Preview - Opportunistic Case Study
The below is a brief excerpt from the Special Situations Investment Case Studies guide, aimed to provide interested readers with insight on the type of writing and analysis they can expect. In every case study written, I highlight the merits and drawbacks of investing in each tranche of the capital structure. The brief excerpt below discusses the considerations for investing in the Company's term loan, and analyzing the market's bet on the Company staying out-of-court or filing for bankruptcy.
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The next capital structure we’ll evaluate is an advancement from the capital structures with a “known” fulcrum security structure in the prior guide, where this Company has the elements of a “good business, bad balance sheet” dynamic that would attract post-reorg investment interest.
Take the capital structure exhibit below for example, from SaturnCo, a steel manufacturer that has faced pandemic-related supply chain inefficiencies coupled with higher shipping expenses amidst a greater shutdown of global logistics networks. The Company is currently suffering from elevated COGS and operating expenses which has compressed EBITDA margins to single digits. SaturnCo has also been forced to invest deeply in growth capital expenditures to fund further factory buildouts to keep up with competition – therefore, the burning cash in the hundreds of millions on an annual basis.
Now, while the Company historically has been a clear market leader in the platinum steeling space, with sticky revenues and a loyal customer base, SaturnCo has faced temporary headwinds, liquidity shortfalls and a near-term maturity that will likely force either an out-of-court negotiation or an in-court filing. The question we’re going to navigate involves navigating a potential investment amidst the possibility of a restructuring and the out vs. in-court implications.
SaturnCo Capital Structure
*Sensitizing potential outcomes that the Company may pursue will be crucial to arrive at an “expected value” return for each tranche of debt. The first action we’ll need to take is to understand the basics of this capital structure and to then get the market’s view on the debt to see if there any dislocated value opportunities amidst either an out-of-court or in-court deal.
Argument for the market believing an out-of-court deal will happen: Since there is still such a wide pricing spread between the Term Loan and Secured Notes, assuming they’re structurally pari, the market may not think that a fulcrum security has been truly identified and therefore believes that the secured debt should not be trading on expected recovery values. From an out-of-court perspective, the market may believe that the Term Loan should have a relatively high trading price given that they are the earliest maturity with the most bargaining power out of any tranche with respect to a negotiation with the Company. Additionally, the market may believe that since the secured notes are the most temporally junior, that should merit a lower cost basis in the belief that through an out-of-court deal, the Company would primarily focus on the two closest maturities (TL and unsecured notes.)
Additionally, another argument for out-of-court has to do with the yields on the secured debt – since they are relatively aligned, the market may believe that an investment in either of the securities should bring a relatively similar outcome. If the market believed this was an in-court candidate, the trading prices theoretically would begin to move closer and therefore the yields would be irrelevant, since with much different coupons (S+200 vs. 9%) the spread on the yields of the two secured credits would widen.
Argument for the market believing an in-court process will happen: Although we are still an outsider looking in with no access to private lender materials, the price and yield of the unsecured notes is interesting. Theoretically, if the market had conviction that the Company would address their maturities out-of-court, then the Dec-25 bonds’ temporal seniority over the Dec-26 secured notes would boost the trading price to be higher than 40pts and would most likely drop the yield to be closer in line with the secured credits. The fact that the bonds trade at such a low-cost basis may imply that the market views them as being layered beneath the fulcrum security (which would be the secured debt) and therefore the temporal seniority of the Dec-25 bonds would be irrelevant. Although the bonds would likely still trade within the 30-50pt range identified in Security Analysis & Capital Structure Investment Considerations given the inherent option value of a potential deal struck out-of-court, the market may think that an in-court filing is more likely than out-of-court at this point. The mid-40s yield on the bonds also imply that the pure out-of-court return is irrelevant, and the credit is trading more on recovery values (or lack of recovery through option value).
Investing in the 1L Term Loan: The thesis behind investing in any of the three tranches must account for both a possible in-court and out-of-court filing and consider the forms of consideration if an in-court process were to happen. The thesis for buying the 1L Term Loan is a bit murky, with arguments for and against it.
On one hand if an investor has conviction that the Company will reach a deal out-of-court, then buying the TL may be of interest – since they have the most bargaining power with the earliest maturity. Investors in this credit may reap several benefits by negotiating with the Company, including a potential partial paydown, extended maturity with enhanced rate, option to provide new money on a super senior basis and prime other liens, participation fees, etc. As mentioned before – if SaturnCo is a fundamentally sound business with quality long-term prospects, then leading an ad-hoc secured lender group as a Dec-24 TL holder may have a lot of economic benefits out-of-court. The most significant leverage that the TL has is its temporal seniority, and we’ll explain why that’s such a critical factor.
If an investor develops conviction that the Company will file, then the thesis for buying the TL becomes much more complicated. If an in-court process were to ensue, the TL’s temporal seniority becomes irrelevant as they get bucketed with the Dec-26 secured notes on an equal recovery basis. Given that secured leverage is very high relative to the estimated value of the business (industry experts think within 5-6x EBITDA range), then the recovery value of the TL through a bankruptcy could be significantly lower than where it currently trades. See below for an exhibit that shows the potential recovery deficits for term loan holders – an in-court filing would most likely result in value leakage. The Term Loan would only make sense to buy if an investor believes that the Company is worth more than 6.0x EBITDA. As evidenced by the Company potentially filing, the prospects of a valuation being north of 6.0x is unlikely coupled with the relatively stable and lower-growth nature of the industry SaturnCo competes in. Any plan value from an in-court process would most likely yield total consideration for secured holders to be less than the current trading price of the Term Loan.
