Chap 22 - Private Credit and Distressed Debt

Question 1

While leveraged loans and direct lending are referred to as private credit, mezzanine and distressed debt instruments can be referred to as private equity due to their equity-like risks.

Question 2

What is known as dry powder ?

Answer 2

Investments pledged to private debt investment firms that have not yet been lent
out to a borrower or capital that has been committed but not yet called or invested.
An oversupply of dry powder may reduce credit spreads and weaken covenant protections. An undersupply of dry powder may mean that there could not be enough private credit available if there is a surge of buyout and merger activity, combined with a continued need for borrowings at small and medium enterprises.

Question 3

What are Interval funds are semi-liquid, semi-illiquid closed-end funds ?

Answer 3

Interval funds are semi-liquid, semi-illiquid closed-end funds that do not trade on
the secondary market but offer the opportunity for investors to redeem or exit their
investments at regularly scheduled intervals. Investors can purchase these funds at
a regular NAV, as frequently as on a daily or weekly basis, with a low minimum
investment.

Question 4

What is a drawdown fund ?

Answer 4

A drawdown fund is a type of private equity fund (that can be used for private credit)
in which investor commitments are called as needed , in essence providing partnership-like liquidity features in a fund structure. These funds may have an indefinite term or a fixed life, such as three or five years or longer. They can purchase bank loans or bonds as well as underwrite new debt, which is when the private debt fund lends directly to a company after carefully reviewing their financials and negotiating with the borrower.

Question 5

What is a loan-to-own investment ?

Answer 5

A loan-to-own investment occurs when the investor focuses on the value of the borrower’s assets and the value of the company that could be repossessed if the borrower was unable to service the loan, not necessarily evaluating the ability of the company to pay back the principal and interest as scheduled. In some cases, the lenders may prefer that the company default in order for the loan to turn into an ownership stake in the firm or its assets.

Question 6

What is a fulcrum security ?

Answer 6

A fulcrum security is the senior-most debt security in a reorganization process that is not paid in full with cash but rather is the security that is most likely to be repaid with equity in the reorganized firm.

Question 7

What is a credit spread ?

Answer 7

A credit spread is the excess of the yield on a debt security with credit risk relative to the yield on a debt security of similar maturity but no credit risk.

Question 8

What is are Covenant-lite loans ?

Answer 8

Covenant-lite loans are loans that place minimal restrictions on the debtor in
terms of loan covenants. Covenants are promises made by a debtor to the
creditor that strengthen the perceived credit quality of the obligation. Loan covenants
may be required by creditors to protect their interests, or they may be offered by
debtors to negotiate better terms.

Question 9

What is an indenture ?

Answer 9

An indenture is the contract between the borrower and the lender that sets out
the terms of the borrowing. These terms may include the interest rate, maturity date,
face value, the schedule of payments, as well as covenants.

Question 10

What are Affirmative covenants ?

Answer 10

Affirmative covenants are requirements for the borrower to comply with, such as to maintain a debt service coverage ratio that requires a minimum income relative to the size of the current year principal and interest payments.

Question 11

What does a Negative covenants ?

Answer 11

Negative covenants, or prohibitions on actions of
the borrower, might prevent the company from increasing their debt load or issuing
any new debt with seniority to the current first-lien debt issues.

Question 12

When a borrower fails to maintain either the affirmative or the negative
covenants, they can be in technical default on the loan. Upon that default, the creditors can step in and take action to accelerate the loan by requiring immediate repayment, restructure the loan at a higher borrowing cost, move to seize collateral, or force the borrower into bankruptcy proceedings.

Question 13

What are Incurrence covenants ?

Answer 13

Incurrence covenants typically require a borrower to take or not
take a specific action once a specified event occurs. For instance, if an incurrence
covenant states that the borrower must maintain a limit on total debt of five times
EBITDA, the borrower can take on more debt only as long as it is still within this constraint. A borrower that breaches this covenant by incurring additional debt is in default of the covenant and the loan. However, if the borrower found itself above the five times EBITDA limit simply because its earnings and cash flow had deteriorated (without having incurred additional debt), it would not be in violation of the incurrence
covenant and would not be in default. Cov-lite loans have bond-like incurrence
covenants, much like high-yield bonds.

Question 14

What are Maintenance covenants ?

Answer 14

Maintenance covenants are stricter than incurrence covenants in that they require
that a standard be regularly met to avoid default.

