Distressed Investing

Page 1

ESCP AIS x TU Investment Club: Distressed Investing

• Educational Presentation #15 – Distressed Investing

• 27. Oct. 25

• Property of the ESCP Alternative Investment Society and the TU Investment Club

• Sources: The Credit Investor’s Handbook, Investopedia, Bloomberg, Hedgeweek, FT, FitchRatings, Reuters

Page 2

Section I: Introduction and Overview

Page 3

Section I: Introduction and Overview

Overview of Distressed Investing

• Distressed Investing involves acquiring the debt or equity of financially troubled companies trading at significant discounts

• The goal is to profit from recovery, restructuring, or asset value realisation once the company stabilises

Distressed Investing ≠ Traditional PE / Equity Investing

Distressed Investing

Traditional PE/ Equity Investing

Targets companies in financial or operational distress

Targets profitable or growing companies

Focuses on debt instruments (bonds, loans, claims) often converted into equity

Focuses on equity ownership from the outset, emphasising growth and operational value

Returns driven by recovery, restructuring or turnaround

Returns driven by growth, expansion, and multiple arbitrage

Involves high legal, credit, and operational risk

Involves market and execution risk, but lower credit risk

Page 4

Section II: Analysis of Distressed Investments

Page 5

Section II: Analysis of Distressed Investments

Qualitative Layer: Industry and Business Risk Analysis

Business specific risks (Internal)

Industry-level risks (External)

• Cyclicality – sensitivity to economic downturns Example: Airlines and construction sectors contrast sharply during recessions

• Management & strategy – poor leadership or failed expansion Example: Overleveraged acquisitions leading to poor integration

• Regulatory pressure – new policies or restrictions Example: Stricter emissions standards increase costs for energy firms

• Operational inefficiency – high fixed costs Example: Outdated manufacturing systems reducing cost flexibility

• Market competition – limited pricing power Example: Fast fashion retailers face price wars and margin compression

• Customer/product concentration – reliance on few revenue sources Example: Semiconductor suppliers dependent on Apple contracts

• Technological disruption – innovation risk Example: Traditional taxis losing share to ride-hailing platforms

• Leverage – excessive debt amplifies losses Example: Real estate developers with high leverage during rate hikes

• Commodity exposure – volatile input costs Example: Rising oil prices inflate logistics and airline costs

• Governance – weak internal controls or oversight Example: Accounting misstatements at corporate subsidiaries

Key takeaway: Distinguishing between industry and business risk helps investors understand whether distress is caused by external market conditions or internal weaknesses,

determining the potential for recovery

Page 6

Section II: Analysis of Distressed Investments

Qualitative Layer: Business Strategy Analysis

SWOT Analysis:

Connecting Business Strategy – Credit Cycle

Strengths Weaknesses

Established market position,

Elevated leverage, high fixed-cost

operating efficiency, scale

base, execution risk on M&A

advantages

Opportunities Threats

Asset acquisitions in dislocation,

Credit tightening, weaker demand,

cost rationalization, liquidity

spread widening across sectors

release

Porter’s Strategies:

• Cost Leadership: Focus on scale and cost efficiency, profitability declines when volumes contract and leverage remains high

• Differentiation: Relies on brand or product premium, pricing power weakens as demand and credit conditions tighten

Conclusion: • The goal of business strategy analysis is to understand how a company competes and whether its strategy is sustainable through the credit cycle • Cost leadership, differentiation, and focus strategies influence margin stability, pricing power, and leverage capacity • Linking SWOT and competitive positioning helps analysts judge if a company’s strategy can withstand market tightening or amplifies risk when credit turns

• Focus: Targets specific markets or customer segments, exposure rises when those areas face cyclical or credit stress

Page 7

Section II: Analysis of Distressed Investments

Qualitative Layer: Management Assessment & ESG

ESG

Management Assessment

• Purpose: Evaluate management’s ability and willingness to protect creditors’ interests

• Purpose: Identify ESG-related risks that could materially impact cash flow, reputation, or access to capital

Area What to look for

• Focus on how environmental, social, or governance risks could affect regulation, cost structure, or investor perception

