Deterioration of lender protections has combined with volatile economics to drive an increase in liability management exercises (LMEs), or aggressive attempts by leveraged companies to avoid bankruptcy by restructuring their senior debt outside of court.
LMEs were running at an all-time high of 34 in August, according to Pitchbook | LCD’s trailing 12-month calculation. That was up from 15 a year earlier and only four in August 2022 – after a pandemic-period spike had subsided and before the Federal Reserve ramped up interest rates to counter inflation.
Many that go the LME route end up in bankruptcy anyway, says S&P Global Ratings.
At the same time, the trailing 12-month count of payment defaults fell to 15 in August, from 22 in August 2023.
LMEs have become easier to deploy as a multitude of institutional investors with diverging interests have displaced major banks in loan syndications, which like bond deals now have fewer and looser covenants.
Low interest rates and strong investor demand for higher-paying bank paper have also contributed to a deterioration of investor protections when negotiating loans. In the wake of the pandemic, LMEs were seen as way to avoid bankruptcy.
Sources: PitchBook | LCD; Morningstar LSTA US Leveraged Loan Index | Data through Aug. 31, 2024
S&P Global Ratings specifically tracks LMEs in which corporate borrowers – typically those sponsored by private equity – seek credit relief by elevating a subset of senior lenders over other, formerly equal lenders in the capital structure, in exchange for benefits such as new money or extended maturities. In recent years, S&P says, the most common LME tactics have been collateral transfers, referred to as drop-downs, and priming loan exchanges, also known as uptier transactions. In the latter, the lender subset provides new, super senior debt secured by the same collateral, to the disadvantage of other senior lenders.
“We try to track LMEs that materially disadvantage existing lenders in a way that tilts the field,” said S&P Global Ratings managing director Steve Wilkinson. “If an LME deal is offered to all lenders, we view that more as a traditional loan restructuring.”
Such transactions tend to only temporarily alleviate the restructuring companies’ problems. Out of 10 collateral-transfer and 25 priming transactions by 32 companies, of which 20 were done since April 2022, 12 have filed for bankruptcy. Another 15 have either re-defaulted or are viewed by S&P as likely to default.
“Five exceptions were later rated B- or higher, suggesting they will avoid a near-term default and can support their capital structures,” Wilkinson said.
Most LMEs don’t seek to disadvantage one group of senior lenders. Daniel Wohlberg, principal at Eagle Point Credit Management, noted that many leveraged companies’ capital structures were assembled when rates were historically low; rising rates led to free-cash-flow issues. LMEs in which lenders take a small haircut on their returns, lengthen the maturity, or otherwise benefit borrowers can help companies to weather the storm.
For that reason, “LMEs appear not only in distressed situations, but also in loans that are trading in the low 90s or high 80s, and cash flow is still positive,” Wohlberg explained. “The LME solves a concern, such as an impending maturity.”
In such instances, he added, unsecured lenders may view secured-level LMEs positively, since they lessen the chance of bankruptcy when they stand next to equity in terms of absorbing first losses.
“On the other side, if it’s an LME that didn’t need to happen or benefits a limited group of secured lenders, then outcomes may be worse for unsecured holders in the long-run,” Wohlberg continued. “It’s very situation-based.”
Bill Zox, Brandywine Global
Still, lenders concerned about LMEs may push for stronger and more cohesive so-called cooperation agreements, said Bill Zox, portfolio manager for Brandywine Global’s high-yield and corporate credit strategies.
“We may be reaching a critical mass of lenders who see that they may win one or two battles but are losing the war, so why not link arms and push back against the equity,” Zox said. He sees LMEs’ upsetting the priority of claims as detrimental to the loan market and to capital markets more broadly.
“It often leads to lower recoveries for creditors,” the portfolio manager said. “Plus, you’re leaking a lot of fees to lawyers and restructuring experts.”
Lenders are incentivized to join broad cooperation agreements because of the lower recovery rates in bankruptcy received by lenders outside LMEs’ favored secured group. S&P Global Ratings found that for 33 of the 35 loans it tracked, expected recoveries dropped significantly for lenders outside the favored group after LMEs were introduced. Only Neiman Marcus and Cirque du Soleil experienced no change.
Cooperation agreements may enable smaller lenders to negotiate lesser negative impacts on their existing loans, even if the lenders driving the transaction still get better terms. Even so, should the company default again, those lenders will often realize lower recoveries because of the widening layer of debt at the top.
“The total debt tends to go up in these restructurings, which is why they don’t really resolve the capital structure problems they’re supposed to address,” Wilkinson said.
Among the few borrowers bucking that trend, Wilkinson said, was Rackspace. It recently did a priming loan exchange that included large enough par-debt haircuts to reduce the total debt, even though the borrower had brought in a new layer of “super priority money,” Wilkinson explained.
The new money’s recovery is now expected to be 90% and another senior layer 50%, he added. A senior unsecured layer and a senior layer that didn’t participate in the LME should see recoveries drop from 10% and 50%, respectively, to 0% in both cases.
Zox said it is too soon to tell if 2024 marks a turning point when there is a retreat from such “lender on lender” conflict.
Lenders are seeking to prevent problematic LMEs with so-called blockers. Moody’s Ratings recognizes six; there were three only two years ago, according to Evan Friedman, the agency’s head of covenant research. A J.Crew blocker is an example of one that makes it harder to do drop-down LMEs, and they are becoming more common in new loans.
“Some of these protections are not yet pervasive, but they are going into more deals,” Friedman said, noting they must be scrupulously written to be effective. “The devil is in the details.”
Blockers will probably only be part of the solution. To Zox, they are “a game you’ll never win” – lawyers will always find more loopholes, and even if blockers are effective, creditors may not have the critical mass to litigate the issue.
Litigation may ultimately be another part of the solution. The Wall Street Journal reported in June that a Texas bankruptcy judge ordered an airplane parts supplier to unwind a 2022 LME that enabled investment firms including Pimco and Silver Point Capital to leapfrog other lenders.
Some judges “may actually side with aggrieved lenders, and that may have a chilling effect on some of the more aggressive permutations,” Friedman said.