Identifying the “fulcrum” debt instrument was once a vital part of a distressed investor’s skillset. But liability management exercises (LMEs), advisor sophistication, private equity sponsors’ desire to retain control and an abundance of capital have created an environment where the fulcrum can shift unexpectedly or even be irrelevant.
What is a fulcrum?
A troubled company’s fulcrum is “the loan or bond most likely to be converted into equity ownership through a restructuring,” says Allan Schweitzer, a portfolio manager at Beach Point Capital Management.
Identifying the fulcrum was once straightforward. An investor takes a balance sheet’s priority-of-payments waterfall and overlays that with an estimated enterprise value today or in the future, producing expected recoveries for each tranche of the capital structure. Whether to use today’s or a future enterprise value is part of a restructuring’s negotiating process and depends on whether investors want a higher or lower valuation.
Segments of the capital structure that are clearly money-good are likely to receive a new debt instrument or even cash in the restructuring. Those investors will be allowed little say during the process.
The first part of the waterfall that doesn’t recover 100 cents on the dollar in cash or new debt gets some, and maybe all, of the equity and is considered the fulcrum. Whether debt claims below the fulcrum get any recovery depends on what value remains for their investors after satisfying the fulcrum’s claim and whether those investors have the leverage to hold up the restructuring process unless they get a recovery.
An investor who wants a safe recovery — perhaps a new bond or cash worth around par — would invest above the fulcrum. Conversely, an investor seeking to control the troubled company would target the fulcrum and argue for a lower valuation to ensure that part of the waterfall gets most of the equity.
At least, that’s how it used to work.
Schweitzer notes that today, LMEs such as uptiering and drop-downs can potentially convert what might have at first seemed to be a control position with a stellar recovery into a subordinated position with an uncertain recovery. In other words, the fulcrum can move.
Why it matters
A big reason the fulcrum isn’t often a topic of conversation these days is that “equity isn’t changing hands as often, so the fulcrum isn’t as important,” said Randy Raisman, the Head of US Opportunistic Credit at Marathon Asset Management.
“We don’t hear about the fulcrum as much because there aren’t as many classic restructurings,” Raisman said. “Equity is not changing hands because companies are executing liability management exercises rather than traditional bankruptcies or debt restructurings.”
“Plus, we don’t see many smaller troubled companies where we would even want to own the equity,” Raisman added.
What Raisman does see is large, multi-tiered capital structures with solid underlying business fundamentals but facing liquidity issues brought about by elevated interest rates rather than by troubled operations and weakening fundamentals.
These larger debt issuers present opportunities for their equity sponsors to retain their equity — and control — rather than lose it to creditors. “They need help paying interest, creditors may agree to a discount or PIK [pay-in-kind] interest, sponsors will put up new money, and the company and its owners live to fight another day,” Raisman said.
In these cases, investors in what would mathematically be the fulcrum debt have no chance to exercise any control at all.
Covenants shoulder much of the blame. “These days, flexible and loose debt covenants don’t give investors a clear picture of the waterfall because of the permissiveness of the covenants,” Beach Point’s Schweitzer explains. “Assets can be carved out, while baskets of permitted investments can enable investors in a lower part of the capital structure to exchange their paper, or make a new investment, that becomes the top of the capital structure.”
Marathon’s Raisman concurs. “Loose covenants enable assets to be moved to facilitate new borrowings that eliminate a position that had been pari passu with you, and now suddenly they’re behind you.”
In other words, liability management exercises can cause the waterfall to change, moving the fulcrum or eliminating its advantage.
How does it work?
Sponsors who want to retain control of a troubled company might, in cahoots with a creditor group, structure an “uptier” LME where bank lenders inject new debt in a “superpriority” position ahead of existing secured debt. Meanwhile, existing secured debt would be exchanged into new debt, perhaps at a discount and almost certainly with a lower priority than the new loan.
The result would be added liquidity and an extended maturity profile but at the cost of more balance-sheet debt. And the equity wouldn’t budge. Even if some equity is provided to induce debtholders to participate in the restructuring, the majority — and control — would continue to reside with the original equity holder.
In this case, what had been the fulcrum — if a classic restructuring had ensued — would be powerless to halt the transaction and be pushed lower in the capital structure. Its value as the fulcrum rendered meaningless.
And it doesn’t have to be bank lenders providing the new, superpriority capital. Lenders anywhere in the capital structure can write a check for a loan that primes current senior debt. All that’s needed is willingness to invest new cash.
Another example where owners of the fulcrum debt can exert little influence is in a drop-down LME transaction. Drop-downs became notorious because of one of their earliest examples, J.Crew Group Inc. In 2016, J.Crew transferred $250 million of intellectual property assets held at a guarantor-restricted subsidiary to a foreign, non-guarantor-restricted subsidiary, using a basket of value available for this sort of move. Next, that foreign subsidiary transferred the IP to an unrestricted subsidiary using another available basket. Now at an unrestricted subsidiary, J.Crew was free to do as it pleased with the assets.
J.Crew’s movement of assets to an unrestricted subsidiary was subsequently known as a “trap door,” not to be confused with bankruptcy “death traps,” where creditors who vote against a reorganization plan are threatened with a poor recovery.
Beach Point’s Schweitzer cites another problem with identifying the fulcrum: the degradation of a troubled company’s enterprise value that ensues during the course of restructuring. “There is more friction in the process than there used to be,” he said.
Schweitzer explained that, the longer the company is saddled with a too-heavy capital structure, the less it may be worth. Operations, already weakened by a lack of cash, can falter as management diverts attention away from running the business and towards dealing with the capital structure and managing tight liquidity.
Moreover, as a sponsor’s investment morphs into an out-of-the-money option, the sponsor may offer less oversight and operational support to the portfolio company.
As enterprise value declines, a debt position in the waterfall can drop from in-the-money — and perhaps even being the fulcrum — to out-of-the-money, seeing little or no recovery.
What’s next?
After J.Crew, there was market chatter that loopholes allowing these LMEs had to be closed. But in this covenant-lite, issuer-friendly debt market, the opposite is happening.
Investors and advisors continue to find ways to inject new cash, extend maturities and preserve optionality for equity owners. And fulcrums keep moving.
Featured image: Tetra Images/Getty Images
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