Professional fees come off the top of the waterfall, so the whole bill lands on the fulcrum class, and it grows with every month the case runs.
They come off the top of the waterfall, so the whole bill falls on the fulcrum class. In an illustrative case with $500 million of enterprise value, nine months of fees at $4.5 million a month plus an $8 million success fee total $48.5 million and cut the unsecured recovery from 46.7 to 30.5 cents. Every extra month in court costs that class another 1.5 cents.
Worked in full in The Distressed Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Recovery models are usually built at emergence: an enterprise value, a list of claims, a waterfall. The professional fees of the case, debtor's counsel, financial adviser, investment banker, the creditors' committee's own advisers and the lender advisers whose fees the estate reimburses, are often a single line of “admin and fees” with a round number in it. That line deserves more care, for two reasons. First, it is senior to everything that matters to a distressed investor: fees are administrative expenses, a plan generally has to pay them in full in cash on the effective date, and the professional fee carve-out in a DIP order typically puts budgeted fees ahead of the lenders' liens, usually with a cap on fees incurred after a termination notice. Second, it is not a number but a rate multiplied by a duration, and nobody in the case controls the duration.
| Claim | Amount |
|---|---|
| DIP facility, including accrued interest | 60 |
| First lien term loan | 300 |
| Senior unsecured notes | 250 |
| Trade and other general unsecured claims (pari passu with the notes) | 50 |
| Enterprise value at emergence | 500 |
The estate's professionals bill $4.5 million a month between them, and the investment banker earns an $8 million transaction fee on emergence. The case runs nine months.
Fees = monthly burn × months + success fee = 4.5 × 9 + 8 = $48.5 million, 9.7% of enterprise value
Distributable value = 500 − 48.5 = 451.5
DIP paid in full: 451.5 − 60 = 391.5; first lien paid in full: 391.5 − 300 = 91.5
Unsecured recovery = 91.5 / (250 + 50) = 30.5 cents
Excel: =MAX(0,MIN(EV-Fees-DIP-FirstLien,GUC))/GUC with Fees=Burn*Months+Success
Without the fees the unsecured pool would receive 140.0 and recover 46.7 cents. The fees cost the class 16.2 cents, more than a third (34.6 per cent) of what it would otherwise have received. The noteholders alone receive $76.25 million instead of $116.67 million: $40.42 million of their recovery went on the case. The first lien is untouched at 100 cents, because the fees never reach it.
The marginal figure is the one to carry around. Every month costs $4.5 million, and spread over $300 million of unsecured claims that is 1.5 cents a month, or 4.9 per cent of the base recovery. The success fee is a one-off 2.67 cents.
| Months in Chapter 11 | Fees ($m) | EV 450 | EV 500 | EV 550 |
|---|---|---|---|---|
| 6 | 35.0 | 18.3 | 35.0 | 51.7 |
| 9 | 48.5 | 13.8 | 30.5 | 47.2 |
| 12 | 62.0 | 9.3 | 26.0 | 42.7 |
| 18 | 89.0 | 0.3 | 17.0 | 33.7 |
The fee effect does not shrink when the value does. It is a fixed number of dollars per month, so at a $450 million enterprise value it takes a larger share of a smaller residual: an 18-month case leaves the unsecured class with 0.3 cents. Going from 9 to 18 months costs the same 13.5 cents at every value in the table, which is the point: duration risk is additive and it lands on one class.
For an investor who bought the notes at 25 cents, the base case returns 1.22 times the price paid. The break-even is the duration at which the unsecured pool receives exactly $75.0 million: the case can absorb $65.0 million of fees, which at $4.5 million a month after the success fee is 12.7 months. A case that slips from nine months to thirteen turns a winning position into a loss before any discounting, and before the effect of time on the annualised return set out in what an 80-cent recovery is actually worth.
Move the enterprise value down to $380 million. Without fees the first lien is covered in full, 380 − 60 leaves 320 for a 300 claim, and the unsecured class receives the last $20.0 million, 6.7 cents. With the same $48.5 million of fees ranking ahead of the liens, and assuming the carve-out covers the whole bill, the fees first wipe out that $20.0 million and then take $28.5 million from the first lien, which now becomes the fulcrum: it receives $271.5 million, a recovery of 90.5 cents. The 9.5 cents it loses is the part of the fee bill that falls on whichever class sits at the break, which is why the fulcrum, as shown in does the fulcrum security move when enterprise value changes, is also the class that pays for the process.
Treating fees as a percentage haircut on the whole enterprise value, or spreading them pro rata across classes. Both understate the damage to the fulcrum and overstate it for the seniors. On these figures a 9.7 per cent haircut applied to every class would take the unsecured recovery to about 42 cents rather than 30.5. The correct treatment is to deduct the fees from the top and run the waterfall again, with the fees modelled as burn times months so the timetable becomes an input. The second mistake is to fix the duration at the debtor's proposed timeline. A contested valuation, a committee objection or a failed confirmation hearing extends the case, and the fee meter does not stop for any of them.
The book's recovery model works with fee leakage as a visible assumption feeding the waterfall, and that model is reproduced in the free workbook for this case.
Model professional fees as monthly burn times months plus success fees, deduct them before the waterfall, and divide the burn by the fulcrum class's claims. That gives cents per month, here 1.5, and the number of months a position can survive before it stops making money, here 12.7.
The estate, as administrative expenses, which a plan generally has to pay in full in cash on the effective date. Economically they are borne by the fulcrum class, the most senior class not paid in full. In the illustrative case the first lien still recovers 100 cents, so the whole $48.5 million falls on the unsecured creditors, whose recovery drops from 46.7 to 30.5 cents.
It depends on the case, but the effect on recoveries is the monthly burn divided by the fulcrum class's claims. At an illustrative $4.5 million a month against $300 million of unsecured claims, each month costs 1.5 cents of recovery, 4.9 per cent of the 30.5-cent base recovery. Eighteen months instead of nine would take the class to 17.0 cents.
Yes, when the secured class is the fulcrum. Fees paid under a carve-out in the DIP order, usually limited to budgeted amounts, rank ahead of the liens. At an illustrative enterprise value of $380 million, nine months of fees wipe out the 6.7 cents the unsecured class would otherwise receive and take the first lien from a full recovery to 90.5 cents.
This article is one calculation from The Distressed Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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