Linn Energy (LINE) paid its March bond interest and elected to take the 30-day grace period on its April bond interest payments. It also negotiated an amendment to its credit facility that prevents a default until May 11. I don't think this changes Linn's situation as the best explanation for Linn's moves is just that it needed more time for restructuring negotiations and wanted to avoid an early default in the meantime.
There has also been discussion about my previous article where I wrote about how I believed that Linn's common equity will be worthless based on the apparent significant impairment of the unsecured bonds. However, there were some examples of companies that had unsecured debt receive limited recoveries in restructuring, and still offered more than zero return for the common equity.
After doing some additional research, I still believe that the common equity is very likely to receive zero recovery. However, it does appear possible that the common equity could get thrown a few crumbs. Those crumbs will be much less than the current market value of the units, though, unless the unsecureds do much better than expected. It would probably take a near full recovery of the unsecureds for the common equity to see a recovery greater than its current price. The unsecureds are trading for around 12 cents on the dollar currently, indicating a lack of confidence in more than a modest recovery.
Recovery Levels During Restructuring
Taking a look at actual recovery results shows that if one level of the capital structure is impaired, then the next level down in the capital structure gets a significantly lower recovery. For example, if the first lien debt is impaired, the second lien debt typically gets a limited recovery. Moody's mentions that the typical recovery should fall to the right and below of the curve in the graph below. So if the first lien recovery is 60%, the second lien recovery should be less than 20% (and three of the four data points around 60% first lien recovery in that document indicate a recovery of less than 10% for the second lien).
Similarly, if the second lien debt is impaired, then the unsecured debt gets significantly lower recovery as well. In Moody's graphs, it appears that a 60% second lien recovery will result in a less than 25% recovery for the unsecureds, with the data points showing a more typical 5% to 15% recovery.
If the recovery for a particular level is 40% or less, then the next level down in the capital structure would be quite lucky to get a 10% recovery. What this means is that in a company with multiple levels of debt, if the first liens have the potential to be impaired, the unsecureds are likely to receive a low recovery and equity would be quite lucky to receive anything. Thus, any situation where a company is in tough negotiations with first lien credit facility lenders is likely to result in a poor result for the equity, especially if there are several levels of debt.
Based on the Moody's graphs, a first lien recovery of 90% would result in a second lien recovery of no more than 60%, which results in a less than 25% recovery for the unsecureds. That is also a pretty optimal result for the lower ranking debt, as a first lien recovery of 90% may more often result in a second lien recovery of 40% and an unsecured recovery of under 10%. The relative size of each class of debt also plays a factor, as lower levels of debt are more likely to see a better recovery if their recovery is inconsequential to the recovery of the next higher level of debt.
For example, one of the outliers in the first lien recovery graph involved WKI Holding. In that case, the second lien debt received a recovery of approximately 40% (compared to the expected less than 20%) while the first lien debt recovered approximately 60%. This is explained by the second lien debt being small in size and having a minimal effect on the first lien recovery. Moody's mentions that if the first lien creditors received 100% of the equity in this case, then the first lien recovery would have increased from 60.3% to 62%, an increase of only 2.8%.
Common Equity Recovery
There are some examples of companies (including Paragon Offshore (OTCPK:PGNPQ) and Swift Energy (NYSE:SFY)) where the unsecured notes were significantly impaired and the common equity still received some recovery. However, in those cases, the recovery rates for the unsecured notes would not have changed much if the common equity received nothing instead. For example, with Paragon Offshore, the unsecured notes had a recovery of 35.9%. If the unsecured notes received 100% of the new equity instead of 35% of the new equity, the unsecured recovery would be 37.5%, which is an increase of around 4.5%. Most of the recovery for the unsecured notes involved a cash payment. With Swift Energy, the equity basket for the unsecured claims is 88.5% of the new equity, while the common equity gets 4% of the new equity. There would be a similar 4.5% increase in the unsecured recovery if the common equity received zero instead.
What this means is for Linn's common equity to receive an implied recovery of $50 million (in the range $0.10 to $0.15 per unit), the unsecured notes would likely need to see a recovery of at least $1 billion, which is a blended (between the Linn and Berry notes) 26% recovery rate. Giving the common equity $50 million value in this case would only affect the recovery of the unsecured debt by approximately 5%, which is similar to the examples above.
For the common equity to receive an implied recovery of $150 million (close to current market value), the unsecured notes would probably need to see a recovery in the $2 billion to $3 billion range, which is a blended recovery rate of 52% to 78% for the unsecured notes. The unsecured notes are currently trading for a blended average of roughly 12 cents on the dollar, indicating a low level of confidence that there will be a significant recovery for the unsecureds.
In any case, it does seem like a poor idea to own the common equity. In a relatively ideal case for the common equity, the unsecureds would recover 5x their current market value before the common equity would breakeven versus current market value. If negotiations are less favorable to the common equity, there will be zero recovery.
Although Linn has delayed restructuring for a little bit, it still appears inevitable that Linn will restructure soon. It is actually in the best interests of the credit facility lenders to push for a near-term restructuring since the value of Linn's hedges should ensure that they receive a full recovery. If Linn continues on, the value of its hedges will decrease faster than the credit facility gets paid down, resulting in a risk of less than full recovery if oil remains below $50.
Companies like SandRidge (NYSE:SD) have made bond interest payments at the end of the 30-day grace period, but I believe that first lien debtholders were content with their position in those cases. SandRidge had around $500 million in first lien debt and $855 million in cash in January, leaving the first lien debt in a well secured position. Linn's first lien debt doesn't have that same level of security.
Given that Linn's unsecured bonds appear highly impaired (with the bonds trading for 12 cents on the dollar), the common equity will likely see no recovery with a restructuring. The best the common equity can probably hope for is a minor recovery of $0.10 to $0.15 per unit if negotiations are quite favorable to it, and the unsecureds make out well (at least double) compared to current bond prices.
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Disclosure: I am/we are short LINE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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