6 Special Situations Interview Questions You Should Know

Coming up with a precise definition for special situations investing is a nearly impossible task. Every special situations group will have a different mandate and will have various levels of flexibility to operate outside of that mandate.

Historically, perhaps the best known special situations group is Goldman's SSG (which has since been rebranded and moved over to the merchant banking division). However, even Goldman's SSG had four distinct groups that all had quite differentiated and defined mandates. 

I think the best way to define a classic special situations group is one that focuses primarily on unique (usually at least stressed) credit situations, but can express their view on that situation outside the realm of credit if so desired. 

So while the impetus for involvement is usually the same across situations (some level of stress in the capital structure), capitalizing on that situation could be achieved by buying or shorting equity, buying credit-linked derivatives, buying a controlling stake of a likely impaired class, or providing some kind of financing somewhere in the capital structure (usually with non-traditional characteristics).

All of this is to say that a classic special situations group (should!) have the ability to use more tools in the toolbox than perhaps a traditional distressed debt group would. Again, all of these lines have blurred over time and I think the industry has got to a point where these are all mostly distinctions without much of a difference.

Note: Of course, one can make an argument that merger arbitrage and work done in the CLO space are also forms of special situations investing, both of which don't necessarily involve any stressed credit situation.

In a prior post I spoke at great length about a few distressed debt interview questions. Here I'll go over some special situations interview questions. All the distressed questions would also be relevant for a special situations interview. However, some of the interview questions in this post may not be relevant to a distressed debt fund depending on how narrow their mandate is.

Anyway, let's get into it.

Special Situations Interview Questions

Below are some questions that cover a wide range of potential topics that are relevant to special situations investing. Obviously while the exact type of questions asked will be contingent on the group's mandate, hopefully this gives you a sense of the general theme behind the questions.

Question 1: What's a total return swap?

Question 2: Let's say that a company has $100M of EBITDA, $100M in Senior Notes, and $200M in Subordinated Notes (both maturing on the same day and trading at par). The company is levered 2x through the Senior Notes and 5x through the Sub Notes. Now let's say that yield is 5% on the Senior Notes and 8% on the Subordinated Notes. What should you invest in?

Question 3: What would be an example of a structurally subordinated security?

Question 4: Could a long put on a company ever increase in value as the company's equity increases in value? If so, explain it to me intuitively.

Question 5: Let's say we're looking at two distressed companies with the same enterprise value and level of debt (where enterprise value is less than total debt outstanding). Let's say that one company has a market cap of $10M while the other company has a market cap of $3M. Which has more volatile equity?

Question 6: What special situations or restructuring deals recently have you found interesting

What's a total return swap?

In recent weeks we've seen the collapse of Archegos a large tech-focused hedge fund that was levered long, uh, like 5-20x? Who knows.

Whatever the case may be, the collapse led to much hysteria - including from reasonably sophisticated circles - about the use of shadowy and dangerous derivative products like total return swaps. 

The general commentary around Archegos was pretty disappointing to see. The reality is that Archegos didn't reveal some kind of outsized risk - powered by complex derivative structures - that could have systemic ramifications. Like in so many aspects of finance post-GFC, everything is much more boring and simple than it was pre-2008.

So what are these supposedly dangerous derivatives used by Archegos to gain leverage? 

Total returns swaps are a way for you to get economic exposure to an underlying, without actually having to own it. Instead, a prime broker (Goldman, Morgan Stanley, etc.) buys what you'd like economic exposure to and passes on the gains or losses to you, which you dutifully pay. For the service rendered, you pay a swap fee so your gains are slightly less than they would be if you just bought the underlying yourself and your losses are slightly more than if you bought the underlying yourself. 

Like in a traditional interest rate swap, you aren't exchanging the full notional value of the trade at time zero and again at the end of the swap. Instead, as a hedge fund, you're paying a swap fee (LIBOR + 115bps, for example), posting an initial slug of collateral, and then getting paid or paying out (variation margin) as the underlying changes in value.

A TRS allows for leverage, of course, if so desired and is an economically efficient way for a hedge fund to get leverage. Instead of having to get margin through a prime broker and go out and buy in full, you simply post a certain amount of initial collateral to the prime broker and then (if the underlying declines) post variation margin that reflects the price decline of the underlying grossed up by the leverage utilized. 

For equities, a TRS can be a useful way to mask your involvement as a hedge fund in a certain equity (by you not needing to disclose your ownership stake being above 5% on a 13D) or having your involvement come up in a Bloomberg holder screen. 

