24.1.1 Mezzanine Debt Structures

Mezzanine debt becomes equity-like when an equity kicker is attached to the debt. This equity kicker, introduced in Chapter 22, is usually in the form of equity warrants to purchase stock, with a strike price as low as $0.01 per share. 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 higher the 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. The equity component can be substantial, representing 5% to 20% of the outstanding equity of the company. For this reason, mezzanine debt is often viewed as an equity investment in the company as opposed to an unsecured lien on assets.

The idea that mezzanine debt becomes more equity-like when call options are attached is clarified through the application of option theory to the capital structure of a firm. Within Merton's view of the capital structure of a firm, discussed in Chapter 25, corporate debt may be seen as the combination of a long position in the firm's assets and a short position in a call option (written to the shareholders), with a strike price equal to the face value of the firm's debt (and a time to expiration equal to the maturity of the debt). Equation 24.1 illustrates this structural view of corporate debt:

(24.1)

When explicit long positions in equity kickers (i.e., call options) are attached to the corporate debt on the left side of Equation 24.1, the options hedge the debt holders' implicit short positions in call options on the right side of the equation. The net result is that the remaining exposure is the debt holders' implicit long position in the firm's assets. Thus, mezzanine debt with equity kickers can behave like an unlevered long position in the firm's underlying assets.

Mezzanine financing does not necessarily involve control of the company, in contrast to an LBO, and is therefore much more passive than an LBO. Mezzanine financing is an appropriate financing source for those companies that have a reliable cash flow. This is in contrast to venture capital (VC), in which the start-up company does not have sufficient cash flow to support debt.

There is no typical or standard mezzanine deal structure. Each financing consists of unique terms and conditions that depend on the preferences of the user and provider and that emerge from a highly negotiated process. The mezzanine piece can be structured as debt or equity, depending on how much capital the owner wants to obtain and how much control the owner is willing to cede to the mezzanine partner. 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. Typically, the total return sought by investors in mezzanine financing is in the range of 15% to 20%. The largest piece of the total return is the coupon rate on the mezzanine security, usually 10% to 14%. The remainder of the upside comes from the equity kicker, either warrants or some other equity conversion. The equity kicker can provide an additional 5% to 10% return to the mezzanine finance provider.

The typical exit strategy for mezzanine debt occurs when the underlying company goes public or obtains capital through a large equity issuance. In addition, the mezzanine debt may be paid prior to maturity if the borrowing firm is acquired or recapitalized. When one of these events happens, the mezzanine debt provider gets back the face value of the mezzanine debt plus the sale of stock from the conversion rights or sale of warrants attached to the mezzanine debt.

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.

24.1.2 Stylized Example of Mezzanine Debt Advantage

The left-hand side of Exhibit 24.1 shows a simple capital structure for a company faced with a 60% bank loan–40% equity capital structure. Bank debt is assumed to be cheap, and equity is assumed to be expensive. Unfortunately, a bank may be willing to lend only up to 60% of the total capital structure of the company. Therefore, expensive equity capital might be used to fill the remaining capital gap if mezzanine debt is unavailable. 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. Exhibit 24.1 illustrates a relatively high weighted average cost of capital (WACC) using only bank loans and equity. Without mezzanine debt, the weighted average cost of capital is 16.8%.

The right-hand side of Exhibit 24.1 lays out how mezzanine capital might lower the capital costs for a company. In this example, half of the equity capital is replaced with mezzanine debt at a coupon rate of 15%. This makes the equity riskier and therefore likely to increase its cost of capital, which is assumed to rise to 32%. At the bottom of the exhibit, the new weighted average cost of capital for the company is calculated. When mezzanine debt is added to the capital structure, the WACC declines from 16.8% to 14.2%.

The reduced weighted average cost of capital is generated by replacing relatively expensive equity financing with less expensive mezzanine financing. The reduction in capital costs illustrated in Exhibit 24.1 demonstrates the motivation for a firm to use mezzanine financing.

This simplified example assumes that the required return on equity changes only slightly when half of the equity is replaced with mezzanine debt and the leverage is increased. In the case of very well-functioning capital markets, it would usually be argued that sources of financing are efficiently priced and that different capital structures cannot be used to generate lower aggregate costs of capital (i.e., lower weighted average costs of capital). The justifications for advantages to mezzanine debt are based on inefficiencies and imperfections in the capital markets for the size companies that tend to use mezzanine financing.

