Tracking the Evolution of Liability Management Exercises
Liability Management Exercises are under increased scrutiny as recent rulings by federal and state courts have reshaped the boundaries of permissible transactions structures.1
LMEs executed by Better Health Group in January and Oregon Tool Inc. in February demonstrate that lenders, sponsors and borrowers are not slowing when it comes down to executing nonpro rata deals. They also highlight the embedded flexibility within many credit documents in order to reshape capital structures. These LMEs used extend-and exchange strategies to achieve nonpro rata results while side-stepping open market purchase concerns raised by Excluded Lenders v. Serta Simmons Bedding LLC which was decided on December 31 by the U.S. Court of Appeals Fifth Circuit. The rise of private credit financing has also changed the dynamics of LMEs as alternative capital sources bring new covenant constraints and strategic concerns. These developments demonstrate the changing nature of LMEs within the U.S. They are shaped by litigation, judicial interpretation and market pressures as much as by the creativity of lenders, borrowers or sponsors. Understanding this history helps explain why the playbook is constantly evolving — and the next move can be reached by just one ruling or transaction. Many have spoken about the current state and importance of LMEs. These are highly complex, highly negotiated transactions which allow a borrower, in cases where conventional refinancings are not possible, to restructure its outstanding debt obligations or refinance them. In recent years, LMEs, which are highly negotiated and complex transactions, have become more sophisticated. They also tend to be controversial as borrowers try to find creative ways of avoiding a court-ordered restructuring within the limits of their existing debt documents. LMEs have been around for decades, despite their recent proliferation.
We take a look below at the various forms of liability management in decades past, and track its evolution into its current form to predict how the next development might take shape.
Liability Management Eras
The Early Years
The 1980s and 1990s were characterized by financial instability stemming from the savings and loan crisis, high interest rates and deregulation, alongside a surge in high-yield bond activity and leveraged buyouts spurred by the creation of the junk bond market a decade earlier. As distressed companies looked for ways to manage their leverage, LMEs began to take shape in the form of exchange offers and consent requests that were designed to lower principal or extend maturities, or modify interest rates. Such structures led to the emergence of case law in the area of liability management. For example, the Delaware Court of Chancery ruling in Katz v. Oak Industries in 1986, which approved the use of exit agreements in exchange offers or consent solicitations, despite the coercive effect of this technique. In the 2000s, LMEs were at the forefront of the market as borrowers struggled to manage unsustainable debt loads. During the financial crisis, borrowers continued to use structured swaps and so-called “amend-and extends” to increase liquidity and to extend runway. This was done to avoid the disruptions and expenses of Chapter 11 and to extend runway.
Flexible terms and covenant-lite covenants were widely used in bond debt and credit facility agreements, giving borrowers greater flexibility to restructure their outstanding debt obligations. Out-of court restructurings became more popular as an alternative to filing Chapter 11 and paved the way for a more aggressive liability management approach.
Leveling up
Beginning the 2010s, LMEs’ landscape changed forever. Borrowers began to take advantage of historically low interest rates by refinancing their outstanding debt.
Long periods of low interest rates led to intense competition among lenders, resulting in unprecedented borrower-friendly documents with weaker protections for creditors. These terms collectively led to loosened covenants, new technology, and a greater flexibility for distressed borrowers in order to find creative capital solutions. These solutions are represented today by three transaction types – or a combination of them – dropdowns uptiers, and double dips.
Dropdowns can be structured so that the borrower is able to move material assets into a nonguarantor-restricted or unrestricted subordinate, removing the assets from the collateral package. After this initial step those assets are used to support new, structurally-senior debt, i.e. debt that has a greater priority in repayment based on its position within the firm’s capital structure rather than explicit contractual juniority.
Dropdowns have the unique feature that they do not require creditor approval as long as the borrower is able to find third-party sources of capital willing to provide new debt, and the dropdown fits within the existing covenant package. Crew Group Inc. implemented the dropdown transaction in 2016 by transferring intellectual property assets from a restricted subsidiary to an unrestricted one, which then used these newly acquired assets as collateral for new financing. J. Crew transferred the assets outside of the creditor group using flexible investment baskets, despite the fact that the IP transferred would no longer benefit existing creditors. Uptiers are a two-step transaction where a majority of participating existing creditor amends their debt documents in order to subordinate existing collateral to new superpriority debt and then exchanges their subordinated loan for the new debt. This can be done within the same agreement, as a sidecar with intercreditor agreements, or more synthetically by pairing the dropdown described above. Serta executed a two-step uptier transaction in 2020 with the consent of both of its creditor groups. It amended its existing credit agreements, modifying lien priorities, and allowed participating creditors to exchange their subordinated debt for new superpriority bonds.
Boardriders, Incora and other notable uptiers followed Serta in 2020 and 2023. Nonparticipating creditors contested each of these transactions on different grounds. We continue to see nonpro rata uptiering in the market. Double-dips are structured deals that allow distressed borrowers raise new capital by leveraging their current capital structure to enhance collateral coverage. In these deals, the borrower, usually an unrestricted company, incurs a new debt, which is secured by the assets of the group and guaranteed by them. This is the first dip. The borrower uses the proceeds of the intercompany loan to fund a loan to the existing group. For example, to buy back the existing debt at a discount. This creates a receivable that is pledged as collateral to the lenders. This gives the new lender a second claim on the group in addition to the “exclusive collateral” and improves their position with respect to other creditors. In 2023, many distressed borrowers, such as At Home Group Inc. and Trinseo, executed double-dip transactions. This shows the increasing adoption of this liability management technique. The Next Era
It is important to note that these three categories of LMEs do not have to be mutually exclusive. This means that some deal structures can combine elements from each. We have seen some transactions move toward a collaborative approach. However, we also see LMEs continue to push the boundaries and use new technologies.
We also begin to see the increasing influence of private credit market on traditional lending structures as alternative sources of funding become available to borrowers. Private credit solutions could also come with tighter covenants, less flexibility in the debt documentation that can be leveraged to mitigate negative scenarios. They may also include smaller groups of lenders less interested in dynamics between in-group and out-group as repeat players.
LMEs are likely to continue to evolve and adapt to the market conditions, as well as the results of recent litigation. However, it is clear that when faced with distressed conditions, borrowers will have to consider these solutions or even more creative options. We expect to continue to see LMEs, both with existing creditors and also leveraging the potential for a loan away with lenders who are not currently on the capital stack.
