A worked Chapter 7 liquidation analysis: proceeds by asset class, the costs most models forget, and the best interests test for the first lien.
A liquidation analysis applies a recovery rate to each asset class, deducts the costs of the wind-down and the trustee, and runs what is left down the priority waterfall. On an illustrative balance sheet with $570M of book assets, mid-case recovery rates produce $201.5M of gross proceeds, $172.45M net of costs, and a first lien recovery of 53.0 per cent. The costs alone take 11.6 points of that recovery, and the range from low to high case runs from 32.2 to 73.7 per cent.
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 →
Every Chapter 11 disclosure statement carries a liquidation analysis, because a plan cannot be confirmed over the objection of an impaired creditor who would receive more in a hypothetical Chapter 7 liquidation: the best interests test. For a distressed investor the same number is the floor under a position. It sets the minimum a dissenting holder can insist on, and it is the recovery that remains if a going-concern restructuring fails.
A manufacturer has a $40M DIP facility, a $250M first lien term loan secured on substantially all assets, and $180M of unsecured claims. The plan offers the first lien 70 per cent of its claim in new debt and equity. All figures are illustrative, and the recovery rates are assumptions an investor would test against appraisals, not market data.
| Asset | Book value | Low | Mid | High | Mid proceeds |
|---|---|---|---|---|---|
| Cash | 20 | 100% | 100% | 100% | 20.0 |
| Accounts receivable | 80 | 65% | 75% | 85% | 60.0 |
| Inventory | 120 | 30% | 45% | 60% | 54.0 |
| Property, plant and equipment | 200 | 20% | 30% | 40% | 60.0 |
| Intangibles and goodwill | 150 | 0% | 5% | 10% | 7.5 |
| Total | 570 | 201.5 |
Costs of the liquidation: $15M of wind-down operating costs, a trustee fee of 3 per cent of gross proceeds, and $8M of Chapter 7 professional fees.
First, gross proceeds: book value times recovery rate, asset by asset. In the mid case that is $201.5M, only 35.4 per cent of book, because the assets that dominate the balance sheet, plant and goodwill, are the ones a liquidator sells worst.
Second, the costs. The trustee fee is 3 per cent of $201.5M, or $6.04M. Add the wind-down and professional fees and the total is $29.05M, 14.4 per cent of gross proceeds. Net proceeds are $172.45M.
Net proceeds = Σ(book × rate) × (1 − 3%) − 15 − 8 = 201.5 − 29.05 = 172.45
DIP: min(40, 172.45) = 40, paid in full
First lien: min(250, 172.45 − 40) = 132.5, or 53.0% of its claim
Unsecured: nothing left; the first lien's deficiency of 117.5 joins the unsecured pool
Excel: =MIN(FirstLien, MAX(0, SUMPRODUCT(Book,Rate)*(1-Trustee)-WindDown-Prof-DIP))/FirstLien
Against the plan's 70 per cent, the first lien is 17.0 points better off reorganising than liquidating. On these numbers the plan passes the best interests test for that class.
| Line | Low | Mid | High |
|---|---|---|---|
| Gross proceeds | 148.0 | 201.5 | 255.0 |
| as % of book | 26.0% | 35.4% | 44.7% |
| Costs | 27.44 | 29.05 | 30.65 |
| Net proceeds | 120.56 | 172.45 | 224.35 |
| DIP recovery | 100% | 100% | 100% |
| First lien recovery | 32.2% | 53.0% | 73.7% |
| Unsecured recovery | 0% | 0% | 0% |
The range is wide, 41.5 points of first lien recovery, and it straddles the plan. In the high case the first lien would receive 73.7 per cent in liquidation, more than the 70 per cent the plan offers. A first lien holder who believes the high-case recovery rates has an argument against confirmation; one who believes the low case has every reason to support the plan.
The break-even sits at gross proceeds of $245.4M, 43.0 per cent of book. Below that, the plan beats liquidation for the first lien. The useful question for diligence is therefore narrow: is there a credible appraisal that gets the assets above 43.0 per cent of book in a forced sale?
Across the case ranges, plant and equipment and inventory drive most of the spread. Per 10 points of recovery rate, plant and equipment moves the first lien recovery by 7.8 points and inventory by 4.7; goodwill would move it by 5.8, but its forced-sale range is narrow. Cash does not move it at all. Spend the appraisal budget accordingly.
The frequent error is to stop at gross proceeds. Without the wind-down costs, the trustee fee and the professional fees, the mid case leaves $201.5M for creditors and the first lien recovers 64.6 per cent. With them it recovers 53.0. The 11.6 points of difference are not a rounding item: they are larger than the gap between the plan and the liquidation in many cases, and omitting them makes liquidation look better for the senior class than it is.
The second error is to treat the liquidation as instant. A real Chapter 7 sale of plant and inventory runs over months, receivables are collected slowly and against set-off claims, and the costs accrue while it happens. A careful analysis discounts the proceeds for the time they take, which widens the margin by which a going-concern plan beats liquidation.
The book builds the liquidation floor independently of the going-concern value, and the free workbook for this case sets both against each tranche on one page. For the going-concern side, see does the fulcrum security move when enterprise value changes.
It requires that each impaired creditor who votes against a plan receive at least what it would get in a hypothetical Chapter 7 liquidation. In the worked case the first lien would recover 53.0 per cent in a mid-case liquidation and is offered 70 per cent under the plan, so the test is met for that class with 17.0 points to spare.
They come from appraisals and the asset's liquidity: cash at par, receivables often at a high share of book, inventory and equipment far lower, goodwill close to nothing. The illustrative mid case uses 75 per cent for receivables, 45 for inventory, 30 for plant and 5 for intangibles, giving gross proceeds of 35.4 per cent of book.
Because they come out before any creditor is paid and fall entirely on the class at the fulcrum. Wind-down costs, a 3 per cent trustee fee and professional fees total $29.05M in the example, 14.4 per cent of gross proceeds, and reduce the first lien recovery from 64.6 to 53.0 per cent.
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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