An analysis of how weak covenant protections have paved the way for distressed exchanges, and the best defences for lenders. The image above is how I imagine lenders look when they get back par...
Distressed exchanges have comprised over half of defaults since YE19, according to a recent report from Barclays. Noting that weaker investor protections and increasingly onerous bankruptcies have permanently changed the default landscape, the authors reviewed 24 liability management exercises since 2017 ex-post. In this blog, I highlight some of the market dynamics and covenant provisions that facilitated the LMEs reviewed in the report and describe how lenders can effectively position themselves against these tactics.
Weaker protections and absence of maintenance covenants facilitate borrower triage
There are no longer many early warning signs of borrower distress – maintenance covenants once served this function, but these are absent from almost all broadly syndicated leveraged loans on both sides of the Atlantic. On top of this, flexibility in terms facilitates balance sheet restructurings outside of a formal process, referred to as liability management exercises, or LMEs. The search for capital deployment opportunities and availability of attractive assets for collateral has attracted third-party lenders, complicating the picture for existing lenders.
Cost and uncertainty of outcomes causes bankruptcy hesitation
The rising costs of formal insolvency processes in the US,which have soared according to Barclays data, has incentivized borrowers to getcreative about out of court solutions. It’s very likely that costs relating to European processes would be in line with those numbers, if not higher given the multi-jurisdictional nature of many capital structures.
Up-tier, drop-down, double dip, doesn’t matter…as long as it’s first lien
The sheer number of varieties of LMEs can be overwhelming for lenders. Broadly, these fall into three main categories:
Using capacity within the Restricted Group: Borrowers can use unencumbered assets (those not currently pledged to other lenders) or provide coveted first-lien collateral to entice subordinated lenders to agreeto new debt terms.
Using capacity to transfer assets outside of the Restricted Group: This requires an analysis of the borrower’s capacity for investments in Unrestricted Subsidiaries, which can be sourced from the Restricted Payments covenant (aggregating the builder basket and Permitted Payment carveouts) and the Permitted Investments definition.
Agreeing with a sub-set of lenders to amend terms to accommodate the LME: The uptier priming transaction typically falls intothis category. An analysis of the amendment and pro-rata provisions is key.
Detrimental LMEs and creditor-on-creditor violence expected to persist
Barclays note in their report that they expect LMEs to become more contentious, in part because documentation remains loose. Further, they highlight that despite the rise of co-op agreements, lender-on-lender aggression will likely continue. Meanwhile, private equity sponsors are incentivized for a range of reasons to maximize covenant flexibility to capturea discount on existing debt.
Recovery rates are not what they used to be
Probably the most surprising findings in the report is the upending of the capital structure in terms of recoveries. Senior instruments do not always perform better than subordinated, and nearer-term maturities don’t always do better than later dated paper. This complicates the analysis significantly, not only for existing debt, but also when making investment decisions in new debt instruments.
Terms have evolved – now the market must adapt
Documentation is not getting tighter anytime soon, and US LME tactics are beginning to make their way into Europe. Now is the time formarket participants to upskill on legal documentation – which is exactly what Fox Legal Training was founded to support.
Shortly we will launch a new course offering specifically designed for the market’s new dynamics – Introduction to Stressed & Distressed Investing.
The new course highlights:
- how to tell when a lender isstressed or distressed
- how to assess documentation impacton recoveries and restructurings, including liability management
- the key features of UK and French insolvency regimes
- how to think about valuation to model recoveries, using a detailed case study
Upon completion, lenders will understand:
- how to protect their position via structuring features
- how to use the documentation effectively
- how to assess risks in legal documentation objectively
- how to spot trends and understand their impacts on risks
The full course outline is available here. Now is a great time to sign up with Fox Legal Training – in addition to the market headwinds, we are running our best ever hybrid learning Back to School offer. Click here to find out more.
Fox Legal Training – Upskill your team to sidestep the downside.
- Sabrina Fox