Private Markets Monthly, June 2024: How Aggressive Out-Of-Court Loan Restructurings Threaten Institutional First-Lien Recovery Prospects

Against the backdrop of still-higher-for-longer rates and slowing economic growth, institutional loan investors are also troubled by increased aggressive out-of-court restructurings facilitated by the weakening of loan documentation over the past decade. The growth of private credit is helping to fund the rise in out-of-court restructurings amid challenging credit conditions for many highly-leveraged companies.

As investors increasingly allocate capital across private markets, evolving macro-credit and financial conditions may require a need for greater transparency. In this edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews Steve Wilkinson, sector lead for leveraged finance and recovery at S&P Global Ratings, about how restructurings and selective defaults are affecting credit quality and recovery prospects.

Why are out-of-court loan restructurings increasing, and how does private credit play a role?

Steve Wilkinson, Managing Director, Sector Lead for Recoveries & Leveraged Finance: Out-of-court loan restructurings are increasing in part because loan documentation has become increasingly flexible (and bond-like) over the years, as the loan investor base has evolved and become both more diversified and similar to the high-yield bond market. As a result, institutional loan documents are predominantly covenant lite (meaning they're without financial maintenance covenants) and have a wide array of provisions (or baskets) that allow companies to incur additional debt and take other actions. This allows borrowers to have more flexibility and negotiating power to execute restructuring transactions with lenders.

It has also become easier to execute these transactions over the past few years. The stigma has abated somewhat, as they have become more common amid credit stress prompted by the pandemic in 2020 and the sharp rise in interest rates that started in early 2022.

Another factor helping firms and their financial sponsors execute out-of-court restructurings is growth in the private credit markets—which often provide access to capital to help fund these transactions. In addition, private lenders can often be more creative than the institutional debt markets in crafting terms to benefit their new loans while ensuring the company (and their sponsors) get the liquidity and flexibility they need to reduce the risk of an imminent payment default or bankruptcy.

Why do financial sponsors prefer out-of-court restructurings, what tactics do they use to execute these transactions, and how are existing lenders affected?

Steve Wilkinson: Sponsor equity used to take the first hit on restructurings. However, today, out-of-court restructurings provide companies and financial sponsors with a strong negotiating position to improve the company's liquidity while getting existing lenders to make various concessions—which can include reduced collateral levels, the subordination of their repayment rights, haircuts to par, or the extension of existing maturities to distressed borrowers. The burden of the restructuring is alleviated from the sponsor and carried by the creditor in many of these situations.

However, these transactions often produce winners and losers from the same group of creditors. Thus, they are often referred to as "lender-on-lender violence."

The two most common loan restructuring tactics have been collateral transfers (more benignly referred to as dropdowns) and priming loan exchanges (also known as up-tiering). J.Crew and PetSmart are the most well-known examples of the collateral transfer. For priming loan exchanges, Serta Simmons is the most well-known, where a slim majority of lenders were able to provide new super senior loans and elevate their existing loans at the expense of the remaining lenders. The impact of these restructurings on nonparticipating lenders is often severe. Our analyses show that aggressive loan restructurings can significantly impair the credit quality and recovery prospects for nonparticipating lenders, as shown in the decline in their expected recovery given default. At the same time, the new lenders, or the group of existing lenders that help negotiate and backstop these transactions, often improve their terms and recovery prospects, which is important since these restructurings have generally not solved the capital structure problems that forced these companies to restructure in the first place.

Of the 32 loan restructurings by 29 companies since mid-2017 (with some undergoing multiple transactions), 11 subsequently filed for bankruptcy. Of the 18 firms that managed to avoid bankruptcy, only four avoided a subsequent default or are rated higher than 'CCC+', highlighting our expectation that an eventual default is more likely than not.

The four exceptions are: PetSmart LLC, which we rate 'B+'; Renfro Corp. and Boardriders, which repaid their debt in full when these companies were subsequently acquired; and Rackspace, which was rated 'B-' after completing a restructuring that included a liquidity boost while also reducing total debt (since existing lenders took a sizable haircut to par).

Two other more recent tactics include "pari plus" and "double dip" structures.

