What is Structural Subordination? HoldCo / OpCo Dynamics
Probably the trickiest kind of restructuring questions surround structural subordination and HoldCo / OpCo dynamics. These were a bit more popular a few years ago – like when I did my summer analyst interviews – but seem to be much less popular now.
Before we begin, I should mention that issues of structural subordination, upstream guarantees, and HoldCo / OpCo dynamics are quite complicated in practice.
Like anything else in restructuring, terms can mean whatever you define them to mean so you will often come across rather thorny or ambiguous scenarios.
I think the best way to try to build up your understanding of structural subordination is through a series of questions and answers. We’ll start with some basic definitions, then get into a few example scenarios where structural subordination is playing a role.
What is a HoldCo / OpCo organizational structure? Why would a company even bother to have one?
A HoldCo / OpCo structure is simply one where we have a series of operating companies – often either diverse in the countries they operate in or with each OpCo being dedicated to one major corporate project – and a HoldCo that owns (holds) the equity of these operating companies.
The HoldCo – as the name implies – is like a legal umbrella under which all the operating companies coexist so the HoldCo has ultimate ownership.
Normally the OpCos are where the assets themselves reside and HoldCo holds nothing other than the equity of the OpCos. One thing to note is that – again, normally – at least secured debt is housed where the assets are located. As a lender you always want to be closest to where the assets actually reside (as you’ll see as we go through examples).
There are two primary reasons why these kinds of structures exist – one generally applicable and one more specific to high yield issuers.
First, if I have a company and I sell products in the U.S., Canada, and France then for regulatory, tax, and / or accounting purposes it is much more efficient to have specific operating companies.
Second, by having a HoldCo we have another area to raise debt off of (ultimately, all HoldCo / OpCo questions surround HoldCo having debt). As you can probably imagine, the kind of debt issued at HoldCo tends to be the highest yielding debt as it is removed from where the assets reside.
Note: Like I mentioned before, in practice things get complicated! Think about a company like Hertz that has a diverse line of businesses and is spread across geographies. Here’s their org structure from their Chapter 11 filing.
Or take a look at Transocean as a complex - but not quite as thorny - current example:
Note: For interview purposes, everything will be kept within the realm of just having a HoldCo and OpCo (or a few OpCos maybe). So, I won’t bother delving into subsidiary guarantors or anything although the reason why Hertz is such a mess stems from numerous OpCos operating like HoldCos over subsidiaries.
What is structural subordination?
Structural subordination involves debt being junior due to where it’s located in the organizational structure. In other words, debt being subordinate or lower in priority solely by dint of where it's located. For example, let’s imagine we have an OpCo with assets of $150 and debt (Unsecured Notes) of $100. Then we have a HoldCo that owns the equity of OpCo, but no assets, and has debt (Unsecured Notes) of $100.
In the event of filing, OpCo’s debt is made whole, and it has $50 in value left over (equity). HoldCo has a claim on this residual value but has $100 in debt so these HoldCo Unsecured Note holders would only receive a fifty cent on the dollar recovery.
In this scenario, we’d say that HoldCo’s Unsecured Notes are structurally subordinate to OpCo’s Unsecured Notes.
So, if we’re a distressed investor, pre-filing we may quickly look and see the market pricing two different unsecured notes with one being around par and one being around fifty cents on the dollar.
This looks like a great arbitrage! Somehow two things called the same thing are trading at wildly different levels!
Of course, in reality debt instruments can be called whatever one wishes to call them. Just because two things are called the same thing doesn’t mean they have the same underlying claim or potential return. In this scenario, because the HoldCo Unsecured Notes are more remote from the assets – and have no guarantees, which we’ll touch on shortly – the market is pricing in what it should based on the expected recovery values.
What are upstream guarantees?
Let’s say a company, like the one we drew above, wants to go raise some HoldCo debt. Potential lenders may very well look at the organization structure of the company and come away asking the company why they would lend at the HoldCo level given that they have, well, no assets (other than holding the equity of OpCo).
