Introduction

I wasn’t quite sure what to title this report, so I went with “Bonus 2021 Questions”.

I should be clear from the outset that these are more obscure (or in some cases more
difficult) questions that may crop up in your interviews.

You should of course focus primarily on the main guide and the associated questions and
answers. For the vast majority of interviews, they’ll cover everything you need to know.

…But I want to make sure all your bases are covered so this little report will be comprised
of both some more obscure questions that have been asked in interviews, and some
questions that I’ve created myself.

Many of these questions are just twists on questions already found in the main guides
that I’ll provide more in-depth commentary on in order to more fully explain certain
concepts.

Bonus Questions
A trend among some firms is asking more detailed questions about the equity value of a
distressed company and how to think about valuation.

We covered this in the main RX Q&A guide already (via the waterfall questions) where we
referred to equity still maintaining some value even if the value of the company breaks at
debt (above equity) because of “optionality”.

So, let’s start by diving a bit deeper into waterfall questions and then go over how to think
about equity value.

Let’s say there’s a company that has a first-lien Term Loan (1L TL) of $100 and a
second-lien Term Loan (2L TL) of $100. The company has an EV of $150. Where would
you think each tranche of debt trades?

This is a standard waterfall question we covered a number of times in the main RX Q&A
guide, but let’s think about it a little bit more.

Obviously, in the event of default, the 1L will be made whole and there will be $50 leftover
for the 2L. So, one would expect the recovery value to be 50 and thus the 2L to trade at
roughly fifty cents on the dollar today.

What we’ve just covered is the basic answer that interviewers will be expecting. However,
there is a bit more we can likely say about where the 2L will trade.

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In reality, one might expect the 2L to actually trade at a little over what it’s recovery value
alone would dictate. In other words, you’d expect the 2L to probably trade a bit over fifty
cents on the dollar.

The reason for this is optionality. If the company has not yet filed for Chapter 11 – as the
question implies – then there is still the possibility that the company somehow turns
things around.

Maybe the company is able to raise some junior debt, maybe the company is owned by a
sponsor and the sponsor injects some fresh cash for equity, maybe a big contract comes
the company’s way and they’re suddenly flush with cash, etc.

If any of these things were to occur, you wouldn’t expect the 1L to move much in value
since it’ll likely already be trading around par (since it’s fully secured and would be made
whole if the company filed tomorrow anyway).

However, you’d expect the 2L to rise in price substantially on any significant positive news
as the prospect of the company having to file decreases and the potential for the 2L to
have a higher recovery value, in the event of filing in the future, increases.

The way one may (simplistically) think about this on the buyside is in terms of a weighted
average. So, we may come up with a fair value for the 2L as follows:

• 90% probability of the company filing and the recovery value being 50

• 5% probability of the company turning things around a bit, but not enough to be
able to just refinance the 2L. Thus, the debtor comes to the 2L with an out-of-court
solution that values the 2L at 75 cents on the dollar

• 5% probability of the company being in such good shape in the near future – due
to whatever catalyst – that the 1L and 2L can be refinanced when they come due
at par

If we set up a weighted average, the fair value of the 2L (meaning where it should trade
today) would be (0.9*0.5 + 0.05*0.75 + 0.05*1.0), which gives us 53.75.

All we’re demonstrating in this stylized example is that so long as the company hasn’t yet
filed, there is optionality embedded in the 2L. Something could occur that could lead it to
be worth more than what it’s recovery value alone would dictate presently. As a result, it
may trade at a bit of a premium to just what the recovery value alone would suggest.

Note: It’s important to recognize that most interviewers are just anticipating hearing fifty
cents on the dollar as the answer. It’s perfectly fine to say that one would think that the
2L would trade at 50 but may trade higher due to the embedded optionality of the 2L.
There’s no need to elaborate further unless you are prompted to.

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I take your point about optionality and how the 2L would likely trade above 50, but what
if we saw the debt trading in the market at 45 (even though we think the recovery value
will be 50)? How would that make sense?

Distressed debt is an erratic and opaque market. Things aren’t necessarily as “efficient”
as in equity markets for large, healthy companies. Spreads are wide and markets are
illiquid (especially when trying to transact in large size).

