Distress Deal Exits

Optimizing the Recovery across the Range of Return Outcomes

In a distressed sale of a borrower's business, the lender may be forced to accept limited or no cash repayment of the outstanding debt at the closing of the transaction and instead agree to receive equity or some other contingent, deferred right to payment.

Interactive Scenario Analysis →

Strategies to Structurally Protect Contingent Future Equity-like Return Entitlements (CVR or Success Fee)

Conversion to Preferred Equity or Other Equity Security

Description

• Excess senior debt is deemed converted / exchanged for equity at closing.
• Conversion security may be the same as what the buyer is issued as part of capitalizing the NewCo / buyer entity, or it may be some other preferred equity security structured to effectuate the agreed business deal regarding sharing of proceeds in a liquidity event.
• In private equity backed transactions, the expectation is usually that a lender will receive "rollover equity" style security at the level of a holding company or a feeder vehicle through which certain stakeholders hold an interest in the holding company.
• Converting secured debt to preferred stock in NewCo or another equity security is often the path of least resistance for the buyer. It requires no special documentation and is easy to explain as "the lender will sit alongside the NewCo investor / buyer in the capital structure — we are partners!"

Structure Considerations — Treatment in a Subsequent Recap or Downround

• Preferred equity may come under pressure in a future financing even if the ultimate outcome is positive. Changes to capital structure and preferred terms happen by majority or majority-class vote.
• If equity is held at a feeder vehicle above the NewCo, the economic return can be affected by changes to capital structure at multiple levels; typically there is no blocking right for this type of equity interest to prevent dilution or creation of senior securities, especially at the level of other entities.
• If a special protection for a lender is structured as a side letter or similar right tied to a lender's interest in an equity interest, such special protections are highly vulnerable in a transaction that requires waivers by other stockholders of their protective provisions. A refusal to provide a consent / waiver is likely positioned as "the lender is blowing up the deal."

Negotiation Considerations

• Any special equity protections invite copycats; CVR terms don't. Attempts to engineer special standalone rights held through investment in equity are often problematic: unusual protections in a side letter tied to an equity position are visible to co-investors and subsequent investors, who may either demand the same treatment or push for removal — spreading the terms degrades the company's financeability. Favorable terms protecting a CVR entitlement are significantly less likely to be picked up and replicated, because a CVR is viewed as a different category of instrument entirely.
• A CVR or success fee is usually bespoke. If we can draft, buyer's counsel may largely defer to client; no obvious form for comparison exists.

Exchange for Success Fee Agreement / CVR

Description

• In satisfaction of the excess senior debt, the lender receives a contractual right for a contingent, deferred, additional payment (subject to trigger(s)/milestone(s)) in the form of a success fee agreement or contingent value right.
• This can be secured or unsecured; any payment can be subject to the buyer / new investor achieving a certain minimum return.
• The payment amount can be structured to mimic an equity return on a liquidity event or any other term agreed among the parties.

Implementation Considerations

• Requires negotiating a separate bespoke agreement for the lender.
• It is a bilateral agreement between NewCo and the lender; it can only be modified with the lender's consent and is not subject to changes approved by a majority of other equity holders.
• Even if the return is structured to mimic an equity-like return, it is an "off-cap-table" arrangement. In architecting a pro forma cap table to implement a recap, parties usually start from agreed economic terms and model a pro forma cap table to show the impact on existing equity holders. The lender's interest under a contractual arrangement may not be considered as something to restructure if it is a contractual right.
• Examples that can be found are other instances of very deal-specific terms on bespoke documentation. It does not lend itself to easy comparison against a standard. The concept of a CVR or success fee is recognizable but also is not easy to map to "standard" market terms for a counterparty to invoke. Assuming the entitlement does not represent an outsized percentage of a potential residual, the terms likely get summarized into a diligence summary and are not further evaluated in detail.

Treatment in a Subsequent Recap or Downround

• It tends to survive restructurings without being targeted. When a future investor or buyer reviews the capital structure, a CVR is often left out of any recap or capital-stack reset because of its off-cap-table nature. The concept is mentally associated with M&A contingent proceeds, not with investor equity interests that need to be brought into alignment when an assessment of valuation requires resetting terms of a prior preferred financing round.
• A CVR does not directly affect the securities held by other investors. By its nature, a CVR does not directly affect the securities held by other investors. If an ask is made to compromise terms in a future financing, the CVR holder can decline without its refusal upsetting the calculus of whether consent to a proposed structure is feasible, or whether the CVR holder's insistence will interfere with the ability to secure other investor consents.
• Often in a financing proposal that requires compressing or resetting the existing capital stack, the CVR may not be included in the calculus. It functions as a proxy for equity return, but it does not appear on the cap table; therefore it does not show up in any pro forma calculation (unless it represents a percentage of total return). Even if other stakeholders request the lender to adjust the terms of any CVR or success fee, the lender would have to agree and is not subject to majority consent by other parties. Declining to provide consent is completely separate from any other stockholder approval required to effectuate a transaction.