A property company offers to swap notes due in a year for fewer, longer, second lien notes, conditional on 90% taking it. Value the offer to a holder who exchanges and to one who holds out, and explain the holdout problem.

If the exchange succeeds, an exchanger holds 60 of second lien notes worth about 60 if Yamuk survives and 55.6 in a liquidation, while a holdout is paid 100 at par in twelve months, about 89 today, and only loses in a liquidation. If it fails, everyone keeps old notes worth about 50. Holding out is never worse and usually better, so every holder wants to be the one who does not tender; the 90% condition and a covenant strip are how the company stops that.

Six friends lend to a shop that cannot repay all of them; if the shop is sold, whoever has security is paid first and the rest share what is left. Yamuk is worth Rs 800 crore; the first lien takes Rs 300 crore, leaving Rs 500 crore for Rs 1,000 crore of unsecured notes, a recovery of about 50 per 100, which is exactly where the notes trade. In twelve months the notes mature and cannot be refinanced, so without an exchange the likely outcome is a court process in which the unsecured holders receive that 50, less the costs and the time of the process. The company's offer of 60 of face in a longer, secured instrument is therefore more than the notes are worth today, which is why it can hope that holders say yes.

Trace the new stack. If 90% tender, Rs 540 crore of second lien notes are issued, Rs 100 crore of old notes remain, and total debt falls from Rs 1,300 crore to Rs 940 crore with only Rs 100 crore due in the next year. An exchanger's Rs 60 of second lienDebt secured on the same assets as the first lien lenders but ranking behind them; it is paid after the first lien in a liquidation and before unsecured creditors. notes earns Rs 7.2 a year and is worth about 60 if Yamuk can refinance in five years. In a liquidation today, Rs 500 crore covers 92.6% of the Rs 540 crore of second lien, a floor of 55.6 per 100 of old notes, above the 50 the notes were worth. The exchanger has traded 40 of face for security, a coupon and five years of time.

Now stand in the holdout's shoes. After the exchange only Rs 100 crore of old notes matures next year, and a company worth Rs 800 crore with Rs 840 crore of long-dated secured debt can pay that, so the holdout receives 100 at par, worth about 89 today at 12%, against the exchanger's 60. The holdout's risk is a liquidation within the year, in which they sit behind Rs 840 crore of secured claims on Rs 800 crore of value and get nothing. But the exchange itself makes a liquidation less likely, because it removed the maturity wall. If the exchange fails, the holdout is no worse off than anyone else: everyone holds old notes worth about 50. So holding out weakly dominates exchanging, and if every holder reasons this way, nobody tenders and the exchange fails.

This is why the offer carries a minimum condition and usually a stick. The 90% threshold caps the free riders at Rs 100 crore, an amount the company can pay, so that exchangers are not funding a large holdout class; and an exit consent, in which tendering holders vote to strip the old notes of their covenants as they leave, makes the remaining old notes a worse instrument to hold. Other sticks: giving the new notes a lien that primes the old notes, or paying an early tender premium that only those who tender by a date receive. Without them, a holder's best response to an offer that is good for the group is to let the group take it and keep the old paper.

Close with a view. The exchange is worth doing for the group, because it turns a Rs 50 recovery in a court process into 60 of secured paper with a coupon, and the 90% condition is the price of making it work. A holder with a small position should exchange and accept being made whole only on 60, because the chance of being inside the 10% that gets par depends on everyone else behaving well. The limit: the Rs 800 crore value is an estimate, and if it is nearer Rs 600 crore the second lien is itself impaired, the exchange floor falls to 33.3, and the holdout's par payment becomes doubtful too.