The fulcrum security and loan to own
In a restructuring, the class where value runs out gets the company. Buy it cheaply enough and you are buying the equity at a bond price.
- Pay three classes in order and find the fulcrum
- Work out what a loan-to-own stake costs and what it becomes
- Find the enterprise value at which the fulcrum moves down a class
- Compare buying the fulcrum with buying the class above it
The intuition
A restaurant owes its landlord, its bank and its suppliers, in that order, and has to be handed over. The landlord is paid in full. The bank is owed more than is left, so instead of cash it takes the restaurant itself. The suppliers get nothing. Anyone who bought the bank's loan cheaply the month before now owns a restaurant for a fraction of its value.
In a restructuring, the class where value runs out, paid something but not in full, is the fulcrum security. Classes above it are reinstated (kept whole); classes below are wiped out; the fulcrum receives the reorganised equity. Loan to own means buying enough of the fulcrum, cheaply, to end up owning the company.
Pay each class min(its claim, the value left). Fulcrum = the most senior class paid less than 100%. Reorganised equity = EV − claims reinstated above the fulcrum. Fulcrum recovery = reorganised equity ÷ fulcrum claim. Loan-to-own multiple of money = recovery ÷ price paid.
Why it works
- The conventions here: three classes (senior secured, senior unsecured, subordinated) paid in strict priority from a reorganisation value. The fulcrum class receives all of the reorganised equity. No new money, no interest during the process, no time value.
- Above the fulcrum there is no upside: the class is reinstated at par. Below it there is nothing. The fulcrum holds all the upside of the reorganised business.
- The multiple decides who owns the company. A lower valuation moves the fulcrum up the capital structure and a higher one moves it down, so every class argues for the valuation that suits it.
- Size buys control. A third of a class can usually block a plan; more than half can drive one.
- Paper returns shrink in practice. The process takes time, new money may rank ahead, and management usually gets a slice of the new equity.
- The market prices of the classes show where other investors think the value runs out.
| Reorganisation EV: 100 × 5.0 | $500M |
| Senior secured: min(250, 500) | $250M, 100% |
| Senior unsecured: min(400, 250) | $250M, 62.5%: the fulcrum |
| Subordinated: nothing left | 0% |
| Buy 34% of the unsecured at 40: 34% × 400 × 0.40 | $54.4M for $85M of equity (34% × 250) |
| Multiple of money: 62.5% ÷ 40% | 1.56x |
At 6.5x EBITDA ($650M), the unsecured would be paid in full and the subordinated notes would become the fulcrum.
The formulas
Strict priority.
Where the value runs out.
What the fulcrum class receives.
Paid in shares, not cash.
Price as a share of face value.
Run it backwards.
Worked example
Pay each class in turn until the value runs out. The first class not paid in full is the fulcrum.
See it move
Same company and the same capital structure. Change the price paid for the fulcrum class and the share of it a fund buys. The chart shows how the valuation moves recoveries; New company and numbers draws a different structure.
- Raise the price paid. The stake costs more and the multiple of money falls; the equity received does not change.
- Buy a bigger share of the class. The cost and the equity received rise together; the multiple of money does not move.
- On the chart, wherever the unsecured recover more than 0% but less than 100%, they are the class where value runs out: the fulcrum.
Run it backwards
Same company, reversed: at what enterprise value would the fulcrum move down one class, with today's fulcrum paid in full?
Today's fulcrum is whole once EV covers every claim through it: the classes above plus its own claim. Divide by EBITDA for the multiple.
That is why restructurings are fights over valuation: at a low multiple the current fulcrum takes the company; at a higher one it is simply repaid, and the class below takes the company instead.
Traps
Say it in the interview
“What is the fulcrum security, and why do distressed investors want it?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Fulcrum = the most senior class not paid in full.
- Reorganised equity = EV − claims above the fulcrum.
- Loan-to-own multiple = recovery ÷ price paid.
- The valuation decides which class owns the company.