Distressed Debt: Buying Obligations at a Discount

Distressed debt is an existing obligation bought in the secondary market well below its face value, from a holder who wants out. In Nilgiri Direct Lending Fund I, invented, one position has a face value of Rs 30,00,00,000 and was bought for Rs 15,00,00,000, being 50 paise in the rupee. The price paid is also the recovery at which the buyer breaks even.

A loan does not stop being a loan when it stops being worth what it says. The claim survives. The rank survives. Whatever the document promised the lender it could do, it still promises, and it promises it to whoever is holding the paper this morning. Only the price moves, and it moves for a reason that often has nothing to do with the claim at all: a lender reshaping its own book, a vehicle running out of contracted life, an institution whose internal rules will not let it carry a defaulted asset any longer. The face valueThe amount an obligation says it will repay, before anything about whether it will. and the price are two different facts about one obligation, and both of them are true at the same time. Moyer, Distressed Debt Analysis, 2005, is the standard treatment of reading a position this way, and the frame used throughout is his: value the claim, not the promise.

The worked case throughout is position 8 of the invented loan book of Nilgiri Direct Lending Fund I. The fund is settled as a trust, its investment manager is Nilgiri Alternatives Advisors Private Limited and its trustee is Nilgiri Trusteeship Services Private Limited, and between them those two discharge what elsewhere in the world would be a general partner's role. Position 8 is the one position in that book of eight that was not lent by the fund at all. The fund bought that position, in a secondary marketWhere an existing obligation is sold by its holder to a new holder., from somebody who already held it and wanted out. The tidy story a reader usually arrives with says that private credit is negotiated and public credit is traded. Position 8 was traded, at a price, in a market, and it is still private credit.

What is the difference between what an obligation says and what somebody paid for it?

Consider somebody who is owed Rs 1,00,000 by a cousin. The written note says Rs 1,00,000. Nothing about that note changes as the months go by and nothing arrives. Now a third person offers that lender Rs 40,000 today for the right to chase the Rs 1,00,000 themselves. If the lender accepts, two numbers now exist about one debt. The note still says Rs 1,00,000. The money that changed hands was Rs 40,000. Neither number is wrong and neither replaces the other, and the mistake almost every beginner makes is to assume the second one has quietly cancelled the first.

The discount to face valueThe gap between what an obligation says it will repay and what somebody paid for it. is the gap between those two numbers. On position 8 of this invented loan book, the face value is Rs 30,00,00,000 and the fund paid Rs 15,00,00,000, so the gap is Rs 15,00,00,000, being 50.0 per cent of the face value. The natural unit for talking about this is not rupees and not a percentage discount but paise in the rupeeWhat a claim receives for every rupee it is owed, so 50 paise is half.: what the claim receives for every rupee it is owed. Fifteen divided by thirty is one half, so this fund bought at 50 paise in the rupee. Paise in the rupee is the only sensible unit here because the eventual recovery will be quoted the same way, and a price and a recovery in the same unit can be compared at a glance without any arithmetic at all.

One more number places this position inside the fund rather than beside it. The Rs 15,00,00,000 paid is 6.25 per cent of the Rs 2,40,00,00,000 that this invented loan book cost in total. The share lands exactly on a half, so it is written unrounded rather than pushed to 6.2 or 6.3 in either direction. Note which denominator that is: against the Rs 3,00,00,00,000 that investors committed to the fund rather than against what the book cost, the same position is 5.0 per cent. Both sentences are true and they are not interchangeable, and a reader given one of them without being told which is being told something false.

Who sells a claim at half its face value, and what does that establish?

Less than the number suggests, and unlearning that is the hard part. A price is made by two people, and a seller who has to sell has a reason for selling. Very often that reason lives inside the seller and not inside the claim.

Take an ordinary human version first. A neighbour is moving cities in three weeks and puts a nearly new refrigerator on sale at a third of what it cost. Nothing has happened to the refrigerator. What happened is the three weeks. Anybody who inspects the price and concludes that the appliance must be broken has read a fact about the seller's calendar as though it were a fact about the goods. The reason a claim is on sale is usually a fact about the holder's situation and only sometimes a fact about the claim, and separating those two is the first thing a buyer at a discount has to do.

