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Fulcrum Security Primer

Fulcrum Security and Value Break Analysis in Restructuring and Distressed Debt Investing Explained (Model Tutorial Included)

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Fulcrum Security Primer

Key Learning Objectives
  • What does the fulcrum security and “value break” represent?
  • What are the implications of being the holder of the fulcrum security?
  • Which factors determine the location of the fulcrum debt, as well as its approximate pricing?
  • How is the placement of the fulcrum security and decision on whether a liquidation might be in the “best interests” of creditors related?

The fulcrum security (or fulcrum debt) is one of the most essential concepts to understand in the context of financial restructuring.

As a result of getting only partial recovery, the fulcrum’s security claims will be converted to equity (usually instead of a debt claim), and often positions the holders of the fulcrum security to lead the plan of reorganization (POR) going forward.

Thus, distressed debt investors often seek to understand what the fulcrum security is for a company under distress, acquire it (at distressed prices from the original holders), and become the majority equity owners as the company emerges from bankruptcy.

Fulcrum Security: Simple Explanation

To explain the concept of the fulcrum security in more simplistic terms, imagine distributing the enterprise value of a distressed company to all claim holders based on their seniority within the capital structure.

Since a borrower is legally obligated to abide by the debt waterfall schedule, an example of the proper order of payment would follow a structure such as:

In practice, for a distressed company, the “value” would “run out” before being able to reach the bottom of the capital structure (i.e. the common equity shareholders).

This tipping point where the remaining value reaches zero is where the fulcrum security will be located – hence, it is often referred to as the “value break.”

Determinants of the Fulcrum Security Location

The location of the fulcrum security and the extent of how far down the capital structure it will be placed is a direct function of the implied enterprise value of the distressed company.

As one can deduce, the fulcrum security becomes a key factor for companies near (or already in) a distressed state.

The placement of the fulcrum security marks the cut-off line that distinguishes the class of stakeholders that should anticipate a full recovery from those that should not.

On that note and as depicted by the graphic below, the fulcrum security’s location represents the cumulative part of the capital structure that lines up with the total economic value of the firm.

Above the Fulcrum Security 🔼 Below the Fulcrum Security 🔽
  • Creditors, usually higher up in the capital stack with more seniority and above the fulcrum security are the most likely to receive a full recovery (typically secured debt claim holders)
  • For those below the fulcrum security, these creditors and other stakeholders are not likely to be paid back in full
  • These stakeholders have higher priority and own holdings that are “in-the-money” (ITM)
  • These stakeholders have lower priority and have holdings that are “out-of-the-money” (OTM)
  • Usually comprises senior creditors that have claims which are backed by collateral such as bank lenders and institutional lenders
  • Typically consists of unsecured creditors such as subordinated debt, mezzanine debt, GUCs, and equity (common and preferred)

Fulcrum Security RX Considerations

In the event of a reorganization, the fulcrum security represents the class of stakeholder(s) that failed to be paid-in-full and instead received either:

  1. No Recovery Proceeds: In this scenario, the class of creditors is below the position in the capital structure where the value break occurred and there are no more residual proceeds left over
  2. Partial Recovery: As the name suggests, the impaired class has received some proceeds – nevertheless, the amount was less than par value (i.e. they are entitled to further compensation)

Q. “So, why does the fulcrum security matter in the context of RX banking?”

To get straight to the point, the answer comes down to negotiating leverage.

An example of when the fulcrum security becomes pertinent to negotiations would be:

  1. Imagine a distressed company that currently has inadequate cash flows to service its debt obligations
  2. To prevent itself from defaulting due to being unable to meet its debt obligations, financial restructuring becomes a necessity to “right-size” its balance sheet
  3. This implies a reduction of the debt held to a reasonable level that the operating business can support, which means finding methods to write off some of the debt (e.g. converting to equity)
  4. Throughout these negotiations, the holder of the fulcrum security has the most negotiating leverage and also has the most to gain (and lose) from the restructuring process
“Equity Tips”

Q. “Do equity holders truly get completely wiped out in restructuring scenarios?”

In short, claims junior to the fulcrum security should receive no proceeds. Under a restructuring process, common and preferred equity are presumed to be wiped out. Likewise, creditors similarly below the fulcrum security would receive minimal (or zero) recovery.

