Restructuring Haircut: a Worked Example

Enforcement has a price. A receiver or administrator charges for the work, assets sold under pressure fetch less than a willing seller would get, and the money arrives months or years later. Some of what the security was worth on paper disappears in that gap. A lender offered a settlement compares it with that net, delayed figure, not with the face value of the loan or the value of the security when the loan was made. Where the settlement is higher, giving up part of the claim is the better recovery.

The haircut is also a negotiation about who bears the loss. In principle the order follows ranking: shareholders' equity absorbs losses first, then junior and subordinated lenders, then senior. In practice the order is bargained, because each party's leverage depends on what it would receive if the deal failed, and a junior creditor that would get nothing in enforcement may still be paid something to agree.

The claim is what the lender is owed today, principal and accrued interest; dividing by it is one common convention, and some analysts compare instead with the present value of the old contract's payments. A face-value haircut is visible in the documents. A present-value haircut is not: an extension at a below-market rate can reduce what the payments are worth by as much as a cancellation, while the balance owed stays the same.

The discount rate decides the answer. A lender might use its own required return on a loan of that risk, or the rate a new lender would charge the restructured business. A higher rate makes deferred payments worth less, so it enlarges the haircut on an extension and on a slow enforcement alike. Any comparison should state its rate, and it is worth testing a second one, as the example does.

A ready-mix concrete supplier, constructed for this page like every figure in it, owes its senior lender US$12m, secured over its plants and trucks, and owes a subordinated vendor loan of US$3m to the family that sold it the business. Its cash flow can no longer service both. Enforcement would realise US$10.0m in about a year, less US$0.9m of costs. Two offers reach the senior lender.

Offer 2 has no face-value haircut at all, and at a 10% rate it costs the lender the same 25% as Offer 1. At 6% it looks much better. The question for the credit officer is which rate fits a four-year exposure to a business that has just failed to pay: the lower rate assumes the US$12m is nearly as safe as a sound loan, the higher one prices the risk that it is not. Both offers beat enforcement in this example, and Offer 1 removes the risk altogether.

The vendor loan shows the ranking at work. In enforcement, after the senior lender's US$12m claim, nothing reaches it. Under Offer 1 the new lender requires it to be released, and the family accepts US$0.3m paid by the shareholders: a 90% haircut that is still more than enforcement would give it.

The haircut sits beside three other numbers in the file. The first is the provision the bank already holds. A loan provided for at 30% has already taken the whole of a 25% haircut through the accounts. Agreeing the deal turns an estimate into a settled loss, followed by the write-off of the part given up, and the provision above the settled loss comes back. The second is the classification: a concession granted because a borrower is in difficulty is forbearance, and supervisors in many markets set rules on how long a restructured loan carries that status, the subject of a probation period.

The third is the alternative to a cut. A debt-for-equity swap asks the lender to give up the same part of the claim in exchange for shares, which keeps a share of any recovery that a haircut hands to the shareholders. And the security haircut taken when the loan was made, the discount behind its lending value, is a useful check: a restructuring haircut far larger than that discount says the security, or the business, was worth less than the bank believed.

DEFINED IN ONE PARAGRAPH → · LIQUIDATION VALUE → · EXPECTED LOSS, WORKED →

It decides the recommendation a credit committee reads: the offer, its present value at a stated rate, the enforcement figure net of costs and time, and the difference. It also decides what the settlement documents must say. A release in full settlement can affect guarantors and other security, and whether a guarantor stays liable for the part given up depends on the guarantee and the release wording, so a lender that wants to keep that recourse says so in the deal.

And it decides whether the haircut is the last. A cut sized to what the business can carry on an optimistic forecast is often followed by a second request. The lender's protection is to size the remaining debt on cash flow it has tested, and to accept the haircut as the price of that test rather than of the forecast.

WHEN YOUR LOAN GOES TO WORKOUT → · PERSONAL GUARANTEE RELEASE →