24.1.3 Mezzanine Financing Compared with Other Forms of Financing

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.

Mezzanine financing is highly negotiated and can be tailored to any company's situation. 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.

Mezzanine debt is typically held by mezzanine debt funds raised by private equity firms. Mezzanine financing stands behind senior debt and is usually analyzed on an earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple basis. Bank loans and other senior loans generally require a loan-to-EBITDA multiple of no more than 2 to 2.5. In other words, a firm with EBITDA of $100 million per year would typically be allowed to borrow between $200 million and $250 million in senior loans. However, mezzanine debt typically allows for a higher loan-to-EBITDA multiple of 4 to 4.5. Thus, a firm with EBITDA of $100 million per year could expand its total debt to between $400 million and $450 million, including perhaps $225 million of senior debt and $200 million of mezzanine debt.

Because mezzanine debt is not backed by collateral, it carries a higher coupon payment than does senior debt. Mezzanine debt is generally medium-term money, usually with maturities from five to seven years. Typically, mezzanine financing requires only payment of interest until maturity; there is no amortization of the underlying debt. 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.

Exhibit 24.2 compares mezzanine debt to leveraged loans and high-yield bonds. Notice that leveraged loans have the strictest debt covenants, which lead to greater protection from default but also to a lower return. Also, a credit rating is typically required before a bank will lend credit through a leveraged loan, whereas this is not necessary for mezzanine debt. 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.

One last point is that leveraged loans do not contain any type of equity kicker, so they do not share in any upside of the company. Mezzanine debt investors focus on the total return from mezzanine financing, including future equity participation through a convertible security or warrants attached to the mezzanine debt. This is distinctly different from bank loans, which focus exclusively on the cash yield. High-yield bonds fall somewhere between these two forms of financing.

24.1.4 Seven Basic Examples of Mezzanine Financing

As noted earlier, 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. The diversity of transaction types that follow demonstrates this flexibility.

There are seven basic transactions to which mezzanine debt is applied: management buyouts, growth and expansion, acquisitions, recapitalizations, real estate financing, leveraged buyouts, and bridge financing.

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 a 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. Typical equity contributions for real estate are in the 10% to 15% range. It is in between bank loans and equity that mezzanine financing exists, historically supplying 10% to 40% of a project's capital structure.
6. MEZZANINE FINANCING IN A LEVERAGED BUYOUT: Mezzanine financing is an established component of many leveraged buyouts. 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 used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of cash.

24.1.5 Investors in Mezzanine Debt

This section reviews four major types of investors in mezzanine debt.

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.

   Mezzanine funds tend to charge a fee structure similar to venture capital (VC) and LBO funds: a management fee in the 1% to 2% range and a profit-sharing fee of 20%. Like hedge funds, VC funds, and LBO funds, mezzanine funds are managed by a general partner who has full investment discretion. Many mezzanine funds are managed by merchant banks that have experience with gap financing or by mezzanine professionals who previously worked in the mezzanine departments of insurance companies and banks.

   There are two key distinctions between other private equity funds and mezzanine funds. The first lies in return expectations. Mezzanine funds seek total rates of return in the 15% to 20% range. Compare this to LBO funds, which seek returns in the 20% to 30% range, and VC funds, which seek returns in the 30% to 50% range. This puts mezzanine funds at the lower end of the private equity risk-return spectrum. However, contrasted to debt, mezzanine financing is the most expensive because it is the last to be repaid, ranking at the bottom of the creditor spectrum, just above equity. Second, mezzanine fund staff have different expertise than is typically found at a venture capital fund. Most VC funds have staff with heavy technology-related experience, including former senior executives of software, semiconductor, and Internet companies. In contrast, mezzanine funds are inundated with financial engineers who are experienced at structuring and negotiating loans that incorporate the use of equity kickers and warrants.

