The LME Wave

Summary

• A surge in liability management exercises (LMEs) is driven by weak credit documentation, elevated debt costs, impending maturities, & resourceful sponsors seeking to create equity value.
• LMEs generally encompass actions taken by troubled borrowers to restructure debt obligations outside of court or raise money through unconventional means to address liquidity needs.
• Executing an LME can generate runway to avoid or postpone a full default but may lead to divergent outcomes for investors holding the same instrument.
• Over 90% of senior loans are now issued with no meaningful covenants due to documentation standards deteriorating during the era of ultra-low interest rates.
• Weak documentation allows borrowers to issue new debt senior to existing debt & pit creditors against each other to obtain concessions.
• Historic increases in interest rates in 2022 served as a significant catalyst, with the average senior loan coupon rising to 8.9% since the start of 2023 from less than 5% in 2020.
• LMEs represent over half of all defaults as borrowers prefer them over formal bankruptcy processes which are expensive & typically result in a change-of-control transaction.
• Prominent forms of LMEs include uptiers where new debt is issued senior to existing debt, drop-downs where collateral is moved to unrestricted subsidiaries, & double-dips where lenders establish multiple independent claims.
• Participation awards offer better terms to lenders who support the new transaction, while non-participating lenders are often left with subordinated claims.
• LMEs often lead to the formation of creditor groups consisting of a steering committee, ad-hoc lenders, & non-participating lenders with varying economic outcomes.
• Aggregate recovery rates are lower for issuers that undergo an LME compared to those that do not, with non-participating lenders facing far worse recoveries in bankruptcy.
• Defense mechanisms against LMEs include blockers incorporated into credit documents & cooperation agreements that unite creditors to prevent non-pro-rata outcomes.
• LMEs have been mostly limited to public credit, though private credit documentation standards are eroding with less than 10% of loans above $500 million having maintenance covenants.
• An increasing portion of private loans are switching from cash-pay to payment-in-kind (PIK), which may provide stressed borrowers with a brief respite but is unlikely to solve fundamental overleveraged capital structure problems.
• LMEs are expected to continue at pace due to elevated interest rates, weak loan documentation, & private equity sponsors keen to avoid painful restructurings.
• Treasury yields rose by nearly 80 basis points in the fourth quarter as market expectations regarding interest rate cuts proved overly ambitious.
• The 10-year Treasury yield ended the fourth quarter 33 basis points above the 2-year yield, reflecting concerns about the sustainability of the U.S. national deficit & stubborn inflation.
• In the UK, the 10-year gilt yield reached its highest level since the Global Financial Crisis driven by worries about sticky inflation & elevated deficits.