Why you could see debt trading below where you think the recovery value is could be
because often debt will be held by large institutional investors from back when it was
issued – and not distressed! – and they will have a certain mandate to get out of the debt
when it trades down below a certain level, or gets downgraded below a certain level, etc.

This can create a kind of forced selling dynamic because obviously not all investors have
the appetite or skillset to hold distressed debt through a potential out-of-court or in-court
restructuring.

This is all to say that if you were confident that the recovery value of the debt will be 50,
but yet the debt is trading at 45, that shouldn’t necessarily be wildly surprising. One would
expect – if the consensus view is that the recovery value of the 2L will be 50 – that over
time this little arbitrage is taken advantage of and the 2L would trade up to 50 or more.

Taking a step back, it’s important to recognize what our recovery values are predicated
on. They are predicated on an estimate of EV, which is not some immutable, objective
reality. Rather, like most things in finance, it can change and until a POR is agreed upon
exactly what the recovery value for any class will be is not guaranteed per se. So, while
we may think the recovery value should be 50, maybe others think it should be 40 and the
overall market consensus is around 45, which is why the debt is trading there.

Carrying forward with our example, where would we expect equity to trade in this
scenario?

Naively one would think that the equity should trade at zero, of course, since the value of
the company breaks at the 2L (and it’s not like the 2L is projected to have a 95-cent
recovery or anything near par).

So, one would think that there’s nothing left for equity, which in the event of filing would
almost certainly be true. However, the equity will retain value prior to filing for the same
reason as mentioned above with the 2L (just to an even greater extent).

The optionality of equity arises from the fact that maybe the company is able to turn
things around. Maybe the company can effect some out-of-court solution that delays
filing, maybe the company is injected with new cash from the sponsor, etc.

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Practically, we’ve seen this in 2020 with Tupperware (the maker of plastic containers and
whatnot). Equity got down to $1.15 and the Senior Notes (lowest in the capital structure)
were trading a touch under 50.

If the lowest part of the capital structure is trading at ~50 cents on the dollar, then the
company is in real distress. If the company filed when Senior Notes were trading at these
distressed levels, then the equity would almost certainly be worthless!

However, Tupperware benefited from the pandemic causing an increase in demand for
plastic containers. Tupperware (advised by Moelis) was able to do some clever tender
offers and then raise a new term loan to take out all the Senior Notes with the proceeds.
The equity is now trading around $36.

So, Tupperware actually mimics the stylized example in the first question. The lowest
tranche of debt was trading at highly distressed levels (around 50 cents on the dollar).

If the company filed for Chapter 11 in March – when equity was trading at $1.15 – equity
surely wouldn’t have gotten anything. However, because the company was able to turn
things around out-of-court, if you had bought equity in March of 2020 you would have had
an absurd gain.

This is because as a company gets more and more distressed, the equity of the company
increasingly begins to trade like a call option. The equity of a distressed company will not
provide any recovery value if it files right now; just like how a far OTM call option won’t
pay off anything in the event that the underlying doesn’t go ITM before expiration.
However, if the company were to turn things around it’ll have incredibly high returns
analogous to when a far OTM call option gets ITM.

Another way to think about this is that when you buy a far OTM call option you pay $X and
if it winds up in the money you will make (for example) thirty times your initial investment
($X). However, if it doesn’t wind up ITM, you lose your initial investment ($X), but nothing
more.

If you had bought Tupperware common equity when Senior Notes were trading at $50
you have a limited, known downside of $1.15 times the number of shares you bought. If
there isn’t a big turnaround in the company, you’ll end up losing your initial investment (as
when it files equity will receive nothing). However, if there is a turnaround you have a
theoretically uncapped upside that is many, many times your initial investment.

So, when interviewers ask how you would value the equity of a highly distressed company
- where the value breaks at debt - you can say that you would value it like a call option.
And like a call option you could value it using the Black-Scholes model.

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How should we think about optionality for various parts of the capital structure?

What we’ve been building toward in these questions is that any part of the capital
structure that trades below par has some level of optionality embedded in it, but not all
parts of the capital structure have the same level of optionality.

For example, carrying forward our initial example, the 1L has no real optionality. It’s
probably trading around par and if the company suddenly turned things around, and didn’t
have to file, that wouldn’t make things much different for the 1L holders (since they would
already receive a full recovery in the event of filing).

