Articles

What an 80-cent recovery is actually worth

Composition and time do more damage to a recovery than the headline number suggests. Two arithmetic steps most screens skip.

Julian R. Sterling · from The Distressed Debt Investor

Seventy-five cents, if it arrives as 30 cents of cash and 50 of face in takeback notes trading at 90. And whether that is a good outcome depends entirely on a date that nobody in the process has any obligation to hit.

Recovery screens are quoted as a single number. The number is a percentage of face, it comes out of a waterfall, and it is the figure that ends up on the committee page. It also omits two things that routinely matter more than the estimate itself: what the recovery is paid in, and when.

Composition: an 80-cent recovery that is worth 75

Plans of reorganisation rarely pay creditors in cash. A typical settlement for an impaired class mixes cash, new debt in the reorganised company, and equity. The waterfall values all three at face. The market does not.

Take a class recovering 80 cents on the dollar, paid as follows.

The takeback notes are new paper issued by a company that has just been through a restructuring. Trading at 90 is an ordinary outcome, not a pessimistic one.

Form of recovery	Face	Value	Worth
Cash at emergence	30c	100	30.0c
Takeback notes in the reorganised company	50c	90	45.0c
Total	80c		75.0c

Five cents of the headline has disappeared, and it disappeared for a reason that has nothing to do with whether the recovery analysis was any good. The waterfall was right. The instrument mix was the variable.

The mistake worth naming: a recovery estimate and a recovery valuation are not the same output. The first is arithmetic on claims. The second requires a view on what the paper you are handed will trade at — which is a second, independent credit judgement on the post-emergence company.

Time: the same 75 cents at four different returns

Now suppose the position was bought at 50 cents. The recovery is worth 75. The return depends on how long the process runs, and restructuring timetables are set by courts, creditors' committees and negotiation, not by the investor's holding period.

Same purchase price, same recovery, same instrument. Only the duration changes.

Time to emergence	Money multiple	Annualised return
1 year	1.50x	50.0%
2 years	1.50x	22.5%
3 years	1.50x	14.5%
5 years	1.50x	8.4%

The money multiple is identical in every row. At two years this is a distressed return. At five years it is worse than the yield available on performing credit at the time of purchase, for a position that carried litigation risk, valuation risk and no coupon.

There is no version of the analysis that fixes this by being more careful about the waterfall. Duration is an input on its own, and it deserves its own sensitivity.

The frictions that come out before anything reaches you

A third layer sits between enterprise value and recovery: the claims that are paid before the pre-petition capital structure sees anything at all.

Step	Amount
Enterprise value	$700M
Less professional fees and administrative claims	($40M)
Less DIP facility (superpriority)	($100M)
Available to pre-petition claims	$560M

Twenty percent of the enterprise value never reaches the capital structure being analysed. On the worked example this is enough to move the fulcrum out of the senior unsecured notes and into the second lien — which, as the underlying chapter puts it, is the difference between owning the security you wanted and owning a zero.

What a recovery estimate should carry with it

• The mix. Cash, new debt, equity — and a stated value for each of the non-cash components, with the reasoning.
• The duration, as a range. Not a point estimate. Two years and five years produce the same multiple and different investments.
• The frictions, explicitly. Fees and new money are the first claims on value and the easiest to omit, because neither appears in the pre-petition capital structure you are looking at.
• The break-even recovery. Not what you expect to get, but what you need in order not to lose money, and how much cushion sits between the two.

A position that clears at the expected recovery and fails at the break-even is a position whose margin of safety is the accuracy of a valuation. That is worth knowing before it is sized, not after.

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