A lender believes it is making a $500 million loan against a business worth $1 billion.
That sounds like 50% loan-to-value. If the borrower defaults, the lender appears to have a substantial cushion: the business could lose half its value before the loan is impaired.
But that analysis is only valid if the lender actually has a claim on the full $1 billion.
Suppose the credit agreement allows the borrower to transfer $300 million of assets or enterprise value to an unrestricted subsidiary. Once those assets leave the restricted group, they may no longer secure the original loan. The lender still has a $500 million claim, but now against only $700 million of value.
The real loan-to-value is therefore 71%, not 50%.
That is not a technical detail discovered during the workout. It is a recovery risk created when the documents were negotiated and the loan was underwritten. The lender’s eventual loss may be determined less by the headline leverage at closing than by what the borrower was contractually permitted to do afterwards.
This is the distinction Michael Gatto wants credit investors to understand.
Gatto is a partner at Silver Point Capital and heads the firm’s private-side businesses. He learned credit on Goldman Sachs’s special situations desk, led Silver Point’s restructuring group and helped build its private credit business. Few investors have assessed the same type of borrower from all three perspectives: as a trading opportunity, as a restructuring situation and as a private loan.
His central argument is straightforward: the industry spends too much time modelling the probability that a borrower will default and too little time modelling what the lender will recover if it does.
A fund does not lose money merely because a borrower defaults. It loses money because the default produces a loss—and because the loss is larger than the underwriting assumed.
That asymmetry makes lending different from venture or equity investing. An equity investor may write off several investments and still be rescued by one ten-bagger. A lender normally lends close to par. There is no ten-times winner elsewhere in the portfolio to offset a loss. Each loss is largely taken in full, which makes the left tail—the amount lost after default—the defining risk.
In this conversation, we examine where that left tail is created: in EBITDA definitions that weaken leverage tests, in drop-downs that move collateral outside the lender’s security package, in uptier transactions that subordinate one group of lenders to another, and in the assumptions managers make about recovery values.
We also discuss the three legal categories into which liability-management exercises generally fall, what the Serta and Incora cases mean for creditors, why private credit is particularly exposed to drop-downs, and the questions allocators should ask when evaluating a direct-lending manager.
“Everyone talks about the probability of default, but as a credit investor, there’s two things. What’s the probability of me making this loan, the company getting into problems and defaulting? But then the second question — if that happens and I get into a workout, what is my severity of loss?”
— Michael Gatto, 25:44
Chapters
00:00 Cold open
01:11 Introduction
02:04 From Goldman’s prop desk to Silver Point
02:58 Trading desk, restructuring, private credit: three roles compared
07:22 Does a trader underwrite a credit differently than a direct lender
10:43 Who thrives on a trading desk, and who in direct lending
12:23 The Quinn restructuring: a violent workout in Ireland
17:20 First Brands, Tricolor and the loss of underwriting discipline
23:00 How a credit fund stays disciplined while it grows
24:04 Why living through cycles makes a better credit investor
25:44 Probability of default versus severity of loss
31:35 The seven-step credit analysis process
33:26 Why the current ratio is analytically worthless
36:11 Where credit analysts go wrong: reading the documents
38:11 How a 50% loan-to-value is really 71%
41:35 What is a liability management exercise
43:18 Drop-downs and uptiering explained
46:32 Serta, Incora and the three buckets of LMEs
52:49 Do LMEs just delay bankruptcy
58:07 Why director duties differ in the US, UK and Germany
59:33 Will private credit see its first LME
1:03:16 Why software is 25-30% of private credit portfolios
1:09:55 Software, AI and permanent capital impairment
1:15:53 Red flags in a private credit manager’s portfolio
1:19:54 The Credit Investor’s Handbook and the second edition
What is in it
Loan-to-value depends on what the lender can actually claim. A $500 million loan against a business valued at $1 billion appears to represent 50% loan-to-value. But if the credit agreement allows the borrower to transfer $300 million of assets outside the original credit group, the lender may be left with a $500 million claim against only $700 million of remaining value. The effective loan-to-value is then 71%, not 50%.
A leverage covenant is only as reliable as the EBITDA definition behind it. If the borrower can add back costs, projected savings or other adjustments at its own discretion, reported EBITDA can increase even while the underlying business deteriorates. The leverage ratio may therefore remain within its limit, and the lender may lose the right to intervene when it expected the covenant to provide an early warning.