For the 2L in our initial example, there’s some optionality there. If the company really turns
things around, maybe the 2L can be refinanced and thus the existing 2L will trade up to
par. That’s a great return! However, there is a definitive or capped upside of around par
(meaning the 2L won’t suddenly trade at 200 because the company turns things around).

For the equity, it will be trading at very low levels. However, if the company turns things
around – in whatever fashion – it’s likely that the equity will not increase by just ~100%
(as the 2L would if it traded up to par), but rather it would trade up by many multiples!

This is what was seen in Tupperware’s case. Remember your corporate finance 101
lesson that equity ultimately has a claim on the residual value of the company after
dealing with debt.

While debt of any kind – whether loans or bonds – have a defined “cap” or upside, equity
is free to go as high as the market desires.

This is all a rather long-winded way of saying that the further down the capital structure
you go with a distressed company, the more optionality will be embedded in the price.

For a real-life example like Tupperware, when the Senior Notes were trading below fifty
cents on the dollar and the common equity was trading at $1.15, that equity value was
reflecting pure optionality (because if the company had filed at that point in time, it’s
almost certain that equity would have received nothing).

In other words, no one was buying equity at $1.15 because they thought their recovery
value if the company filed would be some value greater or equal to $1.15 per common
share!

Anyone who bought equity at the price was purely betting on the capacity of Tupperware
to solve their problems out-of-court in some manner.

Given that Tupperware equity is currently trading around $36, you can see the kind of call
option asymmetric profit profile clearly. At most, those who bought around $1.15 or
whatever would just lose their investment (just like if a call option expired OTM), but the

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upside turns out to have been around 30x the initial purchase price (just like when a call
option with a very high strike price ends up ITM).

Let’s say we have two distressed companies with the same EV and debt (where debt is
substantially greater than EV). Let’s say that Company A has a market cap of $1M and
Company B has a market cap of $5M. Which company has more volatility?

This is a pretty clever question. I’m personally not a large fan of it because it gets away
from the core of what restructuring is all about, but it has been asked before.

The key to this question is understanding that for distressed companies equity trades like
a call option (as we discussed above). Therefore, all else being equal, what this question
is really saying is that the call options on Company B are worth more than the call options
on Company A.

The more volatility that an underlying has, the more a call option is worth (because more
volatility means a higher chance a call option expires ITM). Therefore, Company B must
be more volatile as its equity is worth more and its equity is essentially a call option.

What are the five inputs of the Black-Scholes Model?

The strike price, current stock price, time to expiration, risk free rate, and volatility.

Let’s say that I tell you that we have a bond with a YTM of 20%. Ask me some questions
to figure out how it’s priced.

This is a bit of a tricky question that is just the inverse of the traditional bond math
questions we’ve gone over before (where you need to figure out the YTM).

If we’re trying to figure out how a bond is priced, we need three details: YTM (which we’ve
been given), coupon rate, and years to maturity.

So, for this question you’d want to ask how many years until maturity and what the coupon
rate is. For this example, you could be told it has an eight percent coupon rate and two
years to maturity. This would mean a $80 price.

If we use the estimated yield to maturity formula to confirm it would be (8 + (20/2) / (180
/ 2)) or 18 / 90 = 20%.

Let’s say you’re a hedge fund analyst. Assuming that everything returns par, would you
rather invest in a bond trading at 90 with a maturity of one year or a bond trading at 50
maturing in five years? What kind of factors would you need to consider?

Of course, the primary reason why debt trades down is investors have some view on
whether or not the debt will return par (or be impaired at some level).

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In this question, we’re assuming that no matter which bond you buy, it’ll return par. This
question is asked to see whether or not you can identify secondary characteristics that
inform debt trading levels.

I should say at the outset, that there’s no objective answer here necessarily. Like a lot of
questions in RX, it’s a bit more open-ended and how you answer it is far more important
than what your ultimate hypothetical investment decision is.

So here are some things to consider for this question, assuming as we are that both will
return par.

First, what’s the coupon rate on each of these? Let’s assume we have a capital structure
with just the two tranches of debt mentioned in the question. If one tranche is trading at
90 and the other at 50, then the 90 will be more senior and almost certainly have a lower
coupon.