Three kinds of seller recur, and each of them is about the seller. A lender reshaping what sits on its own book will sell positions that no longer fit that book, and the claim it sells is the identical claim on the morning after it sells. A pooled vehicle approaching the end of its contracted life has to hand cash back to the people who put money in, so it sells what it is still holding whether or not it wants to. And an institution whose own internal rules stop it carrying a defaulted asset will sell because the rule says so. In none of those three did anything change in the document, and in none of them did anybody form a view about the borrower on the day of the sale.

What actually changes hands when the paper is sold?

Everything in the document, and nothing else. The buyer steps into the seller's shoes. The amount claimed is the amount the document always claimed. Whatever rank the claim had in the order in which one borrower's money reaches its creditors, it still has, neither better nor worse. Whatever the borrower undertook to do or not do, it still undertakes. The buyer of a distressed obligation acquires no new right of any kind by having paid less, and the discount is a fact about the trade rather than a fact about the document.

The record on position 8 has limits worth stating exactly. The invented loan book states a security package on four of its eight positions and states nothing either way on three of them, and position 8 is one of the three. The security behind position 8 is therefore not on the record. The record fixes the face value, the price and the share of the book, and nothing more. The general point stands regardless: whatever package the document carried before the sale, that is the package the buyer holds after it, unchanged by the price.

Why is the price paid also the recovery at which the buyer breaks even?

Because both of them are measured in the same unit, against the same face value. The identity is that simple, and it is hard to unsee once seen.

Work it slowly. The fund paid Rs 15,00,00,000. The obligation says Rs 30,00,00,000. If the claim eventually receives 50 paise for every rupee it is owed, it receives half of Rs 30,00,00,000. Half of Rs 30,00,00,000 is Rs 15,00,00,000, and Rs 15,00,00,000 is precisely what the fund handed over. Not approximately. Exactly. The breakeven recoveryThe recovery at which a buyer receives exactly what it paid. is therefore 50 paise in the rupee, and 50 paise in the rupee is also the price. Buying at a price expressed in paise in the rupee sets the breakeven recovery at that same figure, always, and that identity is the whole of what an entry price does.

The reversal is where it locks in, so say it once more the other way round. A buyer who pays 25 paise breaks even at a recovery of 25 paise. A buyer who pays 90 paise breaks even at 90. A lender who put out money at face value, meaning at 100 paise, breaks even only at a full recovery of 100 paise and is behind at anything less. The price is not merely related to the breakeven point. The price is the breakeven point, wearing a different hat.

What does a recovery above and below that price do, in multiples of cost?

It divides. That is all a multiple of costWhat came back divided by what went out, for one position. is: what came back over what went out, for one position. Because the face value is fixed at Rs 30,00,00,000 and the cost is fixed at Rs 15,00,00,000, the arithmetic collapses into something that needs no calculator. The multiple is the recovery divided by 50. Seventy over fifty is 1.40. Twenty five over fifty is 0.50. A hundred over fifty is 2.00. Every reading in the table below follows from a purchase price that is already locked. Nobody knows which recovery will arrive, and the arithmetic makes no recovery likelier than another.

The bottom half of that table deserves attention before the top half. Buying below face value can still lose money, and the losing rows are the ones that decide whether the price was right. At 40 paise this position pays Rs 12,00,00,000 against Rs 15,00,00,000 of cost and the fund is down Rs 3,00,00,000, being 20.0 per cent of what it put in. At nothing at all the whole Rs 15,00,00,000 is gone. The entry price does not remove the possibility of losing everything. The entry price only changes where the line between losing and not losing sits.

Why does the same 40 paise ruin one position and merely dent another?

