Method
Finding the fulcrum
In a company that cannot pay everyone, one class of debt sits exactly where the value runs out. It behaves like equity, and it is where most of the money is made and lost.
When a company is worth less than it owes, value fills the capital structure from the top down and stops somewhere. The class where it stops is the fulcrum security. Everything above it is paid in full. Everything below it gets nothing, or close to it. The fulcrum gets whatever is left over, which in a restructuring usually means it gets the company.
Finding it
Take enterprise value and subtract claims in order of priority.
Suppose a business is worth $800mm and owes $500mm on a first lien loan, $400mm on unsecured notes and $150mm on subordinated notes.
| Class | Claim | Value left before | Paid | Recovery |
|---|---|---|---|---|
| First lien term loan | $500mm | $800mm | $500mm | 100% |
| Senior unsecured notes | $400mm | $300mm | $300mm | 75% |
| Subordinated notes | $150mm | $0 | $0 | 0% |
The unsecured notes are the fulcrum. They are the first class not paid in full.
Why it behaves like equity
Change the valuation by $100mm in either direction. The first lien still gets 100%. The subordinated notes still get nothing. The unsecured notes move from 75% to 50% or to 100%. Every dollar of change in the value of the business lands on one class.
That is what owning equity feels like, and it has three consequences.
The fulcrum has the most at stake in the valuation fight. Senior lenders want a low valuation, because it hands them more of the new company. Junior lenders want a high one, because it puts them in the money. The fulcrum is where the argument is settled, and courts spend most of their time there.
It usually ends up in control. A plan of reorganization typically pays the classes above the fulcrum in cash or new debt and gives the fulcrum the new shares. Buying it is how distressed investors come to own companies.
Its price swings the most. A senior loan in a troubled company might move five points on bad news. The fulcrum can move thirty.
The fulcrum moves
The fulcrum is a statement about a valuation, and valuations change. At $1,000mm the business above covers both the loan and the notes, and the subordinated notes become the fulcrum with a 67% recovery. At $450mm the first lien itself is the fulcrum.
This is the single most useful thing to test before buying anything in a stressed capital structure: across the range of values you think is plausible, which class is the fulcrum, and how wide is the range in which it is yours?
It also moves when the claims change. New super-priority debt pushes every class down by the amount raised. An exchange that lifts some lenders above others can turn a class that was the fulcrum into one that is out of the money without the value of the business changing by a dollar.
Using it
- Run a low, middle and high valuation. Note the fulcrum in each.
- If the same class is the fulcrum in all three, that class is where the control and the upside sit. Price it like equity, with a return to match.
- If the fulcrum moves between cases, the class above your middle-case fulcrum is the safer way to be involved, and the class below is an option.
- Read the documents for anything that lets the company put new debt ahead of the fulcrum. That is the risk a valuation cannot show you.
The recovery tool on each credit page does the first step for you. Drag the valuation and the fulcrum is named as it changes.