Whatever happens, the borrower must pass this test each and every quarter.

Question 15

What are five ways in which covenants can control
risk for lenders (Antczak, Lucas, and Fabozzi - 2009) ?

Answer 15

1- Preservation of collateral: Because the value of the collateral is key to both
the quality of the loan and the eventual recovery rate upon distress, lenders can
control risk by limiting the size of the loan relative to the value of the firm and the
value of the collateral.

2- Appropriation of excess cash flow: Lenders are protected when the uses of
corporate cash are limited. Many lenders require the majority or the entirety of
the value of asset sales and new debt to be paid to the debt holders rather than
to the equity holders.

3- Control of business risk: There is an inherent conflict between stockholders
and bondholders.When the company prospers, the equity holders can experience
large gains, whereas lenders earn principal and interest as contracted. When the
company becomes distressed, the bondholders have a downside risk much larger
than their upside return potential. Simply, the stockholders are long a call option
on the firm’s assets and the bondholders are therefore short a put option on the
assets. Therefore, it is in the best interest of the lenders to limit the types and sizes of investments, mergers, and debt that the firm can undertake.

4- Performance requirements: Under negative covenants, the company must
maintain strong ratios of assets and cash flow relative to the debt and interest
burden of the firm. Capital expenditures may need to be limited in order to
maintain compliance with the requested financial ratios.

5- Reporting requirements: Under affirmative covenants, the company needs to
report financial results to lenders, including other material information regarding
projections of revenues and expenses, litigation, and regulatory issues.

Question 16

What are recovery rates ?

Answer 16

The recovery rate is the portion of the face value of the debt that is paid back
from the assets of the firm in a bankruptcy. In a liquidation bankruptcy, the lenders
or the court have decided that this company is no longer a going concern.

Question 17

What is a chapter 7 bankruptcy ?

Answer 17

Chapter 7 bankruptcy is when the assets of a firm are liquidated when a
company is determined to no longer be a viable business. Essentially, the firm shuts
down its operations and parcels out its assets to various claimants and creditors. The
critical issue in chapter 7 bankruptcies is the priority of claims: who gets paid first,
who gets paid most, and which obligations are never repaid.

Question 18

What is a Chapter 11 bankruptcy ?

Answer 18

Chapter 11 bankruptcy is a reorganization that attempts to maintain operations
of a distressed corporation that may be viable as a going concern. It therefore affords
a troubled company protection from its creditors while the company attempts to
work through its operational and financial problems.

Question 19

What is a plan of reorganization ?

Answer 19

A plan of reorganization is a business plan for emerging from bankruptcy protection as a viable concern, including operational changes. The plan includes how creditors and share-holders are to be treated under the new business plan. The claimants in each class of creditors are entitled to vote on the plan of reorganization.

Question 20

What is A blocking position ?

Answer 20

A blocking position exists when a creditor or group of creditors holds more than one-third of the dollar amount of any class of claimants and utilizes those holdings to prevent a plan of reorganization.

Question 21

What is a Prepackaged bankruptcy filing ?

Answer 21

Prepackaged bankruptcy filing: Sometimes a debtor company agrees in
advance with its creditors on a plan of organization before it formally files for
protection under chapter 11. Creditors usually agree to make concessions up
front in return for equity in the reorganized company. The company then files
with the bankruptcy court, submits a previously negotiated plan of reorganization, and quickly emerges with a new structure

Question 22

What is the Classification of claims ?

Answer 22

Classification of claims: Under the bankruptcy code, a reorganization plan
may place a claim in a particular class only if such claim is substantially similar
to the other claims in that class. For instance, all issues of subordinated debt
by a company may constitute one class of creditor under a bankruptcy plan.

Question 23

What is a cramdown ?

Answer 23

The cramdown: The bankruptcy code provides that a reorganization plan may
be confirmed over the objection of any impaired class that votes against it as long
as the plan (1) does not unfairly discriminate against the members of that class
and (2) is fair and equitable with respect to the members of that class. This process within a bankruptcy is called a cramdown when a bankruptcy court judge
implements a plan of reorganization over the objections of an impaired class
of security holders

Question 24

What is an Absolute priority ?

Answer 24

Absolute priority: An absolute priority rule is a specification of which claims
in a liquidation process are satisfied first, second, third, and so forth in receiving
distributions. Payments to employees, payments for taxes, and accounts payable
generally take priority over payments to security holders. Senior secured debt
holders (typically bank loans) must be satisfied first among security holders.

