High interest rates and circumspect capital markets have caused borrowing costs to rise. This has made it much more challenging for companies with impending maturities to refinance debt that they had raised at ultra-low prices a few years ago.
During these harsh conditions, liability management transactions (LMTs), in which borrowers rework their capital structures without unanimous creditor support, have allowed companies to extend debt maturities and secure liquidity in tough markets.
Though LMTs were once considered a “last gasp” option for companies in deep distress to stave off bankruptcy, the market’s perception of LMTs is changing. Increasingly, lenders and borrowers recognize that, when used appropriately, an LMT can help borrowers weather challenging credit environments by extending maturity profiles and/or securing additional debt capital.
Wide range of options
LMTs provide borrowers with various options to manage liabilities without having to enter restructuring or bankruptcy proceedings. These options can be divided between two main categories: “self-help” and “lender consent.” In “self-help” LMTs, companies can bring in new creditors or reshape capital structures without having to approach lenders and secure their consent. In “lender consent” LMTs, borrowers must secure the support of a certain percentage of lenders (usually a simple majority) in order to amend loan terms.
One example of a self-help LMT is a “drop-down” transaction, where existing flexibility in loan terms is used to move valuable assets outside the reach of existing creditors using vehicles known as “unrestricted subsidiaries.” These subsidiaries can then use those assets as collateral security for new debt.
Another example of a self-help LMT is a so-called “Chewy” transaction, which involved a deal concerning PetSmart and its subsidiary, Chewy—the best-known example of a self-help LMT. These LMTs rely on loan documents that feature (i) the concept of “excluded subsidiaries,” meaning subsidiaries of the borrower that are not required to provide guarantees or pledge collateral in support of the loan and (ii) provisions that provide for the automatic release of guarantees and liens over assets pledged by a subsidiary if it becomes an excluded subsidiary.
Generally, subsidiaries that are not wholly owned will be considered excluded subsidiaries. In a Chewy transaction, the borrower will dispose of a small portion of the equity of a subsidiary with valuable assets, such that it qualifies as an excluded subsidiary and triggers an automatic release of the subsidiary from its guarantee and security obligations. Depending on the terms of the loan document, the released subsidiary may be able to incur new debt secured by those assets or realize value by selling or otherwise disposing of the assets.
Some borrowers have also used “double dip” LMTs, which can be structured as a standalone transaction or combined with the types of asset transfers described above. In a “double dip” LMT, a non-guarantor subsidiary (for example, unrestricted or excluded subsidiaries) will incur new debt. If there is sufficient flexibility in the primary borrower group’s existing debt documents, the non-guarantor subsidiary may (i) obtain credit support for the new debt (i.e. guarantees and collateral pledges) from its affiliates in the primary borrower group and (ii) lend the proceeds from the new debt to those affiliates through an intercompany loan that is secured by their assets, in each case, on a pari passu basis with the primary borrower group’s existing debt.
Through this structure, the new lenders have two possible, overlapping paths to recovery from the primary borrower group without running afoul of any restrictions on incurring debt obligations that prime the existing lenders: (i) directly, through the guarantees and pledges provided by that group, and (ii) indirectly, through a pledge of the secured intercompany note held by the non-guarantor subsidiary.
Creditor versus creditor
Many existing debt documents are flexible enough to allow companies to bring in new capital using these LMT options without securing the consent of existing lenders. However, in some cases, lenders and investors have introduced “blocker” provisions in debt documents to limit a borrower’s ability to pursue LMTs without securing the backing of creditors.
In those instances, borrowers have had to turn to “lender consent” LMTs (typically, where support from a majority of the creditors is required) to achieve their financing goals.
In these deals, borrowers aim to offer “super-priority” ranking for incoming lenders, placing them at the top of the capital structure, ahead of incumbent debt holders. In these “uptier” transactions, companies will usually create a separate facility outside of the existing debt arrangements, with consent from the necessary percentage of existing lenders. The lenders who have agreed to provide the new loans will typically agree to exchange some or all of their loans under the existing facility for loans under the new facility, at a borrower-favorable discount. Therefore, if the minimum required consent threshold is reached, the consenting lenders are rewarded with a higher priority ranking in return for providing the borrower with a discounted debt exchange, while the lenders who do not consent to the new deal are left with subordinated claims.
These lender consent deals come in two forms: an open exchange or a closed exchange. In the former, the offer is made available to all lenders, albeit not necessarily on the same terms. In the latter, the borrower will work with only enough lenders to reach the necessary consent threshold and not let anyone else in on the transaction.
Because these lender consent LMTs usually result in certain lenders achieving a better position to the detriment of other lenders, they have been a source of controversy.
For lenders that are included, the structures can be positive, allowing them to obtain preferential terms, benefit from priority status on the new loans and put more capital to work.
The drawback, however, is that non-consensual LMTs can spur high-profile litigation filed by lenders who were excluded from the benefits conferred to the handpicked creditor groups brought into the deal. Recent examples of LMTs that have been publicly challenged in the courts include Serta Simmons, Wesco and Mitel.
Runway to rebound
Instances of high-profile litigation have led some to argue that “lender consent” LMTs are a catalyst for “creditor-on-creditor violence.” Of course, the particular circumstances of each transaction will dictate how certain groups of lenders might feel.
Context is crucial to how LMTs will be received by creditors. In a tough economic environment where an LMT can hand a company a liquidity lifeline and a runway to rebound, lenders may be less hostile. But if an LMT is being pursued by a healthy borrower to get another strategic transaction off the ground or take advantage of an opportunity to realize a discount, incumbent creditors may be more inclined to resist.
Finding the right balance between being open with all creditors, but also moving a deal forward in good time, is challenging for borrowers.
Strategic borrowers might first identify one or two large creditors that will support the deal, and then work through the loan register to find enough creditors to build on their initial cornerstone to reach the required support threshold. Once sufficient support has been secured, borrowers have more flexibility to inform the other lenders about the deal (though being mindful of any risk of lenders seeking to block the transactions before it closes) and consider opportunities for their participation (in the case of an open exchange) or other potential negotiated outcomes.
Working through these phases does involve tactical decision-making and some degree of gamesmanship as lenders and borrowers try to gauge whether there is sufficient support for a given LMT. However, in circumstances where companies can be open about the LMT options they are exploring and why they may be required, LMTs are more likely to garner lender support.
“Creditor-on-creditor violence” may grab headlines when it comes to LMTs, but the market is much more nuanced. When LMTs are structured appropriately and entered into for sound reasons, positive outcomes can be secured for all parties.