✌️ Welcome to the latest issue of The Informationist, the newsletter that makes you smarter in just a few minutes each week.
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- Cap Structure
- Types of Debt
- Types of Equity
- Bankruptcy and Claims
I used to trade HY with all these accounts…When you own US$100MM of the Coinbase 3 5/8% of 2031 (Like CapRe) you get a little gurgle when the bonds are down to 65% of par (10% ytw).
— Greg Foss – bitcoin DCA 🇨🇦 (@FossGregfoss) May 13, 2022
Greg’s talking about Coinbase bonds here, trading high yield (HY) with the funds on this list, and arbitraging the capital structure of companies. But the most important point he makes is that equity gets wiped out in a situation that bonds are paid back less than 100% (par).
If this all sounds like nonsense to you, don’t worry. We will pull it apart and walk through it simply below.
🏦 Cap Structure
To truly understand an investment, you first have to understand which part of the company you own versus anyone else who has claims to the assets of that company. See, just like ownership of a house, there is the equity owner, the mortgage lender, and possibly a second lien holder on a line of credit.
Here’s how it works:
Let’s say you buy a house with a mortgage by putting 20% down (the equity) and borrowing the remaining 80% from the bank (the debt). When you go to sell the house later, you must first pay off the mortgage (debt) and, after all the fees and expenses, whatever is left over (the equity) is yours to keep. If you had taken out a home equity line of credit (HELOC) to do some renovations say, then it would go like this: pay off mortgage, pay off HELOC, and then you keep the rest.
And if something goes wrong and you stop making payments on the mortgage, you default, then the bank may foreclose on you. If the house is worth less than what you bought it for, then you may lose some or all of your equity in it.
Simple, right? This is called the seniority of claims.
It’s really no different for companies and their borrowing and equity dynamics. The only difference is that there can be many layers of debt and various classes of equity that all have claims on the assets of the company. And just as the mortgage is the most senior (first claim) on a house, one type of lien on the company will have first claim to the company’s assets.
This ladder of debt and equity is called the capital structure of the company, and it’s critical to understand when you’re investing in any company, public or private. And the older the company, the more likely it is to have numerous layers of debt and equity in its cap structure.
So, let’s walk through the different types of debt next and how they may stack up against each other in seniority to claims.
👆Types of Debt
Any debt that is secured by assets or collateral will have first claims to those assets and/or collateral before any other bond, loan, or facility in the claims ladder of the capital structure. These are considered senior secured and have the lowest risk profile, and hence the lowest interest rate, of all the debt on a company’s balance sheet.
After secured debt is accounted for, you then come to the unsecured debt of the company.
The first type of unsecured debt we often see on a balance sheet of a company is called bank debt, and this is typically a credit facility (like a consumer credit card, but with much lower rates). Companies typically use bank debt to bridge short term needs for capital. Like accumulating inventory or raw materials for manufacturing their products. As they receive money in customer payments, they may pay down this line of credit.
After secured debt, bank debt is typically the first in line for claims on assets of a company.
Next in line is senior debt, and this is just a straight bond or tranches (series) of bonds. They typically have a low interest rate compared with bonds that have been issued below them in the capital structure. This makes sense, of course, as they are less risky as they have senior claims.
Just like senior debt, junior or subordinated debt is also a simple bond with an interest rate that is higher than the senior debt, but lower than any debt that is below it on the cap structure. Companies sometimes have numerous layers of subordinated debt, and they all have a line of seniority within this structure as well.
Convertible bonds are a bit trickier than other debt, as they include both an interest payment as well as a mechanism that allows them to be converted into shares of common equity at a certain price. This conversion feature also subjects them to what is called convertible arbitrage. This is where hedge funds buy the convertible debt on the offering and then use a series of calculations to determine the amount of equity they need to short (the delta) to capture an arbitrage of value between the two. They trade around this position as the bonds and/or equity move in price to capture profits.
👇 Types of Equity
Below the claims on the cap structure ladder of debt lies the various forms of equity that the company has issued. In the case of preferred equity, these shares often include attached warrants or a yield that can be paid in cash dividends. The warrants are basically rights to buy shares at a certain price, and are much like options in that they may be in or out of the money and valued using option valuation techniques.
That said, preferred equity sometimes only includes special voting rights and neither warrants or a dividend attached to them. Either way, they sit above common equity in the cap structure table and claims to assets.
Common equity is the most widely held part of the cap structure and is what most retail investors own when investing. While shares of equity have the highest amount of possible upside, they also carry the highest amount of risk, being unsecured and at the absolute bottom of the claims ladder.
They are the most likely to be wiped out in the event a company becomes distressed and has to either restructure its debt or go through a bankruptcy reorganization.
Before we continue, let’s visit one of the points Greg makes above, about cap structure arbitrage. What he is talking about here is buying one of the issues of bonds and then selling a certain amount of common equity short against that bond to ‘hedge out’ the risk that the company defaults on that debt. This, of course, can be done explicitly, like with the convertible bonds, or implicitly without a convertible option.
Profits from this strategy can be realized by either trading out of one or both sides of the trade as the securities move in your favor, or in the best case scenario (worst case for the company), letting the equity fall to zero and waiting for the claims on the debt in a bankruptcy to make additional profits above the purchase price of those bonds.
☠️ Bankruptcy and Claims
As you know now, when a company becomes distressed, it stops paying coupons on its debt and if it cannot renegotiate the terms of that debt or refinance with other debt, then it falls into bankruptcy. In this case, the bankruptcy judge oversees the restructuring and helps determine who gets paid what.
In a restructuring, the bondholders will end up being issued cash and maybe common stock requisite to the amount of the company they would own versus the total valuation and their standing in the cap structure. Sometimes common equity holders retain a sliver of ownership after the restructuring, but this is almost always just a fraction of the original IPO market value, at best.
In a liquidation, the same occurs but instead of being issued ownership of the restructured company, the bondholders will instead be paid cash from the liquidating proceedings requisite again to their percentage of claims and standing in the cap structure. Once all the assets, like real estate, headquarters, inventory, merchandise, company jets, cars, desks and even computers are all sold off, the claims are paid.
Liquidations almost never pay equity anything after the proceedings. Because they are the last claimants on the ladder and the assets are likely worth far less than the debt claims above them, common equity owners are left with nothing.
This is why all debt must be made whole before equity can even see a penny. And if bonds are receiving pennies on the dollar for the claims, equity receives nothing.
So, if you like to buy stocks, from now on pay attention to the capital structure, know what claims lie above the common equity and be aware of how the company is managing the coupons and payments on that debt. This is especially important in recessions that impact many companies at once and rising rate environments where it’s difficult to renegotiate and replace already-expensive debt.
If the company gets in trouble, as common stock holder, you may be left holding the bag.
That’s it. I hope you feel a little bit smarter knowing about the capital structure of companies, claims on assets, and where you stand as a bond or equity holder in the event of a bankruptcy!
As always, feel free to respond to this newsletter with questions or future topics of interest!