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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A distressed company has senior secured bank debt of 300, with the bank holding a first lien on all assets, and unsecured bonds of 200. Enterprise value in liquidation is 350. A proposed out-of-court deal would extend the bank maturity and exchange bonds for equity. The bank is considered likely to be repaid in full under any scenario in which going-concern value exceeds 300. Which assessment is most consistent with creditor incentives?

Bondholders have the stronger incentive to accept the swap. Liquidation value of 350 repays the bank 300 first, leaving only 50 for bonds, a 25% recovery. Converting to equity gives them exposure to going-concern upside that is worth more than that low liquidation recovery.

  1. ABondholders have the stronger incentive to accept an equity swap, as their liquidation recovery is only 50 of 200 (25%), so converting to equity that captures going-concern upside is attractiveCorrect
  2. BBondholders will refuse any swap because equity ranks below debt and liquidation recovery is 100%
  3. CThe bank will reject any extension because its recovery in liquidation is 0
  4. DBondholders and the bank have identical recoveries in liquidation, so neither has bargaining power

Explanation

In liquidation of 350, the bank is paid 300 first, leaving 50 for bonds, a 25% recovery. With such low recovery, bondholders have little to lose by converting to equity that participates in going-concern value. Option B misstates the recovery; C and D contradict the priority structure.

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