Question 25

What is Debtor-in-possession financing ?

Answer 25

Debtor-in-possession financing: When secured lenders extend additional
credit to the debtor company, it is commonly known as debtor-in-possession
financing (DIP financing). The borrower’s desire in seeking DIP financing is clear:
Without additional credit, the borrower might not continue in business and
would be forced to shut down.

Question 26

What is Leveraged loans ?

Answer 26

Leveraged loans are syndicated bank loans to non-investment-grade borrowers. The
term syndicated refers to the use of a group of entities, often investment banks, in
underwriting a security offering or, more generally, jointly engaging in other financial
activities.
Loans made by banks to corporations can be divided into two general
classes: (1) those made to companies with investment-grade credit ratings (BBB or
Baa and above), and (2) those made to companies with non-investment-grade credit
ratings (BB or Ba and lower). This second class of loans refers to leveraged loans.

Question 27

What is Direct lending (shadow banking ) ?

Answer 27

Direct lending (also called market-based lending, shadow banking, or nonbank lending) is a transaction in which investors extend credit to borrowers outside of the
traditional banking system. In direct lending, borrowers do not go to banks for their
lending; rather, they obtain funding from loans originated by private equity, private
credit, and hedge fund lenders. Because the borrowers don’t have access to funds
through bank loans, they might pay higher interest rates, but there are other benefits for the borrowers besides access to credit. Nonbank lenders tend to have more flexible terms and offer faster loan processing than banks.

Question 28

A portion of the private credit market is focused on asset-based lending, where
lenders consider the value of the collateral rather than the strength of the firm’s cash
flows. Some direct lending might be unsecured, but most direct lending is secured
or senior in the capital structure of the corporation. Revolving lines of credit can be
secured by the value of inventory or accounts receivables, while term loans may be
secured by the value of property, plant, and equipment.

Question 29

What is Peer-to-peer lending ?

Answer 29

Peer-to-peer lending is originating loans directly to consumers and is done by both institutional and retail investors who have an opportunity to originate consumer loans, often through an Internet-based underwriting and brokerage platform. Peer-to-peer (P2P) lending can reduce the interest rates that consumers pay when they refinance other consumer credit, such as credit cards and student loans, with lower-cost P2P loans. Investors can earn a higher yield than on other forms of similarly risky credit if the spread between risk-free debt and credit card rates is wide.

Question 30

What is a warrant ?

Answer 30

A warrant is a call option issued by a corporation on its own stock. The number of warrants included in the equity kicker is inversely proportional to the coupon rate: The higherthe coupon rate, the fewer warrants need to be issued. The investor receives both a coupon payment and participation in the upside of the company, should it achieve its growth potential.

Question 31

The flexibility of mezzanine financing is what makes it so popular with borrowers
and investors alike. Both sides can tailor the financing to fit their borrowing and
investment criteria. Mezzanine financing provides a higher risk profile to an investor than does senior debt because of its unsecured status, lower credit priority, and equity kicker. However, the return range sought for mezzanine debt is substantially below that for venture capital and leveraged buyouts. The reduced return reflects a lower risk profile than is found in other forms of private equity.

Answer 31

With a mezzanine fund, the J-curve effect is not a factor. One of the distinct
advantages of mezzanine financing is its immediate cash-on-cash return. Mezzanine
debt bears a coupon that requires twice-yearly interest payments to investors. As a
result, mezzanine financing funds can avoid the early negative returns associated with
venture capital or leveraged buyout funds.

Question 32

What is The weighted average cost of capital (WACC) ?

Answer 32

The weighted average cost of capital for a firm is the sum of the
products of the percentages of each type of capital used to finance a firm times its
annual cost to the firm.

Question 33

Generally, mezzanine financing occurs in amounts below $400 million. In other
words, mezzanine financing is generally used by middle-market companies, which
are the larger stocks within the small-cap classification. These firms do not usually
have access to the large public debt markets as a relatively efficiently priced source of
debt capital. High-yield debt issues tend to start at sizes of $400 million. The same
is true for leveraged loans.

Answer 33

The flip side is that the level of tailoring makes mezzanine debt illiquid.
Exiting mezzanine debt involves a lengthy negotiation process for the investor, either
with the company that issued the mezzanine debt to buy back its securities or with a
secondary private equity investor to purchase the position. In both cases, mezzanine
debt is often sold at a large discount.