But in practice, equity holders (and creditors at the bottom of the capital structure) usually get minimal recovery in exchange for their “support” in a restructuring agreement despite being entitled to nothing.

This is because bottom-tier claim holders can hold up the process if they opt to – which would effectively prolong the time frame for closure and create additional hurdles for all parties involved.

In an effort to prevent any unnecessary delays, an act of gratuity commonly referred to as an “equity tip” can be handed out to equity holders. In most cases, a minor haircut in the total value of their proceeds is worth not having to deal with an extended process with further complications stemming from appeals, complaints, etc.

Now, moving onto an adjacent question:

Q. “What is the value of the common equity and the claims held by creditors below the fulcrum security?”

The holders of the common equity, in theory, are entitled to zero value and equity in the newly emerged company (and can occasionally be completely wiped out under a worst-case scenario).

But due to the equity tip and potential for these lower-tier claim holders to have a role in the restructuring plan in exchange for their cooperation going forward, there can be some value attached to these stakes.

If there is junior or subordinated debt in the capital structure below the fulcrum debt, they would also trade close to zero under a similar logic as the equity shareholders.

Distressed Debt Investing Strategies: Fulcrum Security

In distressed debt investing, the investor will want to locate the fulcrum security, which is the security or debt instrument most likely to be converted into the equity of the distressed company once it restructures its balance sheet and operations.

Locating the fulcrum security can lead to the receipt of a controlling stake in the distressed company and more influence when voting on the plan of reorganization.

By virtue of being part of the capital structure most likely to be converted into equity, the holder of the fulcrum security has the most leverage and greatest chance to lead the company’s restructuring plan.

Otherwise, many distressed investors participate in short-term opportunistic trading, but even then, being aware of the location of the fulcrum security is a useful data point that can lead to more informed, profitable decisions.

For this reason, many distressed investors pursue identifying the fulcrum security not only because it has the highest probability of converting into or receiving equity in the newly emerged company but as a strategy to influence the POR moving forward.

In other words, the investor wants to actively direct the agreement approved by a bankruptcy judge and have a say in the distressed company’s restructuring in bankruptcy, the distribution of value to stakeholders, and its long-term plans to reach a sustainable state.

Locating the Fulcrum Security: Practice Tutorials

Now that we have covered the importance of locating the fulcrum security for RX banking and distressed investing purposes, we can now begin going through various example exercises.

To follow along with a visual representation of the debt waterfall schedule, fill out the form below to download the Excel file used for each of the practice exercises.

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The main question we are attempting to answer in the first two exercises are:

Q. “In which part of the capital structure does the value break?”

Before we begin, we will first lay out some of the simplified assumptions that will be used in all of the practice exercises that we will complete:

  • The date when the analysis is conducted is set around early 2020 (i.e. right when cases of COVID-19 began to see exponential growth and global lockdowns were announced) – thus, the next fiscal year (NFY) is in reference to 2020
  • The new debt financing is completed around December 2019, as the FY is coming to an end
  • There is no mandatory or optional principal amortization on the debt (i.e. all existing debt will roll forward into the next year)
  • For each scenario, an arbitrary industry-multiple will be provided for a comps-derived valuation (and is not meant to be accurate for the industry under any standard)

Locating the Fulcrum Security: Illustrative Example A

LightingCo, a manufacturer of premium lighting fixtures, has historically generated EBITDA of $80mm and $85mm in 2018 and 2019, respectively (approximately ~20% EBITDA margins)

LightingCo’s products are highly discretionary but were in high demand throughout the last two years by consumers as the economy continued its expansion and consumers had higher levels of cash-on-hand to spend on optional goods.

