Capital Structure Review and Debt Capacity Analysis

Introduction

On the second day of a new restructuring engagement, after the bank has been retained and the kickoff call has happened, the analyst sits down with the company's credit agreements, indentures, intercreditor agreements, security agreements, and the most recent compliance certificates. The next 48 to 72 hours produce the document that anchors the rest of the engagement: a capital structure review that maps every dollar of debt the company owes, the priority each tranche occupies, the covenants each tranche carries, the maturity each tranche faces, and the intercreditor architecture connecting them all. Without that map, no recovery analysis works, no LMT can be designed, no plan of reorganization can be drafted, and no DIP can be sized. With it, the rest of the engagement has a defensible foundation.

The companion exercise is debt capacity analysis: working backward from the post-emergence operating model to determine how much debt the company can actually sustain at the point of fresh start. The two analyses connect. Current debt minus sustainable debt is the haircut, and the haircut, distributed across creditor classes by the absolute priority rule, is the math that drives plan economics.

This article walks through the mechanics of both: how a capital structure review is built, what a credit agreement actually tells you and which sections to read first, the intercreditor architecture and the four levels of priority, the basket capacity that drives most LMT activity (with the J.Crew transaction as the canonical worked example), the difference between contractual and structural subordination, the inputs that go into a debt capacity analysis, a worked example that shows the math, and how the two analyses combine into the deliverable that drives every plan negotiation.

A complete capital structure review captures every element of a company's funded debt and contingent obligations. The output is typically a single tab in the master model and a one-page summary slide for the deck.

Each line on the cap stack contributes specific information. The principal amount feeds the recovery waterfall. The coupon and maturity feed the projected interest expense and the maturity wall analysis. The lien position determines who gets paid first if collateral is liquidated. The covenants determine where the leverage points sit (which lenders can accelerate, which lenders must consent before incremental debt can be incurred, which baskets allow LMT activity). The intercreditor position determines how the lenders interact with each other in default and in bankruptcy.

Capital Structure Review

A comprehensive mapping of every debt instrument in a company's capital stack, capturing principal, coupon, maturity, lien position, covenants, security package, intercreditor terms, basket capacity (unrestricted subsidiary, available amount, restricted payment, incremental facility), and any LMT-relevant exception. The review is the foundational document of every restructuring engagement and feeds directly into the recovery waterfall, the alternatives analysis, and the plan of reorganization. A weak capital structure review produces fragile downstream analysis; a thorough one creates an audit trail that survives creditor scrutiny and court challenge.

A typical leveraged loan credit agreement runs 200 to 400 pages, and a senior unsecured indenture another 100 to 200. Restructuring bankers do not read these front to back; they navigate to the parts that matter. The required reading on a new engagement, in priority order:

A senior banker can navigate one of these documents in two to three hours; an analyst on a first engagement will spend a full day, mostly in the definitions section and the negative covenants.

The negative covenants section contains specific exceptions (called "baskets") that allow the borrower to incur additional debt, transfer assets, or make investments outside the otherwise-prohibited list. Basket capacity is the engine of liability management transaction activity in cov-lite credit agreements.

The J.Crew Worked Example

The 2016 J.Crew transaction is the canonical case study for basket-driven LMT activity. The relevant baskets: Section 7.02(c) of the credit agreement permitted investments by loan parties in non-loan party restricted subsidiaries up to the greater of $150 million or 4.0% of total assets, plus the Available Amount; Section 7.02(n) permitted general investments up to the greater of $100 million or 3.25% of total assets, plus the Available Amount.

J.Crew used three baskets in sequence to transfer 72.04% of its trademarks (worth roughly $250 million) to an unrestricted subsidiary outside the lender collateral pool, then used those trademarks to secure new financing without sharing the proceeds with the existing first-lien lenders:

1. Transfer to a Cayman-based restricted subsidiary that was not a loan party (using one basket). 2. Onward transfer to J.Crew Brand Holdings, an unrestricted subsidiary (using a second basket). 3. J.Crew Brand Holdings used the trademarks as collateral for new debt financing outside the existing credit facility.

The first-lien lenders found one of their most valuable collateral assets had legally exited the credit group through three sequential transactions, each of which technically complied with the credit agreement.

