Published in London & New York
10 Queen Street Place, London
1345 Avenue of the Americas, New York
Creditflux is an
company
© Creditflux Ltd 2024. All rights reserved. Available by subscription only.
Analysis CLOs
Bankruptcy 2.0 changes everything
by Lisa Lee, Tom Davidson, Madalina Iacob & Ayse Kelce
CLO managers have been forced to take on restructuring experts and add new safeguards to loan docs. But with seniority of position upended, those moves may still not protect them
Pandora’s box has been opened in the leveraged loan market, and what was once a sacrosanct feature of credit investing — seniority of position — is no longer guaranteed when companies face turbulence. This fundamental shift has changed many aspects of the loan market, including how CLO managers approach handling their portfolio of loans.
Liability management exercises (LMEs) — which had once been an infrequent method to reduce debt burden and perhaps unlock fresh capital for troubled companies — have become the normal course of business for the USD 1.4tn US leveraged loan market. In their worst form, they have also been dubbed lender-on-lender violence, because they pit senior lenders against each other.
US distressed exchanges by deal count*
*As of 2-Dec-24. Source: Debtwire
“It’s a sea change for the leveraged loan market,” said Lauren Basmadjian, global head of liquid credit at Carlyle.
While the change feels new, it has had a long gestation. LMEs have been around for years, including situations like that of pet product retailer PetSmart and preppy clothier J Crew that took away collateral from senior lenders to help companies deal with liquidity issues.
But LMEs morphed into new creatures at the turn of the decade. Mattress maker Serta Simmons rang in the current era in 2020 when it entered into an agreement with only certain lenders that subordinated the claims of others. That was quickly followed by TriMark and Boardriders among other uptiering transactions that created different outcomes for the same lender class.
A fear premium is introduced
Lauren Basmadjian
Global head of liquid credit
Carlyle
Now these approaches are so common they are no longer named. And what was once a strictly US phenomenon went global with Altice, which commands attention in both the US and Europe with an on-going drama over the restructuring of its balance sheets as the French firm attempts to employ LME tactics to disadvantage lenders.
“Creditors are reaching out to companies to strike deals as defensive tactics, to make sure they are not left out of a transaction that may be crafted with others,” said Scott Macklin, head of leveraged finance at Obra.
LME deals have reshaped the recovery outcome for senior lenders. Recoveries in the event of default had been expected to decline from historical averages as the post-GFC era of easy money pushed investors to reach for yield and disregard lender protections — but the advent of lender-on-lender violence has pushed them even lower.
Case study 1
FinThrive
FinThrive, which is back by Clearlake Capital, completed an LME in November. The US-based healthcare revenue software company had been negotiating with an ad hoc group of lenders amid liquidity concerns. It was acquired by Clearlake in 2021 and has been under pressure because its main customers — large hospitals — are cutting costs.
The final transaction created a new super-priority first-out term loan provided by lenders, and exchanged further debt lent by the sponsor into a fourth-out loan tranche. This was backed by roughly 86% of the company’s first lien lenders and around 88% of second lien lenders, which are exchanging their debt into new tranches of super-priority debt.
The transaction contemplates a second phase where all lenders which did not participate in the initial deal can exchange their holdings pro rata at 80 cents on the dollar. First lien lenders will receive 15 cents on the dollar for exchanging into the first-out loan, 25 cents on the dollar for the second out and 40 cents on the dollar for exchanging into the third out loan.
Meanwhile, second lien holders are asked to exchange their holdings at 65 cents on the dollar, comprising 10 cents on the dollar of super-priority second out term loan and 55 cents on the dollar of super-priority third out term loan.
Lenders tightened covenants and included additional collateral to back the super-priority facilities.
Case study 2
iHeartMedia
iHeartMedia’s 2028 senior secured bonds soared a few weeks ago as the radio group moved forward with its proposed “comprehensive” liability management exercise after dropping the requirement that a super majority of the 2028 noteholders consent to the deal.
The radio group originally proposed two potential transactions to extend maturities by three years and slightly reduce debt. This followed negotiations with an ad hoc group of creditors that held majority positions across iHeart’s capital structure except its 2028 senior secured notes.
A majority group of 2028 noteholders rejected the proposals and threatened litigation, alleging among other things violation of the bond indenture. However, the group had limited leverage since the indentures didn’t offer strong creditor protection and the company held the power to adjust participation thresholds for the exchange.
The comprehensive proposal gives creditors the opportunity to exchange at a discount into new term loans and notes, and was originally subject to 95% participation in each tranche of iHeart debt.
As of 29 November, over 90% of holders of iHeart’s 2026 notes and term loan, and 2027 senior secured and unsecured notes, had tendered into the proposal. Only just over 44% of the 2028 notes tendered.
iHeart’s latest announcement said it had revised the participation threshold to be equal to at least the early tender participation amount.
Growth of loss given default
“You have a product that existed on the shoulders of loss given default being rather small. There was predictability that loss given default was small and therefore you had an inordinate amount of cushion in your deals. Now you have a product, because of LMEs, where loss given default has gotten much larger,” says Bret Leas, co-head of asset backed finance at Apollo. “So the question everybody should be asking is, if you hired a manager to manage this thing, can the manager blunt the impact of LMEs?”
