Not Getting Better All The Time

Companies facing financial distress increasingly elect to improve their liability structure or liquidity by offering creditors less than what was originally promised. We believe companies often choose out-of-court restructurings, which are more likely to preserve the equity stake held by private equity owners and their control of the company. Despite the attractions for existing owners, our research shows this incremental approach is frequently insufficient to fix the larger problems facing the company: based on a survey of companies that have experienced a selective default, further defaults occur about 37% of the time.

For six of the last eight years, selective defaults--the majority of which were distressed exchanges--have been the leading cause of overall U.S. and Canadian defaults in entities covered by S&P Global Ratings. Distressed exchanges, which constituted 28% of defaults in 2013, jumped to 46% of overall defaults in 2020 and 60% of defaults so far in 2021. As selective defaults have increased, so have multiple defaulters, with some issuers defaulting up to five times since 2013 (see chart 1).

Chart 1

In Or Out? Chapter 11 Bankruptcy Versus Out-Of-Court Restructuring

To address their unsustainable capital structure, distressed companies can work with their lenders out of court or file for protection under Chapter 11 in the Federal Bankruptcy Code. There are many reasons an issuer may prefer to restructure out of bankruptcy court, including time, cost, and keeping control of the company. Although the average time in bankruptcy has dropped considerably in the last few years (likely because of the rise prepackaged bankruptcies), it is still longer and more expensive compared to an out-of-court restructuring. The average time spent in bankruptcy for companies that exited before 2020 was over eight months (see "From Crisis To Crisis: A Lookback At Actual Recoveries And Recovery Ratings From The Great Recession To The Pandemic," Oct. 8, 2020). There are other reasons to avoid a bankruptcy, such as worse publicity or reputational damage, fewer parties to negotiate with, and more clarity and certainty around the outcome.

What Is "Out-Of-Court" Restructuring?

As the name suggests, an out-of-court restructuring is one where a distressed company would negotiate with its investors instead of filing for bankruptcy to address liquidity or solvency needs. We consider these forms of out-of-court restructurings for distressed entities to be a default (absent adequate offsetting compensation) on the original promise to pay.

Distressed exchange of principal

This is perhaps the most common form of out-of-court restructuring and could involve bonds or loans. In a distressed exchange, the lenders allow the company to relinquish its payment obligation on a portion of its existing debt in exchange for a less than par amount of consideration: cash, new debt, equity, or a combination of these. Based on our default data for 2020, there were 50 distressed exchanges in the U.S. and Canada during 2020.

Changes in interest or maturity

Selective default may also occur as a result of distressed borrowers negotiating for flexibility in their current terms of payment with the lenders without adequate offsetting measures. Typical examples that result in selective default are reducing interest payments, converting cash interest to payment-in-kind (PIK), or extending debt maturity. These changes require 100% consent from the noteholders. During the peak of the COVID-19 pandemic in the first half of 2020, we saw many middle market companies get full approval for changes to their terms of payment from their smaller lender groups to address critical liquidity needs.

The Rating Impact Of Bankruptcies And Out-Of-Court Restructuring

We rate on the original promise to pay on debt obligations. We therefore view in-court and out-of-court restructurings as forms of default.

We lower the issuer credit rating to 'D' if the default is a general default on debt (a bankruptcy filing or general restructuring) or 'SD' if a company experiences a "selective default"--that is, the company defaults on some of its debt obligations (for which those issue ratings are then set to 'D'), but is expected to remain current on other debt issues.

There are two factors for a transaction to be a considered a distressed exchange:

• The issuer is distressed, meaning a conventional default for the company is likely over the near to medium term; and,
• The transaction on the affected securities offers debtholders less than the original promise without adequate offsetting compensation.

A selective default also occurs if there are changes in the terms of payments without adequate offsetting compensation. The exact amount of compensation required to be considered "adequate" depends on the severity of the situation, including a company's proximity to a conventional default and what its options are. For example, an entity rated 'B-' would ordinarily need less compensation for a maturity extension than one rated 'CCC-', given the level of default risk implied by the rating.

For an issuer, a distressed exchange may be a good way to avoid or postpone bankruptcy, improve liquidity, reduce debt and cash interest, or extend its maturities.

Selective Defaults Are On The Rise

About 43% of all defaults S&P has tracked since 2013 have been selective defaults, and the percentage of selective defaults has been increasing since the global financial crisis--partly, we believe, because a selective default does not significantly impact equity ownership, if at all. The number of selective defaults spiked during the 2015-2016 oil and gas crisis where energy issuers engaged in distressed exchanges and avoided bankruptcy. The percentage of selective defaults in the U.S. and Canada increased to 46% in 2016 from just 28% in 2013 (see chart 2).

For a general default, we tend to rate issuers 'CCC' before we lower our ratings on them to 'D'. However, we tend to lower the ratings on many entities to 'SD' from 'CC'. The 'CC' rating indicates a virtual default--likely the distressed exchange or event has been announced and we lowered the entity's rating accordingly to 'CC,' indicating a virtual default, before lowering it again to 'SD' (see chart 3).