So, if the 90-bond has a coupon of 4%, and the 50 has a coupon of 8%, let’s quickly use
the estimated YTM formula to see what the difference in yields would be.

For the 90-bond, it would be 14.73% (assuming annual compounding to make the math
easy). For the 50-bond it would be 24%. In this case, since we are for some reason entirely
confident each bond will return par, the 50-bond is obviously far better!

However, let’s remember that credit markets have been tighter over the past few years
than they have been in a long time. Because the 90-bond only has one year left to maturity,
but the 50-bond has five years left, the 50-bond must have been issued in this recent
“hotter” or tighter credit market so maybe the coupon rates are actually more comparable
than what we outlined above.

Let’s say the 50-bond is 5%, not 8%, and the 90-bond is still 4%. What happens to our
estimated YTM then?

For the 90-bond, the YTM would be 14.73% and the 50-bond would be 20%. All of a
sudden, these bonds look a bit more comparable, and we may need to think more deeply
about which to choose.

Now, obviously in the real world, we’d need to consider things like credit risk. We’d need
to consider that if we’re holding a distressed part of the capital structure for five-years,
maybe we get subordinated, maybe the company files in a few years and our recovery is
only 30 cents on the dollar, etc. However, since we’ve been told in the question that
everything will return par, those issues aren’t applicable.

There are two additional things we would think about from a distressed debt seat at a
hedge fund.

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First, what is our investment mandate? Do we like holding credits in lower parts of the
capital structure? Are we assuming we need to hold either of these until maturity? If so,
do we want to have capital tied up in one credit for five years (even if we assume it’ll
return par and provide a higher YTM than the 90-bond)?

Second, and perhaps more importantly, remember that a YTM operates under the
assumption we are reinvesting coupon income at the prevailing yield. In other words, your
YTM can look great, but it assumes that all the cashflows you’re clipping off can be
reinvested back at an analogous great rate. This is obviously much easier said than done.

So, for the 90-bond, we don’t care quite as much about reinvestment as we are only
getting one coupon payment and it’s not going to compound over years. However, for the
50-bond we aren’t getting back our coupons for five years and are assuming that all our
coupon cash flows are going to be reinvested at very elevated levels. What if we can’t
reinvest these coupons at anything above a 5% yield in practice? Suddenly the YTM
compresses even further.

In reality, given the large difference in pricing and the fact we’re confident both will return
par, then we should likely choose the 50-bond. Hypothetically, maybe the rest of market
in one year realizes the 50-bond will return par and thus it trades up to 80 or 90 then (so
our return would be spectacular over that first year and maybe we can sell it off then).

From an interview perspective, what is important in this question is to touch on some of

the secondary considerations I mentioned above.

Let’s say we have a company with a $500M term loan trading at par. The company also
has three tranches of $500M Senior Notes (all pari with each other and totaling $1.5B
in aggregate). One tranche of Senior Notes is trading at 80, the other two are trading at
60. All have a YTM of 20%. What explains how the YTM is the same?

So, we have three tranches of Senior Notes that all have the same relative claim on the
company. All have the same YTM, but yet one tranche is trading at 80 while the others
are trading at 60.

You should immediately recognize that the only way to explain how the YTM is the same
is that there must be a difference in maturity date for these tranches of Senior Notes.
Because the Notes trading at 80 have the same YTM as those Notes trading at 60, that
must mean the maturity date is sooner for the 80-Notes.

A way to see this is that if we have debt trading at 50 that matures in one year with a
coupon of 10%, the YTM is 80%. If it matures in two years, the YTM drops to a touch under
47%. This is because, all else being equal, getting our principal returned back to us sooner
(instead of being years down the road) bumps up our effective return.

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So, in this case the way that each of these Notes would have a 20% YTM would be if the
80-notes matured in two years, while the 60-notes matured in five years.

Keeping with the last question, why is one tranche of these pari Senior Notes trading
higher anyway? If you’re considering buying one tranche of these pari Senior Notes,
what would you need to consider?

