Need to know
- Distressed borrowers are exploiting ultra-loose covenants to raise new debt through so-called liability management exercises.
- LMEs enable borrowers to raise new debt in ways that benefit certain lenders over others.
- Disgruntled creditors have challenged the exercises in court, but with little success.
- Many struggling companies that use LMEs go on to fail, leaving lenders clawing back historically low amounts on defaulted debt.
- Recovery rates fell to an average of 25% last year, down from a historic average of around 75%, according to Bank of America.
In 2016, US clothing retailer J Crew was running into trouble. A move upmarket had alienated core customers. The halo effect of celebrity fans such as Michelle Obama, who once sung the brand’s praises on a talk show, had dimmed. J Crew was also buckling under a pile of debt and, with maturities looming, it was only a matter of time before the company faced default.
To dig itself out of this hole, J Crew embarked on an exercise in financial acrobatics. It shifted its brand trademarks to a subsidiary and used them as security to raise a $500 million loan.
The company’s existing creditors were unamused. The intellectual property backing their debt had been stripped away in a practice known as a dropdown. To be ‘J screwed’ is now industry slang for a type of financing that is equal parts creative and contentious.
J Crew’s dropdown was an early example of a liability management exercise, in which distressed borrowers raise new debt, often at the expense of some existing creditors. LMEs have been gaining in popularity in the years since: research from a credit hedge fund identified more than 20 last year, and industry participants expect to see more as companies struggle to refinance at hiked-up rates.
Recovery rates for those on the wrong end of these exercises, in cases where companies have subsequently filed for bankruptcy, can be as small as a fiftieth of the payouts to more senior lenders. The left-behind lenders, though, seem unable to do anything about it.
Whether a borrower can enter into an LME is the wrong question, says Derek Gluckman, who, as senior covenant officer at Moody’s Investors Service, tracks and writes research about the terms in high yield lending. The right question, he believes, is how far such transactions can go: “How deep can they cut into the lenders’ flesh, so to speak?”
Groups of lenders have challenged multiple LME transactions in the courts, but with little success. Loan documents crafted when interest rates were low and borrowers were in a position of strength often enable determined companies to do much more than their creditors might like.
As head of covenants at Reorg, a company that provides distressed debt analytics, Peter Washkowitz has broad experience of borrowers exploiting loopholes in loan documents to raise new debt. “Lenders can protect against every single LME transaction that has ever happened, and companies are still going to find ways to pursue other types of LMEs,” he says. He likens creditors’ attempts to stop the trend to playing the fairground game whack-a-mole – and says they are falling far behind.
Last June, a Texas bankruptcy court ruled that Serta Simmons, a 150-year-old mattress maker, was permitted under the terms of its existing debt covenants to enter into a type of LME known as uptier priming. The ruling said the loan documents allowed the company to exchange outstanding debt for super-senior debt with a subset of its lenders and that the transaction did not violate the “implied covenant of good faith and fair dealing” – in short, that it lay within the spirit of the contract.
Lenders can protect against every single LME transaction that has ever happened, and companies are still going to find ways to pursue other types of LMEs
Peter Washkowitz, Reorg
When petrochemical company TPC Group filed for bankruptcy in June 2022, creditors that had not been invited to invest in a new and more senior $200 million bond as part of the deal challenged the transaction in court – and lost.
“The [legal] challenges have not favoured aggrieved lenders,” Gluckman says. “It has been difficult for lenders to find recourse through the courts.”
Dan Zwirn, chief executive officer and chief investment officer at credit investment firm Arena Investors, says that for lenders that accepted lax covenants over the past 15 years – which was almost all of them – “the chickens are coming home to roost”.
Zwirn, whose company participates as a new lender in LMEs, has long predicted that the “everything bubble” in financial markets would pop, and that this would expose the true risk of lending to companies that borrowed too much, too cheaply and on terms that were too lax.
Risk of a double dip
LMEs have come mostly in three forms: dropdowns, uptier priming and, more recently, double dips.
With double dips, the company creates a subsidiary, often offshore, that raises new debt and passes cash to the parent through an intercompany loan. The loan is then pledged as collateral to the new creditors. These creditors, as guarantors of the debt, also hold a claim over the parent company’s assets, and are therefore in a stronger position during any restructuring.