Credibility and Transparency Clarity of reporting, timely disclosure, realistic guidance

Dimension Credit Relevance

Incentive Alignment % management equity ownership, debt-linked comp, payout policy

Environmental / Regulatory Regulatory exposure can tighten liquidity or raise costs

Track Record in Stress Past restructurings handled without default, liquidity management

Social / Reputational Impacts brand equity, top-line stability

Governance and Controls Board independence, internal audit quality, control failures

Governance Weak oversight can mask leverage or risk transfers

Strategic Disciple Capex discipline, M&A integration history

Disclosure Transparency is tied to investor confidence and pricing

Page 8

Section II: Analysis of Distressed Investments

Quantitative Layer: Financial Statement Analysis I.

• Profitability ratios are the starting point for identifying declining efficiency, deteriorating margins, and early signs of distress • Persistent margin compression and declining returns often signal distress years before liquidity crises • Profitability analysis shows whether a company’s core operations remain viable post-restructuring

Most important metrics:

Metric Formula Distress Interpretation

Gross Margin (Revenue – COGS) / Revenue Compression → pricing pressure, poor cost control

Operating Margin (EBIT) EBIT / Revenue Decline → inefficiency, weak cost structure

Net Margin Net Income / Revenue Often negative in distress, signals unsustainable leverage

ROA / ROE Net Income / Assets or Equity Decline → capital inefficiency, erosion of shareholder value

Page 9

Section II: Analysis of Distressed Investments

Quantitative Layer: Financial Statement Analysis I. (continued)

• After identifying surface-level margin trends, the next step is to dig into underlying drivers – how reported profits differ from true, recurring performance • Profitability analysis then involves adjusting and interpreting financial data to assess earnings quality and sustainability

Detailed Profitability Analysis – 6-Step Framework

Step Description

1. Adjust Reported Figures Remove nonrecurring items (asset sales, restructuring costs, write-downs) to reflect normalized earnings

2. Build Adjusted Income Statement

Summarize 3 - 5 years of historical performance, including at least one full economic cycle for cyclical sectors

3. Assess Earnings Quality Identify accounting red flags: aggressive revenue recognition, frequent one-offs, inconsistent margins

4. Benchmark vs. Peers Compare adjusted metrics against competitors to isolate company-specific vs. industry-wide issues

5. Draw Conclusions Evaluate margin trends, sustainability of profitability, and main drivers of improvement or decline

Page 10

Section II: Analysis of Distressed Investments

Quantitative Layer: Financial Statement Analysis II.

• Evaluating cash flow and liquidity is a core part of financial statement analysis in distressed investing – how long a company can operate without new funding • Linking liquidity trends with the debt-maturity profile reveals when cash and credit capacity can no longer cover obligations, marking the shift from stress to financial distress

Example: From Stressed to Distressed Territory

Interpretation: Debt Maturity Schedule

Metric 2022 2023 2024 Interpretation

Year Debt Due($m) Interpretation

2024 250 Front-loaded maturities; high refinancing risk

Cash & Equivalents

180 125 95 Declining balance leads to tightening liquidity

($m)

2025 310 Concentrated short-term obligations

Undrawn RCF

($m) 100 80 60 Limited headroom for contingency funding

2026 420 Exceeds current liquidity capacity

Total Liquidity

($m) 280 200 150 Liquidity runway < 12 months at current burn

Free Cash Flow & Liquidity Dynamics:

FCF ($m) 45 -30 -65 Transition from positive to negative leads to distress phase

WC Change

($m) -10 -35 -25 Receivable buildup, supplier stretch

Capex ($m) 60 55 40 Reduction indicates defensive cash preservation

Debt Maturing

• 2024–2026 maturities represent > 70% of total debt • Near-term refinancing is unlikely without equity injection or asset sales • Negative FCF indicates self-funding is no longer viable • Liquidity burn suggests runway < 12 months • Declining WC efficiency (receivable buildup, stretched payables) implies operational strain

< 2 yrs ($m) 250 310 420 Front-loaded maturity wall creates refinancing risk

Page 11

Section II: Analysis of Distressed Investments

Quantitative Layer: Financial Statement Analysis II.

