By Konstantin Danilov, CFA
Even though the rate of public company bankruptcies is at an all-time low, there has recently been lots of discussion regarding proposed chapter 11 reform. If enacted, some of these proposals may have interesting implications for distressed debt investors in the future.
Proposed Reforms and Response
The American Bankruptcy Institute (ABI) Commission to Study the Reform of chapter 11 recently undertook a lengthy study in an attempt to make the bankruptcy process less costly, more effective and more “fair.” The final report makes numerous proposals regarding various aspects of the chapter 11 process which the Commission hopes to present to Congress in 2018. The commercial lending industry has responded that this is an attempt to diminish the rights (and potential recoveries) of secured lenders, stating that the reforms “to diminish secured creditors’ control over the bankruptcy process and the protections that come with collateral rights.” Similarly, Fitch Ratings noted that some of these reforms could “adversely alter recovery prospects of first lien debt claim holders.” Although there are various aspects of the proposed reforms that would impact distressed investors, this post focuses on one of the more controversial proposals – the so-called Redemption Option (“RO”).
The “Redemption Option” Proposal
While the exact technical details of the mechanics are beyond the scope of this article, a high-level overview is necessary to understand the implications (for those interested, a detailed technical discussion can be found in our ARIA Journal article). The successful confirmation of a reorganization plan or sale in a chapter 11 bankruptcy hinges on the agreement by stakeholders on a single valuation of the company. Generally, the senior creditors would prefer a lower valuation, which would allow them to receive the new reorganized equity and potentially benefit from future improvements in the company’s performance. However, a low valuation may preclude the junior stakeholders (unsecured and subordinate creditors, and equity holders) from recovering anything on their claims; as such, they would prefer a higher valuation to ensure their claims are “in the money.”
Given this dynamic, if junior stakeholders expect to receive little or nothing based on a proposed reorganization plan (with a “low” valuation) have little downside from delaying the process in the hopes that the company’s outlook improves with time. If the valuation increases to a level above that of the senior creditors’ claims, the junior stakeholders will receive some excess value. They have an implicit call option on the value of the firm, with the “strike price” being the full value of the senior creditor claim and creating additional time before the reorganization is completed increases the value of this option.
The ABI's proposed solution is to require the class of senior creditors receiving the equity of the reorganized firm (the “fulcrum” class) to pay the next most junior stakeholder class the dollar value of this implicit option (as determined by the BSM or another option valuation method).
Implication for Distressed Debt Investors
If implemented in its current form the proposal could have several implications for distressed debt investors. For instance, fulcrum security investors will need to consider the potential value of the option when projecting expected investment returns. Holding all else constant, having to pay out a higher RO value to the junior stakeholders will reduce their expected investment return (unless it’s outweighed by reduced litigation costs and increased expediency). Conversely, investors in debt further down in the capital structure – who would be the recipients of the RO value – would face the prospect of potentially higher returns. They too would have to take into account the expected value of the option when considering potential returns. Yields on loans and high-yield bonds would need to incorporate these new adjustments to the absolute priority rule of the credit recovery waterfall.
Overall, the Residual Option proposal would increase the overall level of risk and uncertainty for distressed investors. In bankruptcy, firm valuation – an inherently inexact endeavor – is compounded by the uncertainty of negotiated outcomes and court decisions; adding option valuation into the mix would add new layers of complexity. This would likely provide opportunities for higher returns for those investors who are able and willing to bear the additional risk.
Konstantin A. Danilov, CFA, Analysis Group
Analysis Group is distinguished by the combination of thought leadership and pragmatic experience we bring to assessing the economic and financial issues involved in bankruptcy matters. Mr. Danilov specializes in applying economic and financial analysis to valuation and other issues in cases involving bankruptcy, M&A and securities and financial instruments at Analysis Group.