which may lead to higher default rates

Effect on Loss Magnitude: in the absence of covenants, borrowers may take on more risk, worsening their financial condition before default, this can lead to higher loss rates as recovery becomes more difficult

Question 3

Describe mezzanine financing

Answer 3

mezzanine financing is a hybrid of debt and equity financing, typically subordinated to senior debt but senior to equity in the capital structure. It often includes an equity kicker, such as warrants or convertible features, to provide additional upside potential

Question 4

Does mezzanine debt with an equity kicker exhibit the J-Curve pattern?

Answer 4

• No, the J-curve is characteristic of PE investments due to their initial cash outflows followed by delayed and potentially significant returns
• mezzanine debt provides steady interest payments

Question 5

Why can mezzanine financing lower a firm’s weighted average cost of capital (WACC)?

Answer 5

• it offers higher returns to investors compared to senior debt, attracting capital without diluting equity significantly
• if fills financing gaps that traditional senior debt cannot, enabling the firm to pursue growth opportunities without overleveraging

Question 6

Differences between mezzanine debt, high-yield bonds, and leveraged loans

Answer 6

Mezzanine Debt:
- seniority: subordinated to senior debt
- term: intermediate-term (5-10 years)
- liquidity: illiquid

High-Yield Bonds:
- seniority: senior unsecured
- term: long-term (10+ years)
- liquidity: liquid

Leveraged Loans:
- seniority: senior secured
- term: short- to medium-term
- liquidity: moderately liquid

Question 7

Standards distinguishing distressed debt from non-distressed debt

Answer 7

• distressed debt typically trades at a significant discount to face value (e.g. below 70%)
• the issuing company often faces financial challenges such as insolvency, inability to meet debt obligations, or ongoing bankruptcy proceedings

Question 8

Two major sources of distressed debt

Answer 8

• companies that have defaulted or are on the brink of default
• companies undergoing bankruptcy proceedings, particularly Chapter 11

Question 9

Primary distinction between Chapter 7 and Chapter 11 bankruptcy

Answer 9

Chapter 7: focuses on liquidation, with the debtor’s assets sold to repay creditors in order of priority

Chapter 11: aims at reorganization, allowing the debtor to continue operations while restructuring its debt and financial obligations

Question 10

Initial investor in debtor-in-possession (DIP) financing

Answer 10

the initial investor in DIP financing is often an existing lender, hedge fund, or private equity firm willing to provide capital in exchange for priority status in repayment and influence over the bankruptcy process

Question 11

What are the key types of private credit?

Answer 11

1. Leveraged Loans:
   - senior debt for firms with high leverage or poor credit ratings
   - high interest rates and low credit quality
   - commonly used for acquisitions or refinancing
2. Direct Lending:
   - non-bank financing provided by private lenders directly to businesses
   - targets small and medium enterprises that face credit access challenges
3. Mezzanine Debt:
   - hybrid financing combining debt and equity features, often with warrants
   - high-risk, high-return investments
4. Distressed Debt:
   - investments in debt of financially troubled companies, purchased at a discount

Question 12

Describe credit ratings and default risk

Answer 12

• credit ratings by agencies like Moody’s or S&P guide investors on default probabilities
• investment-grade debt has low default rates, while speculative-grade (junk) bonds experience cyclical default spikes during crises

Question 13

What are covenant-lite loans?

Answer 13

• loans with minimal restriciton on borrowers
• increase in covenant-lite loans correlates with higher default rates and losses during financial downturns

Question 14

Why do investors purchase distressed debt?

Answer 14

• to gain control of a company during restructuring
• to acquire undervalued assets at a discount and benefit from eventual recovery

-> requires expertise in bankruptcy law and credit risk management

Question 15

What is an equity kicker (e.g. in mezzanine financing)?

Answer 15

• typically offered as warrants, options or convertible securities that allow lender to acquire equity under predefined terms
• often tied to performance milestones or future events such as IPO
• compensates for high risk in mezzanine financing