• Liquidity analysis also examines the underlying drivers of cash deterioration – how operational performance, financing, and management affect funding capacity • Assessing working-capital dynamics, refinancing ability, supplier terms, and capex flexibility helps determine whether liquidity pressure is temporary or a sign of structural distress

Example (continued): Liquidity Drivers and Credit Implications

Driver Key Indicator Liquidity Implications

Working Capital & Cash Cycle Receivable buildup, supplier stretch Slower cash conversion, weaker internal funding

Debt Capacity & Refinancing Negative FCF, interest cover < 2×4 Dependence on external capital, refinancing risk rising

Trade Creditor Relations Tightened terms, prepayment requests Confidence erosion, accelerating cash burn

CapEx Management Spending cut from $60m to $40m Defensive cash preservation, minimal further flexibility

Other Levers Asset sales, SG&A cuts, equity raise, covenant relief Near-term liquidity boost, structural fixes still required

Conclusion: The interaction of operational drag, tightening credit terms, and limited refinancing options shows that liquidity pressure is now structural. With both internal cash generation and external funding channels exhausted, the company can no

longer self-fund and has effectively entered financial distress

Page 12

Section II: Analysis of Distressed Investments

Quantitative Layer: Capital Structure

Capital Structure Analysis Steps

1. Lay out company‘s capital structure table

4. Understand the company‘s credit ratings (current, historical, trajectory)

2. Calculate credit ratios

5. Draw conclusions on capital structure

3. Adjust for note off-balance sheet and debt-like obligations

1. Lay out Company‘s Capital Structure Table

First step in the capital structure analysis is to draft a table that includes every debt instrument used to finance the company. The table is used to calculate ratios, show real-time valuations, and serves as a list of potential investments

Amount ($m) Coupon Maturity Price (% of par) YTM Ratings (S&P /

Moody’s)

Leverage (LTM EBITDA)

LTV (%EV)

Revolver / Term loan 250 SOFR + 3.0% 2029 99.0% 6.0% BB / Ba2 2.8x 40.0%

Unsecured bond 200 7.5% 2031 85.0% 11.2% B+ / B1 4.3x 60.0%

Example:

Subordinated debt 100 10.0% (PIK Toggle) 2032 70.0% 15.0% B- / B3 5.5x 75.0%

… … … … … … … … …

Page 13

Section II: Analysis of Distressed Investments

Quantitative Layer: Capital Structure

3. Off-Balance Sheet or Debt-Like Instruments

2. Calculate Credit Ratios:

Leverage Ratio: Measures debt relative to adjusted EBITDA. Shows how many turns of earnings the firm is levered to and helps compare risk across capital-structure layers

• Certain obligations, like leases, pensions, or guarantees, aren’t booked as debt but still create binding cash outflows – raising true leverage and affecting recoveries in bankruptcy

Leverage Ratio = Debt / Adjusted EBITDA

Leases: Contractual payments to use property, plant, or equipment for a fixed period. Even when not recorded as debt, lease obligations create future cash outflows similar to loan payments

Loan-to-Value Ratio: Indicates how much of enterprise value is financed with debt. Higher LTV means less equity cushion and greater impairment risk if valuation falls

Loan-to-Value Ratio = Debt / Enterprise Value

Pensions: Promises of future employee payments under definedbenefit plans. Underfunded pensions represent legal, debt-like obligations that compete with other creditors in bankruptcy

Examples:

Coverage Ratio: Tests whether operating cash flow covers interest after capex. Below 1× suggests insufficient funds and rising distress risk

Coverage Ratio = (Adjusted EBITDA – Capex) / Interest Expense

Contingent Liabilities: Potential obligations (lawsuits, warranties, guarantees) that may or may not become actual liabilities. These exposures often sit off-balance-sheet but can suddenly crystallize, draining liquidity or triggering defaults

