The Debtwire Restructuring Forum brought together a wide array of private credit lenders, opportunistic investors, restructuring professionals, financial press and a member of the judiciary to discuss trends from 2023 and predictions for 2024. Here are a few key takeaways from the panels and Freshfields’ discussions at the event.
Significant Decline in Credit Quality
Over the past 24 years, the average recovery rate on defaulted leveraged loans has hovered around 64%. However, over the past 12 months the average recovery rate on defaulted leveraged loans has fallen to just below 40% (as reported, in each case, by JPMorgan). This decline in credit quality has had an impact on the way credit investment decisions are being made by credit funds. In particular, of late there is greater emphasis, particularly in the syndicated market, on reviewing documentation more closely to make investors aware of the risks and unanticipated transactions.
Anecdotally, we at Freshfields have received an increasing number of instructions from our credit fund clients to shadow arranging bank’s designated counsel and/or conduct an independent review prior to participating in the syndication or buying in to a credit.
Liability Management Transactions Are Not a Silver Bullet
Given the high cost of Chapter 11, over the last few years there has been an uptick of liability management transactions that have been implemented to avoid Chapter 11. Notably, panelists at the conference highlighted that approximately 50% of issues that have affected LMEs have still subsequently filed for Chapter 11. This underscores the fact that LMEs are only part of the equation – companies must also have achievable business plans and good management to implement a successful turnaround.
Despite these statistics, from both a sponsor and lender perspective, such transactions are often still worth undertaking given the high cost of Chapter 11 and the potential disruptive impact it can have on companies’ from an operational and reputation perspective.
Attention on Reputational Risks in Liability Management Transactions
Many of the credit fund participants highlighted that the reputational risks of non-pro rata liability management transactions are becoming a larger part of their calculus. As a result, funds increasingly have been more inclined to undertake pro rata transactions that are open to existing lenders, while preserving the ability for the backstopping parties to seek additional backstop fees. However, if on balance the economics outweigh the headline and litigation risks, funds frequently would still opt for a non-pro rata transaction.
Liability Management Transactions May Be Structured to Exclude Certain Categories of Lenders
Although more liability management transactions are open to all lenders on a pro rata basis, certain categories of lenders (such as CLOs) may be precluded due to their own investment parameters. Some of the common issues discussed included an inability to receive equity or non-cash pay interest paper, as well as concentration limits and covenants in their own relevant indenture documents.
While many CLOs are beginning to address these hurdles during the formation stage, lenders driving out-of-court restructurings may be cognizant of this limitation for CLOs and intentionally propose structures that are difficult for such CLOs to participate in because of their structure. Interestingly, the expectation was that a lender unable to participate in a liability management transaction due to its internal investment limitations would be unlikely to succeed in using that limitation to challenge a transaction.
Increase in Double-Dips, Fewer Drop Downs
Data shows that many borrowers that have the covenant flexibility to undertake double-dip transactions under their existing credit documentation are opting for this structure over asset drop downs. From a borrower’s perspective, these transactions (as opposed to asset drop downs) are less disruptive to its day-to-day operations given that they do not require that assets be transferred to different entities and do not eat into investment capacity if subsidiaries holding such assets are designated as unrestricted subsidiaries. From a lender’s perspective, a double-dip transaction ostensibly provides new money creditors with multiple independent claims against the borrower’s capital structure.
The jury, however, is still out as to how a bankruptcy court may view double-dip transactions and whether such multiple bites at the apple would be enforced. Notably, a member of the judiciary mentioned (in their personal capacity) that a key part of the analysis will be considering the general principle that like situated creditors should get like treatment and that they expect increasing challenges from other stakeholders in the bankruptcy estate to the corporate benefit provided in such structure.
Liquidity Will Continue to be a Major Problem for Companies
With today’s higher interest rates, more companies are unsurprisingly struggling with liquidity issues and addbacks for interest expense are becoming a larger and larger portion of EBITDA. The resulting trend is to address such looming liquidity issues earlier rather than later through liability management transactions – and the Freshfields team is increasingly being asked by private credit clients to step in at earlier stages of the distressed lifecycle. And while different sponsors will have different approaches to dealing with their portfolio company’s liquidity issues, basic economics means they will fundamentally prefer liability management transactions which reduce cash interest (and overall debt) burden to putting in fresh equity capital.
Growth of Private Credit is Expected to Continue
As has been widely reported, private credit has exploded over the last few years, with certain reports highlighting that private debt AUM has increased from around $1 Trillion in 2020 to almost $1.5 trillion in 2022 (as reported by AllianceBernstein). What has been less reported on, however, is that given headwinds in the more traditional syndicated underwriting markets, private credit providers are frequently stepping up to take the last few turns of leverage in a deal, including through last out tranches, preferred equity and hybrid debt and equity instruments.
Ultimately, as traditional banking institutions address capital requirements and regulatory scrutiny, private credit has been able to fill a gap in available lending post-financial crisis, particularly due to speed, certainty of funding and operating in different regulatory environments. In addition, these private debt providers have been able to service more high-risk borrowers such as companies in development stages that are not yet ready to go through the rating agency process. Finally, the opportunistic arms of credit-focused asset managers are also rapidly growing by providing new money capital solutions to distressed borrowers where existing investors or lenders are “tapped out,” as these situations provide significant upside from a return perspective.
Private Credit Is Embracing Problem Credits
Many modern private credit funds are emphasizing that they view their investments from a “cradle to grave” perspective as capital partners with the relevant equity holders, rather than with a view towards selling prior to maturity or workout. Based on our own experience at Freshfields, and as highlighted by others in attendance at the conference, private credit funds are often willing to provide additional credit in both growth and downsides scenarios. In this way, they are acting similarly to private equity firms in viewing their investments as portfolio companies rather than passive investments. In fact, many funds at the conference emphasized that they are prepared and incentivized to support a company throughout the restructuring cycle.
This is a notable shift from the “vulture fund” or “loan to own” perception of private credit two decades ago and today private credit firms are distinguishing themselves as more “user friendly” in downside scenarios than ad hoc TLB lender groups in the syndicated market given the diverse, and at times inconsistent, set of objectives of such syndicate members.
A Complex and Dynamic Market
The topics discussed at the Debtwire conference highlight the complexity and constantly changing nature of private credit and the general distressed debt universe. Market participants need to be well versed in these increasingly complicated structures and be willing to be creative in the face of novel or contentious situations. Whether originating a new financing, buying into a syndicated loan facility or addressing (or investing in) underperforming credit, the Freshfields’ fully integrated Private Credit and Capital Solutions team and Restructuring and Capital Solutions team are well equipped to partner with you in navigating this new world to achieve your strategic objectives.