The most aggressive borrowers have combined more than one technique. KKR-backed Envision Healthcare in 2022 pursued a form of liability management that involved both a dropdown and uptier priming. Participating lenders exchanged around 30% of Envision’s outstanding term loan for a smaller facility backed by the company’s valuable AmSurg business, which runs minor surgery clinics.
A few months later, after garnering support from select lenders in bilateral discussions, Envision raised a further $300 million of super senior debt. Those creditors that refused to consent to the plan found their debt sitting below three more-senior tiers of lending. Of the company’s original $5.7 billion term loan, just $157 million remained.
Other companies have found surprising ways to bend the terms of existing obligations.
Lenders to Diebolt Nixdorf thought the credit agreement in their loan was all but watertight. However, during a $400 million restructuring in December 2022 the cash machine manufacturer offered additional fees and collateral to most lenders; in return, the grace period on missed interest payments was extended from the usual five days to any time before maturity. If the company failed to pay interest on the loan, lenders would be powerless to act until the debt fell due.
Wake-up call
The growth in unconventional financing reflects, in part, borrowers’ realisation that their loan covenants will permit it.
In leveraged lending following the global financial crisis, parties adopted loose terms that had only previously been seen in high-yield bonds. Exceptions to covenants – known as ‘baskets’ and intended to help companies grow – became broader.
Washkowitz says that five years ago a standard investment carve-out would enable a company to raise about 35% of Ebitda for acquisitions. He estimates that the figure today is nearer to 60% or 70%, and in some cases 100%.
At the same time, addbacks, which enable borrowers to write-off certain costs and inflate their Ebitda, have grown to what Washkowitz calls “absurd” levels. This has the effect of broadening still further the scope of the borrower carve-outs.
Around nine in 10 US loans are now cov-lite, and lenders have been slow to tighten up terms. “It [has been] almost a point of pride for sponsors to show how flexible these credit agreements are,” Washkowitz says.
Now, in the age of LMEs, borrowers can exploit carve-outs to make additional borrowing possible. J Crew, for example, took advantage of a handful of carve-outs so it could shift collateral into a Cayman Islands subsidiary and then to an unrestricted subsidiary.
Eric Wise, a partner at Alston & Bird who has advised borrowers on LMEs, says dropdowns, uptiers and double dips all rely on generous exceptions that were conceived for other purposes. “None of these provisions were, for the most part, designed for this,” he says. “You’re looking at the covenants that were supposed to do X, Y and Z and you’re saying, ‘Hey, if we do this and we do this, we can achieve something that’s radically different.’”
In a similar vein, borrowers in the past were required to offer all the lenders on a credit agreement the same terms in any future debt exchange. However, in recent years borrowers have offered a better deal to a subset of lenders while freezing out those creditors that are unwilling to comply.
Daniel Ehrmann, head of restructuring at $24 billion credit hedge fund King Street, says that with double dips “sponsors now have realised that they can do this without their cost of capital going up – and without getting sued”.
The willingness of creditors to work together has fractured dramatically
Allan Schweitzer, Beach Point Capital Management
The success of LMEs is also due to creditors’ increasing willingness to turn on each other. More than two-thirds of TPC’s existing noteholders voted to allow the company to raise new, more senior debt, for example. “The willingness of creditors to work together has fractured dramatically,” says Allan Schweitzer, a portfolio manager at credit hedge fund Beach Point Capital Management.
In some cases, lenders wary about ending up on the losing side of an LME have pre-emptively proposed one themselves. “If you’re in a capital structure as a lender and you think an LME might be coming down the pike that’s adverse to your group … the better strategy might be to propose a better alternative for the company,” Wise says.
Before being shunted down the capital structure by the uptier transaction, a group of Serta Simmons creditors, led by Apollo and Angelo Gordon, had proposed their own aggressive financing solution: a J Crew-style dropdown that would have stripped other creditors’ debt of collateral.
Specialist distressed debt investors, such as King Street and Arena, meanwhile, are actively looking to engage in opportunities created by the LME trend.
Ehrmann, who trained as an M&A lawyer and has advised on corporate workouts for more than two decades, including Lehman Brothers’ bankruptcy, says he is often a participant in deals offering struggling companies new debt, and at the same time is looking for better terms.
“We are focused on ensuring that the assets that are dropped down … are high-quality assets, and that the loan-to-value is south of 60%,” he says. “Our [new] debt sits in a far better, more protected box.”
