Case 076Liability management and refinancingHard

A stressed borrower offers to swap its unsecured bonds, trading at 60, into new secured bonds at 75 of face. If 80% accept, how much debt goes, what do exchanging and holdout holders end up with, and why do holdouts matter?

The situation

Kovalan Mills, a cotton spinner, has Rs 600 crore of senior unsecured bonds with a 9% coupon and three years left to run. After two years of weak margins the bonds trade at 60. Kovalan has no cash to buy them back, so it offers an exchange: for every Rs 100 of old bonds, a holder receives Rs 75 of new five-year bonds paying 10% and secured on the company's mills.

Holders of 80% of the bonds accept. The rest keep their old bonds. If Kovalan later fails, the mills and other assets would fetch about Rs 330 crore after costs, and there is no other significant debt.

Your task

How much debt does the exchange remove, what does each group of holders end up with if Kovalan survives or fails, and why does the company care so much about holdouts?

Quick check

Kovalan recovers and repays everything at maturity. What does a holdout receive for each Rs 100 of old bonds?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The exchange removes Rs 120 crore, taking debt from Rs 600 crore to Rs 480 crore. Exchangers swap 480 of old bonds for 360 of secured bonds: 75 per 100 if Kovalan survives, about 69 if it fails. Holdouts keep 100 of face behind the new security: paid in full if Kovalan survives, nothing if it fails. Every holdout shrinks the relief and rides on the others' sacrifice.

Step 1How much debt does the exchange actually remove?

Only the bonds that join are cut. Holders of Rs 480 crore hand in their bonds and receive Rs 360 crore of new ones, a Rs 120 crore reduction. The Rs 120 crore of holdouts is untouched. An exchange is a set of private bargains, one per holder, not a vote that binds everyone. Think of a landlord asking every tenant to accept a lower deposit refund: the tenants who sign get less back, the ones who refuse keep their original lease. Had every holder joined, the cut would have been Rs 150 crore; each 10% of holdouts gives back Rs 15 crore of it.

The exchange cuts debt only on the bonds that join it, Rs croreUnsecured bonds9% coupon, trade at 60600BeforeNew secured360 (480 x 75%)Holdouts 120removed 120After, 80% joinWho carries what afterwardsExchangers: 360 secured,first claim on the millsHoldouts: 120 unsecured,still owed 100, now behindTotal debt 480, down 20%At 100% joining: 450,down 150
Kovalan's debt falls from Rs 600 crore of unsecured bonds to Rs 360 crore of new secured bonds plus Rs 120 crore of holdout bonds, Rs 480 crore in all, so the Rs 120 crore reduction comes entirely from the 80% who exchanged.
Step 2What does each holder end up with if Kovalan survives or fails?

Work it per Rs 100 of old bonds. If Kovalan survives, the exchanger is repaid 75 and the holdout 100. If it fails, the secured bonds take the first Rs 360 crore of the Rs 330 crore of value, so they recover 91.7%, or 68.75 per 100 of old face. Nothing is left for the holdouts. The exchanger buys safety by giving up face value; the holdout keeps face value but moves to the back of the queue. Before the exchange, a failure would have paid every holder 55.

Per Rs 100 of old bonds: holdouts win if Kovalan survives, lose if it failsKovalan survives and repays75Exchanger100HoldoutKovalan fails, mills fetch Rs 330 crore68.8Exchanger0Holdout55 for all, had nobody exchangedThe two choices are worth the same at a 26.7% chance of failure; above it, exchanging is the better bet.
For each Rs 100 of old bonds, the exchanger gets 75 if Kovalan survives and 68.8 if it fails, while the holdout gets 100 if Kovalan survives and nothing if it fails, so the choice turns on the chance of failure, with the two equal at 26.7%.
The relationship
100 (1−p)=75 (1−p)+68.75 p  ⇒  p=2525+68.75=26.7%100\,(1-p) = 75\,(1-p) + 68.75\,p \;\Rightarrow\; p = \frac{25}{25 + 68.75} = 26.7\%
pthe chance Kovalan fails before the bonds mature
100what a holdout receives if Kovalan survives
75what an exchanger receives if Kovalan survives
68.75what an exchanger recovers per 100 of old bonds if Kovalan fails
What it says in wordsA holder who thinks failure is more likely than about 27% should exchange; one who thinks it less likely does better holding out, ignoring the coupon difference.
Step 3Why does the company care so much about holdouts?

Because the holdout's best outcome depends on everyone else joining. With 80% in, interest falls from Rs 54.0 crore to Rs 46.8 crore and debt from 600 to 480, which raises the chance Kovalan survives, and survival is exactly when holding out pays. Every holder is tempted to let others take the haircut, and if enough of them think that way the exchange fails for all. This is the holdout problemIn a voluntary debt exchange, each holder gains by refusing while others accept, so too few may accept for the deal to work.. Issuers answer it with a minimum participation condition, often set high, and sometimes with exit consents that strip covenants from the old bonds as holders leave them. Whether exit consents are allowed depends on the bond documents and the governing law; confirm them for any real deal.

Close with a view. At a price of 60 the market is signalling a real chance of failure, well above 27%, so a holder acting on the numbers exchanges. For Kovalan, a Rs 120 crore cut and Rs 7.2 crore of interest saved is modest relief; it buys time rather than fixing the balance sheet, and the lender's next question is whether the mills can earn enough to carry Rs 480 crore.

Where candidates lose it

The common loss is assuming the exchange binds everyone and cutting the whole Rs 600 crore by a quarter. It cuts only what is tendered, so the answer is Rs 120 crore, not Rs 150 crore, and the holdouts still hold a claim for 100.

The second is saying the holdouts are simply worse off because they rank behind the new secured bonds. That is only true if Kovalan fails. If it survives, they are paid in full and beat the exchangers by 25 points, which is why holdouts exist at all.

What the interviewer asks next

  • What minimum participation would you set as a condition, and why?
  • The new bonds trade at 90 after the exchange. Was exchanging worth it at a price of 60 before the offer?
  • How would a cash tender at 65 compare with this exchange for Kovalan?
  • Could the holdouts sue to block the new security, and what would they argue?

Company names and figures are illustrative.