A cramdown pays the secured class in full on paper; the discount rate decides how much of that is real.
Discount the note's payments at the rate the market would actually demand, not at the rate the plan sets. An illustrative seven-year cramdown note on a $200.0M secured claim, paying a Till formula rate of prime plus 1.50 per cent, 9.00 per cent, is worth 86.31 cents on the dollar, $172.62M, when comparable exit debt would price at 12.00 per cent. The creditor is paid in full on paper and gives up $27.38M of value.
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 →
A plan can be confirmed over a secured class's objection if the class keeps its lien and receives deferred cash payments that total at least its allowed claim and have a present value, at the effective date, at least equal to the value of its collateral. The whole fight is over the discount rate in that present value test, because the rate the court accepts becomes the coupon on the note.
In Till v. SCS Credit Corp. (2004), a Chapter 13 case, the Supreme Court plurality endorsed a formula: the prime rate plus a risk adjustment, noting that courts had generally approved adjustments of 1 to 3 per cent. A footnote left room for a market rate in Chapter 11, where an efficient market for exit financing may exist. Courts have split since: the Second Circuit in Momentive (2017) looks first for an efficient market rate and falls back on the formula only if there is none, while other courts apply the formula directly. Whichever rate is used, a buyer of the claim prices the note at what it would trade for, and that is the number that matters for a recovery.
| Input | Value |
|---|---|
| Allowed secured claim, equal to collateral value | $200.0M |
| Prime rate (illustrative) | 7.50% |
| Risk adjustment accepted by the court | 1.50% |
| Note coupon, paid annually | 9.00% |
| Tenor, principal at maturity | 7 years |
| Rate the market would demand on this note (illustrative) | 12.00% |
Note value = coupon × claim × annuity factor + claim ÷ (1 + market rate)n
Annuity factor = (1 − (1 + y)−n) ÷ y
Excel: =PV(12%,7,-18,-200) returns 172.62
Step 1, the coupon. 9.00 per cent of $200.0M is $18.00M a year.
Step 2, the coupons' value. The seven-year annuity factor at 12.00 per cent is 4.5638, so the coupons are worth $82.15M.
Step 3, the principal's value. $200.0M in seven years, at a discount factor of 0.4523, is worth $90.47M.
Step 4, the total. $172.62M, 86.31 per cent of the claim. The 3.00 point gap between the plan rate and the market rate costs the creditor $27.38M, 13.69 per cent.
| Year | Payment | Discount factor | Present value |
|---|---|---|---|
| 1 | 18.00 | 0.8929 | 16.07 |
| 2 | 18.00 | 0.7972 | 14.35 |
| 3 | 18.00 | 0.7118 | 12.81 |
| 4 | 18.00 | 0.6355 | 11.44 |
| 5 | 18.00 | 0.5674 | 10.21 |
| 6 | 18.00 | 0.5066 | 9.12 |
| 7 | 218.00 | 0.4523 | 98.61 |
| Total | 326.0 | 172.62 |
The nominal payments add up to $326.0M, 163.0 per cent of the claim, which is why the statutory test of payments totalling at least the claim is rarely the binding one. The present value test is.
| Risk adjustment | Market rate 10% | Market rate 12% | Market rate 14% |
|---|---|---|---|
| 1.0% | 92.7 | 84.0 | 76.4 |
| 1.5% (case) | 95.1 | 86.3 | 78.6 |
| 2.0% | 97.6 | 88.6 | 80.7 |
| 3.0% | 102.4 | 93.2 | 85.0 |
Each point of market rate is worth about four points of recovery on a seven-year note: moving from 12 to 13 per cent takes the value from 86.31 to 82.31. Tenor works the same way. At the 9.00 per cent coupon and a 12.00 per cent market, a three-year note is worth 92.8, five years 89.2, seven years 86.3 and ten years 83.0. A debtor proposing a long note at a formula rate is asking the secured class to lend at a below-market rate for longer, and the valuation hearing should be fought on both numbers. To be worth par, the note would need a 12.00 per cent coupon.
A fund that bought the first lien at 80 and expects a cramdown does not earn 9.00 per cent. Holding the note to maturity, it earns 13.61 per cent a year on its 80, and if it sells the note on emergence at the market price it books 6.31 points. Neither is a loss, but both are a long way from the par recovery the plan's disclosure statement may show. The recovery to model is the market value of what the class receives, the same discipline as for any takeback paper, worked in what an 80-cent recovery is actually worth.
Reporting the secured class as recovering 100 per cent because the note's face equals the claim, or discounting the note at its own coupon, which always returns par by construction. The plan rate is a legal outcome; the value is a market fact. On this case the difference is $27.38M. The opposite error is just as costly in a negotiation: assuming the court will pick the market rate. Under a formula approach, the likely range of 1 to 3 per cent over prime is the range of outcomes, 84.0 to 93.2 at a 12.00 per cent market, and that range is the price of objecting.
Model the note three ways: at the formula rate the debtor proposes, at the top of the formula range, and at a market rate supported by evidence of comparable exit financing. The spread between the three is the value at stake in the confirmation fight.
The Distressed Debt Investor covers the Chapter 11 process, recoveries and what plan currency is worth; the free workbook for this case builds recovery and return from the waterfall. For the vote that decides whether a plan needs cramdown at all, see how much debt you need to block a Chapter 11 plan.
The formula rate from Till v. SCS Credit Corp. (2004): the prime rate plus a risk adjustment, which the plurality noted courts had generally set at 1 to 3 per cent. With an illustrative prime of 7.50 per cent and a 1.50 per cent adjustment, the note pays 9.00 per cent. Some courts in Chapter 11 look first for an efficient market rate.
About four points of recovery on a seven-year note. The illustrative 9.00 per cent note is worth 86.31 cents at a 12 per cent market rate and 82.31 at 13 per cent. Longer notes are more sensitive: at 12 per cent a three-year note is worth 92.8 and a ten-year note 83.0.
Its payments must total at least the allowed claim and have a present value at least equal to the collateral value. The total test rarely binds: the illustrative note pays $326.0M on a $200.0M claim. The present value test, and the discount rate used in it, is where the value is decided.
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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