Subchapter V: CARES Act Credit Investment Implications

The podcast below pertains to distressed investment opportunities in the lower middle market (LMM), herein defined as businesses with up to $20 million in EBITDA:

The New Normal for Distressed Investing: https://www.axial.net/forum/the-new-normal-for-distressed-investing/

Changes made to Subchapter V in the CARES Act have created an interesting opportunity in for unsecured credit investments in small businesses. 

Importantly, Subchapter V eliminates the “absolute priority rule” - this would ordinarily be a major credit negative.

Despite the recent economic downturn, we are not seeing bankruptcy filings that are in-line with the numbers associated with larger businesses. This is especially interesting because subchapter V is intended to lower the direct cost of bankruptcy proceedings for small businesses. 

So why aren't small businesses filing and what are the investment implications regarding subchapter V?

There are significant disincentives associated with bankruptcy for small businesses, despite the stipulations in subchapter V. Subchapter V may lower direct costs of a chapter 11 proceeding, but it does not account for the indirect costs of bankruptcy, such as frictional costs associated with customer or vendor arrangements. The magnitude of these frictional costs disincentivizes LMM businesses from pursuing filing under subchapter V. 

The disincentive to file under subchapter V, which is not credit-friendly, creates an opportunity for unsecured lenders. Subchapter V protects secured lenders and allows pre-bankruptcy control parties to retain control through the proceeding, wiping out unsecured creditors; however, this risk is partially mitigated by frictional costs of bankruptcy. This dynamic gives unsecured creditors an opportunity to lend on better terms and benefit from protection provided by the incentives of  distressed small business owners.