As to why one tranche of pari Notes would trade higher than the others, the answer is that
some market participants must believe that the Notes coming due in two years should be
able to be refinanced, or be dealt with in some way, but it’s much less certain that five
years from now the two other tranches of Senior Notes (totaling a billion in face value)
can be refinanced.

Holding the 60-Notes is riskier in so far as you’re assuming more risk that the company
may keep faltering, or can’t turn things around sufficiently, by the time the two latter
tranches need to be dealt with (plus they’re double the size of the 80-Notes).

On the other hand, if you buy the 80-Notes, one runs the risk that if the company files
Chapter 11 before they can be refinanced or otherwise dealt with then they will be pari
with the rest of the Senior Notes (with a recovery value that may be significantly below
80 cents on the dollar).

So, the kind of price premium you’re seeing with the 80-Notes reflects the fact that the
market views it as being relatively likely these 80-Notes can be dealt with, but there’s
much less certainly the 60-Notes will be able to be dealt with when they come due in five
years. Perhaps the company has quite a bit of cash, but it’s not performing well at present,
so it can likely deal with this smaller tranche coming due soon, but won’t have much left
over (and will not likely be in a position to be able to roll over the 60-Notes) later on.

On the flip side, the 60-Notes are probably trading closer (although there are many
complicating factors) to where the recovery value of the Notes would be in the event of
filing. So, as I mentioned before, if you buy the 80-Notes you run the risk that if the
company has to file before dealing with the 80-Notes they’ll be in the same class as the
$1B of other Senior Notes and likely have a recovery value well below 80.

So, if you simplify it all down, buying the 80-Notes would be a bet on the company not
filing before being able to deal with the 80-Notes. If you happen to think the company can
really turn things around over the next few years, then you’d get the best return by buying
the 60-Notes (as they’d likely trade up significantly over a few years if a turnaround in the
company’s fortunes does occur, thus bumping your return if you sell after a few years).

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Let’s say that a PE firm acquires a $200M EBITDA company for 10x with 60% debt. The
company’s EBITDA, over a five-year hold period, grows to $300M. All cash is swept out
to pay down debt, which at year five totals $400M. No cash is left at the time of exit,
which is for a 10x multiple. What’s the IRR?

This is a bit of a longer question and is unlikely to be asked in a pure RX interview (but
firms like Moelis and Centerview that have generalist programs may ask it).

What the interviewer is looking for is that you don't get overwhelmed and can get through
each of the steps (none of which, individually, are that difficult).

First, the EV at initiation will obviously be $2,000M (or $2B). $1,200M of the acquisition
will be funded by debt, and we can assume the remaining $800M will be funded by equity.

The EV at exit will be $300M*10x or $3,000M. Since debt of $400M was paid down, with
no cash being left over, that leaves us with $800M of debt remaining at exit.

At exit the equity proceeds will just be the $3,000M minus the debt remaining of $800M
or $2,200M.

So $800M of equity was put into the company, $2,200M is taken out at exit five years
later, which gives a 2.75x return.

You should know rough IRR calculations for various multiples like 2x, 3x, and 4x. A 2x
return over five-years is 15% and a 3x return over five-years is 25%. Thus, we can guess
the IRR as being in the low twenties.

Note: It's perfectly fine (and expected) for you to simply lay out the round multiples and
associated IRRs and then narrow in on roughly what the actual IRR would be. No one
expects you to calculate the actual IRR in your head.

What is FCCR?

The fixed charge coverage ratio (FCCR) is simply (EBITDA - Capex - Cash Taxes) / (Cash
Interest Expense + Mandatory Debt Repayment).

If you think about this formula for a few minutes, you'll see all this is really saying is: do
we have enough cash flow - using the rough approximation in the numerator - to meet
what our actual cash obligations are that arise from our capital structure (the
denominator).

You'll often see FCCR minimums in secured debt instruments such as revolvers and term
loans. For example, a minimum FCCR of 1.0x is frequently used.

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What did the Fed do for credit markets in 2020?

During the Eurozone crisis of 2011 / 2012, sovereign bond yields were soaring for some
of the weaker euro-members and it looked like things were at risk of spiraling out of hand.

Mario Draghi – the then ECB president – made a speech in which he said the ECB will do,
“…whatever it takes” to bring bond yields back under control.

