Distressed Debt Interview Questions and Interview Format

I've been asked quite a bit to write about distressed debt interview questions and more generally about how to think about distressed investing. So since credit markets are absurdly tight, there's an excess of capital sloshing around chasing any modicum of yield, etc. I have some free time so I figured I'd walk through some questions.

Before beginning, I'll just say what you probably already know: credit recruiting in general is quite ad hoc relative to other areas of the buy-side (like private equity if you're coming out of M&A). 

Distressed Debt Interview Format

Speaking in the most general terms, whether your recruiting for a position in direct lending, private credit, or distressed debt you should expect a series of pretty ad hoc interviews - that will be both fit and technical - followed by a modeling test or case study of some kind (it'll vary as to what the test or case entails, unlike in PE where it's pretty predictable and standardized).

While I hesitate to make any sweeping generalizations, I would say when you think about the structure of credit buy-side recruiting you should anticipate having somewhere between five and eight roughly 30-minute rounds of interviews that will be primarily one-on-one. 

If we assume there are six rounds, then the first four are likely to be one-on-one sit-down interviews. These will look more or less like what you went through in banking. However, the primary difference is that while in banking you're getting quite a few short questions that have relatively objective answers, for distressed debt or special situation interviews these will feel much more like intelligent conversations that will flow relatively naturally.

In these one-on-one interviews - I mean, maybe some will be two-on-one, but whatever - you'll certainly get some fit questions, but most of how you will be evaluated on fit will come through how you articulate your answers to relatively broad questions surrounding your background, deals, why distressed debt, etc. 

For example, when discussing a deal you worked on are you articulate and succinct? Are you skewing your answer toward what a distressed debt investor is most interested in, as opposed to what a banker would be most interested in? Did you consider how a distressed debt hedge fund was thinking about their 2L position, even though you were advising the debtor so didn't necessarily need to that much? And, just as importantly, do you seem at all interested in discussing the deal and have some general level of enthusiasm?

You will likely be asked some more pure "technical" interview questions as well. Depending on your background - especially if you're coming out of a non-restructuring job - you may get some that have quite objective answers. For example, what's contained in a plan of reorganization (POR)? What out-of-court solutions exist for a troubled debtor? What kind of consideration could you receive as part of a Chapter 11?

With that being said, most technical interview questions will be slightly more open-ended and difficult (which is what we'll be going over in this post).

Like with everything in the realm of restructuring and distressed debt, reasonable people can disagree about almost everything. What your interviewer is looking to see is that you have thought about how someone on the buy-side would think about the question, can articulate your answer in a definitive and reasonably persuasive manner, and that you aren't caught completely blind by the very nature of the question. 

Moving on, the final few rounds of the interview process will involve some kind of modeling test or case study. Normally there's a bit of modeling and then a few slides you have to create pitching buying (or not) a certain part of the capital structure. 

While every firm will view these differently - and give different tests / cases - I think it's fair to view these as more of a competency test. I think (generally) you can view it as a bar to hurdle as everyone knows these aren't overly representative of the work done in practice. It's more about showing that you have the capacity to model and then put some thoughts to paper in a limited time frame than showing that you are some kind of modeling savant. 

Most often, you'll have one "round" where an interviewer just pokes around your model and slides, asks some questions, etc. Then another round will follow where an interviewer - or group of interviewers - will hear you walk through what you've done, etc. They'll probably be quite aggressive and contrarian, because that's what you should expect in investment committee meetings anyway.

My personal view - which, again, may not extend to everyone else! - is that probably the most important thing to do when you're doing these tests or cases is to make sure you have a slide or two going over "Additional Considerations".

Because you definitely won't have the time to go through - or perhaps even be given - all the credit docs, etc. you should make reference to what else you'd want to look at before making a definitive decision. You should frame the investment you're choosing (or not) as a kind of initial indicative decision, subject to change based off of these "Additional Considerations" you've laid out. 