So, a total return swap is just a simple instrument that can applied to any given underlying or basket of underlying. If you have a basket of things you want economic exposure to then you can be sure you can go to Goldman and have them write up a TRS on that (and charge you a nice swap fee for their troubles). 

For instruments like levered loans in particular, a TRS can be a very efficient way to gain exposure due to some of the complexity that can be involved in transferring ownership and voting rights. This is why if you do a holders screen on Bloomberg for some secured parts of the capital structure you'll see banks holding large swaths of the debt. While there could be a number of different reasons for this, one of them is likely that a hedge fund has a TRS on it. 

Let's say that a company has $100M of EBITDA, $100M in Senior Notes, and $200M in Subordinated Notes (both maturing on the same day and trading at par). The company is levered 2x through the Senior Notes and 5x through the Sub Notes. Now let's say that yield is 5% on the Senior Notes and 8% on the Subordinated Notes. What should you invest in?

A simple, back-of-the-envelope way to answer this is to look for how much yield per turn of leverage you're getting. At the Senior Notes level, you're getting 5% / 2x, or 250bps per turn of leverage. At the Subordinated Notes level, you're getting 8% / 5x or 160bps per turn of leverage. 

Assuming all else being equal, you're getting more out of the Senior Notes and should be looking at them.

Of course, maybe you don't find the yield overly enticing on the Senior Notes to begin with. If the Sub Notes are trading at par, and are only levered 5x through to them, then maybe that's a better yield and is obviously relatively safe. However, it's important to remember what the first question touched on: leverage. 

Note: With bonds you're normally just going to get leverage through margin, not through a TRS.

What would be an example of a structurally subordinated security?

While you could use a real world example, it's just as easy to create a stylized little example, so that's what we'll do here.

Let's imagine a company has a simple HoldCo / OpCo setup. At the OpCo there are $150 in assets and $100 in Unsecured Notes. At the HoldCo level there are $100 in Unsecured Notes as well along with the equity of OpCo.

Here all the tranches of debt involved are called Unsecured Notes and all have a general unsecured claim. However, in terms of recovery values we would see the OpCo Unsecured Notes being made whole and the HoldCo Unsecured Notes getting a recovery value of fifty cents on the dollar.

In other words, the HoldCo Unsecured Notes are structurally subordinated as a result of being removed from where the assets are held. This would be remedied by there being an upstream guarantee in place whereby you'd have both Unsecured Notes being pari and each getting a recovery of seventy-five cents on the dollar. 

Could a long put on a company ever increase in value as the company's equity increases in value? If so, explain it to me intuitively.

I probably should have come up with a better way to word this question, as it probably comes across as quite a leading question. However, what this question is really getting at is how volatility affects the value of long put and long call options.

During the chaos and general degeneracy of the GameStop spectacle, you actually saw deep OTM puts go up in value as the price of GameStop soared.

So how does this make sense? Let's imagine that a stock is trading down over time in a reasonably lock-step and not overly volatile fashion. Then a bunch of nonsense occurs and it gets pumped up to $40 and kind of oscillates around $30-50 for a month. 

Perhaps you're in a special situations group and are involved in the credit of this company. You look at the equity and think to yourself that this makes no sense! There's some irrational stuff happening and perhaps you think putting on some equity puts will enhance your returns or whatever. Because you're in a special situations group with a broad mandate, you buy some puts with an expiration date set three months out.

Then all of a sudden even more nonsense occurs and the stock spikes to $200 one day, then $350 the next, then $175 the next, then $325 the next, etc. You're still months away from expiration, but you're convinced the value of your poor puts must be near zero. 

Could it be the case that the option value of your put actually increased in value?

Sure! I mean, maybe. Generally speaking, of course, a stock increasing in value when you're long a put is bad, but if the stock moves upwards violently enough in a short enough period of time it can be not so bad (or even good, as in profitable!). 

The reason why is that for long call and long put positions volatility drives value as the greater the level of volatility the greater the chance sometime before the expiration date you'll be in the money. So, as a theoretical matter, because of the massive spike in vol in this stylized example your put position (which was struck quite out of the money) is potentially more likely to end up in the money than if the stock stayed more range bound around $40 like when we initiated it. 

As mentioned, this all was actually seen for some very OTM puts on some equities, like GameStop, in February 2021.

Let's say we're looking at two distressed companies with the same enterprise value and level of debt (where enterprise value is less than total debt outstanding). Let's say that one company has a market cap of $10M while the other company has a market cap of $3M. Which has more volatile equity?