This spooked the market. When a central bank – with their huge amount of fire power –
says they’ll do whatever it takes to rectify a situation you generally are going to think twice
about being on the other side of that trade.

The point I’m trying to get across is that words can alter markets as much as actions
themselves can (although the ECB would eventually end up taking a lot of actions).

Or, alternatively, saying you will take action in the future can have as much effect at
calming a situation as taking the action itself immediately (so long as the central bank
has credibility).

In mid- to late-March of 2020 credit markets were grinding to a halt, spreads across the
investment grade and high yield universe were exploding, and debt capital markets
activity all but halted.

A seizure of the credit markets ran the risk of causing massive financial disruption and
so the Fed stepped in by necessity. My personal view is that in actuality, the Fed didn’t do
much in practice, but them saying they planned to do something was enough for credit
markets to calm. This was a win-win for the Fed. They got their desired result (calming
the credit markets), without having to do much of the actual heavy lifting (of fully utilizing
or expanding their novel programs that they announced).

Chances are you know broadly how the rest of the story unfolded. Credit markets within
a month of the Fed’s announced plans were nearing the levels they were prior to the crisis
(in terms of yields) and by late-2020 / early-2021 credit markets are quite literally as tight
as they ever have been, and debt issuance is absolutely booming.

Without getting into too many details, what the Fed did is announce the creation of two
facilities: A Primary Market Corporate Credit Facility (PMCCF) and a Secondary Market
Corporate Credit Facility (SMCCF).

The Treasury – for regulatory reasons surrounding 13(3) of the Fed Reserve Act –
invested $75B into these two facilities that the Fed could then lever up between 3-1 and
10-1 (depending on the nature of the assets being bought and their risk profile). Therefore,
the general amount of purchasing power that the Fed had was somewhere in the range
of $500B-750B.

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As the names imply, the Secondary Facility was aimed at making open market purchases
in corporate credit ETFs and the Primary Facility was aimed at making co-investments (or
buying up the whole issuance) of debt issued by companies directly.

In other words, while the Secondary Facility was aimed at calming markets generally –
which aimed to try to reduce down spreads and create a more amenable issuance
environment - the Primary Facility was aimed at being able to help specific companies
that perhaps couldn’t find enough investors to fill the size of their issuance.

Both of these programs were terminated on December 31, 2020.

While there hasn’t been a full post-mortem yet, my own view is that the Secondary Facility
was likely a success. The Fed bought primarily corporate credit ETFs that focused on
investment grade debt – later expanding a bit to ETFs that are focused on high yield debt
– and as folks piled into the trade alongside the Fed yields plummeted.

We likely wouldn’t have seen such a near immediate tightening in spreads without this
program. While the purchasing power of the Fed – relative to the amount of corporate
debt outstanding – was quite tiny, it was an important sentiment shift. In particular, the
Fed’s focus on dealing with Fallen Angels (companies that were investment grade pre-
crisis but had fallen to high yield after) helped prevent any kind of bifurcation where
investment grade markets recovered quickly, but high yield markets didn’t.

For the Primary Facility, it was likely always a bit impractical and many market
commentors aren’t entirely sure the Fed ever really wanted to do too many deals here
because of the more specific credit exposure they’d have to take on.

The Primary Facility required companies wishing to participate to have to go through

quite a few compliance hurdles and then charged an excess 100bps of “Facility Fee”
above the rate others were participating at. The Fed’s term sheet for the Primary Facility
was produced months after the announcement of the creation of the Primary Facility, by
which time markets had already rebounded, and no one was overly interested in using it.

For an interview, all of this is probably too much detail. I’d say it’s most important to know
the two kinds of facilities that were created, what they were aimed at doing, the aggregate
size of them (roughly $500-750B), and then have a view on how effective they were.

My own view is that the Secondary Facility was likely effective in helping compress
spreads down quickly; acting as a kind of catalyst or impetus for the credit markets
rebounding so quickly and effectively. For the Primary Facility it strikes me as being much
more of a “show of force”. The Fed wanted to show they were ready to act decisively and
aggressively – in a surprising fashion to market participants – by actually lending directly
to single issuers. However, in reality very few took up the Fed on their offer – because of
the slow roll out and more convoluted and onerous terms they requested – which is
probably exactly what the Fed wanted all along.