Set position 8 beside position 5 of the same invented loan book, and hold the recovery still at 40 paise in the rupee for both. Position 5 is subordinated debt of Rs 20,00,00,000 that the fund lent at face value, meaning at parBought or lent at face value, with no discount at all.. Position 5 was written down to 40 paise, so it recovered Rs 8,00,00,000, and the loss is Rs 12,00,00,000, being 60.0 per cent of its cost. Position 8, at the identical 40 paise, receives Rs 12,00,00,000 on its Rs 30,00,00,000 of face value against Rs 15,00,00,000 of cost, so the loss is Rs 3,00,00,000, being 20.0 per cent of its cost.

The same recovery, in the same unit, on the same day, did three times as much damage to the position bought at face value, and the only thing separating them is what was paid to get in. Nothing in that comparison is a claim about which borrower was in worse condition. Position 5's recovery is what it is for reasons of rank and security that are covered separately. The comparison here is between two entry prices against one number, and that arithmetic holds whoever the borrower is.

The comparison has a mirror image worth keeping, and the mirror image needs no borrower in it at all. Ask what recovery position 8 would need in order to suffer the same 60.0 per cent loss that position 5 suffered. A 60.0 per cent loss on Rs 15,00,00,000 leaves Rs 6,00,00,000, and Rs 6,00,00,000 on a face value of Rs 30,00,00,000 is 20 paise in the rupee. The recovery would have to halve again. Run it the other way and position 5 would have needed 80 paise to get its loss down to the 20.0 per cent that position 8 suffered at 40. The entry price is the whole of that room, and it is the reason the same word, loss, describes two very different mornings.

What did paying half not buy?

Paying half bought a price, and a price is the whole of what it bought. Paying half did not buy a seat, a lever, a promise or a place further forward in the queue.

The discount did not buy a better rank. Whatever position that claim held in the order in which a borrower's realised money reaches its creditors, it holds the identical position now, and a claim does not move forward because its current holder paid less for it than the last one did. The discount did not buy a right the seller did not have. If the document gave no power to demand early repayment, the buyer has no such power either. The discount did not buy influence over anybody else's claim; other creditors are unaffected by a trade they were not party to. And it did not buy information. The discount is a term of the trade between two holders, and a term of that trade cannot rewrite a contract between the lender and the borrower. Everything the buyer can do, the seller could have done, and everything the seller could not do stays undone.

Where does a formal insolvency process fit into any of this?

A formal insolvency process is the setting in which many of these questions eventually get answered. When a borrower's affairs move into a formal process, what a claim receives stops being a matter of negotiation between the parties and becomes a matter of a statutory procedure with its own authority, its own officers and its own timetable. The statutory procedure is where a recovery of 40 paise or 85 paise or nothing at all actually gets determined for a great many claims.

The procedure is set out by a statutory authority, named below. The text changes, so a reader who needs the procedure reads the current version at the source on the day it is needed rather than trusting a summary written earlier.

What does this position look like in the fund's own schedule?

A schedule of investments is the practical end of the matter, and it is where the whole distinction earns its keep. Somebody reading a private credit vehicle's schedule of investments is looking at a list of lines, and for seven of the eight lines in this invented book the amount lent and the amount it cost are the same number. On position 8 they are not, and a reader who does not notice will foot the wrong column.

The two columns differ by Rs 15,00,00,000 and the whole of that difference is one line, so a reader who foots the face value column and calls the answer the cost of the book has overstated it by 6.25 per cent of what the book actually cost. That single line is also why the same position produces two different answers when somebody asks how big it is. Measured by what the fund paid, it is 6.25 per cent of the Rs 2,40,00,00,000 cost of the book. Measured by what it can claim, its Rs 30,00,00,000 of face value is the same size as position 3's Rs 30,00,00,000 of principal, and position 3 is 12.5 per cent of the book by cost, exactly twice position 8's share. One position, two honest sizes, and the sentence has to say which one it means.

An analyst reading such a schedule therefore does three plain things and no more. The first is to establish which column the total was struck on. The second is to establish whether any line was bought rather than lent. A bought line is the only kind where the two columns can diverge. The third, when a recovery figure appears somewhere later in the same report, is to establish what it is being measured against. A recovery quoted in paise in the rupee is measured against face value while a multiple is measured against cost, and on a bought line those two denominators are not the same number.