Debt Capital Markets puzzles, solved step by step

The bank recovers about Rs 304.5 crore, 76.1%; the bondholders get about Rs 109.1 crore, 36.4%. The bank takes the plant, Rs 250 crore, and is still owed Rs 150 crore. That shortfall ranks as an unsecured claim beside Rs 300 crore of bonds and Rs 100 crore of trade claims. The Rs 200 crore of other assets is shared across Rs 550 crore of claims at 36.36% each.

What does security actually give the bank?

A pawnbroker holding your watch gets the watch first. If the watch sells for less than you owe, you still owe the rest, but now as an ordinary debt. Security gives a lender first call on the pledged asset, up to its value; for any shortfall the lender becomes an ordinary unsecured creditor. Here the plant covers Rs 250 crore of the Rs 400 crore loan, so the bank is undersecuredOwed more than the value of the collateral pledged against the loan, so part of the claim is effectively unsecured. by Rs 150 crore.

How is the unsecured pool shared?

Pro rata, by the size of each claim. All unsecured claims of the same rank share the unencumbered assets in proportion to what they are owed, and the bank's deficiency counts in full. The pool is 150 plus 300 plus 100, which is Rs 550 crore, against Rs 200 crore of assets, a recovery of 36.36%. The bank receives 36.36% of 150, Rs 54.5 crore, the bonds Rs 109.1 crore and trade creditors Rs 36.4 crore.

What would change the numbers in a real case?

Several things the puzzle strips out, and naming one or two shows judgement. Insolvency costs and any claims the law ranks ahead of unsecured creditors, such as some employee and statutory dues, come out of the pool first, so the real unsecured rate would be lower than 36.4%. Plant values in a forced sale are often below appraisal. And the priority rules differ by country and by process, so check the regime that applies. The core mechanics, collateral first and deficiency pari passu, hold widely.

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.

About 35.7%. Set the price equal to the probability-weighted payoff: p times 100 plus 1 minus p times 30 equals 55. The 30 is paid either way, so the price only has to cover 25 of the 70-point gap between recovery and par, and 25 over 70 is 35.7%. The market thinks restructuring is nearly twice as likely as repayment.

How do you turn a price into a probability?

Suppose a raffle ticket pays Rs 100 if you win and Rs 30 as a consolation prize if you lose, and it sells for Rs 55. Everyone gets the Rs 30, so you are really paying Rs 25 for a shot at an extra Rs 70. A price between two outcomes is a probability-weighted average of them, so you can solve for the weight. The consolation prize matters: ignore it and you would read the Rs 55 as a 55% chance.

What does ignoring discounting hide?

Both payoffs arrive in the future, often a year or more away, and a distressed investor wants a high return for waiting. If the payoffs arrive in a year and the buyer demands 12%, the price must equal the expected payoff divided by 1.12, which lifts the implied repayment probability to about 45.1%. So the 35.7% is a floor: part of the discount to par is a charge for time and risk, not only for default. That is why desks quote these as risk-neutral probabilities, not forecasts.

The other soft spot is the recovery of 30. It is an estimate, and the implied probability is sensitive to it: at a recovery of 40, p is 15 over 60, 25%. Before trading on the number, a credit analyst would test the recovery from the balance sheet and the claims ranking ahead of this bond.

At Rs 700 crore, senior secured recovers 100%, senior unsecured 66.7% and the subordinated debt nothing, so the senior unsecured layer is the fulcrum. Value is paid down the stack in order: Rs 500 crore to the secured lenders leaves Rs 200 crore for Rs 300 crore of unsecured claims, and nothing below. The equity is worth something only once enterprise value exceeds total debt of Rs 950 crore.

How is value shared out when it falls short of the debt?

Picture water poured into a stack of glasses, each filling completely before any spills into the next. In a recovery, value pays each layer of the capital structure in full, in order of priority, before anything reaches the next layer down. The senior secured lenders' glass holds Rs 500 crore, the senior unsecured Rs 300 crore, the subordinated Rs 150 crore, and the equity takes whatever is left. Pour in Rs 700 crore and watch where it stops.

Why does the fulcrum matter to a credit investor?