Because any test or case study is necessarily stripped down and simplified, you want to show that you understand what additional things you'd need to consider. If nothing else, this will help buffer any deficiencies in what you actually did (e.g. "Well they missed a few things, but they had some good points for what else to consider, so chances are if they had more time they would've picked up some of the things they missed as well"). 

Note: Some firms are more apt to do the test or case upfront -- especially if they view it as just being a hurdle to weed out candidates.

Distressed Debt Interview Questions

Obviously in banking there are some questions that everyone gets asked and this is more or less the way you compare and contrast candidates.

On the buy-side - at least in the distressed world, in my view - questions are asked much more with an eye toward your process of answering, what you prioritize including in answers to open-ended questions, etc. as opposed to just being expected to give a definitive one-sentence answer. 

The following interview questions aren't necessarily ones that you will invariably get if you interview across enough distressed debt funds. Rather, I've put these together to kind of be a representation of what style of questions you can expect and so you can see what they're testing.

I'd treat these as being indicative, not illustrative, and as a way to help prod your thinking on areas where perhaps you haven't given much thought.

When asked questions like these, I wouldn't restrict yourself to a one or two minute answer like you may in banking. Chances are these questions will spark follow-up questions and a conversation will more naturally develop. 

Question 1: Let's say we're looking at a company with a Term Loan trading at par due January 2023, Senior Notes due July 2021 trading at 85, and Senior Notes due January 2023 trading at 70. What would you estimate the max downside risk of the July '21 Notes to be?

Question 2: Let's say this capital structure now has Subordinated Notes as well and they're trading at 50. Let's say you like the idea of buying the July '21 Senior Notes, but want to hedge your exposure within this capital structure in some way. How would you think about doing that?

Question 3: Let's say we do go long the '21 Notes and short the Subordinated Notes. What do we need to be careful here?

Question 4: Non-pro rate uptiers have obviously been a big story line in the distressed debt world over the past year. What do you think of them?

Let's say we're looking at a company with a Term Loan trading at par due January 2023, Senior Notes due July 2021 trading at 85, and Senior Notes due January 2023 trading at 70. What would you estimate the max downside risk of the July '21 Notes to be?

This is a typical question in that there's no objective answer necessarily (who knows what is truly ever baked into debt pricing and what the ultimate downside will be in the future?), but we can ramble on for quite a bit of time about this and circle around a potential answer. 

Note: Let's pretend the we're looking at all of this at such a time in which the '21s are a year away from maturing and so we'll have a few coupons between now and maturity.

So first of all, let's set the stage a bit. There are a few things that should immediately jump out here.

1. Given the current credit environment we have debt trading at levels that are at least stressed if not distressed
2. The Term Loan is trading at par, so it is likely fully covered without much issue
3. The July '21 Notes are coming due first and the Term Loan and January '23 Notes are due at the same time (the TL probably springs before the Notes)
4. Despite the pari status of the Notes in the event of filing, we see a 15 point spread between the '21s and the 23s

I think the best way to frame the answer to broad questions like this is to begin by stating a simple answer - a kind of best first guess - and then provide complicating factors that need to be considered that could lead to a closer, more real-world answer.

So the simple answer is that the '23 Notes are probably pricing in the recovery value with a touch of optionality (reflecting a potential turnaround in the company's fortunes that would lead to the ability to roll these over in a few years).

What the '21 Notes are pricing is the enhanced probability that given that current state of the company - whatever it is - there's a higher likelihood these will be able to be dealt with.

In other words, the spread between the '21 Notes and '23 Notes is likely reflecting a scenario where the '21 Notes have a good shot at being refinanced, but that the '23 Notes will probably not when they come due (thus they're trading at more or less what their recovery value would be should filing occur).

Simplistically, if we assume just two outcomes - refinancing of the '21 Notes or filing before maturity - then we can say the market is pricing in a 50% probability of either happening as 50%*0.70+50%*1.0=0.85 (this assumes the actual recovery value is just the market price of the '23 Notes).