Outside funding was easily accessible in the debt and equity capital markets and could be raised under favorable terms, as the general sentiment regarding the broader economy was largely positive.

For the first time since inception, LightingCo raised debt financing to re-invest into its operations, as it had seemingly found a stable niche, loyal customer base, and improved branding.

Given its stable performance in the years preceding 2020, LightingCo’s management team and lenders were unconcerned with its ability to handle the increased debt burden.

Following its first financing round, the types of debt and the amounts sitting on LightingCo’s balance sheet comprises:

  • $100mm of Senior Secured Bank Debt
  • $100mm of Senior Unsecured Notes
  • $100mm in Subordinated Debt

Restructuring Catalyst

On the date of financing, the total leverage multiple raised came out to 3.5x, which we can assume is a conservative amount of debt given LightingCo’s mature state and having seemingly reached a sustainable growth rate.

However, the unexpected breakout of the coronavirus completely altered the projected financials and growth trajectory for the year.

If the face value of debt obligations of the firm is in excess of the enterprise value of the firm, the location of the fulcrum security becomes critical to track.

Only a few months into 2020, LightingCo was forced to cut its forecasts to generate $50mm of EBITDA – a significant drop-off from prior years.

Under 2020 projections, the total leverage multiple has inflated to 6.0x due to the deterioration in LightingCo’s EBITDA and profit margins.

The moderate amount of debt raised has turned out to have been unfortunate timing.

As of the present date, the market values companies in its industry peer group at 3.0x EBITDA. Based on trading comps analysis, the implied value of LightingCo is currently $150mm ($50mm × 3.0x).

LightingCo’s outstanding debt balance was $300mm whereas its implied enterprise value based on current projections (and the industry multiple from peer group benchmarking) comes out to $150mm.

Causes of Financial Distress – LightingCo Example

To address the reasons LightingCo’s management team is suddenly concerned about becoming distressed and/or declaring bankruptcy, there is a multitude of reasons:

Cyclical Revenue & Consumer Demand

  • LightingCo’s total revenue in 2020 is being anticipated to decrease by about 17%, with a significant fall in demand already seen in Q1 due to sales being tied to consumer discretionary spending
  • LightingCo’s products are optional purchases with high selling prices, but economists are now projecting an unprecedented decrease in GDP in 2020 with uncertainty surrounding the pace of vaccine development
  • The main cause for concern is how LightingCo’s margins have contracted substantially far more than expected due to having high operating leverage and increased capex to adapt to the new environment

Concentration in Physical Sales Channel

  • Historically, most of LightingCo’s sales have come from in-store purchases and showrooms with no online digital / e-commerce presence
  • From the over-reliance on in-person sales, LightingCo was required to spend significant sums of capital to build out its online infrastructure to adjust to the changing landscape
  • Keep in mind, these increased expenditures and operating expenses are being incurred while the company is experiencing a fraction of the normal level of demand for its products

Tied to Discretionary Consumer Spending

  • LightingCo’s primary end market consists of affluent consumers, but contrary to a common misconception, the spending patterns of high-income consumers deviate significantly under different macroeconomic conditions
  • LightingCo suppliers are highly concentrated overseas in China and cannot operate throughout the lockdowns – thus, LightingCo was forced to urgently find US suppliers deemed essential businesses with practically no negotiating leverage with these new suppliers

Deterioration in Working Capital Management

  • LightingCo’s cash conversion cycle (CCC) is expected to lengthen – more specifically, the numbers of days that inventory is held on average will inevitably increase whilst the optionality to extend its A/P days is non-existent from the lack of leverage over its new US-based suppliers
  • Despite the increased spending on home improvement, LightingCo fails to benefit from the “DIY” consumer spending trends as discretionary spending is incomparably outpaced by home repairs and lower average selling price (“ASP”) purchases
  • In effect, the prolonged cash conversion cycle makes the required cash-on-hand for meeting its net working capital (NWC) requirements (i.e. the minimum cash balance) shift upward, which decreases the free cash flow (FCF) available to pay down debt obligations and re-invest into its operations

So, returning to our first example, the economy has unexpectedly entered a recessionary period because of the pandemic and based on management’s current projection model, LightingCo could face difficulty servicing its debt obligations in the coming year(s).

