Lesson 5 of 8
Where the value breaks
In one documented plan the revolver was repaid in full, a term loan received 23.0 million shares, the notes below it 3.6 million, and the shareholders nothing.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The fulcrum is the claim that is partly repaid: everything above it recovers in full, everything below it gets little or nothing.
- It is where the enterprise value runs out, so the holders of that claim usually receive the equity of the reorganised company.
- A confirmed plan states the distribution class by class, which makes the fulcrum a matter of record rather than of opinion.
In a reorganisation the value of the business is divided among claims in order of rank. Somewhere in that list the value runs out, and the claim it runs out in is the one that decides everything.
What each class received, Chesapeake Energy's plan
- Pre-petition revolving facility · repaid in full, dollar for dollar, in loans0 shares
- First lien last out term loan23,022,420 shares
- Second lien notes · plus warrants struck above the plan value3,635,118 shares
- Senior unsecured notes · plus warrants1,311,089 shares
- General unsecured claims · plus warrants231,112 shares
- Existing common and preferred stock · cancelled, no distribution0 shares
Reading the break
The revolving facility was reinstated dollar for dollar as new loans: a full recovery in cash terms, and no equity. That claim was above the line.
The first lien last out term loan received 23.0 million shares of the new company and no cash. That is a partial recovery paid in equity, which is the signature of the fulcrum. Everything below it received a token: 3.6 million shares for the second lien notes, 1.3 million for the senior unsecured notes, 0.2 million for general unsecured claims, each with warrants struck at 27.63, 32.13 and 36.18 dollars, above the plan's own valuation of the new shares.
The existing common and preferred stock was cancelled and released without any distribution.
Why the fulcrum is the interesting claim
Three reasons, and they are the reason distressed investors look for it.
It converts into the equity. The holders of the fulcrum usually emerge owning the reorganised company, so the analysis of that claim is an equity analysis wearing a debt instrument.
Its price contains the whole argument. A claim trading at 60 cents is a statement that the enterprise value covers 60 percent of it. Disagreeing with that requires a view on the enterprise value, which is a valuation question rather than a credit question.
Everything else is decided by it. Above the line, recovery is a question of timing. Below it, the claims are options on the enterprise value being larger than the plan says.
Locating it before a plan exists
Add the claims from the top until the cumulative total passes your estimate of the enterprise value. The claim you are in when that happens is the fulcrum.
That means the exercise needs two things this course has already built: the ranked stack with the amounts, and an enterprise value you can defend. The second is where it is hard, because a distressed enterprise value is exactly the case where a discounted cash flow is least reliable.
What the record shows about the equity
In this plan the old shareholders received nothing, which is the ordinary outcome when the reorganisation value is below the claims. The same filing states it plainly: reorganisation value of about 6.8 billion dollars against post-petition liabilities and allowed claims of 13.2 billion.
Old equity occasionally does receive something, usually when the estate proves solvent or when creditors trade a small distribution for speed. It is the exception, and the absolute priority rule is the reason.
Check yourself
Which claim is the fulcrum?
- The most senior secured claim
- The one that is only partly repaid, so the classes above it recover in full and those below get little
- The largest claim by amount
Show the answer
Answer: B.
It is where the enterprise value runs out, which is why its holders usually receive the equity of the reorganised company.In the plan above, how can you tell which claim was the fulcrum?
- It was the largest debt outstanding
- The revolver was repaid in full while the term loan below it received equity rather than cash
- It was the only secured claim
Show the answer
Answer: B.
Full cash recovery above, a partial recovery paid in shares at the term loan, tokens below: the break is visible in the distribution itself.What does the price of a fulcrum claim represent?
- The probability the company avoids bankruptcy
- A view on the enterprise value, since the recovery depends on how far the value reaches up the stack
- The recovery rate on similar claims historically
Show the answer
Answer: B.
Analysing the fulcrum is a valuation exercise. That is what makes it an equity analysis conducted through a debt instrument.Sources
- Chesapeake Energy Corporation, Form 10-K, fiscal year ended 31 December 2021, filed 2022-02-24, accession 0000895126-22-000029: the plan's distribution by class, the share and warrant counts, the exercise prices, and the reorganisation value against allowed claims.
- The US Bankruptcy Code, Chapter 11, and the absolute priority rule.
- Moyer, Distressed Debt Analysis, 2005: locating the fulcrum by accumulating claims against an enterprise value estimate.
What this leaves out
- One closed case. The ranking generalises; the recovery rates in it do not, and they depend on an enterprise value set in one negotiation at one moment.
- The share counts above are the classes named in the plan. Others, including backstop parties to the rights offering, received shares not shown here.
- Warrant exercise prices are as stated in the filing and were above the plan's own valuation of the new equity.
- Nothing here is advice about any security.