Page 14

Section II: Analysis of Distressed Investments

Quantitative Layer: Capital Structure

5. Draw Conclusions

4. Credit Ratings

• Assess how agencies rate a company’s probability of default and recovery, providing a common benchmark across issuers

• Now all prior steps come together to form a complete view of the company’s capital structure. The goal is to judge whether leverage is appropriate for the firm’s risk profile, where value breaks, and which creditors are most exposed

• Because ratings are issuer-paid and backward-looking, analysts must use them as context and form an independent, forward view of credit quality

Example – Company ABC:

Well-known rating institutions:

Company ABC shows:

• Leverage & LTV: Debt at 5× EBITDA and 70% of TEV → limited cushion

• Coverage: 1.3× → interest barely covered after maintenance capex

• Off-Balance-Sheet: Lease adjustments push true leverage even higher

• Credit Rating: BB–, but market spreads imply single-B risk

Conclusion: Company ABC’s balance sheet is stretched for its business risk;

recovery value likely breaks below the unsecured layer, signalling elevated

default risk

Page 15

Section III: Bankruptcy

Page 16

Section III: Bankruptcy

Legal Perspective on Bankruptcy

What is Bankruptcy?

• Bankruptcy is a legal process triggered by insolvency, in which a firm’s assets and liabilities are reorganized or liquidated under court supervision • It aims to maximize recovery for creditors while providing a potential path to financial restructuring

• Insolvency is defined as a company’s inability to meet its debt obligations when they become due, either because of insufficient cash flow or because liabilities exceed assets How is Insolvency defined?

Bankruptcy does not immediately end trading activity

Company in Distress

Day of bankruptcy filing

Chapter 7

Chapter 11

Share and Bond Value

End of Firm

Capital Restructuring

Time

Page 17

Section III: Bankruptcy

Bankruptcy – In-Depth Overview

Chapter 7 Bankruptcy – Liquidation

Chapter 11 Bankruptcy – Reorganization

• Chapter 11 allows financially distressed companies to remain operational under court supervision while restructuring their obligations

• Chapter 7 represents the most severe form of bankruptcy, in which the company terminates all operations and proceeds to liquidate its assets

• The debtor typically continues to manage the business as a debtor in possession, maintaining day-to-day operations while negotiating with creditors

• A court appoints a trustee who assumes full control over the firm’s property, sells off assets, and distributes the proceeds among creditors according to a strict legal hierarchy

• The objective is to reduce debt burdens, reject or renegotiate unfavorable contracts, and restore financial stability

• Secured creditors are paid first, followed by unsecured creditors, while shareholders typically receive nothing

• A reorganization plan is drafted and must be approved by both the bankruptcy court and the majority of creditors

• Management loses all authority, and the company’s legal existence is dissolved after liquidation is complete

• This framework provides breathing space for firms with viable business models to recover and avoid liquidation

• Chapter 7 is chosen when a business is beyond recovery, and a reorganization would not generate sufficient value to justify continuation

Overall, Chapters 7 and 11 cover the main procedures of corporate bankruptcy, whereas other chapters provide more specialized frameworks for particular circumstances, such as individuals or municipalities

Page 18

Section III: Bankruptcy

Paths to Control in Distressed Firms

In financially distressed or near-bankrupt firms, investors can gain control through different mechanisms depending on the stage and severity of the crisis. The main distinction lies between debt-based and equity-based paths to control, with a special case of operational influence

Debt-based Control

Equity-based Control

Special Case: Operational Control

Investors acquire distressed debt, such as

This form of control arises when investors or

Investors accumulate equity positions cheaply as the firm’s valuation collapses, often gaining

secured loans or bonds, that can later be converted into equity during a restructuring

strategic buyers gain influence through operational or procedural means, rather than

control through open-market purchases

process (Debt-for-Equity Swap)

by owning a majority of debt or equity

Operational

Equity-based

Process- or management-driven influence

Debt-based

(pre-pack sale, MBO, stalking-horse) Ownership through capital injection or share

accumulation Creditor enforcement or debt-for-equity swap

Chance of Turnaround

Timing of distress

Page 19

Section III: Bankruptcy

Strategic Options for Distressed Companies

Capital Restructuring

Going Concern Sale

Spin-Off or Carve-Out

• The company attempts to reduce its overall debt burden and restore solvency through financial restructuring measures • Typical mechanisms include debt-for-equity swaps, maturity extensions, or renegotiations of interest payments