To get ahead of the curve and address the increasingly growing concerns amongst their lenders and shareholders, the management team has retained an RX bank for its advisory services as a preventive risk measure.

In theory, the economic value of the company is less than the cumulative face value of the total debt it has raised, as its enterprise value is $150mm whereas the total debt outstanding is $300mm.

Fulcrum Debt Written-Out Calculation

Formula: $150mm [Enterprise Value] = $100mm [Senior Secured Bank Debt] + ($50mm ÷ $100mm) [Senior Unsecured Notes] + ($0mm ÷ $100mm) [Subordinated Debt]

*The red text denotes the class of creditors at which the fulcrum security is located*

The graphic above shows the debt waterfall and we can see that the senior unsecured notes were paid down 50% before the value break take place after the senior secured bank debt was paid down fully.

In this specific case, the fulcrum security is the senior unsecured notes as it signifies the point in which the cumulative capital structure lines up with the enterprise value of the firm.

Theoretically, since the enterprise value breaks halfway through the senior unsecured notes tranche, the remaining bottom-half of the senior unsecured notes, the subordinated debt, and common shareholders should be ascribed to no recovery value.

Locating the Fulcrum Security: Illustrative Example B

In our next example, LightingCo’s financials in the two years preceding 2020 are the same as the previous example.

But this time around, LightingCo is the portfolio company of a private equity firm and holding a highly levered capital structure consisting of $200mm in senior secured bank debt, $100mm in senior unsecured notes, and $100mm in subordinated notes (a total leverage multiple of 5.0x in 2018).

While the leverage multiple is on the higher end, this is not an uncommon amount of debt for LBOs and was not a cause of concern as of 2019, even after raising an additional $150mm in subordinated debt for the debt-funded acquisition of competitor TargetCo (bringing the total leverage multiple up to 6.5x in 2019).

Upon completion of the add-on and the coinciding new debt financing, LightingCo’s capital structure at the end of FY 2019 consisted of:

  • $200mm in Senior Secured Bank Debt (Pre-Existing Roll-Forward)
  • $100mm in Senior Unsecured Notes (Pre-Existing Roll-Forward)
  • $100mm in Subordinated Debt (Pre-Existing Roll-Forward) + $150mm in Subordinated Debt (Newly Issued to Fund the Add-on)

To list out some of the relevant valuation data:

  • Comparable high-end, discretionary lighting fixtures companies were trading on the public markets at an average valuation of 3.0x EV / EBITDA in Q4 of 2019 when the debt was raised
  • Upon completion of the purchase near the EOY in 2019, an economic slowdown caused by the pandemic soon followed with operational issues, and higher-than-expected expenditures required to maintain its historical revenue levels
  • And resulting from the unexpected market conditions and disproportionate fall in demand for discretionary lighting fixtures, the industry-wide trading multiples dropped to 1.5x EV / EBITDA
  • These losses in profitability were further worsened by the difficulties integrating new acquisitions amidst the changing environment

Now, moving onto the key financial metrics and total debt outstanding:

  • Combined together, these external factors have caused LightingCo’s management to cut its projected EBITDA to $50mm in 2020
  • The valuation of LightingCo, therefore, comes out to a mere $75mm
  • The face value of the debt for the company is $400mm ($100mm of Secured Bank Debt + $300mm of Unsecured Senior Notes + $250mm Subordinated Debt)

In effect, LightingCo incurred a substantial reduction in its revenue following the acquisition of TargetCo and failed to benefit from M&A synergies of any sort – thereby, the purchase premium paid was a poor corporate decision (i.e. caused value destruction, not incremental value creation).

If LightingCo had timed the acquisition a few months later when the severity of the coronavirus became more well-known, the acquisition likely could have been terminated with no (or minimal) break-up fees due to the presence of a material adverse change (MAC).