This question picks up on the general theme of the prior question. 

So first of all, let's qualify what's going on in the capital structure of both of these companies. If we imagine they have a simple capital structure, with perhaps a term loan and senior notes, then given that the debt is greater than the EV we would expect at least the senior notes to be trading below par. 

Therefore, as we've talked about in prior posts, you would expect equity to trade a bit more like a call option (depending on just how distressed the debt in the capital structure is trading).

So, if we know nothing other than that these two companies are identical and that one has a larger market cap than the other, what can we infer? We can infer that the one with the larger market cap must have more volatility as more volatility in an underlying leads to more option value (and given that we're saying these equities trade like call options, that must mean the value is tied to volatility).

In the last question we discussed how enhanced volatility leads to enhanced long call and long put option values due to the increased chance of the option ending up ITM.

In the context of buying straight equity in a distressed company, what does this really mean though? The way that you can think about it is as enhanced volatility being translated into an enhanced chance of the company being able to turn things around - perhaps via an out-of-court transaction or general business turnaround - without obviously having to file, which would lead to outsized gains for the equity.

For example, if you had a company with steadily declining fundamentals (negative FCF, declining same-store-sales if they're in retail, etc.) then you'd expect the equity to exhibit relatively modest volatility. It'd just grind down lower and lower as the inevitable Chapter 11 date approached.

On the other hand, if you had a company that had volatile earnings, then announced they had engaged PJT or Evercore or whoever to advise them on alternative restructuring solutions, then what would you expect from equity? Probably a lot of volatility! This scenario doesn't preclude the possibility that the company ultimately decides to go Chapter 11 and that the equity gets (almost certainly) wiped out, of course. But if some market participants are betting on an out-of-court that solves the catalyst for filing then you'd see lots of swings in the equity over any piece of news regarding the company as folks re-evaluate what the likely outcome. 

What special situations or restructuring deals recently have you found interesting?

Of course, you should do as much due diligence as possible on the group you're interviewing with (which is often easier said than done!) to figure out what kind of deals or transactions would be best to talk about.

For example, a case like Serta (which I wrote a rather long case study on in Restructuring Interviews) is neat to talk about and everyone will be familiar with it. However, it's not that actionable or applicable for most special situations groups. Although you could try to frame discussing Serta from the vantage point of being defensive (understanding the need to pay attention to how open-market purchasing language is defined, who holds what amount of secured debt, how aggressive the debtor will be in seeking restructuring alternatives, etc.).

Keeping in the more distressed, but not quite conventional mold, you could talk about Tupperware's Senior Notes. They were trading below fifty cents on the dollar and then Tupperware, advised by Moelis, drew down their entire revolver and did a few tender offers. 

This didn't solve the impetus for filing (there will still quite a few Senior Notes outstanding), but created a scenario in which the Senior Notes traded up a bit. Then the dilemma becomes, from a special situations seat, do you believe filing is inevitable - in which case your recovery value will probably be less than you bought in at - or do you believe that Tupperware could get outside financing to go and take out the rest of the Senior Notes (that were holding out) at par. Ultimately, the latter happened and many did well off of this trade.

You could also discuss the new financing Tupperware got - which were two term loans, with most of the proceeds specifically earmarked for taking out the Senior Notes - coming from Angelo Gordon and JPMorgan's new Special Situations Initiative Group. 

Getting more into pure special situations territory, you could talk about the CDS trades made out of GSO and Tac Opps (Blackstone) a few years ago. While they aren't as relevant these days - due to changes in what constitutes triggering default - it'd show a continued interest in creative transactions and in understanding CDS.

Conclusion

There you have it. Given the diversity of special situations investing it's hard to come up with an entirely representative sample of questions without going over many more. But hopefully these make you think about a few different lines of questioning that could crop up in an interview.

If I get time over the coming months I might write up a few more pure special situation case studies to illustrate some of the things that have been done in the past, why they make sense, and what the ultimate result was.

If you're thinking about joining a special situations group - but aren't coming out of restructuring investment banking - the course I put together on restructuring may be helpful. It has hundreds of interview questions created from Moyer, Whitman, etc. to help with terminology along with more standard RX analyst and associate questions and answers.

If these kinds of posts are helpful, let me know and I'll be sure to put together more resources as I find the time. I find it fun to do and given the lack of writing on buy-side credit interviews online, hopefully it helps out in some way.

Best of luck!

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