A drop-down moves assets outside the original lenders’ collateral package; the debt remains where it is. The borrower transfers assets to an unrestricted subsidiary, which is outside the original covenant and security group. That subsidiary can then borrow against the transferred assets. The original lenders still hold their original loan, but their security may no longer cover the assets they underwrote as part of the recovery value.
An uptier changes the ranking of creditors without necessarily moving any assets. A majority group of lenders agrees with the borrower to create new debt that ranks ahead of the existing debt. The participating lenders provide new money and often exchange some or all of their existing loans into the new senior facility. The lenders that do not participate keep their original loans, but those loans now rank behind the new debt.
The legal analysis of an LME starts with the credit documents, not with whether the transaction seems fair. The documents may clearly permit the transaction, clearly prohibit it, or leave the position genuinely ambiguous. That classification determines the strength and likely value of litigation. The Serta and Incora cases illustrate how courts have examined whether the relevant documents permitted the transactions and whether the necessary lender majority was validly established.mayerbrown+1
An LME can change who gets paid first, but it does not necessarily repair the company. Bankruptcy can provide a stay, allow the rejection of certain contracts and result in the discharge or restructuring of debt. An LME generally does not provide those tools. It may raise new money, extend maturities or shift value towards participating creditors, but it may also postpone rather than solve the company’s underlying solvency problem.
Private credit is generally less exposed to a classic uptier, but it is not protected from liability-management risk. A private-credit fund often holds the entire loan or controls the relevant lender group, making it harder for another lender group to prime it through a creditor-on-creditor exchange. A drop-down can be different: if the documents permit the transfer, the borrower may be able to move assets outside the lender’s collateral package without creating a divided lender group.
A manager’s underwriting discipline can be tested by examining what happens after a credit weakens. Ask the manager to identify investments where covenants were amended, cash interest was converted into PIK interest or the maturity was extended. Then ask how those positions are valued and what evidence supports the marks. A position that has experienced all three events and is still marked above 95 may be defensible, but it requires a clear explanation rather than automatic acceptance as a normally performing loan.
Chapters
00:00 Cold open
01:11 Introduction
02:04 From Goldman’s prop desk to Silver Point
02:58 Trading desk, restructuring, private credit: three roles compared
07:22 Does a trader underwrite a credit differently than a direct lender
10:43 Who thrives on a trading desk, and who in direct lending
12:23 The Quinn restructuring: a violent workout in Ireland
17:20 First Brands, Tricolor and the loss of underwriting discipline
23:00 How a credit fund stays disciplined while it grows
24:04 Why living through cycles makes a better credit investor
25:44 Probability of default versus severity of loss
31:35 The seven-step credit analysis process
33:26 Why the current ratio is analytically worthless
36:11 Where credit analysts go wrong: reading the documents
38:11 How a 50% loan-to-value is really 71%
41:35 What is a liability management exercise
43:18 Drop-downs and uptiering explained
46:32 Serta, Incora and the three buckets of LMEs
52:49 Do LMEs just delay bankruptcy
58:07 Why director duties differ in the US, UK and Germany
59:33 Will private credit see its first LME
1:03:16 Why software is 25-30% of private credit portfolios
1:09:55 Software, AI and permanent capital impairment
1:15:53 Red flags in a private credit manager’s portfolio
1:19:54 The Credit Investor’s Handbook and the second edition
About the guest
Michael Gatto is a Partner at Silver Point Capital and Head of the firm’s Private Side Businesses. He learned credit on Goldman Sachs’s special situations proprietary desk and joined Silver Point in 2002, shortly after two of the partners he worked for at Goldman founded it. Across 24 years there he has run positions on the trading desk, built and led the restructuring group, the team that takes over an investment once a complex negotiation begins, and helped build the private credit business, which makes him one of the few people who has underwritten the same borrower from three different seats. He is an adjunct professor at Columbia Business School and Fordham Gabelli, and wrote The Credit Investor’s Handbook, now the standard text for analysts entering leveraged and distressed credit. A second edition is roughly 18 months away and will add international bankruptcy and a chapter on using AI in credit analysis.
Michael on LinkedIn · Silver Point Capital · The Credit Investor’s Handbook
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Fixed + Floating
Fixed + Floating is a credit podcast hosted by Portfolio Manager Josef Pschorn. Long-form conversations with credit market practitioners - portfolio managers, analysts, restructuring advisers and academics - on private credit, high yield, distressed debt, CLOs, liability management and credit policy.
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Fixed + Floating is for informational purposes only. Not investment, legal or tax advice. Guest views are their own and do not represent their employer.