Fulcrum Debt Written-Out Calculation

Formula: $50mm [Enterprise Value] = ($50mm ÷ 200mm [Senior Secured Bank Debt)] + ($0mm ÷ $100mm) [Senior Unsecured Notes] + ($0mm ÷ $250mm) [Subordinated Notes]

As shown above, the value break takes place right after 37.5% of the senior secured bank debt is paid down. This means that LightingCo would be incapable of compensating even half the most senior creditor class (i.e. the senior secured bank debt).

Worst-Case, Liquidation Scenarios

Oftentimes, the distressed company will be severely impaired to the point that it is in the best interests of all claim holders that the business be liquidated under a Chapter 7 bankruptcy.

This is seen in Example B, which represents an example of a failed LBO in which an otherwise well-performing company took on too large of a debt burden, which was exacerbated by the additional debt raised to fund an add-on acquisition.

Hence, the focus in private equity investing is on pursuing companies with recurring, predictable free cash flows in non-cyclical industries.

In these worst-case scenarios, such as Example B, the fulcrum security would be within the senior secured bank debt and the senior unsecured notes and subordinated debt should trade close to zero.

But some examples of mitigating factors that could help a struggling company in the short term would be Divestitures of non-core business segments (and using the proceeds to remain afloat) and a pre-existing Revolving Credit Facility (“Revolver”).

Assigning Value to the Fulcrum Security: Practice Exercises

While this should go without saying, accurately locating the fulcrum security is a very challenging task in practice.

The perceived valuation of the distressed company deviates widely across different RX bankers, distressed investors, and creditors due to its subjective nature.

For our purposes, we used an arbitrary industry multiple that was adjusted downward to reflect the distressed state.

However, the valuation of a distressed company is never this simple as it is driven by discretionary assumptions regarding the companies’ odds of emergence, the validity of the proposed turnaround plan, and other qualitative factors that can impact the valuation (e.g. the relationship amongst the creditors and all stakeholders, the quality of the management team).

Q. “On a dollar basis, at what price should the fulcrum security be trading at?”

The value attributed to the fulcrum security would be a byproduct of the probability of re-emergence into a sustainable business, which can be estimated by the percentage of debt paid down and how far down the capital structure the fulcrum security is located.

But again, as this bears repeating, the estimation of the fulcrum security’s pricing is a simplification meant to introduce the concept.

Pricing the Fulcrum Debt: Illustrative Example C

Let’s say that WidgetCo is a widget manufacturing company that was highly levered due to its strong historical performance and market-leading positioning. Throughout the past two years, WidgetCo generated EBITDA of $325mm and $350mm heading into 2020.

Since 2015, WidgetCo has held $200mm in senior bank debt, $300mm in senior unsecured notes, and $300mm in subordinated debt on its balance sheet with no issues regarding default risk.

Until 2020, the implied valuation of WidgetCo was always greater than the debt it has held (unchanged for the past four years), based on the industry-derived multiple. However, this took a turn for the worse in 2020 as the valuation multiple had a drastic reduction to 3.5x.

Similar to the case of LightingCo, WidgetCo was also negatively impacted by COVID-19 and the debt on its balance sheet soon became a concern, as the face value of its debt surpassed its enterprise value.

Credit Metrics – WidgetCo

For FY 2020, EBITDA for WidgetCo is being projected to be $200mm,  a ~43% contraction YoY.

To calculate a few of the important credit metrics:

  • Senior Secured Leverage Ratio: Comes out to 1.0x ($200mm in Senior Bank Debt ÷ $200mm in EBITDA)
  • Senior Leverage Ratio: Corresponding leverage ratio is 2.5x ($500mm in Senior Debt ÷ $200mm in EBITDA)
  • Total Leverage Ratio: Under the inclusion of all debt instruments, the total leverage is $800mm ($200mm + $300mm + $300mm), which corresponds to a total leverage ratio of 4.0x ($800mm in total debt ÷ $200mm in EBITDA)

A noteworthy takeaway is that while a 4.0x leverage multiple is not necessarily low, it is nowhere near as severe as the 11.0x multiple seen in the previous example (i.e. the failed LBO of LightingCo).