The legacy is the "J.Crew Blocker," a covenant restricting transfers of material IP to unrestricted subsidiaries that became standard in post-2020 large-cap credit agreements. The structural lessons (count basket capacity, watch for serial transactions stringing baskets together, model what happens when the most valuable asset exits the collateral pool) remain central to how RX bankers analyze a new engagement.

In any meaningful capital structure with more than one tranche of secured or unsecured debt, the relationships among tranches are governed by intercreditor agreements that specify rank order, enforcement standstills, payment-blockage periods, and bankruptcy waivers. The intercreditor architecture is the difference between a recovery waterfall that holds and one that gets re-litigated.

Four levels of priority drive most distressed analysis.

Structural subordination is a separate, often misunderstood layer of the priority analysis. It arises when debt is issued at a holding company that does not itself own operating assets but instead owns equity in operating subsidiaries (OpCos) that hold the assets and incur their own debt. The HoldCo creditors do not have direct claims against OpCo assets; they are equity holders in the OpCo, and as equity holders they sit behind the OpCo's creditors in the OpCo's own waterfall.

Structural Subordination

The economic and legal subordination of holding-company creditors relative to operating-company creditors that arises from corporate structure rather than contractual subordination. HoldCo creditors do not have direct claims against OpCo assets; they have equity claims in the OpCo, which means they are paid only after the OpCo's own creditors have been paid in full. Structural subordination can be partially mitigated by upstream guarantees (where the OpCo guarantees the HoldCo debt), but absent guarantees, HoldCo unsecured debt is effectively subordinated to all OpCo debt regardless of contractual ranking. The concept is one of the most-tested topics in RX interviews because it requires the candidate to understand corporate structure, not just contract terms.

Structural subordination drives meaningful real-world recoveries. A HoldCo with $500 million of senior unsecured notes whose only asset is the equity of an OpCo with $1.5 billion of debt and $1.2 billion of enterprise value will see those HoldCo notes recover essentially zero: the OpCo enterprise value is consumed by the OpCo's debt before any value flows up to HoldCo. Mitigants exist (upstream guarantees from the OpCo to the HoldCo, downstream guarantees, intercompany loans), but absent those, HoldCo unsecured debt is effectively structurally subordinated. The banker's job is to map the corporate structure, identify the assets at each entity, and trace where each tranche of debt sits relative to each pool of value.

When a company nears a financial covenant breach, credit agreements typically permit cure rights covered in detail in the covenant-breaches article. For capital structure review purposes, the analyst captures three things: how many cures are permitted (typically three or four over the life of the loan, with restrictions on consecutive quarters and a maximum of two per twelve-month period), how the cure equity is applied (added to EBITDA in some agreements, applied to reduce Net Debt in others), and how many cures have already been used. A sponsor with two cures remaining has more time for out-of-court paths than one with zero cures and a covenant test approaching.

If the capital structure review answers "what does the company owe today," debt capacity analysis answers "what can the company afford to owe after the restructuring." The Net Debt walk strips reported gross debt down to the figure that creditors actually claim against operating cash flow:

The leverage stack then runs from gross-and-total down through each lien layer, with each ratio answering a different question:

Coverage ratios test whether projected cash flow can service the proposed structure:

For asset-heavy structures, loan-to-value caps the secured tranche by collateral support:

The gap between current debt and the level supported by these ratios is the principal that has to be eliminated, converted to equity, or extended at lower coupons. The standard debt capacity analysis works in three steps:

1. Project stabilized EBITDA. Build a post-emergence operating model that reflects the cost reductions, headcount changes, store closures, asset sales, or other operational restructuring assumed in the plan. Stabilized EBITDA is the EBITDA the company can sustainably generate after the restructuring is complete, typically projected for the year of emergence and the following two to three years. 2. Apply coverage requirements. Set a minimum interest coverage ratio (often 2.0x or higher for emergence credits, depending on industry) and a minimum fixed-charge coverage ratio. Working backward from EBITDA through these ratios produces the maximum interest expense the company can sustain. Dividing by an assumed coupon (typically the rate at which a CCC- or B-rated emerging-from-bankruptcy company can issue debt in current market conditions, often 9-13%) produces the maximum debt principal. 3. Cross-check against industry leverage benchmarks. Most industries have a sustainable leverage range that markets impose regardless of the company's individual coverage analysis. Healthcare services typically clears at 5-7x net debt to EBITDA; consumer products at 4-6x; energy at 3-5x with cyclicality adjustments. Emerging-from-bankruptcy issuers often start at the lower end of their industry range with the explicit understanding that the company needs ratings headroom to absorb operational variance.

