Accept or hold out, priced as two scenarios and a break-even probability of default, with participation and enterprise value as the levers that move it.
A bondholder should accept a distressed exchange offer when the probability of default is higher than the break-even at which accepting and holding out are worth the same. In an illustrative offer of 65 of new 10.00 per cent second lien notes for each 100 of 8.00 per cent unsecured notes, with 90 per cent participation and a $600M default value, accepting is worth 55.7 if the company survives and 54.8 if it defaults, against 88.6 and 18.3 for holding out. The break-even is a 47.4 per cent probability of default.
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 →
An exchange offer is a bet on two futures at once. If the company survives, the holdout is paid par on the old schedule while the participant has accepted a haircut and a longer maturity. If it defaults, the participant has moved up the capital structure and the holdout has been primed. The decision is the weighting between those two outcomes, and it can be computed.
| Input | Value |
|---|---|
| First lien term loan | 300.0 |
| Unsecured notes, 8.00% coupon, due in 2 years | 500.0 |
| Market price of the notes | 55.0 |
| Offer per 100 of notes: new second lien face | 65.0 |
| New notes: coupon, maturity | 10.00%, 4 years |
| Participation | 90% |
| Enterprise value if it defaults (in year 1, emerging in year 2) | 600.0 |
| Discount rate | 15% |
At 90 per cent participation, 450.0 of notes become 292.5 of second lien and 50.0 stay out. Total debt falls from 800.0 to 642.5, a reduction of 157.5, and annual interest from 40.00 to 33.25. That is what the issuer is buying.
Value after the first lien: 600.0 − 300.0 = 300.0
Second lien claim 292.5: paid 100.0%, so 65.0 per 100 of old notes
Left for holdouts: 300.0 − 292.5 = 7.5 on 50.0 = 15.0 cents
Without any exchange, the unsecured would have shared 300.0 across 500.0: 60.0 cents
Discounted at 15 per cent, with one year of coupon before default and the recovery at emergence in year 2, accepting is worth 6.50 ÷ 1.15 + 65.0 ÷ 1.15² = 54.8. Holding out is worth 8.00 ÷ 1.15 + 15.0 ÷ 1.15² = 18.3.
Accept: 6.50 a year for 4 years plus 65.0 at year 4, at 15% = 55.7
Hold out: 8.00 a year for 2 years plus 100 at year 2, at 15% = 88.6
In Excel: =PV(15%,4,-6.5,-65) and =PV(15%,2,-8,-100)
If the company survives, the holdout is 32.9 better off. If it defaults, the participant is 36.5 better off. Those two gaps are the whole decision.
Accept when p × 54.8 + (1 − p) × 55.7 > p × 18.3 + (1 − p) × 88.6
p* = Survival gap ÷ (Survival gap + Default gap) = 32.9 ÷ (32.9 + 36.5) = 47.4%
At a 30 per cent default probability holding out is worth 67.5 against 55.4 for accepting. At 60 per cent, accepting is worth 55.2 and holding out 46.4. Notice how flat the accept value is: 54.8 in default, 55.7 in survival. The offer turns a binary bet into something close to a fixed payment, and that payment sits right at the 55.0 market price. Accepting is selling volatility at the market; holding out is keeping it.
| Participation | EV 500 | EV 600 | EV 700 |
|---|---|---|---|
| 70% | 44.0% (0.0) | 74.4% (48.3) | never (100.0) |
| 80% | 47.4% (0.0) | 65.1% (40.0) | never (100.0) |
| 90% | 50.5% (0.0) | 47.4% (15.0) | never (100.0) |
| 95% | 51.9% (0.0) | 41.5% (0.0) | never (100.0) |
Participation is what makes holding out dangerous. At 70 per cent, 350.0 is exchanged into 227.5 of second lien and 72.5 is left for 150.0 of holdouts, so they recover 48.3 cents and the break-even is 74.4 per cent. At 95 per cent the second lien itself is no longer paid in full at $600M and the holdouts get nothing. At $500M the second lien recovers only 68.4 per cent at 90 per cent participation, so accepting is less valuable in default and the break-even rises to 50.5. At $700M everyone is covered and the exchange simply hands value to the holdouts.
The coercion is the point. Each holder is better off holding out if everyone else accepts, which is why issuers make the offer conditional on a high minimum participation, attach exit consents that strip the old indenture's covenants, and sometimes add an early tender premium. A holder's real decision depends on what it believes the others will do, and the grid above is the way to price that belief.
The common mistake is to compare 65.0 of new face with the 55.0 market price and call the offer an 18 per cent premium. It ignores that the holdout keeps a claim to 100 in two years, and that the new notes run four years at a coupon on a lower face. The second mistake is to value the holdout position at the pre-exchange recovery, 60.0 cents, when after a 90 per cent exchange it is 15.0. The exchange changes the waterfall, so both choices must be valued on the post-exchange capital structure, scenario by scenario. A change in the discount rate moves the answer only a little: at 12 per cent the break-even is 45.5 per cent, at 20 per cent it is 50.0.
The book's recovery models, including the fulcrum finder and the frictions between headline and realised recovery, are in the free workbook for this case. The loan market version of the same priming is worked in how much an uptier costs the excluded lenders.
Because the exchange moves the participants ahead of them. With 90 per cent participation, $450.0M of unsecured notes become $292.5M of second lien. At a $600M default value the first lien takes 300.0, the second lien is paid in full, and only 7.5 is left for $50.0M of holdouts: 15.0 cents, against 60.0 cents if no exchange had happened.
A vote that exchanging holders give, as they tender, to strip covenants from the old indenture. It does not change the holdouts' payment terms, but it removes protections, which is part of what makes the offer coercive. In the worked case the holdout still gets 100 if the company survives two years, worth 88.6 at a 15 per cent discount rate, which is why holding out can still pay.
Usually, because a smaller holdout class shares less residual value. At a $600M default value the break-even default probability falls from 74.4 per cent at 70 per cent participation to 47.4 at 90 and 41.5 at 95. But if the default value is $700M, holdouts recover in full at any participation and holding out always wins.
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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