As a side remark, the precise definition of “distressed” can differ, but here we are defining it as when the TEV is less than the face value of the total debt for the sake of simplicity.

Thus, despite the moderate (or above-average) leverage multiple, WidgetCo is still considered distressed under our definition for these exercises.

If the RX investment banking analyst or distressed analyst thinks that WidgetCo is worth 3.5x EBITDA, the fulcrum security is accordingly the subordinated debt.

In that case, the senior unsecured notes and bank debt will both trade at par and would anticipate full recoveries.

To calculate the pricing of the fulcrum security:

  1. At a 3.5x industry multiple, the value of the WidgetCo is $700mm ($200mm × 3.5x)
  2. There will be $200mm of residual value post-paydown of the bank debt ($200mm) and the senior unsecured notes ($300mm)
  3. In the final step, the subordinated debt should trade around $200mm residual value ÷ $300mm face value (66.7% paydown), which comes out to roughly 67 cents on the dollar

But as noted earlier, this particular mandate would likely be much more straightforward for an RX banker in comparison to a worst-case scenario example in which the value breaks in the first class of creditors.

Since the value breaks at the lowest debt tranche (i.e. the subordinated debt) with 66.7% of the total amount paid down, WidgetCo is not in too bad of shape and could figure out a solution, as the holder of the subordinated debt should be more receptive to negotiating something beneficial for both parties.

Pricing the Fulcrum Debt: Illustrative Example D

In our 2nd scenario for WidgetCo, the only adjustment we will make is that the industry comparables are more impaired and thereby leads to WidgetCo being valued at a multiple of 2.0x EV / EBITDA (a $400mm implied valuation).

Under this lower valuation assumption, the fulcrum security becomes the senior unsecured notes, as opposed to the subordinated notes.

To calculate the pricing of the fulcrum security:

  • The implied value of WidgetCo is $400mm, which leaves $200mm for the senior unsecured notes after paying off the senior secured bank debt
  • Of the $300mm in senior unsecured debt, only $200mm can be paid down (66.7%)
  • Same as the previous example, the fulcrum security trades at ~67 cents on the dollar, but this time around the break occurs at the senior unsecured notes tranche
  • In addition, the bank debt trades around par whereas the subordinated debt trades close to zero

Compared to Example C, the fulcrum security is located higher in Example D as a byproduct of the lower comps-derived valuation.

To reiterate a point made earlier, the fulcrum security being higher in the capital structure means that fewer claim holders receive full recovery. And so, the higher the fulcrum security is located, the more concerned the lower creditor(s) and equity owners should be.

Non-Distressed Companies: Fulcrum Security

As another concept test, answer the following question in a hypothetical non-distressed scenario:

Q. “If WidgetCo is NOT in financial distress and is being valued at 6.0x EV / EBITDA in the open market, where would the fulcrum security be located in the capital structure?”

There should be $12bn of observable market equity value while all of the debt trades at par or face value, adjusted for changes in interest rates.

Here, the fulcrum security is not relevant as the residual common equity is $400mm.

This ties back to how the fulcrum security is not meaningful in financially stable companies – hence, it is not tracked for non-distressed companies.

Below, we can see the same financial performance and capital structure was used as Example D, and the only variable that was adjusted upward is the valuation multiple from 2.0x to 6.0x.

Since this time around the industry multiple being used to value WidgetCo is 6.0x, the valuation is considerably higher.

The residual value that flows to the common shareholders (under the assumption there are no preferred equity holders) is abundant as WidgetCo is not distressed and its TEV of $1.2bn exceeds the $800mm in debt.

Only after a significant deterioration in the debtor’s financials and/or a contraction in the industry valuation multiple would it become necessary to locate the value break and then price the fulcrum security.

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