Collateral Damage

Ya boy caught the writing bug and is back at it with another blog. Can you tell deal flow is light? It’s a quick read today. I want to discuss the different types of subordination. These are some of the fundamentals of credit, that for some reason are never discussed in college classes.

[Sidenote/Tangent/Rant: why the fuck there aren’t real life applicable finance classes that teach issues that bankers/investors deal with on an everyday basis confuses me. Actually wait, no it doesn’t, its because college finance professors are usually career academics or had a lackluster finance career. The best finance teacher I ever had was an FP&A manager in his prior life, not exactly Goldman TMT. Dude was a baller though and somehow knew his shit – his tests were brutal, they were 3 hours, 100+ questions long, all multiple choice but the choices were A,B,C,D,E,F, and NONE OF THE ABOVE. So you’d do some DCF question and when you calc’d it you’d get $502.27 but the closest answer was $502.04. So you’d have to decide if you fucked up a rounding error or if you needed to select “none of the above”. Also, you got penalized if you got a question wrong, so maybe you should leave it blank? Certified mind fuck.

You read all that? Nice, you’ve unlocked a secret double sidenote/tangent/rant: Reminiscing on my college days made me think of when I was a leader for a finance networking club that would bring in different alum to discuss their careers and any job openings they had. Was usually pretty uneventful (one time I curbed some dork from Northwestern Mutual who wanted to show up and he was pissedddd), except when we had a guy from Marsh come in who performed insurance due diligence for private equity transactions. Back then I thought he was a badass but now I realize that job is not legit and would absolutely suck. Anyways, dude went completely off topic on a rant about his clients, and how they are all former bankers. Then he goes “I lot of you are probably looking at getting into investment banking. I’d suggest you first read the book Monkey Business. You know the hot girl sitting across you from the bar? Imagine that as an investment banking career, and reading that book will be the equivalent of watching her take a shit.” You could fit a large burrito into all 50 of the shocked students/teachers gaping mouths in attendance after that line.

Is this thing still on? Since there probably will never be another time to recount college recruiting stories, going to sneak one more very quick one in. I interviewed for an Houlihan Lokey M&A internship once, and I asked the MD his favorite part of the job. He straight faced responds “the money. Any other questions?” Oh, ok. Respect for telling the truth I guess.]

*End Tangent*

Whew, ok where were we? Ah yes, subordination. Subordination is just a very fancy way of getting cucked lmao. But instead of someone stealing your girl, they’re stealing your cash. Let’s get into the three main categories. The first two are very straight forward, with the third one a little more complex.

1. Payment/Contractual Subordination: This literally just creditors saying to each other “ok, ill take less risk and get paid less. You agree to take more risk for more $$$”. A great example is 1st lien debt vs 2nd lien debt. Even though both loans have claim to the same collateral, they negotiate a document (called an “Intercreditor Agreement”) which contractually ensures that 1st lien debt gets repaid first in an event of financial distress where the Company can’t afford to pay 100% of its interest expense. In exchange, the 2nd lien gets paid ~325-450bps of spread over the 1st lien. Imagine that a capital structure is the ship from Titantic. Bad news - it just hit an iceberg constructed entirely of high interest rates and is now sinking. In this example, the 1st lien debt would be the woman and children – save them ASAP. The second lien are the rest of the male passengers. Save them if you can. And then the equity is the actually ship – can’t be saved, so its safe to say it will be swimming with the fishes. Fun fact: the below meme is fresh off the press and debuting via blog rather than IG post. Never say I didn’t do anything for you loyal blog readers.

2. Collateral: A good example for this is a 1^st lien loan compared to an unsecured loan. The 1^st lien has a full claim to the vast majority of the borrower’s assets. They can seize these assets in a bankruptcy and sell them to get repaid. Meanwhile, the unsecured has no asset claim, and is instead 100% reliant on the Company’s cash flows and associated enterprise value of the Company. Its important to note that leftovers after the 1st lien gets paid will go to unsecured before equity. Being subordinated through collateral is like being late to someone’s birthday party at the office. At the beginning of the party, there were some chocolate chip cookies, cake, maybe even some pizza. But unsecured debt had a call go long because another lender was asking dumb fucking questions during Q&A - so they showed up late to the party and all that was left was oatmeal raisin cookies and trail mix. Oof.  

   1. Sidenote: the movie Collateral with Tom Cruise and Jaime Fox is phenomenal and a borderline must watch. In it, Fox is an innocent taxi driver who gets caught up driving hitman Cruise around murdering people. Not quiet as exciting as if they were 1st / 2nd lien holders engaging in nasty intercreditor negotiations, but good nonetheless.

3. Structural: Structural subordination is the most complicated of the three subordinations so hang with me. No silly metaphors, just going to shoot it straight here. So, the official legal Borrower entity is normally housed within the Operating Company entity of the org structure. This is the entity where all the assets actually reside and where the cash flow is generated, while the HoldCo (aka the parent company) assets are mainly just stock in the opco. As a general rule of thumb, secured debt is held at the opco (to match up collateral with their security claim) while unsecured is held at the HoldCo. This gives secured debt first priority through structure, collateral, and payment (insert “I have the high ground” quote from Star Wars). As a hypothetical though, what would happen if the opco held unsecured debt and the  holdco held secured debt? Answer: the opco debt would get repaid first. The secured asset at the holdco would just be the equity that the holdco has in the opco sub, so if there’s nothing left to distribute to the holdco after the unsecured is paid out, the secured debt is out of luck.

   1. Guarantees can complicate things a bit. They can work both ways (Holdco can guarantee Opco or vice versa), and somewhat negates the structural subordination. An interesting scenario occurred at Ceasars casino when Apollo (the owners) engaged in fuckery that removed the parent’s guarantee. This mattered because they had moved some casinos out of OpCo to a different entity, with the only connection being the Parent. So cutting the guarantee removed OpCo’s access to the previously removed casinos and leaves it on an island fighting for its life. Oof. There a bunch of crazy shenanigans you can get into by playing with subsidiaries, but that will be discussed in a separate blog.