• In a going concern sale, the entire operating business (or substantial parts of it) is sold to another buyer • The proceeds are used to satisfy creditor claims and, if sufficient, to compensate shareholders

• When certain divisions of a distressed firm remain profitable or strategically viable, they may be spun off into a separate entity • The new company continues operations, while the unprofitable segments are liquidated or written off

Depending on which strategic path is pursued, the degree of value recovery differs substantially, reflecting the trade-off between preserving operations, satisfying creditors, and minimizing overall value loss

Color Index

100% 85%

65%

Company Value at Start

55%

45%

Recovered Value

35%

15%

Value Loss

Company Value Capital Restructuring Going Concern Sale Carve-Out

Page 20

Section IV: Valuation of Distressed Investments

Page 21

Section IV: Valuation of Distressed Investments

Valuation Framework for Distressed Companies

Going Concern Value

• Approach: Based on expected future cash flows (DCF or multiple)

• Traditional valuation methods, such as the Discounted Cash Flow (DCF) approach, assume that a company will continue operating indefinitely with stable cash flows and access to capital (going concern)

• Typical Use Case: Company expected to survive or restructure successfully

• In distressed situations, this assumption breaks down. Cash flows become unpredictable due to declining revenues, operational inefficiencies, or restructuring costs. Financing becomes more expensive or entirely unavailable as lenders demand higher risk premiums, and asset values often fall below their book or replacement value.

Reorganization Value

• Approach: Value post-restructuring (e.g. operational turnaround)

• As a result, traditional valuation models tend to overstate the true economic value of a distressed company, requiring investors to apply modified methods that account for uncertainty, insolvency risk, and potential liquidation outcomes

• Typical Use Case: Chapter 11 / StaRUG (Germany‘s restructuring law) proceedings

Going Concern

Liquidation Value

Reorganization

• Approach: Assuming sale of assets (orderly or fire-sale)

Enterprise Value

Liquidation

• Typical Use Case: Insolvency inevitable, no turnaround possible

Level of Distress

Page 22

Section IV: Valuation of Distressed Investments

Key Valuation Adjustments under Distress

Cash Flow Adjustments • Projected CFs should exclude one-time or non-recurring income • Account for restructuring expenses, working-capital pressures, and operational disruptions

Discount Rate

• Higher risk premium for cost of capital to capture the probability of distress • Through increased WACC, use of an Adjusted Present Value (APV) framework, or by including expected bankruptcy costs in the model

• binary nature of outcomes (recovery vs. failure) • multiple scenarios →successful turnaround, partial restructuring, or liquidation (each weighted by likelihood)

Scenario or Probability- Weighted Valuation

Asset-based

Key Takeaway

Liquidation Value

As financial distress deepens, valuation methods

Recovery-based

Reorganization Value

shift from earnings-based approaches to assetbased approaches, reflecting declining confidence

Valuation Logic

in future cash flows

1 Going Concern

Level of Distress

Earnings-based

Page 23

Section IV: Valuation of Distressed Investments

Incorporating Financial Distress into DCF Valuation

Volatility & Uncertainty When a company faces liquidity shortages, high leverage, or potential insolvency, its cash flows become highly volatile and uncertain, and in many cases even negative. This makes it difficult to estimate reliable future free cash flows

Terminal Value In a distressed context, assuming perpetual growth is unrealistic, the company may not survive to reach a “terminal” phase at all. The DCF framework therefore tends to overvalue distressed companies by implicitly assuming survival and stability

WACC The discount rate in a standard DCF does not adequately capture the additional risk of default or restructuring WACC In reality, distressed firms face sharply higher financing costs and limited access to capital markets