Question 34

What is a payment in kind (PIK) toggle for mezzanine debt ?

Answer 34

Mezzanine debt often includes a payment in kind (PIK) toggle. A
PIK toggle allows the underlying company to choose whether it will make required
coupon payments in the form of cash or in kind, meaning with more mezzanine
bonds. Leveraged loans do not have such a provision.

Question 35

In addition, leveraged loans typically have a floating interest rate tied to the London Interbank Offered Rate (LIBOR), whereas mezzanine debt has a fixed coupon.

Question 36

What consists sponsored lending ?

Answer 36

Many private credit funds participate in
sponsored lending, whereby the borrowing firm is backed by an investment from a
private equity fund or buyout fund sponsor. Investing in the debt that’s generated
through an LBO transaction might be a bit safer because there’s a private equity or a
buyout fund that owns the equity and maybe some of the debt of the firm.

Question 37

Mezzanine financing can be viewed as filling either a gap in a company’s financial structure or a gap in the supply of capital in the financial markets.
This makes mezzanine financing extremely flexible.

Question 38

What are the seven basic transactions to which mezzanine debt is applied ?

Answer 38

1-Mezzanine financing for a management buyout (MBO): When the senior
management team of a firm leads an MBO, mezzanine debt can fill the gap
between senior debt claims and equity.

2-. Mezzanine financing for growth and expansion: A company pursuing
growth that cannot raise traditional bank financing or public financing may seek
mezzanine financing.

3-Mezzanine financing for an acquisition: A middle-market company seeking to purchase an even smaller company may seek mezzanine debt financing as
part of the capital for the acquisition.

4-Mezzanine financing to recapitalize a company: Mezzanine debt may
be used as part of a new capital structure for a firm to create a new balance
sheet, such as having: senior term loan, senior subordinated mezzanine debt,
junior subordinated mezzanine debt, convertible preferred stock, and common
equity.

5-Mezzanine financing in commercial real estate: Mezzanine capital fills the
gap between first-mortgage financing, which usually has a loan-to-value ratio of
40% to 75%, and the equity contributed to the project.

6-Mezzanine financing in a leveraged buyout: An LBO requires a large amount of debt, and not all debt can be senior. A significant amount of the financing may come from mezzanine investors.

7-Mezzanine financing as bridge financing: Often, a good portion of the
initial debt in an LBO is raised as bridge financing. Bridge financing is a form
of gap financing—a method of debt financing that is temporarily used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of
cash.

Question 39

What are the s four major types of investors in mezzanine debt ?

Answer 39

1- Mezzanine funds: Mezzanine funds are organized like hedge funds, venture
capital funds, and buyout funds. Investors in mezzanine funds are generally pension funds, endowments, and foundations. These institutional investors do not
have the internal infrastructure or expertise to invest directly in the mezzanine
market. Therefore, they enter this alternative investment strategy as limited partners through a mezzanine fund.

2-Insurance companies: Insurance companies are a major source of mezzanine financing. They are natural providers of mezzanine debt because the durations of their liabilities (life insurance policies and annuities) are best matched
with longer-term debt instruments.

3-Traditional senior lenders: Interestingly, banks and other providers of senior
secured debt often participate in mezzanine financing. This financing takes the
form of so-called stretch financing, where a bank lends more money than it
believes would be prudent with traditional lending standards and traditional
lending terms. This excess of debt beyond the collateral value of a company’s
business assets is the “stretch” part of the financing. Senior lenders may ask for
an equity kicker, such as warrants, to compensate the institution for stretching
financing beyond the assets available.

4-Traditional venture capital firms: When the economy softens, venture capital firms look for ways to maintain their stellar returns. In addition, times of large flows of capital into venture capital funds make it necessary for them to expand their investment horizons, resulting in a greater interest in mezzanine financing.

Question 40

What are the eight characteristics mezzanine debt has, in order to help distinguish it from other sources of financing and types of investments ?

Answer 40

1-Board representation: A subordinated lender generally expects to be considered an equity partner. In some cases, mezzanine lenders may request board observation rights; in other cases, mezzanine lenders may insist on a seat on the board of directors with full voting rights.

2-Restrictions on the borrower: Although mezzanine debt is typically unsecured, it may still come with restrictions on the borrower. The mezzanine lender may have the right to approve or disapprove of additional debt and require that any new debt be subordinated to the original mezzanine debt.