   Mezzanine funds look for businesses that have a high potential for growth and earnings but do not have a sufficient cash flow to receive full funding from banks or other senior creditors. Banks may be unwilling to lend because of a short operating history or a high debt-to-equity ratio. Mezzanine funds look for companies that can repay the mezzanine debt over the next four to seven years through a debt refinancing, an initial equity offering, or being acquired. Mezzanine funds are considerably smaller than the huge ($20 billion plus) leveraged buyout funds. This reflects the fact that mezzanine financing is distinctly a middle-market phenomenon and cannot support megafunds of the type commonly associated with LBOs.

   Mezzanine funds are risk lenders. This means that in a liquidation of the company, mezzanine investors expect little or no recovery of their principal. Mezzanine debt is rarely secured. As the last rung of the financing ladder, it is often viewed as a form of equity by the more senior lenders.

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. These investors take more of a fixed-income approach and place a high value on the scheduled repayment of principal. Insurance companies are more concerned with a higher coupon payment than with the total return, including equity warrants. Therefore, insurance companies act more like traditional lenders than like equity investors. They provide mezzanine financing to higher-quality credit names and emphasize preservation versus appreciation of capital.
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. Mezzanine financing and venture capital frequently go hand in hand, with mezzanine debt serving as the bridge. In this case, the bridge is the last round of private financing before a start-up company goes public. The lines between mezzanine financing and different forms of private equity can become blurred. With respect to pre–initial public offering (IPO) companies, it is difficult to distinguish where venture capital ends and mezzanine financing begins. Also, mezzanine financing can be used as the last leg in the capital structure of a start-up company before it goes public. This bridge financing allows the company to clean up its balance sheet before its IPO.

24.1.6 Eight Characteristics of Mezzanine Debt

Mezzanine debt has eight characteristics that help distinguish it from other sources of financing and types of investments:

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. The lender may also enjoy final approval over any contemplated acquisitions, changes in the management team, or payment of dividends.
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. For example, mezzanine debt can be structured so that no interest payments begin for two to three years.
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. The intercreditor agreement may be negotiated separately between the senior creditors and the mezzanine investor, or it may be incorporated directly into the loan agreement between the mezzanine investor and the company. Intercreditor agreements usually restrict amendments to the credit facility so that the terms of the intercreditor agreement cannot be circumvented by new agreements between the individual lenders and the borrower.
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. This typically forces a default and allows the senior lender to enforce the collateral security.
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.

24.2.1 Describing Distressed Debt

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.

Distressed debt investors are usually equity investors “in debt's clothing.” They are relatively unconcerned with coupon payments, debt service, and repayment schedules, being interested in distressed debt for the capital appreciation that can be achieved in various situations. They are sometimes viewed as vultures looking to swoop in, purchase cheap debt securities, convert them to stock, turn the company around, and reap the rewards of appreciation. As discussed in Chapter 22, the risks are large because the underlying company is in some form of distress. Consequently, distressed debt investors are exposed to event risk that the company will not be able to emerge from bankruptcy protection or will otherwise fail.

Within the risk spectrum, private equity distressed debt investors fall between LBO firms and venture capital. Like LBO firms, distressed debt investors purchase securities of companies that have established operating histories. In most cases, these companies have progressed far beyond their IPO stage. However, unlike LBO firms that target successful but stagnant companies, distressed investing targets troubled companies. These companies have declined and may already be in bankruptcy proceedings. Like venture capital and LBO funds, distressed debt investors assume considerable business risk. A company's current problems might be due to poor execution of an existing business plan, an obsolete business plan, or simply poor cash management. These problems are more likely to be fixable than in the case of a start-up company with a nonviable product.

Mezzanine debt is made equity-like primarily through equity kickers. Distressed debt becomes equity-like through potential default risk. 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. Equation 24.1 illustrated this option view of corporate debt.

If the value of the firm's assets falls near or below the face value of the debt, the debt holders' short position in the call option moves out-of-the-money and becomes a smaller and smaller value relative to the debt holders' long position in the firm's assets. The further out-of-the-money the call option moves, the closer the value of the call option on the right-hand side of Equation 24.1 moves toward zero. Thus, the corporation's debt behaves increasingly like an unlevered long position in the firm's assets as the value of the firm's assets falls below the face value of the firm's debt.

24.2.2 The Supply of Distressed Debt

Debt rarely becomes distressed because of some spectacular event that renders a company's products worthless overnight. Rather, a company's financial condition typically deteriorates over a period of time due to inefficient or tired management. The management of a company that was once established in the marketplace may become lacking in energy or rigid, unable or unwilling to cope with new market dynamics. 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.

