Interview Question: Chapter 7 Liquidation Analysis (Brief Case Study)

One of the most basic restructuring interview questions rests around the distinction between Chapter 7 and Chapter 11. In fact, it's such a basic question that it rarely gets asked directly anymore.

This is because most interviewers will assume you know the difference since the distinction between a liquidation and an in-court restructuring is invariably the first thing you'll learn when reading up on restructuring. 

However, a more common question drills into what Chapter 7 entails; what is a liquidation analysis, how do you determine what assets are worth what; and what does this mean for creditors.

Note: If you're looking for more details on what restructuring investment bankers actually do and what the most common interview questions are, make sure to check out Restructuring Interviews.

Why Do We Care About Chapter 7 in Restructuring Investment Banking?

It's important to understand that Chapter 7 - unlike Chapter 11 - is largely overseen by a U.S. Trustee who is in charge of liquidating the company's assets in the most prudent way possible and then distributing the cash proceeds by rule of absolute priority.

It's fair to then ask why a restructuring investment banker would care about Chapter 7 and a liquidation analysis. After all, if Chapter 7 is truly just a liquidation, done by a U.S. Trustee, then why would a banker care? Why would they ask an interviewee about it?

The answer is that in a Chapter 11 you'll still have a liquidation analysis done just as if the company was going to file Chapter 7. 

The purpose of this liquidation analysis is ascertain whether the plan of reorganization (POR) submitted to the court by the debtor (company) passes the so-called Best Interests test. 

The Best Interests test essentially says, "If the liquidation value of the company provides a greater recovery to creditors than in the proposed Chapter 11 solution (the POR), then a Chapter 7 (liquidation) should occur as it's obviously in the best interests of the creditors (they'll get a higher recovery)."

In other words, the liquidation analysis sets a floor of value for creditors. Almost invariably companies that file Chapter 11 will provide a greater value to creditors with their solution (their POR) than under a liquidation; that's why they chose to file a Chapter 11 in the first place!

However, the Best Interests test still must be shown to have been passed. 

Liquidation Analysis Case Study

Let's quickly go over a little real world case study. 

As you likely know, running an airline profitably is hard. You have a lot of fixed costs, a lot of pension liabilities, a lot of debt in the capital structure, and generally very thin margins.

So over the past few decades we've seen many airline Chapter 11s. One of them was Delta Airlines back in 2006. The liquidation analysis of Delta can be viewed here.

It's just eight pages and is worth skimming through in its entirety. However, we're going to focus primarily on the liquidation analysis on page two. 

A liquidation analysis is pretty straight forward in theory. 

What you're doing is listing the assets of the company, what you believe you could get for them if you just sold them off, and then how much recovery that provides for each of the creditors owed. 

What an interviewer will want to hear - if they ask you about a liquidation analysis or what Chapter 7 involves in detail - is that you understand that different assets will have different recovery rates. 

For example, as you can see cash and short term investments is assumed to have a 100% recovery rate. This should be relatively obvious as they're very liquid and have a clear market value.

However, as you move down the asset rates of recovery vary. There's no general rule as every company has different assets. Generally speaking, the more commoditized the asset is the higher the recovery rate will be (for example, jet fuel is determined to have a 95% recovery rate, which makes sense as you can sell jet fuel on the open market or to another airline). 

In a liquidation analysis you'll generally have two or three scenarios that show at least the "best case" and "worst case" recovery rates. 

You then go through all the assets, applying the % of recovery for each asset, and then sum them up. The "low case" for the total cash generated in the hypothetical Delta liquidation was estimated to be $8,406 and the "high case" was estimated to be $9,487.

What you then do is begin subtracting the claims against the company to see what each creditor will end up with.

So the first priority will be the hypothetical Chapter 7 specific administrative claims. These will be, in a Chapter 7, largely composed of Trustee fees. In other words, paying the folks that oversaw the hard work of liquidating the company. They need to be the highest priority as no one would do the hard work of liquidation if they couldn't be sure that they'd be paid!

You can see with Delta that it totals $424 in the "low case" and $603 in the "high case". 

After paying the Chapter 7 administrative claims, you then look at your capital structure. You can see for Delta you have three categories:

1. Secured Creditors
2. Admin and Priority Creditors 
3. Unsecured Creditors

Remember that before I mentioned that cash is distributed by rule of absolute priority in a waterfall. This means if you don't provide at least 100% recovery (meaning making a certain class par) then you don't give anything to those below.

As you can see, in the "low case" only a 94.4% recovery is estimated to go to the Secured Creditors. Therefore, everyone below them gets nothing.

However, in the "high case" you see a 100% recovery for Secured Creditors meaning there's some (but not much!) money left over. Admin and Priority Creditors get just a 3.3% recovery and Unsecured Creditors get nothing (as the class above them wasn't made par). 

A Note on the DIP

Looking closes at the picture above - or the PDF of the liquidation analysis - you may have noticed I skipped something: the DIP!

I did this to avoid confusion, but let's circle back and address why this is included.

If we were doing a straight liquidation analysis, there would be no DIP as a DIP is provided once the company (debtor) is in Chapter 11 (often it's provided by existing creditors).

However, once in Chapter 11 you also need to understand what happens if the Chapter 11 turns into a Chapter 7 before the Chapter 11 is completed (with a DIP already in place). As Delta says, on page three:

"The Debtors, with the assistance of their financial advisors, have prepared this Liquidation Analysis for the purpose of evaluating whether the Plan meets the so-called "best interests test" under section 1129(a)(7) of the Bankruptcy Code. The Liquidation Analysis has been prepared assuming the Debtors' current Chapter 11 Cases convert to Chapter 7 proceedings..."

When doing a liquidation analysis with a DIP in place (meaning a liquidation analysis once in Chapter 11) you need to reflect the fact that the DIP loan has super-priority. Therefore, the first step is to take your most liquid assets - cash and short term investments - to repay the DIP in full. Then you proceed as normal from there (as I reflected above).

So in the case of Delta, when they entered Chapter 11 they got a $2,015 DIP loan. They then had $2,808 in cash. So you assume that you pay back the DIP in its entirety first, which leaves behind $793 in cash and short term investments.

This cash and short term investments can then be used - along with the other liquidated assets - to pay back administrative claims relating to the Chapter 7 (primarily U.S. Trustee fees) first and then the other creditors in order of absolute priority. 

Conclusion on Chapter 7 & Liquidation Analyses

Hopefully this is all reasonably straight forward. The important things to keep in mind about any liquidation analysis is:

• They're done not only in a Chapter 7 itself, but they're also done in a Chapter 11
• The reason why you have a liquidation analysis in a Chapter 11 is to ensure that the "Best Interests" test is met; meaning the creditors will get more via a Chapter 11 than a Chapter 7 (otherwise, a Chapter 7 should just be done)
• If a DIP is already in place, then that must be paid back first in full
• Different assets will have different recovery rates. Cash and short term investments will get 100%; commoditized products (like oil) will get nearly, but not quite 100%, recovery rates; recovery rates for other assets like PP&E, etc. will vary by company and industry tremendously 
• The U.S. Trustee will oversee a liquidation if one is done and the cash recovered from the liquidation will be disbursed by rule of absolute priority 
• Therefore, if a certain class is not given a 100% recovery then no class of creditors below them will get anything

If you're looking to better understand what restructuring investment bankers really do all day - and what the most common interview questions are - be sure to check out the Restructuring Interviews course. 

Best,

Alex