Once a borrower defaults, the contractual cash flows stop being the asset. The mark has to come from the enterprise value and the queue in front of the loan.
Once a borrower defaults, value the loan on what it will recover, not on what it promises. For each way the default can resolve, take the enterprise value, deduct costs and the claims that rank ahead, cap the result at par, discount it at a distressed buyer's required return and weight it by probability. An illustrative 50.0 senior term loan behind an 8.0 super senior revolver marks at 52.4 cents. The undiscounted recovery, 62.6 cents, overstates it by 10.2 cents, 5.11 on the position, and a yield approach on the contractual coupon would say 84.3.
Worked in full in The Private Markets Valuation Specialist by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A fund holds a senior secured term loan to a fictional mid-market company. EBITDA has fallen to 8.0, the borrower has missed an interest payment and advisers have been appointed. A revolving facility of 8.0, drawn in full, ranks ahead of the term loan on enforcement proceeds. All figures are illustrative.
| Scenario | Probability | Value basis | Gross value | Costs | Years to cash |
|---|---|---|---|---|---|
| Consensual restructuring | 55% | 8.0 × 6.0x | 48.0 | 3.0 | 1.0 |
| Sale of the business | 30% | 8.0 × 5.0x | 40.0 | 2.5 | 1.5 |
| Liquidation | 15% | Asset realisations | 24.0 | 2.0 | 2.0 |
Term loan par 50.0, contractual coupon 9.0 per cent with three years to run. Discount rate 16.0 per cent, the illustrative return a buyer of defaulted senior debt would require.
Recovery to the term loan = MIN(gross value − costs − senior claims, par)
Restructuring: 48.0 − 3.0 − 8.0 = 37.0, or 74.0 cents
Sale: 40.0 − 2.5 − 8.0 = 29.5, or 59.0 cents
Liquidation: 24.0 − 2.0 − 8.0 = 14.0, or 28.0 cents
Excel: =MIN(MAX(EV-Costs-Senior,0),Par)/Par
In a restructuring the recovery usually arrives as a new, smaller loan plus equity rather than cash. The 74.0 cents is the fair value of that package at the expected date, which is itself a valuation: the reinstated debt at a market yield, the equity from the post-restructuring enterprise value. Here it is taken as one number to keep the mechanics visible.
| Scenario | Recovery | Discount factor at 16% | Present value | Probability | Weighted |
|---|---|---|---|---|---|
| Restructuring | 74.0 | 0.8621 | 63.8 | 55% | 35.1 |
| Sale | 59.0 | 0.8004 | 47.2 | 30% | 14.2 |
| Liquidation | 28.0 | 0.7432 | 20.8 | 15% | 3.1 |
| Fair value | 62.6 | 100% | 52.4 |
The weighted recovery before discounting is 62.6 cents; after it, 52.4 cents, or 26.19 on the 50.0 position. The discount is not a technicality. Nobody buying this loan today would pay 62.6 for a recovery that arrives in one to two years with this much uncertainty; the 10.2 point gap is what a market participant charges for time and risk, and fair value is the price that participant would pay.
| Multiples | 12% | 16% | 20% |
|---|---|---|---|
| One turn lower (5.0x / 4.0x) | 42.7 | 40.9 | 39.3 |
| Base (6.0x / 5.0x) | 54.6 | 52.4 | 50.3 |
| One turn higher (7.0x / 6.0x) | 66.5 | 63.8 | 61.3 |
One turn of multiple moves the mark by 11.4 points; the whole range of discount rates moves it by 4.3. The term loan is the fulcrum of this capital structure, so every unit of enterprise value above the revolver lands on it one for one. The work that matters is therefore the enterprise value: normalised EBITDA after the problem that caused the default, and a multiple for a business in that condition, with the same discipline as any equity mark in the bridge from enterprise value to equity value. Probabilities matter too: shifting weight from restructuring to liquidation, 40, 30 and 30 per cent, takes the mark to 45.9 cents.
Check the scenarios against each other. Restructuring at 6.0x implies a buyer would pay more for the company after a balance sheet fix than in a sale today; that is defensible only if the restructuring brings something a sale does not, such as time to complete a turnaround. If not, use one multiple.
Keeping the yield approach after default. Discounting the 9.0 per cent coupon and par at 16 per cent gives 84.3 cents, and even at 20 per cent it gives 76.8. Both value cash flows the borrower has already stopped paying. Widening the spread is the right tool while the loan performs, as in how to fair value a private credit loan when spreads widen; once enterprise value of 48.0 covers only 83 per cent of the 58.0 of senior claims, the contract is no longer the asset.
Marking at the undiscounted recovery. 62.6 cents is an expected outcome, not a price. It overstates the mark by 10.2 cents, 5.11 on the position, and the overstatement is largest exactly when resolutions are slow.
Confusing fair value with an impairment provision. A lender carrying the loan at amortised cost discounts the same scenario recoveries at the loan's original effective rate, not at a buyer's 16 per cent, so its provision leaves the asset higher than this mark; that calculation is in how to calculate a loan loss provision on a defaulted CRE loan.
Forgetting the claims that rank ahead. A super senior revolver, hedging close-out amounts or enforcement costs come off the enterprise value before the term loan sees anything. Leaving out the 8.0 revolver here would add 16 cents to every scenario.
The book walks one term loan from performing into trouble in the free workbook for this case.
When the contractual cash flows are no longer the best estimate of what the holder will receive: a payment default, a covenant breach heading to restructuring, or an enterprise value that no longer covers the debt. In the illustrative case enterprise value of 48.0 covers only 83 per cent of the 58.0 of senior claims, so discounting the 9.0 per cent coupon at any spread misprices the loan.
The return a buyer of distressed debt would require, which is well above the original yield because the outcome and its timing are uncertain. The illustrative case uses 16 per cent. Moving it between 12 and 20 per cent shifts the mark only from 54.6 to 50.3 cents; the enterprise value assumption matters far more.
Very. Each turn of multiple on 8.0 of EBITDA is 8.0 of enterprise value, all of which lands on the term loan once the revolver is covered. In the illustrative case one turn moves the mark by 11.4 points, from 52.4 to 63.8 cents, nearly three times the effect of the whole range of discount rates tested.
This article is one calculation from The Private Markets Valuation Specialist. 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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