Leveraged buyout firms are a major source for distressed debt, as the debt used to initiate the LBO often becomes distressed debt. There is a natural cycle between private equity and distressed debt investing. Since LBOs use a substantial amount of debt to take a company private, this debt burden sometimes becomes too much to bear, and the private company enters into a distressed situation. These so-called leveraged fallouts occur frequently, leaving large amounts of distressed debt in their wake. However, this provides an opportunity for distressed debt buyers to jump in, purchase nonperforming bank loans and subordinated debt cheaply, eliminate the prior private equity investors, and assert their own private equity ownership.

24.2.3 The Demand for Distressed Debt

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.

One reason the distressed debt market is attractive to vulture and other investors is that it is an inefficient market. First, distressed debt is not publicly traded like stocks. Further, most distressed bonds were originally issued in private offerings and sold directly to institutional investors seeking investment-grade debt. These bonds lacked liquidity from the outset, and what little liquidity existed dried up when the company became distressed. This lack of liquidity can lead to bonds trading at steep discounts to their true value. Institutional investors uncomfortable with the increased risk of their positions in distressed bonds may need to sell their claims at depressed prices.

Sometimes investors use distressed debt as a way to gain an equity investment stake in a company. In these cases, the distressed debt owners agree to exchange their debt in return for stock in the company. At other times, distressed debt owners help the troubled company get back on its feet, thus earning a substantial return as their distressed debt recovers in value.

Finally, distressed debt is not always an entrée into private equity; it can simply be an investment in an undervalued security. At these times, distressed debt buyers may serve as patient creditors. They buy the debt from anxious sellers at steep discounts and wait for the company to correct itself and for the value of the distressed debt to recover.

Like LBO funds and venture capital funds, distressed debt funds tend to run concentrated portfolios of companies. However, distressed debt investors tend to invest across industries as opposed to concentrating in a single industry. This may lead to better diversification than is found in VC funds. Distressed debt portfolios may be viewed as suffering credit losses at rates that are more than offset by coupon income and recoveries from firms that turn around. Equation 24.2 illustrates this minimum criterion based on an annual coupon rate, a default rate, and a loss rate:

(24.2)

Equation 24.2 is a highly simplified approximation that ignores risk premiums, riskless returns, and timing of cash flows. But as a heuristic exercise, it illustrates the distressed investor's goal of receiving at least enough coupon income to cover credit losses. Credit losses are the product of the default rate and the loss rate given default on the portfolio.

24.2.4 Three Distressed Debt Investment Strategies

There are three broad categories of investing in distressed debt securities, introduced in the previous section.

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. This strategy of gaining control also seeks seats on the board of directors and even the chairmanship of the board. This is the riskiest and most time-intensive of the distressed investment strategies. Returns are expected in the 20% to 25% range, consistent with those for leveraged buyouts. Often, these investors purchase fulcrum securities. Fulcrum securities are the more junior debt securities that are most likely to be converted into the equity of the reorganized company.

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. Their return target is in the 15% to 20% range, very similar to that of mezzanine debt investors.

Last, 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.

24.2.5 Distressed Debt and the Bankruptcy Process

Distressed debt investing and the bankruptcy process are inextricably linked. Many distressed debt investors purchase the debt while the borrowing company is in the throes of bankruptcy. Other investors purchase the debt before a company enters into bankruptcy proceedings with the expectation of gaining control of the company through the bankruptcy proceedings. In either case, distressed investors need to be experts in bankruptcy procedures. This section illustrates issues involved in bankruptcy using U.S. bankruptcy law.

There are two major forms of U.S. corporate bankruptcy: chapter 7 and chapter 11. Chapter 7 bankruptcy is entered into when a company is no longer viewed as a viable business and the assets of the firm are liquidated. 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.

Chapter 11 bankruptcy 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. Generally, under a chapter 11 bankruptcy, the debtor company proposes a plan of reorganization. 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 shareholders 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. If all impaired classes of security holders vote in favor of the plan, the bankruptcy court conducts a confirmation hearing. If all requirements of the bankruptcy code are met, the plan is confirmed, and a newly reorganized company emerges from bankruptcy protection.

