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Understanding debt

Usually bank debt is cheaper than high yield debt. It will be cheaper because less risky than high yield debt (“junk bonds”). Bank debt will be more senior so in case of liquidation, banks will receive the money first. In addition, bank debt will be more likely to be secure against the company assets.

A debt for equity swap is when debt is converted into equity. It happens as potential outcome of a restructuring situations when debt is reduced (to allow the company to survive). As compensation, debt holders can receive Equity.

  • Increased leverage 
  • Might offer lower cost of capital (since cheaper than equity) with less equity dilution
  • Interest paid on Mezzanine debt is tax deductible where dividends are not
  • Senior creditors benefit from the cushion of the junior debt 
  • Debt under mezzanine arrangements is often payable after certain years (PIK interest), delaying obligation to buyer

Here, Par value is 100 so you lost 20 cents on the dollar (100-80). 
That twenty cents is divided by five since you still have five years left on the investment (20/5=4). 
So the current yield on the note is 14% (10+4=14).

When a company borrows debt, it will sign debt contracts with the banks (or other debt providers). To protect the debt holders, clauses will be in the contract defining the event of default. An event of default is often linked to the fact that the company cannot pay the debt (principal or interests).

Usually, even if a company cannot pay the debt, it can benefit from a “grace period” or deb holders can decide to postpone the debt repayments etc…

In conclusion, an event of default is a specific event set out in the credit agreement which has not been remedied or waived after any grace period and which allows creditors to accelerate their debt (put the company in default and cease what they can cease).

There can be different types, “tranches” of debt in the total debt of a Company. All these tranches do not have the same priority on getting the cash from the company. The tranches are ordered by seniority. Thus the most senior debt will be paid first, and the most junior one will be paid last.

It does not really matter if everything goes according to plan. On the contrary, it is particularly important if the company has trouble repaying the debt. Seniority will indicate who gets paid first.

There can be different types, “tranches” of debt in the total debt of a Company. All these tranches do not have the same priority on getting the cash from the company. The tranches are ordered by seniority. Thus the most senior debt will be paid first, and the most junior one will be paid last.

It does not really matter if everything goes according to plan. On the contrary, it is particularly important if the company has trouble repaying the debt. Seniority will indicate who gets paid first.

It depends how you look at it. If you are the company and you want to assess your debt “burden”, you just need to look at how much interests you need to pay (cash or PIK) compared with the total debt outstanding.

If you are a looking at the company from the “outside” (a debt holder for instance), you would look at the current yield on each of the debt instruments. If the company is going through a distressed situation, it is fairly likely debt will lose some value as it becomes riskier. If debt is becoming riskier, yield would be higher (expected returns are higher). You can then calculate the average cost of debt using current yield if available.

“PIK” stands for Payment In Kind. A PIK interest means that the company does not have to pay the interest in cash at each period. PIK interest will add up and will have to be repaid at maturity.

 

When you look at the impact of a particular item on the 3 financial statements, you need to approach the financial statements one by one:

  • Income Statement: PIK interests decrease earnings before tax so taxes are lower
  • Cash Flow Statement: PIK interests are not paid by the company yet so they have to be added back in the Cash Flow Statement. Due to lower taxes, cash flow is higher
  • Balance Sheet: PIK interests increase debt position

A covenant is a condition written into a loan agreement, which, if broken, can trigger an event of default. There are generally two sorts of covenant: maintenance covenants and incurrence covenants.

Covenants are check points, which have to be verified at specific dates. If the companies complies with the covenants, everything is fine, if it does not, the debt holders can take actions to recover their money.

The leverage is the amount of debt in a company.

When you decide to assess the leverage capacity of a company, you want to know the maximum leverage of the company.

When you want to assess a maximum leverage you need to make sure that the company can repay 1) interest expense and 2) the principal.

To do so, it is important to look at cash flow before debt service, its evolution and sensitivity to different parameters (sales growth, costs evolution etc…). This cash flow will have to be sufficient to 1) pay interest, 2) pay principal and 3) gives some headroom to allow the company to grow or face bad situations.

You can back-calculate the maximum leverage by taking the amount you can afford to give up to the debt holder.

To assess maximum leverage, you need to also look at the market: are companies in this sector very levered? Are banks landing money to this type of companies?

To assess leverage for a target, the financial sponsor need to be sure that the company can repay the debt quickly and gives space for equity value creation! If you have too much debt, equity value might get to 0 if things go badly!

Impact of a debt write-down on the 3 financial statements:

When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by GBP 1,000m due to this write-down. Assuming a 40% tax rate, Net Income is up by GBP 600m.

On the Cash Flow Statement, Net Income is up by GBP 600m, but we need to subtract that debt write-down (GBP 1,000m) – so Cash Flow from Operations is down by GBP 400m, and Net Change in Cash is down by GBP 400m.

On the Balance Sheet, Cash is down by GBP 400m so Assets are down by GBP 400m. On the other side, Debt is down by GBP 1,000m but Shareholders’ Equity is up by GBP 600m (Retained Earnings) because the Net Income was up by GBP 600m – so Liabilities & Shareholders’ Equity is down by GBP 400m and it balances.

Private debt: senior or mezzanine.
Public debt: financial instruments that are freely tradeable on a public exchange (bonds).

For this one, it really fluctuates depending on the market. To answer the question “how is the debt market currently doing?”, you need to have a look at current government bonds, do you have countries in distressed? Do banks land money at the moment for levered transactions (LBOs), is the debt market closed or open?

Unfortunately, we can’t give you a straight answer as it will probably change! Have a look on mergermarket or in the press and you may find some answers!

A Revolving Credit Facility (“RCF”) is a line of credit where the Company pays a commitment fee and is then allow to draw on the facility whenever it has a need (generally operating need).

It means that the Company will pay a fee, to be able to borrow money (the amount is capped) whenever it wants, to finance particular swing in working capital or other operating needs. When the Company draws on the RCF (for example £20m out of a £50m RCF), it will pay interest on the drawn amount and will continue paying the commitment fee on the undrawn amount (£30m).

The company repays the drawn amount whenever it can (as it is the most expensive part of the RCF, vs. undrawn amount).

Usually bank debt is cheaper than high yield debt. It will be cheaper because less risky than high yield debt (“junk bonds”). Bank debt will be more senior so in case of liquidation, banks will receive the money first. In addition, bank debt will be more likely to be secure against the company assets.

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