Chart 2

Chart 3

Sector Breakdown Of Defaults

The forest products and building materials and technology sectors have reported the greatest percent of selective defaults since 2013 at 75% and 53%, respectively. However, the absolute number of defaults in these sectors has been relatively low over the last decade. Leading the way on all types of defaults, the energy and consumer/retail sectors have had the largest number of defaults in the region, and over 40% were selective defaults.

Chart 4

How Effective Are Out-Of-Court Restructuring Mechanisms?

Although the appeal of an out-of-court restructuring has increased the number of selective defaults, recidivism is an issue for many of those entities. This raises questions around the efficacy of their out-of-court restructurings.

Based on our data on defaults (see chart 1), 208 U.S. and Canadian companies experienced a selective default since 2013. Of these 208 entities, 76 entities (37%) experienced another default either by way of another out-of-court restructuring ('SD') or a general default or bankruptcy ('D'). The odds of these companies experiencing a third default was 22%.

On average, the companies that restructured twice had 614 days (20.2 months) between their two out-of-court restructurings, while in the second category the average time between an out-of-court restructuring ('SD') and a conventional second default was 555 days (18.2 months). The timing between defaults also provides a view on the effectiveness of a restructuring (whether the company was able to avoid bankruptcy or stabilize the capital structure). However, on average the time between defaults does not necessarily increase with each subsequent default.

For example, oil and gas producer Chesapeake Energy Corp. originally defaulted on May 13, 2016, and has since defaulted four times. Chesapeake's first four defaults were distressed exchanges; with each default, the issuer looked to reduce debt and improve liquidity. Each time, Chesapeake Energy was able to improve its financial metrics enough to extend the time between the next default from only 27 days between the first and second defaults to nearly three years between the third and fourth defaults (see table 1).

Table 1

There are several issuers that have had more than one selective default but have managed to avoid a general default or bankruptcy, such as U.S. health care operator Community Health Systems Inc. The issuer has experienced three selective defaults since 2018, with an average time between defaults of 449 days (nearly 15 months). We currently rate Community Health 'CCC+' with a stable outlook, and it has been 138 days since its last distressed exchange.

Recent Default Experience Due To The Coronavirus Recession

In 2020, U.S. and Canadian defaults rose to 145, their highest number since 2009. Defaults jumped as the number of COVID-19 cases in the region spiked and governments began to enforce strict social distancing measures. The largest number of defaults in these early pandemic-impacted months were due to bankruptcy or missed interest payments as the economy nosedived into recession.

By June, financing conditions became far more accommodative as the U.S. government and the Federal Reserve stepped in to support financial markets, slowing the rapid pace of defaults. By fourth-quarter 2020, traditional defaults decreased, and distressed exchanges increased. Nearly 70% of defaults in fourth-quarter 2020 were distressed exchanges (all but two of which were selective defaults), compared to only 30% in the second quarter (see chart 5).

Chart 5

Many issuers heavily impacted by the recession were in sectors that were already stumbling before the pandemic, including parts of retail. Beauty and personal care supplier Revlon Inc. had been on the decline since 2016. Mandates to control the spread of the virus then caused consumer spending to plummet, exacerbating Revlon's ability to restore declining sales trends. As market conditions improved just a few months in, Revlon was able to negotiate two distressed exchanges--one in June 2020 and the second in November 2020. We currently rate Revlon 'CCC-' with a negative outlook, reflecting our view of the company's unsustainable capital structure and heavy debt service burden, and our belief that Revlon could default on its debt obligations in upcoming quarters (see "Revlon Inc. Upgraded To 'CCC-' From 'SD' On Completion Of Distressed Debt Exchange; Outlook Negative", Dec. 8, 2020).

The Time Between Defaults In 2020 Accelerated For Repeat Defaulters

Multiple defaulters were likely to default sooner in 2020 than had historically been observed. For example, the average time between second and third defaults dropped more than a year, to 458 days in 2020 compared to 849 in 2019. The average time between third and fourth defaults also dropped to 379 days in 2020 compared to 833 in 2019. This shows us that in times of market stress, issuers that were highly leveraged despite previous attempts at restructuring were no longer able to hold off a subsequent distressed exchange, or in some cases, more traditional forms of default such as a missed interest payment or bankruptcy (see chart 6).

So far in 2021, the number of defaults in the region has begun to slow compared to the elevated numbers seen in 2020. There have been just 16 defaults so far in 2021, 56% of which were selective defaults (see chart 7). We expect the U.S. trailing-12-month speculative-grade corporate default rate to fall to 5.5% by December 2021 (see "U.S. Speculative-Grade Corporate Default Rate Forecast For Year-End 2021 Falls To 5.5%", March 30, 2021).

Chart 6

Chart 7

Table 2