To pacify lenders, an upstream guarantee could be put in place. Look at the little structure we drew above. All an upstream guarantee means is that OpCo guarantees HoldCo debt.
Now, guarantees can be structured (hypothetically) in whatever way folks will agree to. However, in general guarantees – especially for interview purposes – are going to give HoldCo lenders an unsecured claim at the OpCo level. In other words, this gives HoldCo lenders assurance that even though their debt resides in a HoldCo, they are effectively a part of the OpCo capital structure where the assets actually reside.
Note: Like I said, however, you should be aware of the fact you can have senior / secured guarantees as well.
A downstream guarantee is (obviously!) just the inverse. HoldCo guarantees OpCo debt. In our simplified HoldCo / OpCo structure above, obviously OpCo wouldn’t care about having a downstream guarantee from HoldCo as that doesn’t help (or harm) them in any way.
Let’s say that OpCo has $300 in assets and $200 in unsecured debt. HoldCo has $200 in unsecured debt and holds the equity of OpCo. What are the recovery values?
Alright, we’re starting off with the simplest scenario here. Note that there are no upstream guarantees here. So OpCo’s unsecured debt is made whole as it’s fully covered by the assets at OpCo.
There’s $100 left over at OpCo, which flows through to HoldCo (since they own the equity of OpCo) so HoldCo gets $100 for a recovery value of fifty cents on the dollar.
We can then conclude that that HoldCo's debt is structurally subordinate to OpCo's debt.
Let’s say that OpCo has $300 in assets and $200 in unsecured debt. HoldCo has $200 in unsecured debt and holds the equity of OpCo. There’s an upstream guarantee from OpCo to HoldCo. What are the recovery values?
Now we have an upstream guarantee. This upstream guarantee will result in HoldCo debt being pari with OpCo’s debt (as both are general unsecured claims at OpCo).
Therefore, we have $400 in debt with assets of $300, giving a recovery to both tranches of debt of $300/$400 or seventy-five cents on the dollar.
Obviously, what this upstream guarantee has done is effectively get rid of the structural subordination that would otherwise exist without the guarantee.
Let’s say that OpCo has $300 in assets and $200 in secured debt (backed by the assets at OpCo). HoldCo has $200 in unsecured debt and holds the equity of OpCo. There’s an upstream guarantee from OpCo to HoldCo. What are the recovery values?
Here we have an upstream guarantee but remember that generally upstream guarantees will result in HoldCo debt being unsecured at the OpCo level.
As I mentioned, guarantees can be defined and structured however folks want, but unless you’re told that this is some form of senior secured guarantee, this will not result in HoldCo and OpCo debt being pari.
Instead, the OpCo debt will be made whole and the HoldCo debt – even though they have an upstream guarantee – would get a fifty cent on the dollar recovery ($100 / $200).
So while the upstream guarantee does get rid of the structural subordination, it doesn't change the outcome that OpCo debt is dealt with first due to its specific claim.
In the members area I've uploaded some more questions going over a few more structural subordination examples (entirely overkill for interview purposes, but better safe than sorry).
Whenever you're thinking about structural subordination, try to draw it out and place arrows where they need to go. In the real-world, things aren't necessarily as complicated as Hertz, but you are normally going to have more than two layers to the structure. For example, you'll commonly see a HoldCo, an OpCo, and then a series of operating subsidiaries below the OpCo.
Another thing to always keep in mind with structural subordination is the need to carefully read what guarantees do or do not exist and what benefits they confer.
As I've harped on many times before, things mean whatever they are defined to mean in credit docs. Guarantees can sometimes have unique sounding names, so you need to carefully review what benefit is being conferred by the guarantee (meaning where the guarantee effectively places the HoldCo debt in the OpCo capital structure).
Finally, also keep in mind that in the real-world it's not invariably the case that HoldCo will have no assets of their own! Capital structures creep up and evolve over time; their messiness is due to the fact that they are usually not elegantly structure from the beginning. So be sure to track where assets reside and where they flow (or not).
As always, best of luck!