Restructuring Interviews 2021 – All Rights Reserved 12

Copy of PMCCF term sheet (calling it a fully fleshed out term sheet may be a bit
generous):
[Link]
.pdf

Some facts from the Fed about these two facilities:

[Link]
credit-facility-faq

Where are credit markets now?

This is a pretty common open-ended question that you’ll get. Especially in a superday
where not everyone will want to just run through technical questions.

Given that I don’t know when you’re reading this – and credit markets are always changing
as we saw in 2020 – I’ll provide more general commentary about what an answer to this
kind of question should touch on.

First, you should reference credit indices to provide a lay of the land for where credit is
generally right now. The three that I would touch on would be BBB, BB, and CCC. The first
because it’s the lowest category for investment grade (which also contains the most debt
of any IG category), the second because this is the “fallen angel” category that makes up
the largest swath of high yield debt (and shows the yield bifurcation between IG and HY
debt), and CCC because that’s the lowest ratings category.

The Fed has good interactive charts on these that you can play around with to get a feel
for where we are now, and how this has related to where we’ve been in the past.

BBB: [Link]

BB: [Link]

CCC: [Link]

The next thing you may want to touch on is any information you can find on the uptick (or
not) of issuance volumes in IG or (preferably) high yield debt. There’s no need to have
exactly up-to-date information. Just show you know roughly where things have been in
the past year if the credit market doesn’t seem to have drastically changed over the past
month or two.

S&P Global usually makes freely available “Credit Trends” commentaries where they
discuss issuance volumes and break it down by ratings category:
[Link]
play-record-issuance-lifts-global-corporate-debt-by-6-11725838

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Another interesting comment to add is regarding when debt is coming due. Obviously if
there is variability in the years when debt is issued, there’s variability in the years in which
debt comes due.

This is a more “macro” point, but I think it’s a nice addition to any answer to note that
there is a glut of debt coming due in (for example) 2025 due to the record issuances we’ve
seen over the past few years. Again, S&P Global has a good write up on that here:
[Link]
refinancing-rated-corporate-debt-due-through-2025-totals-11-3-trillion-11828370

Of course, just because a lot of debt comes due in a given year isn’t necessarily indicative
of higher restructuring transactions occurring in that year. Maybe in 2025 the economy is
roaring, and debt capital markets are hot so companies can roll everything over. But in
general, as you’d imagine, there is some correlation between when lots of debt comes
due and when companies need to restructure due to an inability to manage their capital
structure.

If you’re looking to add a bit more nuance, you can reference the number of fallen angels
we’ve seen in past months, as well.

[Link]
pulse-potential-fallen-angels-continue-to-decrease-even-as-risks-remain-11810815

To drill down on things that are a bit more immediate to the world of restructuring, you
can reference S&P’s projections for speculative grade default rates moving forward. For
example, S&P is projecting around 9% for 2021. Whenever you talk about projected
default rates, you should make reference to both where we were last year (around 7%)
and where we were during the last large recession (the financial crisis) in which we saw
default rates for speculative grade debt of around 12%.

[Link]
headlines/s-p-global-ratings-projects-9-speculative-grade-default-rate-by-september-
2021-61425400

Let’s say that a company has some Senior Notes trading at fifty cents on the dollar and
they go and buy back $100 (face value) worth of these Notes. Can you walk me through
the three statements?

So, what we’re doing here is buying back debt at distressed levels. We’re going to retire
$100 in debt, but only have to pay $50 in order to do it (due to the debt trading at such
distressed levels).

This obviously creates a bit of a “hole” in our three statements. $50 in cash is going out,
but debt is being reduced by $100.

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The way this works is that we need to recognize the spread between where the debt was
bought back at ($50) with the par value ($100) on our income statement as a gain. This
isn’t operating income per se, so would be considered to be an “Other” source of income
in the form of a gain on the retirement of debt.

So, on the income statement we have this $50 gain (again, this is the spread between the
level the debt was bought at and the face value). We’ll apply a 40% tax rate (you can apply
a 20% rate to be more current, I’ll just use 40% here) and get to $30.

On the cash flow statement, under CFO, we have net income up $30, but had the non-cash
gain of $50, so we’re down $20 on the CFO.

