Liability Management Exercises Flex Their Strength

Liability management exercises (LMEs) have become more frequent—and arguably increasingly important—in the US high yield, leveraged loan, and collateralized loan obligation (CLO) markets over the past several years. LMEs have emerged as an alternative for highly leveraged companies to avoid or delay costly courtroom default exercises, to restructure existing debt, or to raise additional liquidity. For companies backed by private equity, LMEs may be a means to protect or improve equity holder positions at the expense of debtholders. While LMEs may offer benefits to borrowers, some creditors—particularly those left outside of any ad-hoc groups, or committees of stakeholders that join for greater leverage—may be subject to increased risks or losses.

LME: Let Me Explain

LMEs encompass a broad range of scenarios and are not a one-size-fits-all approach. These exercises can be preemptive, forced by distress, or somewhere in between. Some common objectives among the many types of LMEs that have arisen in recent years include:

• Amend and Extend: These types of LMEs seek to modify existing terms, which could include pushing out maturities, amending terms such as coupons, or adding payment-in-kind (PIK) provisions.
• Opportunistic Exchange: In these situations, old debt is exchanged at or near 100 cents on the dollar for new debt with more bond-friendly terms.
• Distressed Debt Exchange: In distressed situations, issuers may exchange new debt for existing debt. However, the new debt has inferior structure, such as a lower value or lower priority claim in the debt stack. These types of LMEs are considered default events by traditional rating agencies and have the highest likelihood of unequal, or non-pro-rata, outcomes across bondholders.
• Consent Solicitations or Covenant Stripping: In these aggressive actions by issuers, the issuer asks for approval to modify contractual terms of existing debt.

The Rise in LMEs

We have written previously about the current strength of the US high yield market. The market’s average quality remains near highs not seen in years. In general, healthy leverage and strong interest coverage have kept default rates, including qualifying LMEs, below the historical average. On the other hand, we are observing rising defaults among smaller issuers, with current rates closer to the historical average (Exhibit 1).

However, traditional defaults have been eclipsed by LMEs in both high yield and leverage loan markets over the last few years (Exhibit 2). One could argue the stage was set for LMEs during the low-rate environment that followed the Global Financial Crisis. Investors traded covenants and lender protections in a frenzied reach for yield. Then in 2022, rates rose quickly, and the prospect of a higher-for-longer backdrop became a real risk, especially for floating-rate borrowers. At-risk issuers sought unconventional approaches to managing their liabilities while avoiding or delaying traditional defaults and the high court costs, slow speeds, and reduced flexibility associated with them.

Behind the Popularity of LMEs

As mentioned above, LMEs can be an alternative to costly traditional Chapter 11 or Chapter 7 court proceedings, which also tend to be lengthy and rigid. LMEs may offer more flexibility through a broader range of out-of-court solutions, and management teams and sponsors typically maintain more control over the potential outcomes. Lastly, by avoiding public bankruptcy filings, issuing companies may minimize reputational risk.

Recovery rates on LMEs may be similar or even higher compared to traditional defaults. However, the potential advantages for sponsors and issuers may come at the expense of certain creditor groups, pitting some creditors against others in what is referred to as “creditor-on-creditor violence.” As key groups wrestle to obtain the best possible terms, other creditor groups may be excluded from negotiations and fare far worse than would be expected in traditional bankruptcy proceedings.

This uncertainty and growing prevalence of LMEs can lead to increased downside in the stressed portion of the high yield and leveraged loan markets. Creditors who lack the scale and/or relationships to get a seat at the table run a high risk of severe dilution and may want to sell at almost any price. Issuers may want lower prices of their loans or bonds to “capture discount”—satisfy 100 cents on the dollar of liabilities for something less than 100 cents while avoiding severe dilution of the equity. Therefore, issuers may withhold information from the market or cast the information in a negative light. While these factors lead to lower prices going into and during an LME, a successful outcome can result in much better trading levels when the LME is concluded.

Can LMEs Be Avoided?

Both issuers and creditors may seek to minimize the occurrence or negative impact of LMEs by following, among others:

1. LME Blockers: Creditors may include contractual provisions in agreements that bar companies from executing LMEs. These often occur at initial issuance.
2. Cooperation Agreements: These agreements are legally binding contracts between two or more groups of creditors. No two “coop” agreements are the same, and some still lead to non-pro rata deals from a slim minority, referred to as “offensive coops.” The strongest coops have large-scale support from creditors and push for pro-rata treatment of members.
3. Enhanced Underwriting: Tighter due diligence may include avoiding privates, especially sponsor-backed deals, or avoiding investing in issues that are owned by creditors who have used aggressive tactics in past deals.
4. Disqualified Lenders Lists: Controlled by the issuer, these lists prevent current debtholders from selling or assigning debt to certain lenders, like aggressive distressed debt shops or litigious, “loan-to-own” lenders. Issuers seek to maintain a friendly creditor group that does not aggressively seek equity. These types of lender groups are willing to collaborate with issuers on out-of-court debt management but not activities that result in equity dilution, in-court-filings, or post-restructuring litigation.

Legal challenges may be pursued post-LME. However, these are both time-consuming and costly.

Obtaining Favorable Outcomes in LMEs

Best practices to help obtain favorable outcomes in LMEs:

1. Conduct rigorous fundamental research and thorough covenant review.
2. Join ad-hoc creditor groups, if applicable.
3. Pursue scale, internally or across firms, to potentially provide a single tranche capital solution. In the event of an LME, larger debt holders typically have more influence.
4. Agree to commit more capital in the restructuring if it makes sense.
5. Sign any coop agreement if the terms are agreeable.
6. Maintain strong relationships with company management, sponsors, legal advisors, and other creditors, especially the steering committee. If possible, be on the steering committee.

The sheer amount of high yield bonds and leveraged loans outstanding and an uncertain interest rate environment make the continued prevalence of LMEs likely. Fundamental research, risk analysis, strong industry relationships, scale, and experience will be increasingly important to stakeholders seeking to obtain favorable outcomes.