You Can Work It Out! Valuation and Recovery of Private Debt with a Renegotiable Default Threshold

Abstract

Large infrastructure projects are often financed through limited-recourse project finance (PF) vehicles with a high proportion of senior debt. PF is a unique form of corporate governance that creates extensive creditor rights when certain covenants are broken, most notably the option to “step in” upon a credit event, and to restructure the firm to maximize either expected recovery or expected payoff, depending on the nature of the credit event. These options significantly impact the outcome of credit events, and credit rating agencies report anecdotal evidence of very high recovery rates in project finance debt compared to comparable corporate debt. However, data paucity forbids robust reduced-form modeling of expected recovery rates. In this article, we extend the structural credit risk model of illiquid debt developed by Blanc-Brude and Hasan [2016] to incorporate the step-in option of senior creditors in PF, and model its impact on the valuation and risk profile of senior unsecured project debt, taking into account the bargaining power of creditors and borrowers in investment projects that are relationship-specific. Step-in options also can be understood as trading off credit risk and duration, depending on creditor risk preferences.