That question remains unanswered at the moment. Leveraged loan investors, the vast majority of which are CLO managers, are attempting to fight back. Many have developed a playbook: get involved early, organise, understand the ownership structure and game theory on the path the restructuring can take. And if you aren’t satisfied with the predictability of that, reduce or exit.
That approach, though, has unleashed other forces. Nowadays aggressive lawyers haunt the margins of what would once have been considered performing, if troubled, names. According to managers the most active law firms can pounce and set up ad hoc lender groups even for credits with prices in the 90s. For large investors with teams of distressed experts that is a headache, but manageable. But smaller investors are having to add staff and costs to cope.
“You need to have restructuring expertise and the resources to manage what is becoming a heavier load of these LMEs,” said Dagmara Michalczuk, co-chief investment officer of CLO investor Tetragon Credit Partners. “It’s becoming a brave new world where it’s taking a lot of thoughtfulness and resources to manage a CLO.”
LMEs are increasing volatility
The market has worked to add extra language into loan docs (see box, below), although with limited success. And recoveries this year have improved from the dire sum in 2023, say market participants. But in another product of the fear of being caught out, investors are changing the liquidity profile of the secondary loan market.
“Not only do we believe LMEs are causing more volatility in loan prices, as often there is a fear premium introduced when the market hears rumours about a potential non-pro rata transaction, in certain circumstances they are also allowing different managers to recover different amounts on the same loan. So how you manage your portfolio has to reflect this market shift,” said Basmadjian.
You need to have restructuring expertise
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
While it is hard to draw conclusions regarding which loans or bonds currently at par may be susceptible to a liability management transaction in the future, sources point to two critical factors to focus on. The first is obvious. How strong is the credit, and what is likely to be the volatility of outcomes down the road? Initial underwriting quality is more important than it has been in any previous period because of the lack of protections in credit agreements and indentures, as well as the propensity of equity owners to try to capitalise on volatility.
The second factor is that capital structure considerations are critical. According to one investor there is no worse place than being a medium- to long-maturity lender in a stressed capital structure in which there are short dated or subordinated debt instruments. The collateral you think you have becomes the collateral that can be offered to other lenders to incentivise maturity extensions.
Effective LME blockers are rare
by Charles Tricomi, Xtract Research
Companies faced with liquidity issues have always managed their liabilities by seeking extensions, amendments or waivers from lenders. What is relatively new — and has given rise to the dreaded terms “liability management exercise” and “creditor-on-creditor violence” — is the weakened state of creditor protection.
The increased appetite for yield in the face of declining rates led lenders to accept covenant packages that were riddled with exceptions. These “flexible” covenants, coupled with rising bankruptcy costs, led companies to pursue out-of-court restructurings, often at the expense of a subset of their lenders.
Here’s a look at the current state of play for the various iterations of LMEs.
Drop-down transactions
Lenders were slow off the mark demanding “J Crew blockers”, and even when they did, the blockers had (and have) varying degrees of effectiveness. Since the asset transferred in J Crew was intellectual property, IP is almost exclusively the subject of the blockers, even for borrowers with no significant IP. In other cases, the blocker prevents only loan parties from transferring IP to an unrestricted subsidiary, leaving loan parties free to transfer it to a non-guarantor restricted subsidiary, which in turn (as a non-loan party) could transfer it to an unrestricted subsidiary.
Only a fraction of blockers preclude the transfer of material IP to an unrestricted subsidiary. Recent innovation in this area is the so-called “Envision” protection: for investments in unrestricted subsidiaries, the company can use only the investment basket dedicated to investment in unrestricted subsidiaries. It can’t use any other basket (such as the general investment basket or the leverage-based basket) to invest in unrestricted subsidiaries. Unfortunately, this type of protection has yet to gain traction in the BSL market.
Up-tier transactions
Lenders have had greater success incorporating language that would prevent a Serta-like up-tiering. The amendment provisions that permitted the borrower to issue priming debt with the consent only of majority lenders have largely been replaced with those that require the consent of each adversely affected lender.
However, these provisions allow for the consent of a lender to be dispensed with if it has been offered the chance to participate in the priming debt, which leaves those unwilling or unable to participate out in the cold.
Double dip transactions
The intent of these transactions, in which a subsidiary of a company incurs debt guaranteed by the company, the proceeds of which are then loaned to the company on a secured basis, is to give the subsidiary’s creditors two claims in bankruptcy with respect to the one loan.
The first is a direct claim on the guaranty. The second is an indirect claim on the intercompany receivable, which is pledged by the subsidiary borrower to secure the initial loan.
Double dips have gained currency in the past two years. But unlike the J Crew blocker and anti-Serta protections, which are discrete mechanics that can be added with minimal drafting, provisions to prevent double dips will need to be more nuanced since the transaction implicates a number of debt and lien permissions. Perhaps as a result, a market standard for precluding them has not yet developed.
Guaranty releases
Meant to prevent a guarantor from being released from its guaranty obligations solely as a result of being less than wholly-owned, Chewy blockers, like J Crew blockers, come in varying degrees of effectiveness.
At their most potent, they require that the transaction pursuant to which the subsidiary became less than wholly-owned is with a non-affiliate for a legitimate purpose. In their weakest (and most common) form, they require only that, post-transaction, the company has sufficient investment capacity in non-guarantors to hold its remaining equity in the now non-guarantor subsidiary. Given the expansive investment capacity of companies, this is a low bar.
