Distressed investing

[tpchan]

Hi David,

On T8 study note p.74, it says the loss on bond position is $200 per bond based on the assumption of unfavorable outcome. Would you please demonstrate how to come up with this $200 loss per bond? I have spent some time on it but in vain.

Thank you.

 

[David Harper CFA FRM]

Hi tpchan,

The scenario notes are simply based on the assigned Stowell reading, Exhibit 12.20 on page 237, which itself is not well-explained. I think:

• The original distressed company has an enterprise value of $3.3 billion = $3.0 billion in debt + $300 billion in equity ($3 per share * 100 MM shares)
  • $3.0 BB debt = trading at a deep discount amount of $30 per 100 face = $10.0 billion face value
• Then downside risk scenario causes a drop to $2.0 billion in enterprise value [text says 20 billion, but a I *think* scenario anticipates drop from $3.3 EV to 2.0 BB)
  • $1.0 billion in equity = $10 per share * 100 million shares, plus
  • $1.0 BB debt = $10.0 billion face value * 10% PV (not stated, far as i can tell, but rather implied by the given enterprise value and equity)

Such that long 1 bond at $300 (i.e., $30 per $100 with $1,000 face. A little awkward presentation, in my opinion) has loss of $200 per when price drops to $100 per bond (10% of $1,000 face value). I hope that explains, thanks,

 

[tpchan]

Thank you. One clarification, should the enterprise value drop to 2 billion or 20 billion?

 

[David Harper CFA FRM]

right, i think it's $2.0 billion. The text on p 237 say $20.0 billion but I *think* the example is confused by a multiple of 10. Actually, i think my initial equity is incorrect and should be $300 million. Changed that, too. I'm not completely sure, the example is hard to decipher. thanks,

 

[tpchan]

It solved all problems in my head regarding this example. Thank you very much.

 

[David Harper CFA FRM]

thanks b/c i am still trying to figure it out, it's the first time i looked at it closely ... i guess it is really a sort of "capital structure arbitrage" distressed bet where long bond + short equity is expecting to payoff under bankruptcy such that bonds payoff in liquidation but shareholders are wiped out so both trades profit.

Then, a downside (risk) outcome is the opposite: bond prices drop but equity increases because the assets are worthless but a regulatory-driven acquisition happens. So, the math seems to work: EV drops from 3.3 to $2.0 billion with debt dropping fully from $3.0 bb to $1.0 bb such that equity actually increases from $0.3 to $1.0 billion. So, long bond at $300 (30 per 100 face, face = $3,000) drops to 200; short equity at $300 million gains to $1.0 billion (100 mm shares = $7 per share)
... the $2.0 billion appears to be based on 10% probability of $20.0 EV of the acquiring company (due to a shift in regulation)
... actually it says share price would increase to "$10 per $100 face" (?)

okay, i am still not sure about the numbers above, sorry. Might be correct. Might all be off by a factor of 10.