This is unnerving talk for existing lenders at risk of being left behind. King Street estimates that around two-fifths of borrowers that have completed transactions of this type eventually go bankrupt.
Fresh financing was not enough to revive Serta Simmons, which limped on for two more years before filing for bankruptcy in January 2023. Nor was KKR’s financial alchemy enough to save Envision, which also had to file for bankruptcy last May.
A matter of principal
Existing creditors that have seen their claims to company assets watered down are clawing back historically small amounts of principal when issuers default.
Serta Simmons’ restructuring plan shows that lenders that engaged in the uptier transaction will recover around 75% of the principal, while excluded lenders will claw back as little as one percent. Lenders to TPC that rolled into the new, senior tranche recovered 100%, whereas the original creditors in the junior tranche clawed back less than half.
Although the Envision bankruptcy case is ongoing, Fitch reckons lenders that took part in the LME are likely to recover around 100% of the principal, whereas the lenders that did not will only receive “minimal” amounts.
Recovery rates across US loans fell to an average of 25% last year, down from a historic average of around 75%, according to Bank of America research.
Not every LME burns existing lenders. When secondhand car retailer Carvana uptiered last July, all creditors were invited to participate. Yet even the prospect of such an exercise can leave existing creditors between a rock and a hard place. They must either hold on to the credit in the hope they will be invited to participate in new debt issuance, but risk seeing their existing debt subordinated in the capital structure; or sell and probably crystallise a loss.
For some investors, there is scant choice. “We’re not going to have a large size in the debt of a particular company,” says a collateralised loan obligation manager. “We’re not going to be brought to the negotiating table. You make the decision to just sell out of it, rather than stick with it.”
Against the wall
All eight of the practitioners who spoke to Risk.net for this article expect LMEs to become more common as an increasing number of companies face difficulties.
Meredith Dixon works alongside Washkowitz as senior distressed debt analyst at Reorg and previously traded distressed debt at Barclays. She says a $200 million double dip last May by US home furnishing provider At Home paved the way for similar transactions, and such deals have been “in vogue” ever since.
Dixon explains that although double dips are nothing new, distressed borrowers using them intentionally to raise new capital most definitely are. “Once it was market tested, people were willing to do it,” she says. “We’ve seen a cascade of subsequent transactions.”
Last June, software company Sabre raised around $700 million in a double dip from a group including Oaktree and Centrebridge Partners. In September, materials group Trinseo used a similar structure to raise around $1 billion from a group of lenders including Apollo, Oaktree and Angelo Gordon.
Beach Point’s Schweitzer says private equity sponsors are “backed up against the wall” as more of their portfolio companies become distressed, and this makes these businesses especially likely to pursue LMEs. Spreads on triple-C rated loans have widened sharply, reflecting market pessimism about the fortunes of those borrowers with the most fragile balance sheets.
To stop dropdowns, some lenders are now adding in so-called ‘J Crew blockers’ that limit the types of asset that can be offloaded on to unrestricted subsidiaries.
“The market has adjusted to these risks in drafting for new deals,” says Gluckman at Moody’s. “Not every deal incorporates relevant protective provisions, but they have grown more common.”
Data from Moody’s shows that around two-thirds of broadly syndicated loans now have provisions against Serta Simmons-style uptiering and J Crew-style dropdowns.
Existing creditors, though, have found that distressed borrowers can be craftier – and collateral more slippery – than they expected. Lenders to Travelport learned this in 2020, when the travel retail platform raised new debt by using a slice of intellectual property not covered by a blocker.
Nor can creditors beef up protections immediately. The absence of maintenance covenants that require borrowers to pass regular tests or risk default – another casualty of the shift towards cov-lite – makes it more likely that lenders must wait for borrowers to come to them.
“No matter how badly they want it, [lenders] can’t demand the addition of these protections unless and until the borrower needs something in exchange,” says Gluckman.
Creditors may hope that litigation over double dips proves more successful than court action over other types of LME. None of the companies that have double dipped have gone bankrupt yet, and only when creditors are left to scrap over a business’s remaining assets will the structure’s robustness become fully clear.
Further controversies and court battles are inevitable. “We will continue to see LMEs and they will almost always be litigated, because – why not?” says one expert. “The disadvantaged creditors are going to want to recoup as much value as they can.”
As things stand, that may not be much.
Editing by Daniel Blackburn
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