Therefore, carrying this simplistic example forward, we can think of the potential upside as involving buying at 85 and getting back par. Similarly the potential downside would be buying at 85 and getting back 70 in recovery. Therefore, the max downside would be 15 cents on the dollar.

However, this is all a bit too simple! There are obviously a few nuances that should be considered.

First of all, is our downside really 15 cents on the dollar if we buy at 85? Even assuming we're certain (for whatever reason) as to the recovery value being 70, what about the coupons we'd be clipping between now and when filing occurs? They need to be blended in because chances are you wouldn't have the company file immediately after buying the Notes at 85 (or before the first coupon is clipped). So, the actual downside would be some amount lower than 15 cents.

The other nuance to consider is our belief that the '23 Notes are pricing in the recovery value. Chances are the recovery value is actually lower than what is priced into the '23 Notes as the '23 Notes will have some level of optionality reflected in the price (as previously mentioned). This optionality is not just reflective of the potential capacity for the company to turn things around, but also reflective of perhaps the belief that the '21 Notes will be dealt with before filing occurs so that the impaired class would just be the '23 Notes (not the '21 and '23 Notes in the same class, diluting down the recovery values for all holders). 

So, when thinking about the max downside risk to the '21 Notes we know it will be whatever their recovery would be in the event of filing. We can say this is certainly some non-zero value as the term loan is trading at par and the Senior Notes are the only things behind the Term Loan.

For the purposes of the '21 Notes max downside, we would need to assume filing occurred when both were outstanding so you have both pari tranches getting recovery. We can't per se look to the '23 trading levels as reflecting filing happening when both are outstanding, as one could imagine them pricing in a) optionality of a full company turnaround that allows both tranches to refi and b) the recovery level that would be obtained if the '21 Notes are dealt with before filing.

So, a more fulsome picture of what the true max downside is would need to be obtained by modeling out the company and making your best guess as to the recovery value if filing were to occur prior to maturity of the '21 Notes. Chances are, we'd come up with a downside between 13 and 20 cents. The fact that 13 cents (which is just an illustrative number, since we haven't actually assigned any coupons here) is  less of a downside than the 15 cents priced between the '21 and '23 would reflect being able to clip some coupons before filing occurs and then getting a 70 cent recovery, which would be the best case scenario. In other words, the 70 price of the '23 Notes is probably the ceiling on any recovery value.

Note: You may look at this little cap structure and say obviously the company will try some out-of-court solution. That's probably true! But remember, we're just looking to our max downside risk and an out-of-court solution involving the '21 Notes would probably be providing us a level of compensation well in excess of ~70 cents on the dollar (probably closer to where the '21s are trading now give or take). So our max downside must involve the company filing.

Let's say this capital structure now has Subordinated Notes as well and they're trading at 50. Let's say you like the idea of buying the July '21 Senior Notes, but want to hedge your exposure within this capital structure in some way. How would you think about doing that?

Taking a step back, if we're interested in buying the '21 Notes then the rationale behind it is obvious: we think these Notes will be able to be refinanced.

So our belief is that we'll be able to clip some coupons and pick up 15 points when the Notes mature, which provides a great YTM (I mean, we haven't specified a coupon rate for anything in this little capital structure, but even if it was absurdly low it'd still provide a great YTM in the current credit environment given where the '21 Notes are trading now).

Now what risk are we really trying to hedge here? Obviously, we're trying to hedge the risk of the '21 Notes not being refinanced, but instead the company filing prior to that event. As we discussed in the last question, the '21 Notes would then fall pari with the other Senior Notes due in '23 and provide a recovery significantly below where the '21s are trading now (and probably below where the '23 Notes are trading too).

Now if we're looking to hedge our exposure - operating within this capital structure - then we first need to find the most ideal part of the capital structure that would move the most in the event of a default.