3-Flexibility: There are no set terms to mezzanine financing. The structure of
mezzanine debt can be as flexible as needed to accommodate the parties involved.

4-Negotiations with senior creditors: The subordination of mezzanine debt
is typically accomplished with an intercreditor agreement. An intercreditor
agreement is an agreement with the company’s existing creditors that places
restrictions on both the senior creditor and the mezzanine investor.

5-. Subordination: The subordination (lowered priority) may be either a blanket
subordination or a springing subordination. A blanket subordination prevents
any payment of principal or interest to the mezzanine investor until after the
senior debt has been fully repaid. A springing subordination allows the mezzanine investor to receive interest payments while the senior debt is still outstanding. However, if a default occurs or a covenant is violated, the subordination springs up to stop all payments to the mezzanine investor until either the default is cured or the senior debt has been fully repaid.

6-Acceleration: The violation of any covenant may result in acceleration. Acceleration is a requirement that debt be repaid sooner than originally scheduled, such as when the senior lender can declare the senior debt due and payable immediately.

7-Assignment: Senior lenders typically restrict the rights of the mezzanine investor
to assign, or sell, its interests to a third party. However, senior lenders generally allow an assignment, providing the assignee executes a new intercreditor agreement with the senior lender.

8-Takeout provisions: A takeout provision allows the mezzanine investor to purchase the senior debt once it has been repaid to a specified level. This is one of the
most important provisions in an intercreditor agreement and goes to the heart
of mezzanine investing. By taking out the senior debt, the mezzanine investor
becomes the most senior level of financing in the company and, in fact, can take
control of the company. At this point, the mezzanine investor usually converts
the debt into equity through either convertible bonds or warrants and becomes
the largest shareholder of the company

Question 41

What is Distressed debt ?

Answer 41

Distressed debt is often defined as debt that has deteriorated in quality since issued
and that has a market price less than half its principal value, yields 1,000 or more
basis points over the riskless rate, or has a credit rating of CCC (Caa) or lower.

Question 42

As in the case of mezzanine debt, the idea that debt can be equity-like can be clarified using Merton’s view of the capital structure of a firm. In that framework, corporate debt can be seen as being equal to the combination of a long position in the firm’s assets and a short position in a call option on the firm’s assets.

Question 43

This is where successful private equity managers earn superior returns. Revitalizing companies and implementing new business plans are their specialty. The adept distressed investor is able to spot these tired companies, identify their weaknesses, and bring a fresh approach to the table. By purchasing the debt of the company, the distressed debt investor creates a seat at the table and the opportunity to turn the company around.

Answer 43

There is no standard model for successful distressed debt investing. Each distressed
situation requires a unique approach and solution. Successful distressed debt
investing entails selection of companies (credit risks) that are undervalued in the
marketplace and intervention in the operations of the companies and in bankruptcy
reorganizations to secure high returns.

Question 44

What is The annual default rate ?

Answer 44

The annual default rate is the annual portion of debt issues that default by failing to
pay principal and interest as scheduled or that experience a technical default when
a company is unable to comply with the covenants, or terms of the loan outside the payment of principal and interest.

Question 45

What is the annual loss rate ?

Answer 45

The annual loan loss rate is the annual default rate
multiplied by the losses on the debt that aren’t recovered through bankruptcy

Question 46

What are the three broad strategic categories of investing in distressed debt securities ?

Answer 46

1-The first approach is an active approach with the intent to obtain control of the company. These investors typically purchase distressed debt to gain control through a blocking position in the bankruptcy process with the goal of subsequent conversion into the equity of the reorganized company.

2-The second general category of distressed debt investing seeks to play an active
role in the bankruptcy and reorganization process but stops short of taking control of
the company. Here, the principals may be willing to swap their debt for equity or for
another form of restructured debt. An equity conversion is not required, because
control of the company is not sought. These investors participate actively in the
bankruptcy process, working with or against other creditors to ensure the most beneficial outcome for their debt. They may accept equity kickers such as warrants with their restructured debt.

3-There are passive or opportunistic investors. These investors do not usually
take an active role in the reorganization of the company and rarely seek to convert
their debt into equity. These investors buy debt securities that no one else is eager to
buy. These distressed debt buyers usually buy their positions from financial institutions that do not have the time or inclination to participate in the bankruptcy reorganization, from mutual funds that are restricted in their ability to hold distressed securities, and from investors with positions in high-yield bonds who do not want to convert a high cash yield into an equity position in the company.