Example

Scenarios Probability Firm Value (EV, m€) Weighted Value

Going Concern 60% 100 60

Reorganization 25% 70 17.5

Liquidation 15% 40 6

Going Concern Reorganization Liquidation Enterprise Value

Expected Enterprise Value 83.5

Firm Value (€m) Weighted Value (€m)

* This example provides a simplified overview of how to value a distressed company. A more detailed breakdown follows on the next slide

Page 24

Section IV: Valuation of Distressed Investments

Damodaran’s Adjusted Framework

• Conventional DCF models assume stable operations, which rarely apply to firms facing insolvency risk

• Damodaran’s adjusted framework therefore introduces probability-weighted cash flows and hybrid valuation methods that explicitly account for the likelihood of distress, recovery scenarios, and expected bankruptcy costs

Probability-Weighted Cash Flows

𝐸[𝐹𝐶𝐹𝑡] = 𝐹𝐶𝐹𝑡× (1 −𝑝𝑑𝑖𝑠𝑡𝑟𝑒𝑠𝑠,𝑡) 𝑉𝑎𝑙𝑢𝑒= ෍

𝐸[𝐹𝐶𝐹𝑡] (1 + 𝑊𝐴𝐶𝐶)𝑡+ 𝑇𝑉 (1 + 𝑊𝐴𝐶𝐶)𝑇

𝑡

Hybrid Approach (Expected Value Method)

𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒= (1 −𝑃𝑑𝑖𝑠𝑡𝑟.) × 𝑉𝑔𝑜𝑖𝑛𝑔𝑐𝑜𝑛𝑐𝑒𝑟𝑛+ 𝑃𝑑𝑖𝑠𝑡𝑟. × 𝑉𝑑𝑖𝑠𝑡𝑟.𝑠𝑎𝑙𝑒

Hybrid Approach (Expected Value Method)

𝑉𝑎𝑙𝑢𝑒= 𝑉𝑢𝑛𝑙𝑒𝑣. + 𝑃𝑉𝑇𝑎𝑥𝑆ℎ𝑖𝑒𝑙𝑑−𝑃𝑉(𝐸𝑥𝑝. 𝐵𝑎𝑛𝑘𝑟. 𝐶𝑜𝑠𝑡𝑠)

Page 25

Section IV: Valuation of Distressed Investments

Asset Valuation in Liquidation Scenarios

• In a liquidation, the company’s assets are sold individually rather than as a going concern

• The valuation focuses on realizable market values, not on discounted future cash flows (as in DCF)

• Each asset category is valued separately, adjusted for liquidity discounts, depreciation, and fire-sale effects

Asset Category Valuation Basis Typical Discount

Cash & Equivalents Nominal Value No discount

Accounts Receivable Face Value * collection probability 80 - 90%

Inventory Cost or realizable sale value 30 - 60%

Machinery / Equipment Appraised resale value Fire-sale discount 20 - 50%

Real Estate / Land Market appraisal 5 - 15%

Intangibles (IP, brand) Often minimal realizable value Heavily impaired (up to 90%)

Page 26

Section IV: Valuation of Distressed Investments

Liquidation Valuation – Formulas and Key Concepts

Valuation Formula

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛𝑉𝑎𝑙𝑢𝑒= σ(𝐹𝑎𝑖𝑟𝑀𝑎𝑟𝑘𝑒𝑡𝑉𝑎𝑙𝑢𝑒𝑜𝑓𝐴𝑠𝑠𝑒𝑡𝑠−𝑅𝑒𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠) −𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛𝐶𝑜𝑠𝑡𝑠−𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Simplified Concept

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛𝑉𝑎𝑙𝑢𝑒= 𝑇𝑜𝑡𝑎𝑙𝑟𝑒𝑎𝑙𝑖𝑧𝑎𝑏𝑙𝑒𝐴𝑠𝑠𝑒𝑡𝑠– (𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+ 𝐶𝑜𝑠𝑡𝑠)

Asset-based Method

Market Conditions

Repayment Order

The method is asset-based, not income-based

The timing and market conditions strongly influence achievable prices

Creditors’ seniority determines in what order proceeds are distributed

Difference in Value

Bottom

Timing

Liquidation typically yields significantly less than book value, especially for illiquid assets