Hypothetically, we don't care if our hedge position moves down or up a lot as we can express our hedge via a functionally long or short position. We just want to find a hedge that:

• Will provide the largest gain in the event of a default (offsetting our losses at least partially on how our long '21 Notes position will fall)
• Will not be too costly to execute at initiation and to hold
• In the event the 21' Notes are refi'ed we don't want our hedge to move so negatively that it offsets our gains as well

If we think about this little capital structure, what would we expect to move the most in the event of a default? Chances are it will be the tranche of debt that has the highest level of "optionality" priced into it.

If we think about the TL, there's really no optionality priced in. If the company magically becomes the picture of ideal health, the TL will probably trade around par like it is now.

However, when we begin moving down the capital structure more and more of the price we see in the market will reflect the optionality of the company potentially turning things around (as these areas of the capital structure will provide for larger gains should a turnaround occur). 

This is most evident, obviously, when we look at equity for a distressed company where you have a very clear asymmetric profit profile. If you buy equity - when the debt above you is significantly distressed - you know when the company files you'll almost certainly have no recovery, but if the company does turn things around you could expect equity to trade up many multiples. A real-world example of this is Tupperware, which went from $1.15 in March 2020 to ~$32 at year end after skirting needing to file after it appeared likely they would (the most junior part of the capital structure trading below fifty cents on the dollar at one point).  

The same holds true for debt, but of course debt has a more obvious upper-bound on how high it could ever trade up. 

So if the lower down the capital structure we go, we find more optionality priced in then we'd expect in the event of default for the lowest parts of the capital structure to trade down the most all things being equal. 

Perhaps another way to say this is that you can consider debt trading levels the further you go down the capital structure as becoming more and more detached from what the recovery value will actually be. Or, said yet another way, as you move down the capital structure there will be more optionality premium layered over the market consensus for what the recovery value of the tranche will be. This premium, of course, is extinguished when filing becomes evident.

So one would imagine (probably!) that the piece of the capital structure (excluding equity) that will move down the most in the event of filing will be the Subordinate Notes. This is because it is probably trading at a premium due to outsized gains that could occur if the company turns things around or is able to forestall filing by dealing with the '21 Notes.

Therefore, the trade we could do within the current capital structure is going long the '21 Notes (expressing our bullish view on refinancing these) and hedge this by going short the Subordinated Notes (since they will likely fall the most in the event of filing, given that the optionality premium will evaporate). 

Note: Of course, we could also go short the equity if it's publicly traded as well since it will have the sharpest reaction to a filing. But I'm assuming we're dealing with the capital structure in the strictest sense of the word for this question. 

Let's say we do go long the '21 Notes and short the Subordinated Notes. What do we need to be careful here? 

The obvious thing to be mindful of here is that we're dealing with a negative carry scenario.

Although I haven't specified what the coupon rates are for anything in this capital structure, it's safe to say the Sub Notes are going to have a much higher coupon than the Senior Notes. 

So let's say the Sub Notes have a coupon of 8% and the Senior Notes have a coupon of 4%. We're clipping coupons on the 4%, but having to pay out the 8% coupons. 

As long as we have this trade on we are dealing with a negative carry of 4%. Assuming that over a year no prices on either of these tranches of debt are moving, then we're just bleeding money.

Now given how I've set up the question, this isn't a huge deal as the catalyst for the trade (refi or not) will take place in a year so we won't be bleeding this negative carry over a prolonged period of time.

But with that said, you should be mindful of how this hedge is dampening returns. If our thesis proves true, then the Sub Notes will probably increase in value (as the '21 Notes being refi'ed will almost certainly be good news for the Sub Notes prospects) and we will be paying negative carry.

If our thesis does not prove to be true, then we'll have a sharp decline in the '21 Notes we're long, a gain in the Sub Notes that trade down, and we will still be paying negative carry. 