The fulcrum securityThe most senior layer of the capital structure that the company value does not cover in full, so it is likely to receive the equity in a restructuring. is the layer where the value runs out. It usually ends up owning the business in a restructuring, because the layers above are paid in full and the layers below are wiped out. Here the senior unsecured lenders would likely exchange their Rs 300 crore of claims for most of the new equity. Distressed investors buy the fulcrum because its value moves most with the enterprise value: between Rs 500 and Rs 800 crore, every extra Rs 1 crore goes straight to it.

At what value does the equity come back to life?

The equity is out of the money until enterprise value covers every debt claim, Rs 500 plus 300 plus 150 crore, which is Rs 950 crore. At the original Rs 1,000 crore it was worth only Rs 50 crore, 5% of enterprise value, which is why a 30% fall wiped it out and went on through the subordinated layer too. The limit: this is a strict priority waterfall; in real restructurings junior classes often receive a small share to win their votes, and claims include accrued interest and fees, so treat these recoveries as the starting point of a negotiation.

At Rs 60 crore the lender gets 60 and shareholders nothing; at Rs 140 crore the lender gets 80 and shareholders 60. Shareholders prefer riskier assets. The lender's payoff is capped at the Rs 80 crore it is owed, while shareholders keep everything above 80 and cannot fall below zero. Equity works like a call option on the assets with a strike of 80, so more volatility moves value from the lender to the shareholders.

Who gets what in each outcome?

A student borrows Rs 80,000 from a relative to start a small business and owes it back in a year. If the business ends up worth Rs 60,000, the relative gets Rs 60,000 and the student nothing; if it is worth Rs 1,40,000, the relative gets Rs 80,000 and the student keeps Rs 60,000. The lender's payoff is the smaller of the asset value and what it is owed; the shareholders' payoff is whatever is left above the debt, never below zero. Here that is 60 or 80 for the lender and 0 or 60 for the shareholders.

Why do shareholders like risk and lenders dislike it?

Keep the average at Rs 100 crore but widen the outcomes to Rs 20 or Rs 180 crore, each equally likely. The lender now gets 20 or 80, an average of 50 instead of 70, while shareholders get 0 or 100, an average of 50 instead of 30. Nothing about the business improved on average; Rs 20 crore of value simply moved from the lender to the shareholders. That is the shape of a call optionThe right, not the obligation, to buy something at a fixed price, so the holder keeps the upside above that price and loses nothing more below it.: capped loss, open-ended gain, so volatility helps the holder.

Say why a lender cares, because it is the point of the question. Loan documents restrict what a borrower can do with its assets, with limits on new debt, asset sales, dividends and changes of business, to stop shareholders swapping safe assets for risky ones after the loan is made. The pull is strongest near distress, as here, because shareholders have little left to lose. The limit: the 50/50 odds are an assumption, and the option view ignores that managers may also care about keeping the company alive.

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%.

Equity falls 50%, from Rs 40 crore to Rs 20 crore. Enterprise value drops Rs 20 crore to Rs 80 crore, but the Rs 60 crore of debt does not shrink, so the whole Rs 20 crore comes off equity. Equity was only 40% of the business, so a 20% fall in the business is 20% x 2.5 = 50% of the equity.

Why does a 20% fall become a 50% fall?

Buy a Rs 1 crore flat with Rs 40 lakh of your own money and a Rs 60 lakh loan. If flat prices fall 20%, the flat is worth Rs 80 lakh, the bank still wants Rs 60 lakh, and your stake is Rs 20 lakh: half gone. Debt is a fixed claim, so every rupee lost in enterprise value comes off the equity, and the smaller the equity slice, the bigger the percentage fall. The multiplier is enterprise value over equity, here 100 over 40, or 2.5.

How does a lender read the same numbers?

From the lender's chair the question is how much cushion is left. The loan to value ratio climbs from 60% to 75%, so the equity buffer that protects the debt has halved even though the debt itself is untouched. Another 25% fall in enterprise value, to Rs 60 crore, would take equity to zero and put the lenders' own money at risk. That is why credit desks track enterprise value and covenants tied to it, not just whether interest is being paid.