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Distress caused by LMEs triggers headache for recovery calculators
by Tom Davidson
The headaches caused by liability management exercises (LMEs) or transactions (LMTs) are well known. But a new question has arisen about how the US leveraged loan and CLO markets should record the outcomes of restructurings with multiple outcomes for the same initial loan.
While everyone from investors to data-providers are impacted by murky recovery rates, this question is most pressing for rating agencies. In a new report, S&P’s Steve Wilkinson wrote: “In theory, it seems straightforward that LMTs should generally depress first-lien recovery statistics because these restructurings typically layer additional first-lien debt on top of already overburdened structures. In practice, the impact on aggregate recovery statistics is murky, and the best way to measure this may not be obvious given the complex and idiosyncratic nature of these transactions.”
In the old world order, the default of a first lien loan led to roughly consistent outcomes for everyone invested in a specific tranche. After an LME, those able to join ad hoc lender groups achieved materially better results.
One recent example is Del Monte Foods. Recovery estimates for the troubled name’s first lien term loans were around 35% before a debt exchange and asset transfer raised USD 240m of new first-out money.
Recoveries for the first-out term loan are now around 95%. The unfortunate lenders which couldn’t participate in the exchange are expected to be wiped out.
Wilkinson also highlights that the pressure from LMEs comes on top of existing problems for loan recovery rates. “Even before considering the impact of LMTs, our recovery ratings (which estimate future recovery rates) on first-lien debt in the US have declined into the mid- to low-60% area in the past six years. This has been driven by a combination of increasing total and first-lien debt leverage, shrinking junior debt cushions, and the predominance of covenant-lite loan structures.”
With the difference in outcomes between first-lien first-out, second-out and third-out tranches so dramatic, large CLO managers want better treatment based on their LME expertise.
Derek Miller, head of the US structured credit group at Fitch Ratings, said: “We continue to observe outcomes and don’t adjust our recovery expectations based upon potential winners and losers prior to an LME.”
In S&P’s view the ultimate impact on CLOs should be limited. Stephen Anderberg, the firm’s sector lead for US CLOs, said: “Recovery rates are fundamental to our CLO ratings, but we already include meaningful haircuts to the corporate estimated recovery rates.”
