Buying Time Post-Default with Private Credit

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Among the defaulters that we reviewed, we found several such examples.

One example of a borrower that ran into financial difficulties that led to multiple defaults after it took on too much debt was David’s Bridal.

David’s Bridal filed for bankruptcy in 2018 in a restructuring that erased roughly $400 million in debt from its books and turned ownership over to its lenders. Existing lenders also contributed new debt financing to support the turnaround. However, a subsequent default followed five years later.

David’s Bridal filed for Ch. 11 bankruptcy protection in April 2023, which resulted in a no-cash bankruptcy sale in July put the chain to business development company CION Investment Corporation. Cion’s acquisition included the assumption of certain bankruptcy related liabilities and an investment of $20 million into the business, and enabled the company to avert a total shutdown, with 195 stores (from about 300) remaining open.

Another such example, S&P Global Ratings lowered the issuer credit rating to ‘D’ in April 2019 of telecommunications company Fusion Connect, Inc. after it filed for Ch. 11 bankruptcy. A year earlier, Fusion had borrowed $680 million to fund reverse mergers with Birch Communications Holdings, Inc. and MegaPath Holding Corporation in 2018, but revenue growth post-merger fell well short of projections.

This restructuring wiped $400 million in debt from Fusion’s books and brought a $115 million exit financing loan. It also placed Fusion’s former lenders as its new owners. Despite this restructuring, Fusion continued to struggle. Fusion conducted a subsequent distressed exchange in January 2022, with a debt for equity swap that made Morgan Stanley Private Credit the company’s majority owner.

Fusion’s distressed exchange in 2022 is one example of a trend we’ve observed of the increase in distressed exchanges as a share of defaults. Since 2008, S&P Global Ratings has detected a marked increase in the percentage of distressed exchanges as a share of defaults. Half of defaults in 2022, and over 40% of defaults this year through October, have been distressed exchanges, and this is up from a range of 20%-30% in 2010-2014.

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This matters because a rising share of distressed exchanges may indicate future default pressure. We’ve observed that re-defaulters (or issuers with multiple defaults) were nearly five times more likely after a selective default (such as after a distressed exchange) than after a general default within a 48-month period post-default. S&P Global Ratings found in A Rise In Selective Defaults Presents A Slippery Slope, June 26, 2023, that repeat defaults occurred after about 34.9% of distressed exchanges within a 48-month period.

The growing prevalence of distressed exchanges among defaults could lead to more defaults on the horizon in cases where the borrower’s debt position remains unsustainable following the exchange.

Buying time with private credit

Among the re-defaulters, the time to default between the initial default and the subsequent default can vary substantially. At the long end, a handful of the re-defaulters lasted more than 10 years between defaults, while at the short end, a few borrowers had less than 20 days in between defaults.

In some cases where there is little time between defaults, an initial selective default can be a trigger that leaves the borrower with few alternatives besides a bankruptcy restructuring. One example of this is House of Fraser (UK & Ireland).

The company conducted a distressed exchange on July 30, 2018, that resulted in the withdrawal of an offer by C. Banner to acquire a majority stake in the firm in a deal that would have provided cash equity relief. House of Fraser is one of the defaulters for which we have no record that it received private credit funding, and once C. Banner’s deal was off the table, House of Fraser was left facing heightened liquidity and insolvency risk as it was confronted by a lack of funding options. House of Fraser subsequently entered its operating subsidiaries into administration 11 days later, on Aug. 10, 2018. Through this pre-packaged bankruptcy, it agreed to a sale of the company to Sports Direct (now Frasers Group).

We found a somewhat shorter average time between defaults for re-defaulters with private credit funding than without. This shorter time between defaults could reflect firms with debt structures that are too aggressive or even unsustainable. Among the re-defaulters we observed, the average time between defaults was about 2.2 years for those without private credit, versus about 1.8 years for those with private credit. The median time between defaults was somewhat shorter, closer to 1.1 years for borrowers with private credit versus 1.5 years for those without.

There are a few characteristics of private credit that could contribute to this shorter time between defaults. First, there is the higher concentration of private equity sponsors and leveraged buyouts among private credit borrowers that can correspond with more aggressive financial profiles. Another potential factor is financial maintenance covenants, which are more common among private debt than among broadly syndicated loans. These covenants can serve as an early warning system for a lender that their credit is in trouble, potentially heightening the need to arrange a restructuring sooner rather than later.

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However, even though the time between defaults for re-defaulters with private credit is shorter than for those with no private credit funding, we see variations emerge based on the deal type for the funding that was received.

Re-defaults were less common among those issuers that received private credit for restructuring purposes than among other entities, including those that received private credit for other purposes, as well as those without private credit.

In these cases, the work between borrower and lender to arrange restructuring funding may be able to help put a borrower on stronger footing to weather a difficult period. One example of such a turnaround, Gibson Brands, Inc., manufacturer of some of the world’s best-known electric guitars, turned to private debt after declaring Ch. 11 bankruptcy in May 2018. The restructuring deal allowed lenders to swap debt for equity, which allowed one of the firm’s largest debtholders, KKR & Co., to take control of the company. Gibson exited bankruptcy less than six months after its default in 2018 and has not subsequently defaulted.

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The most pronounced example of this was luxury department store Barney’s New York, which defaulted through a distressed exchange in 2012 that turned control of the firm over to private equity firms Yucaipa Cos. and Perry Capital in a deal that reduced the firm’s debt by over 90%. Barney’s was able to survive for seven more years before it subsequently filed for Ch. 11 Bankruptcy in 2019 and liquidated in 2020.

In the best outcomes, a contribution of new capital for restructuring from the PE sponsor or additional loans from new or existing lenders, helps the borrower meet liquidity and capital needs and gives it some runway to weather the storm until business and economic conditions improve.

During the height of the COVID-19 pandemic in 2020, private credit lenders were willing to make concessions or contribute additional funding to their portfolio companies to allow time for business conditions to improve. As that period wound up being one of the shortest (and steepest) recessions on record, things returned to normalcy very soon.

However, the macroeconomic landscape is changing, with both borrowers and alternative investment managers potentially challenged by higher-for-longer interest rates, coupled with the specter of slowing growth. In such a scenario, private equity firms could find themselves in a position where they need to choose which of their existing portfolio companies to support. For the private credit lenders, they may have to grant more concessions; we are already seeing more instances of either push back of maturities and classes deferring interest.

That said, plenty of private credit dry powder remains on the sidelines.

Private credit dry powder may provide a source of funding for struggling borrowers

Dry powder available for private credit lending has swelled as investors have increased allocations to private credit funds. While this dry powder serves as a source of funding for new deals and new investments, private credit funds may also hold some of this in reserve for reinvestment in struggling portfolio companies. Private credit firms currently have more than $400 billion in dry powder according to PreqinPro. Of this, $150 billion is earmarked for distressed investments and special situations, providing lenders with a war chest to hunt for opportunities or support challenged portfolio companies should credit conditions weaken.