The output is a sustainable debt level that can be compared to current debt. If current funded debt is $3 billion and sustainable debt is $1.4 billion, the haircut is $1.6 billion, distributed across creditor classes through the recovery waterfall. The fulcrum security is whatever class the haircut hits at the boundary of impairment.

A Worked Example

Consider a hypothetical company with stabilized post-emergence EBITDA of $220 million. Apply a minimum interest coverage of 2.0x: the company can sustain $220M $/ 2.0 =$ $110M of annual interest expense. At an 11% blended coupon (reflecting the cost of post-emergence debt for a fresh-out-of-bankruptcy issuer), that equates to $110M $/ 0.11 \approx$ $1.0B of debt principal. Cross-check against a 4.5x leverage benchmark for the industry: 4.5 $\times$ $220M $=$ $990M. The two methods triangulate to roughly $1.0 billion of sustainable debt. If pre-petition funded debt is $2.5 billion, the haircut is $2.5B $-$ $1.0B $=$ $1.5B.

The next question is where the haircut lands. If senior secured first-lien debt is $1.2 billion, that tranche likely recovers fully in cash (or rolls into the new debt structure on amended terms). The remaining $2.5B $-$ $1.2B $=$ $1.3B of unsecured and subordinated debt absorbs the haircut, with the senior unsecured class becoming the fulcrum at roughly 60-70% recovery (paid out in a combination of new equity and a reduced new debt instrument), and the subordinated class wiped out. This is the kind of math that drives plan negotiation: senior unsecured creditors negotiate over their recovery rate and the form of consideration (more new equity vs more new debt), while subordinated creditors negotiate for any recovery at all (often a small "tip" to obtain their support or to avoid contested confirmation). The debt capacity analysis sets the constraint; the recovery waterfall allocates within that constraint.

The Best Interests Test

Debt capacity analysis interacts with the "best interests" test under Bankruptcy Code Section 1129(a)(7): each impaired creditor must receive at least as much under the plan as in a hypothetical Chapter 7 liquidation. The liquidation analysis sets a floor under the recovery waterfall, which becomes a binding constraint for asset-heavy companies in declining industries (regional retailers, traditional media) where going-concern value approaches liquidation value.

The capital structure review and debt capacity analysis combine into a deliverable that goes to the board, the bankruptcy court, the creditor committees, and the DIP lender. The standard format includes a capital structure summary slide (one page, color-coded by seniority), an intercreditor architecture diagram (lien priority, structural subordination, basket locations), a basket capacity table (unrestricted-sub, available amount, incremental facility, with current capacity and cumulative usage), a debt capacity output table (side-by-side current vs sustainable, with implied haircuts and recoveries by class), and a covenants and key terms appendix (section-by-section summary with cross-references to source documents). Different audiences focus on different parts: senior bankers spend most of their time on the summary slide; lawyers on the intercreditor diagram; LMT teams on the basket capacity table; creditor committee advisors on the debt capacity output.

The two analyses combine in the recovery analysis that drives plan negotiation. Capital structure review tells you the legal claims; debt capacity tells you the value that can support them. The recovery waterfall allocates value in priority order, identifies the fulcrum, and quantifies impairment per class. The LMT path uses basket mechanics to alter priority without filing; the Chapter 11 path uses cramdown to bind dissenting classes. Both run on the same capital structure review.

The capital structure review and debt capacity analysis together produce the foundation on which every other RX deliverable depends. Built well, line by line, with primary-source documentation, they defend the rest of the engagement against creditor challenge. Built quickly with placeholder numbers, they expose fault lines at the worst possible moment, which is usually the day before confirmation when a committee expert files an objection that lands on a foundational error.