Overview
As credit market dynamics have evolved, so too has the playbook for distressed investing. The traditional method of investing in this space has shifted, allowing for the disruption of lender seniority and ultimate recoveries for creditors. Liability management exercises (LMEs) have taken shape as a primary tool in distressed investing. LMEs are strategies that companies employ to restructure or refinance their debt outside a formal bankruptcy process. As lender safeguards have eroded in bond and loan markets, companies and financial sponsors have been more active and aggressive in exploiting credit document weakness in order to extend maturities, increase liquidity, delever or increase future flexibility. These LME transactions have taken many forms but almost always at the expense of existing creditors. In periods of elevated interest rates, LMEs can be essential for maintaining a company's financial health and sustainability as issuers deal with upcoming maturities. While this dynamic can pressure future creditor recoveries, it can also potentially lead to attractive opportunities for sophisticated investors in the space.
Conventional Approach To Distressed Investing
Traditionally, when maturity walls have coincided
with higher capital costs and specific issuer and/or market slowdowns, the result has been the classic "good business, bad balance sheet," where operating results no longer supported a firm's debt obligations. With existing sponsors and lenders unwilling to extend or refinance, and capital markets unwilling to provide support at subordinate levels, firms were forced into traditional bankruptcy proceedings. In cases in which this dynamic was more broadly based, a negative feedback loop would begin, with corporate downgrades and increasing defaults causing lending markets to seize, resulting in higher default rates and reinforcing the "credit cycle." The ebbs and flows of a traditional credit cycle have historically provided fertile opportunities for liquidity providers, such as hedge funds. Once the market had gotten a whiff of potential stress, a firm's debt would trade down in recognition of potential downgrades/lower recoveries. Some holders might then look to sell ahead of any formal restructuring (some of which might be forced due to investment policies). For opportunistic investors, such as hedge funds, this presented an opportunity to buy the majority of senior debt or fulcrum security at steep discounts, often leading creditor committee negotiations that improved the firm's capital structure while ensuring value creation.
This was frequently done through a debt-forequity exchange and by monetizing in a better economic environment.
Credit Market Evolution
In the years that followed the global financial crisis (GFC), structural market shifts and investor sentiment drastically changed the credit landscape. Corporate debt issuance significantly expanded as issuers took advantage of reduced interest costs in a lower-rate environment. As appetite for yield intensified amid declining rates, investors accepted increasingly weaker creditor protections - "covenants" - in exchange for slightly higher yields. These covenants are the agreements imbedded in a loan document or bond indenture designed to protect the rights of lenders and define what actions a borrower can take. As the hunt for yield endured, the quality of these investor safeguards continued to erode. This resulted in the highest share of "covenant-lite" debt on record, often from riskier, lower-quality companies. This period also coincided with a dramatic shift in lending markets, with the growth in private debt funds taking significant issuance flow from the once-dominant investment banks and syndication markets. These years of large issuance have resulted in record amounts of debt maturing in the coming years. In a benign rate environment, where refinancing or future debt issuance can be issued at similar interest rates, maturities present less of a problem. However, following an increase in interest rates (and current expectations of higher for longer), the looming maturity wall now presents headwinds for many issuers in terms of either meeting current interest expenses or assessing the cost of future capital needs.
Source: King Street, PitchBook LCD, Bank of America.
Source: Diameter, BofA Global Research.
Source: Diameter, PitchBook LCD.
As a result, many companies or sponsors have taken advantage of these weakened debt covenants to find creative solutions to manage their outstanding debt, strategically enhance liquidity and support long-term growth - the LMEs discussed above. These LMEs are also referred to as "creditor-on-creditor violence" given the face-offs between lenders in the fight over leading processes, claims and recoveries. LMEs have transitioned to the accepted state of play, disrupting the original seniority and recovery waterfalls for existing lenders. Rather than entering a formal bankruptcy proceeding, many companies now seek to get ahead of future capital needs and maturities by taking on new and different forms of debt to avoid a traditional default cycle. This can be seen in the increasing levels of amend-and-extend activity (see Figure 3 above) in lieu of traditional Chapter 11 filings. With new lenders recognizing the weakness in existing covenants, new debt in an LME is typically secured, stands senior to all existing debt, cannot be worked around or further layered, and benefits from a healthy underlying value cushion.
Strategies In Liability Management
The implementation of LMEs has taken many forms, although it is most prevalent in the following scenarios:
- Drop-down transactions: The company takes collateral originally pledged to back existing restricted loans and reallocates it away from existing borrowers to support new unrestricted loans. This "dropped down" collateral secures the new debt and increases the company's liquidity. Drop-down transactions typically do not require majority creditor consent or the amendments of existing loan documents.
- Up-tier transactions: A majority subgroup of lenders provides new money to a company in the form of new loans that are senior to the company's other outstanding loans. This is a practice known as "priming." Through creating a different workout arrangement, the investors that provide new money often experience a better recovery than those that are left out.
Impact On Recovery Rates
Given their nature, these LME strategies can severely disadvantage existing creditors that are not participating in the transactions. This can be through a change/weakening in the collateral backing their investment or a change in the degree of subordination. In particular, in the case of uptiering transactions, recovery expectations for nonparticipating lenders can be drastically reduced, often by upward of 90%.1 Investors in this space should expect more aggressive behavior and, as a result, overall lowerthan-average recoveries in the event a company does file for bankruptcy. Some lenders have begun to form cooperation agreements to bind themselves together and reduce the negative risk for minority lenders. However, the prevalence of aggressive LME behavior emphasizes the need to fully understand the implications of existing credit agreements.
Geographic Bias
While LMEs have been used in capital structures globally, the majority of activity to date has been in US markets. Many other jurisdictions, such as Europe and Asia, do not allow for the same degree of disadvantageous treatment of paripassu creditors, and more cautious case rulings have limited LME activity. In Europe, for instance, loan documents often require a super-majority consent, and European boards of directors may face personal liability for these types of strategic decisions.
Conclusion
Following a period of massive issuance of cheap debt, many companies are now faced with increased interest expense and looming debt maturities. Weakened creditor protections have changed the credit landscape. This has allowed for more flexible and sometimes aggressive behavior by stressed issuers in managing debt maturities and capital needs. LMEs have now become a mainstream playbook within credit investing. The use of LMEs has resulted in more distressed exchanges and outof-court restructurings and fewer Chapter 11 bankruptcy filings while ultimately pressuring creditor recoveries for some. Investors should remain flexible in their approach. Opportunistic investment managers with scale and a deep and seasoned team with legal expertise should be best positioned to navigate this environment.