Debt Capital Markets puzzles, solved step by step

Senior debt gets Rs 250 crore, the subordinated notes nothing, and trade creditors Rs 50 crore. All three are unsecured, so first share Rs 300 crore pro rata across Rs 600 crore of claims: 150, 100 and 50. The notes then turn their Rs 100 crore over to the senior debt, which is still owed 150, leaving senior at 250. Trade creditors signed nothing, so they keep their 50.

What is contractual subordination, in plain terms?

Two siblings borrow from their parents and from a neighbour. The younger sibling promises the elder that any repayment the younger receives will be handed over until the elder is repaid. The neighbour never heard about that promise and is unaffected. Contractual subordinationAn agreement by one class of creditors to be paid only after a named senior class, enforced by handing over anything received until the senior class is paid in full. is a promise between two classes, so it moves value between them and leaves every other creditor exactly where the law puts them.

Why share pro rata first, before applying the subordination?

Because in the eyes of the insolvency law all three claims are unsecured and of equal rank. The legal waterfall treats them pari passu; the subordination agreement then works on what the noteholders receive, not on the waterfall itself. So compute the pro rata split, 50% each on Rs 600 crore of claims, then apply the turnover: senior is still owed Rs 150 crore, and the notes' Rs 100 crore goes to it in full. Had the notes' share exceeded what senior was owed, the surplus would stay with the notes.

What would a wrong reading cost each class?

Reading the notes as subordinated to everyone, a straight ladder, would pay senior 300 in full, trade nothing and notes nothing, a strict waterfall that takes Rs 50 crore from trade creditors who never agreed to it. The difference between subordinated to a named class and subordinated to all creditors is worth real money, so a credit analyst reads the subordination clause before building any recovery table. In real cases, check also whether senior's post-filing interest counts in the turnover, which the documents decide.

Yes: settling leaves the seniors Rs 361 crore against Rs 342 crore by fighting, Rs 19 crore better. A fight that costs 10% of Rs 380 crore shrinks value to Rs 342 crore before anyone is paid. Giving the juniors 5% of Rs 380 crore costs Rs 19 crore. The seniors should pay anything up to 10% of the equity to avoid the fight, before counting six months of delay.

Why pay anything to a class that is out of the money?

Two heirs argue over a house worth Rs 38 lakh. One has the clear legal claim; the other can drag the case through court for a year and run up lawyers' fees of Rs 3.8 lakh. The strong heir who hands over Rs 1.9 lakh to end it keeps more than one who wins in court. A settlement payment to a junior class is rational whenever it costs less than the value the fight would destroy. Being right about priority does not make fighting free: the costs come out of the same pot.

Here the seniors are owed Rs 400 crore against Rs 380 crore of value, so under absolute priorityThe rule that each class of creditor is paid in full before the class below it gets anything. the juniors get nothing and the seniors take the whole company. The juniors' only lever is delay and cost. Fighting burns 10% of value, Rs 38 crore, leaving Rs 342 crore.

How big a gift would still make sense?

The seniors break even at a gift of 10%, the same as the share of value the fight would destroy. At 5% they are comfortably inside that line, and the six months of delay tips it further, because a recovery received now is worth more than the same recovery received later and a distressed business often loses customers and staff while it waits. Senior recovery rises from 85.5% to 90.25% of their claim.

Say the limits too. The answer assumes the seniors would win the fight outright; if there is any chance the juniors win something, settling looks better still. It also assumes the 10% cost estimate is honest. And a gift to one class can invite others to threaten the same thing, which is why seniors often pair the equity with warrants or tie it to the juniors voting for the plan.

Without the guarantee the bonds recover 50%; with it, about 87.5%. The operating lenders are paid first from the Rs 700 crore, so only Rs 100 crore reaches the holding company for Rs 200 crore of bonds. A guarantee gives the bonds a direct claim on the operating company, equal with its loans if both are unsecured: Rs 700 crore across Rs 800 crore of claims, Rs 175 crore to the bonds.

Why do holding company bondholders get only what is left?

Lend money to a friend whose only asset is a stake in the family shop. If the shop fails, its suppliers and its bank are paid out of the shop's till first, and your friend receives only what is left over, if anything. Holding company bonds sit in exactly that position. The holding company owns shares, not assets, so its lenders are paid only from the equity value of the operating company, after every creditor of the operating company has been paid in full. This is called structural subordinationBeing junior not because of a clause in the documents but because your borrower sits higher up a corporate chain than the assets., and no ranking clause in the bond documents can undo it.

What does the guarantee change, and for whom?

An upstream guarantee from the operating company gives the bondholders a second claim, this time directly against the operating assets. If that claim ranks equally with the operating loans, the two groups share Rs 700 crore across Rs 800 crore of claims: 87.5% each, Rs 175 crore to the bonds and Rs 525 crore to the loans. The bondholders' gain of Rs 75 crore is exactly the operating lenders' loss of Rs 75 crore; a guarantee does not create value, it moves the queue. That is why operating lenders often limit or prohibit such guarantees in their own documents.

What assumption would flip the answer back to 50%?

If the operating loans are secured on all of the operating assets, they are paid in full from the collateral before any unsecured guarantee claim, and the bonds are back to the Rs 100 crore residual. Label and security both matter: a guarantee only helps against creditors it can rank alongside. In real documents guarantees can also be capped or challenged, so a credit analyst reads the guarantee and the intercreditor terms before trusting a number like 87.5%.