Under cash flow from financing, we reflect the retirement of the debt (-$50), so our net
change in cash is -$70.

On the balance sheet, we have cash down $70. On the flip side, we have debt down $100
(since we retired $100 face value of debt) and retained earnings is up by $30.

Let’s say we have $50 in PIK interest and $50 in cash interest. Can you walk through the
three statements?

We already covered in the main guides how to deal with cash interest and PIK interest
questions. I’m just including this question here to make you aware of the fact that
sometimes you’re asked to walk through a comingled example.

There’s nothing at all different about this question. Just walk through the two processes
of dealing with PIK and cash interest in unison.

What are some trends in RX?

When asked about trends in an interview, talking about Serta (see the case study in the
members area) is a fantastic choice as Serta’s restructuring demonstrates two of the
major trends in restructuring solutions over the past five years (IP transfers and non-pro
rata uptiers).

If you’re looking for another trend, then one worth thinking about is how the rise of more
highly levered and covenant-light (cov-light) loans has led to decreasing recovery values
in recent years for loan holders.

This shouldn’t be overly surprising given that the whole point of cov-lite loans is that you
give a company more leash to do what they want. Or in other words, more runway to get
into distress before being forced to truly deal with it (in-court or out-of-court).

Further, with the rise of direct lending and private credit shops we’re seeing more “top
heavy” capital structures. By this I mean we’re seeing some companies with a large 1L

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and 2L and maybe just a small tranche of Senior Notes (or nothing at all). By
concentrating debt at the top of the cap stack this, quite obviously, leads to lower
recoveries for those at the top if the company gets in trouble as there’s no high coupon
paying subordinated notes, for example, below the loans to absorb the loses.

This is all part of the broader trend we’ve seen post financial crisis where “non-traditional”
lenders – whether that be sole direct lending shops or the private credit arms of mega-
fund PE firms - have raised huge amounts of capital in order to lend at often quite senior
positions in the capital structure.

Predictably, this competition to place money has led to more permissible credit docs
(less covenants), lending at high leverage, and generally lower yields.

This all isn’t entirely illogical as many of these lenders – unlike large banks in decades
past – are not against participating in a restructuring if the company gets distressed.
Many former RX analysts are at these kinds of shops and so when they think about
downside risk, they think in terms of how they could work out these loans in an out-of-
court or in-court scenario (for example, they may ask themselves if they’d be comfortable
or inclined to own the equity of this company should the company file in the future with
them being impaired).

Another interesting trend in default recoveries is that we’ve seen high recovery values in
recent years for bonds primarily as a result of debt exchanges out-of-court enhancing the
economics of holders.

Of course, I don’t want to overstate these trends or make you think that we’re in some
new era where all capital structures are fundamentally different than they were before!
These are just some undercurrents that have been brewing largely since the last financial
crisis.

My personal opinion is that restructuring – in particular out-of-court – has become a bit

more normalized in a way (which is great for RX bankers!). Lenders are increasingly not
thinking about just downside risk in terms of what their recovery value would be in a
freefall Chapter 11 filing. Instead, many lenders are comfortably getting involved in thorny
out-of-court or in-court work (like providing DIP loans for companies they provided a term
loan to pre-filing to try to enhance their blended rate of return).

In other words, many lenders aren’t thinking in just the binary terms of either the debt
returns par at maturity and we clip all our coupons or the company files and we get $[Link]
recovery. They’re thinking in a more nuanced way about how, even if the company gets in
distress, they could mitigate their losses or maybe enhance their returns (by holding post
reorganization equity in the company over a longer time horizon, for example).

Restructuring Interviews 2021 – All Rights Reserved 16

Again, I don’t want to overstate all of this! It’s just an interesting trend. S&P Global has a
reasonably good write-up on it linked below. It perhaps makes things look a bit starker
than I think they are in reality, but you’ll likely enjoy the write-up.

Either way, if somehow you can bring this up in an interview – in particular what I
mentioned about these alternative lenders fueling this change due to their different
incentive structure to the old-school lenders of decades ago – I imagine your interviewer
would be quite impressed.

[Link]
recovery-u-s-recovery-study-clouds-loom-as-defaults-rise-11762662

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