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What enterprise value does a distressed bond price imply?

Reading a distressed bond price as a view on enterprise value: the formula, the return it needs, and the two claims the shortcut forgets.

Julian R. Sterling · from The Distressed Debt Investor

To find the enterprise value a distressed bond price implies, add every claim ranking ahead of the bond to the price multiplied by the whole pool of claims the bond shares with. Notes at 30 cents, behind $580M of senior claims and fees and sharing with $50M of trade claims, imply $670M, or 6.70x EBITDA, just to break even. To earn 20 per cent a year over eighteen months the buyer needs about $698M, or 6.98x: that is the real bet behind the price.

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 →

The case

A manufacturer with $100M of EBITDA is heading into a Chapter 11 process. Its senior unsecured notes trade at 30. A buyer looking at them is not buying a coupon; the notes will receive whatever value is left after the claims ahead of them, shared with every other claim of the same rank. The price is therefore a statement about enterprise value, and the first job is to read it. Every figure is illustrative, and claims include accrued interest to the filing date.

Capital structure and assumptions, $ millions

Claim	Rank	Amount
Administrative and professional fees	Priority	30
First lien term loan	Secured	400
Second lien notes	Secured, junior	150
Claims ahead of the notes		580
Senior unsecured notes	Unsecured	250
Trade and other general unsecured claims	Unsecured, pari passu	50
Unsecured pool		300

Other inputs: notes price 30, EBITDA 100, required return 20 per cent a year, time to emergence 1.5 years.

The calculation

At break-even, with no time value, the notes must recover their price. A recovery of 30 cents on every dollar of the unsecured pool means the pool receives 90. Everything ahead of the pool must be paid in full first, so:

Break-even is not the bet anyone makes, because it ignores time. A buyer who needs 20 per cent a year for eighteen months needs the recovery to reach 30 × 1.20^1.5, or 39.44 cents. Put that into the same formula:

So the trade is a view that the reorganised business will be valued at close to 7.0x, against a range in which the notes are impaired: anywhere between $580M, where they receive nothing, and $880M, where the whole pool is paid in full. The notes are the fulcrum security across 5.80x to 8.80x of EBITDA.

What the notes return at each enterprise value

Notes bought at 30, emergence in 1.5 years

EV	EV / EBITDA	Recovery (cents)	MOIC	IRR
600	6.0x	6.7	0.22x	−63.3%
650	6.5x	23.3	0.78x	−15.4%
680	6.8x	33.3	1.11x	7.3%
700	7.0x	40.0	1.33x	21.1%
750	7.5x	56.7	1.89x	52.8%

Each turn of EBITDA multiple is worth 33.3 cents to the notes, more than the entire purchase price. That is the leverage of a fulcrum position: the claims ahead absorb no change in value, so every dollar of enterprise value above $580M lands in a pool of only $300M. Half a turn either side of 7.0x is the difference between losing 15.4 per cent a year and making 52.8.

What if the price is different?

Implied EV by notes price

Price	Break-even EV	Multiple	Recovery for 20% a year	EV for 20% a year	Multiple
20	640	6.40x	26.3	658.9	6.59x
30	670	6.70x	39.4	698.3	6.98x
40	700	7.00x	52.6	737.7	7.38x
50	730	7.30x	65.7	777.2	7.77x

Ten points of price move the break-even enterprise value by $30M, because each cent is multiplied by the $300M pool, not by the $250M of notes. Compare the implied multiple with where comparable companies trade and with the valuation the debtor's adviser is likely to put in the plan. If the market price needs 7.4x and the comparables sit at 6.0x, the price is not cheap whatever the headline discount to par.

The common mistake

The usual shortcut adds the secured debt to the price times the notes outstanding: 400 plus 150 plus 0.30 × 250, or $625M, 6.25x EBITDA. It leaves out two things. The fees and administrative claims of $30M come out of enterprise value before any lender is paid. And the trade creditors share the unsecured pool pari passu, so 30 cents on the notes means 30 cents on $300M, not on $250M. Together they understate the break-even value by $45M, and the value needed for a 20 per cent return by $73.3M.

Both errors make the notes look safer than they are, by telling the buyer that the market requires less value than it actually does. In a larger case the gap is wider: fees grow with the length of the case, and trade, lease rejection and litigation claims can enlarge the unsecured pool after the trade is placed. Below $580M the notes already recover nothing in this structure, where all value is collateral; a second-lien deficiency claim joining the pool would dilute them only if the company also had unencumbered assets.

Takeaway

• Implied EV = everything ahead, including fees, plus price times the full unsecured pool: $670M here.
• Add the return requirement: 20 per cent a year over eighteen months needs $698.3M, or 6.98x.
• Compare that multiple with the plan valuation you expect, not with par.

The book's fulcrum chapters run a capital structure across several enterprise values, and the free workbook for this case includes a waterfall that re-identifies the fulcrum automatically and a workbook that sets market prices against the enterprise values they imply. For what happens once the recovery is paid partly in paper, see what an 80-cent recovery is actually worth.

Questions readers ask

How do you calculate implied enterprise value from a bond price?

Add every claim that ranks ahead of the bond, including administrative and professional fees, to the bond price multiplied by the full pool of claims of the same rank, including trade creditors. With $580M ahead and a $300M pool, a price of 30 implies an enterprise value of $670M at break-even, before any return for time.

Why do trade claims matter when valuing distressed notes?

Because general unsecured trade claims usually rank pari passu with senior unsecured notes and share the same recovery. Here $50M of trade claims enlarge the pool from $250M to $300M, so 30 cents of recovery needs $90M of value, not $75M. Ignoring them understates the enterprise value the price requires.

What makes a bond the fulcrum security?

It is the first class in the waterfall that is not paid in full at the expected enterprise value, so it typically receives the reorganised equity. In the example the notes are impaired at any enterprise value between $580M and $880M, and each turn of EBITDA multiple moves their recovery by 33.3 cents.

Also on this site

• Does the fulcrum security move when enterprise value changes?Yes, and it can move two tranches on a swing you would call a rounding error. A worked capital structure at $450M, $600M and $750M of enterprise value.
• What an 80-cent recovery is actually worthPaid as 30 cents of cash and 50 of face in takeback notes at 90, it is worth 75 cents. And the return turns on a date nobody sets.
• How do you calculate a high-yield bond's yield after expected default losses?Loss-adjusted yield = yield to maturity minus PD × (1 − recovery). A CCC bond quoting 10.06 per cent is expected to earn 1.06, below a 4.00 bill.
• How do you calculate recoveries in a liquidation analysis?Recovery rates by asset, less wind-down and trustee costs, down the waterfall: $201.5M gross gives the first lien 53.0 per cent, against 70 under the plan.
• What is a Chapter 11 rights offering worth to a creditor?Shares at plan value less the subscription price: a $150M offering at a 25 per cent discount gives each 100 of claims a right worth 10 points.
• How do you calculate a fixed charge coverage ratio on a direct loan?(EBITDA less capex and cash taxes) over interest plus principal: 31.0 over 23.65 gives 1.31x, against 1.86x of interest cover. Worked case.

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