So the fact we're paying negative carry dampens down the upside potential of the trade and adds insult to injury should the trade not go our way (although, of course, negative carry is the price you pay to have the hedge, which dampens the max negative returns you'd get in this scenario).

Of course, how much this effects our returns is contingent on how large of a hedge we're dealing with here. 

If we're dealing with a YTM of ~21% on the '21 Notes - assuming a year to maturity and a 4% coupon - then we may be reluctant to engage in any hedge that limits our upside to anything below a 14% IRR. 

If we think we the company won't file until after a few coupons have been clipped, then that income dampens down the max downside risk.

So, if we think the recovery is - just to throw out an example - 70 cents on the dollar, but we'll be able to clip two coupons, then our IRR would be ~(15%) if the company files. So we already have a bit of asymmetry between the downside (-15%) and upside (+21%) due to the coupon income embedded in this trade. 

If placing a small hedge within the capital structure - that has negative carry - causes our range of outcomes to go from +21% / -15% to +14% / -10% then maybe we have enough conviction in the trade (assign a high enough probability to the refi occurring) that we roll the dice without a hedge since we don't want to crimp our upside too heavily. 

Non-pro rate uptiers have obviously been a big story line in the distressed debt world over the past year. What do you think of them?

This question is emblematic of the kind of open-ended, more conversational style that many interviews can devolve into. 

I could ramble on this subject in a number of different directions for far too long, but I'll try to keep it short given how long this post already is and try to provide a more interesting take. 

Many have commented that the case of Serta - where we saw a non-pro rata uptier done - is indicative of the increased "creditor on creditor violence" we've seen over the past few years.

I mean, sure, that's true. But traditionally when we think of creditors battling it out we're talking about more activist distressed funds getting involved as a company heads into distress; jockeying for position, arguing over valuation, fighting over language or priority nuances, etc. 

One side of the Serta case had traditional players (Apollo, Angelo Gordon, et al.), but the other side had, uh, mutual funds? Rather robust mutual funds, etc. etc. but still not exactly the kind of classic activist distressed players we're used to seeing.

This strikes me as being a natural out growth of the size these kinds of funds control within the secured tranches of large debtors in general and their realization that they don't need to be entirely passive players through the process. 

From a distressed seat, this is troubling as you're faced with needing to be more careful not to get into a position and then get squashed by a large holder - or consortium of similar large holders - who decide they want to more actively dictate a restructuring.

It also poses a challenge in that if you're going to get involved in one of these larger debtors, proposing something controversial, you may need to up the size of your position (which is logistically difficult and likely will lower your return or require more leverage).

As for non-pro rata uptiers themselves, I think it's quite clear that there's no getting around an anti-subordination provision if they exist in the underlying credit docs. So if they exist in credit docs, then worry about something else. If they do exist, pay attention to current holders and think about how you could be blind sided by this kind of transaction. 

I think the open-market purchases language argument around non-pro rata uptiers is of more interest in general. I would be curious to see it tested in the courts when it is not so explictly defined in the underlying docs as it was for Serta. 

Conclusion

Hopefully this has all been somewhat helpful or at least enjoyable to read. Given that distressed debt and special situations interviews tend to be a bit more conversational and open-ended, I've tried to reflect that in how the questions above were answered.

Of course, for some of these questions you could go on at much more length and perhaps take them in different directions.

For example, while the hedging question limited the type of hedge to being within the current capital structure itself, you could be asked about how you would think about using CDS and how that would work. 

I've often been asked to put out a guide - like I did for restructuring - focusing on distressed debt and credit more broadly. While it'd be impossible to create a comprehensive overview guide - given how diverse the buy-side is in credit - I do have fun writing up these questions and talking through my perspective on them.

If you think more of these kinds of questions would be good, be sure to let me know and I'll work away (as time permits) on putting forty or fifty of these questions together in a little guide.

As always, best of luck!