Thus, the sequence of events in a chapter 11 bankruptcy centers on a plan of reorganization. The skeleton of the process is as follows:

• The debtor company files for protection under chapter 11.
• The bankruptcy court automatically stays, or suspends, all default notices from lenders.
• The debtor company exclusively has 120 days to develop and file a plan of reorganization.
• The debtor company then has another 60 days to convince creditors to accept the plan.
• If half of the number and two-thirds of the value of each class of claimants accept the plan, then court approval is sought through a confirmation hearing.

During the first 180 days after filing for protection, no other party of interest may file a competing reorganization plan. By giving the debtor company 120 days to propose its reorganization plan and another 60 days to persuade creditors, the bankruptcy code puts the emphasis on reorganization over liquidation and puts the debtor in the driver's seat, at least initially. After the exclusive period ends, any claimant may file a reorganization plan with the bankruptcy court. At this point, the process can become very acrimonious.

There are numerous variations and contingencies of the process. The following items provide introductions to some of the most important concepts involved in bankruptcy proceedings:

• 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. Similarly, all secured bank loans (usually the most senior of creditor claims) are usually grouped together as one class of creditor. Finally, at the bottom of the pile is common equity, the last class of claimants in a bankruptcy.
• 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.
• BLOCKING POSITION: A single creditor can block a plan of reorganization if it holds one-third of the dollar amount of any class of claimants. Recall that acceptance of a plan is usually predicated on a vote of each class of security holders, which requires support of two-thirds of the dollar amount of the claims in each class of creditors. Therefore, a single investor can obtain a blocking position by purchasing one-third of the debt in any class. A blocking position forces the other parties to negotiate with the blocking creditor.
• 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 (the plan is “crammed down the throats” of the objecting claimants). Cramdowns are usually an option of last resort when the debtor and creditors cannot come to an agreement. Bankruptcy courts have considerable discretion to determine what constitutes unfair discrimination and fair and equitable treatment for members of a class. In practice, cramdown reorganizations are rare. Eventually, the debtor and creditors usually come to some resolution.
• 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. The company's bondholders come next. These may be split between senior and subordinated bondholders. The company's preferred and common shareholders get whatever remains. As the company pie is split up, it is usually the case that senior secured debt is made whole and that subordinated debt receives some payment less than its face value, while the remainder of the company's obligations is transformed into equity in the reorganized company. Last, the original equity holders often receive nothing. Their equity is replaced by the new equity converted from the old subordinated debt. The ability of the court in the bankruptcy process to wipe out the ownership of existing shareholders and to transform the debt of senior and subordinated creditors into the company's new equity class is a key factor in distressed debt investing.
• 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. Creditors are often willing to grant DIP financing for a number of reasons. First, it keeps the debtor company afloat and gives it a chance to work out from under its debt load. Second, under bankruptcy law, DIP loans get priority over any forms of debt or financing incurred by the debtor before filing for bankruptcy under chapter 11.

24.2.6 Risks of Distressed Debt Investing

The main risk associated with distressed debt investing is business risk. Just because distressed debt investors can purchase the debt of a company on the cheap does not mean it cannot go lower. This is the greatest risk to distressed debt investing: that a troubled company may ultimately prove to be worthless and unable to pay off its creditors. Although creditors often convert their debt into equity, the company may in the end not be viable as a going concern. If the company cannot develop a successful plan of reorganization, it simply continues its downward spiral. Purchasers of distressed debt must have long-term investment horizons. Workout and turnaround situations do not happen overnight; it may take several years for a troubled company to correct its course and appreciate in value.

It may seem strange, but traditional views of credit-worthiness, such as probability of default, may not apply here. In other words, lack of credit-worthiness is already established. Credit risk and other fixed-income-based views of risk are less relevant. The debt is already distressed and may already be in default. Consequently, failure to pay interest and debt service may have already occurred.

Instead, vulture investors consider the business risks of the company. They are concerned not with the short-term payment of interest and debt service but with the ability of the company to execute a viable business plan. From this perspective, it can be said that distressed debt investors are truly equity investors. They view the purchase of distressed debt as an equity-like investment in the company as opposed to a decision to become a fixed-income investor.