As one example, Trinseo PLC (which we rate 'CCC+' with a negative outlook) is an interesting case study on creative structuring that helped the firm plastics producer procure new debt financing to address pending near-term maturities. The company used provisions under its credit agreement and indentures to provide enhanced protections to new lenders. This pari plus restructuring tactic gave the new lenders a priority claim to the value of the transferred asset, as well as an equal claim to the remaining assets that collateralized the legacy secured debt. The new private credit debt repaid pending loan maturities and some unsecured debt at par, which the lenders liked (given the 'CCC+' issuer credit rating) even though their remaining debt was disadvantaged.

Under a double dip structure, lenders provide new loans to a nonguarantor subsidiary, and these loans are also guaranteed on a first-lien basis by the obligors on the companies' existing debt. The proceeds from the new loan are then lent back to the obligors via an intercompany note that is also guaranteed on a first-lien by the existing obligors. As a result, the new lenders get the benefit of their own liens plus those from the intercompany loan, hence the double dip label. At Home Group and Sabre Corp. are two examples of double dip structures.

While the number of out-of-court restructurings remains limited, they are becoming more frequent and are likely to persist since the weak protections that allowed them to proliferate remain widespread.

Let's talk about "lender-on-lender violence." How does this differ from the risk of aggressive out-of-court restructurings that bondholders face?

Steve Wilkinson: Out-of-court restructurings have long been risks to bondholders, but only more recently have become a risk to loanholders. In some ways, however, the risks from these restructurings may be higher for lenders than for high-yield investors.

Historically, high-yield investors with unsecured notes or bonds in distressed firms may face coercive tender offers to exchange their unsecured notes for new notes (typically at a notable discount to par). However, while the bondholders may take a haircut in a restructuring, their remaining exposure to the company may become secured with a junior-lien position that may improve their recovery prospects relative to their prior position and potentially relative to other remaining unsecured creditors.

The situation is different for the aggressive loan restructurings we've seen in recent years. As noted earlier, these restructurings of mainly sponsor-owned companies reflect a willingness to take advantage of the weak loan documentation terms that have proliferated in the institutional loan market over past six years or so, including "cov-lite" term loan structures and enhanced flexibility to take various actions.

The rationale for these terms is that if a borrower undergoes some stress that it is not possible to negotiate with a widely diversified lender group, so it was important to give the borrower some financial flexibility upfront. In reality, however, this flexibility is pitting lenders against one another to be part of a restructuring that enhances their position at the expense of other formerly equal lenders in the same debt instrument. So, after the restructuring, many lenders end up worse off while other (formerly equal) lenders are better off.

This is quite different than for bondholders where restructurings are offered to all bondholders on a pari passu, or equal footing, basis as is required by regulators for debt classified as securities. Even worse, most of the loan restructurings aren't resolving the capital structure problems that triggered them in the first place.

Many lenders have been affected by aggressive loan restructuring tactics, and various terms have evolved to try to limit associated risks. How do you think this will evolve over time?

Steve Wilkinson: These types of loan restructurings continue to grow and can spike during periods of economic stress. As these transactions become more common, even publicly traded firms have been taking advantage of the flexibility to restructure outside of the generally expensive bankruptcy process—and this is likely to continue.

Many of the document provisions devised to combat these issues have been around for several years but generally do not make it into institutional credit agreements—especially in periods with high demand for loans. This reflects the limited negotiating power of individual institutional loan buyers in the broadly syndicated loan market.

More recently, many out-of-court restructurings are producing a less-extreme gap in the terms realized by the "winners" and "losers." The goal of offering less lopsided terms is to spur a high participation rate in the restructuring to mitigate the risk that the disadvantaged lenders will pursue litigation, which can be expensive and time consuming for the company. But if the restructurings don't resolve the underlying capital structure problems and the companies subsequently redefault or file for bankruptcy, the disadvantaged lenders in these less lopsided restructurings will still bear the brunt of the damage because they generally have less favorable positions in the new capital structure.

Many such restructurings are likely to continue to be driven by new private credit lenders (rather than a subgroup of existing lenders), given the large amount of dry powder raised in the private markets in recent years. Such restructurings often use pari plus or double dip structures that may repay existing lenders at par, which may be welcome by many existing lenders.

Private Markets Monthly, Edition 9

Contributors: Steve Wilkinson

Written by: Molly Mintz