No rational buyer would pay less than the realizable liquidation proceeds

Liquidation is the least desirable and final option for a company

Page 27

Section V: Case Study – First Brands Group

Page 28

Section V: Case Study – First Brands Group

Bankruptcy of First Brands Group (FBG)

First Brands Group

Interest rate on Debt

First Brands group

Healthy Leveraged Firms

High-grade Firms

0.00% 5.00% 10.00% 15.00%

• U.S.-based automotive parts manufacturer operating in the aftermarket segment • Pursued an aggressive, debt-financed M&A strategy to consolidate multiple component producers • Rapid expansion made it a major player in the automotive aftermarket but left the balance sheet highly leveraged • Filed for Chapter 11 bankruptcy in September 2025 after excessive leverage and integration challenges strained liquidity

How did they get into trouble?

The Struggle in Numbers

• Founded in 2013, expanded rapidly via debt-financed acquisitions • Industry slowdown recently pressured margins • Tricolor, a comparable lender in low-priced used cars, filed for Chapter 7 bankruptcy two weeks ago • Rising material costs and tariff uncertainty made FBG’s high leverage unsustainable despite initially stable capital structure

• Reported 50% revenue growth in 2023, mainly from two acquisitions • Fitch projected only 3.5 – 4% organic growth going forward • Faced high borrowing costs: ~10.5% on first-lien loan, ~14.5% on second-lien • Rates considered unusually high for a major manufacturing firm

Source: https://tinyurl.com/5ewcbtbs

Page 29

Section V: Case Study – First Brands Group

Struggles with the Debt Structure

The Problem

The lack of Transparency

• Insolvency driven mainly by a low interest coverage ratio • Reported EBIT of $1.1B implies ~1.7× coverage at an average 11% interest rate • Held $6.1B of debt on the balance sheet • Estimate excludes unsecured debt and off-balance-sheet obligations (e.g., invoice financing)

• Expected $2.3B from a factoring deal to bolster capital structure • Post-bankruptcy, estate lawyers found no evidence the funds were received; segregated accounts are empty • Unclear whether some receivables were factored multiple times • Factoring firms may not have been fully paid

Interest Coverage Ratio

The Debt Structure

Asset-Based Lending Obligations $596m

Term Loan Obligations $5.5B

Off-balance sheet obligations $2.4B

Unsecured Loans $812m 0

Long-term average in U.S. First Brands Group

Source: https://tinyurl.com/c34xxj52

Page 30

Section V: Case Study – First Brands Group

Under Bankruptcy Protection

• Following its Chapter 11 filing, First Brands Group is pursuing a going-concern sale – selling key brands and subsidiaries to repay creditors while maintaining operations during restructuring

Going Concern Sale

What is happening now?

9%

8%

• First Brands Group filed for Chapter 11 bankruptcy and is now managed by restructuring specialist Charles M. Moore under court supervision.

8%

Top 5 brands

of FBG

7%

62%

• The case represents a typical Going Concern Sale, with current leadership aiming to sell FBG’s 24 acquired subsidiaries.

6%

• Creditors are expected to be repaid from sale proceeds, while equity holders will likely receive nothing.

FRAM Trico Rain-X Autolite Centric Parts Others

Source: https://tinyurl.com/yc7yrt5d

Page 31

Section V: Case Study – First Brands Group

Key Takeaways and Warnings

The Private Credit Market Size (B$)

Transparency of Firms

Private firms aren’t required to disclose financials, hindering due diligence and transparency. Companies in distressed sectors, like FBG, may use financial engineering and take on excessive risk

Popularity of Private Credit

The private credit market has grown rapidly, becoming a major funding source for banks and private firms, often preferred over traditional options like IPOs

Possible Bubble

Rapid market expansion raises bubble concerns. Lenders have issued high-interest loans aggressively, often neglecting proper risk assessment. As one former FBG lender noted, “You are not paid to do due diligence in this market,” reflecting widespread complacency and risk exposure

Source: https://tinyurl.com/3a65jny6

Page 32

X

TU Investment Club