The Fulcrum Security
Educational Series
The fulcrum security is a fundamentally important concept in restructurings and distressed investing that is rarely covered in traditional financial media. This concept will come up repeatedly in our posts as we take our readers further down the restructuring rabbit hole.
Typically, companies requiring a financial restructuring will have an Enterprise Value lower than the value of the debt obligations owed.
The fulcrum security is where value “breaks” or “runs out” in the cap stack. Where the EV = cumulative debt as per absolute priority.
The fulcrum is important in a restructuring because the creditor group involved in this security will be able to exert the most influence over the process. Generally speaking, creditors that are below the fulcrum security in payment will receive little to no value, and creditors above the fulcrum will typically receive a full recovery because they are “in the money.”
Let’s go through an example using a hypothetical cap stack for a company we will affectionately name “BadStack.”
BadStack experienced record profits during the pandemic. With cheap access to capital and ambitious growth plans, the company completed huge capital raises successfully. As the market turned the company’s prospects worsened and profitability took a hit. EV fell 40% and the value of its equity as well as junior debt fell.
BadStack’s debt burden eventually became untenable and the company was forced to restructure its debt. At BadStack’s current EV, parts of the cap stack are underwater.
The most senior parts of the cap stack (the term loan and 2nd lien debt) are fully covered and receive a 100% recovery. The subordinated bonds, preferred equity and common equity are fully wiped out.
The senior bonds are the fulcrum security - the last lenders to receive some value. The senior bonds are where BadStack’s value “runs out.” They do not get a 100% recovery, and they do not get fully wiped out. In this hypothetical scenario let’s assume they achieve a recovery of 75%.
How to Identify the Fulcrum Security
A quick check you can do is to look at the trading prices of the bonds. If bonds are trading at 75, creditors expect to receive 75 cents on the dollar when the bonds mature or in a restructuring. Generally, this approach is for bonds trading below 80 as the market is pricing the bonds based on recovery value. For bonds above 80, they may be trading at that price to adjust for yield relative to similar credits (due to changes in interest rates). This is not a hard and fast rule but it can work for a quick n’ dirty approach.
Another approach would be to analyze the company’s credit ratios, such as Debt to EBITDA.
For example, let’s say a company is valued at 5.0x EV/EBITDA and has a Debt / EBITDA of 7.5x. The most junior debt piece where value runs out (where Debt/EBITDA reaches 5.0x) would be the fulcrum.
More involved approaches would entail constructing valuation models and analyzing a company’s debt capacity. Valuation is an essential component of restructurings because it determines what recoveries are available to creditors and the fulcrum security. Given its importance, it’s common for creditor classes to disagree on the valuation.
A “valuation fight” occurs when creditors litigate to determine the outcome of a restructuring’s plan valuation, which determines the recoveries each creditor receives.
This closes out the first of our educational series on restructurings and distressed debt.
Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.