Twenty-twenty was a year of extraordinary measures. Many companies, facing unprecedented uncertainty and precipitous drops in revenue needed solutions to solve sudden, and often dire, liquidity issues. To improve their liquidity positions, several companies used aggressive--and controversial--tactics to raise new capital. This included collateral transfers (also known as "asset drop-down transactions") that allowed companies to raise cash secured by first liens on the transferred assets and "uptiering priming loans," that allowed them to secure new funds with superpriority liens against all loan collateral.

Loan investors are largely familiar with collateral transfers following the J. Crew Group Inc. and PetSmart LLC transactions in 2017 and 2018, respectively (see the Related Research section for more of our articles on this topic). Uptiering priming loan transactions were less known before last year, even though a couple of these transactions were completed previously (e.g., Not Your Daughter's Jeans [not rated] in late 2017, and Murray Energy Corp. in mid-2019). Both tactics can significantly damage recovery prospects for existing lenders and illustrate the lengths that companies (and private equity sponsors) will go when under duress.

Although these transactions have slowed since the second and third quarters of 2020, they are both likely to remain options for distressed borrowers. For one, they worked, and it is widely believed that most credit agreements have the flexibility to enable contractual priming transactions (like those we address here) to be completed. With that in mind, we explore the dynamics of recent priming loan transactions, and start by comparing recent uptier loan exchanges to collateral transfers to highlight their impact on recovery expectations and credit risk for lenders.

Uptier Loan Exchanges Versus Collateral Transfers

What we found with uptier loan exchanges is that in addition to moving participating lenders to the absolute front of the line in the capital stack, these transactions, on average, put more debt ahead of the already existing and newly subordinated debt. The bulk of the priming debt, however, stems from the cashless exchange--or roll up--of existing loan exposure by participating lenders rather than from the new capital provided, which is comparatively modest. So far, uptier cashless loan exchanges have compromised the recovery prospects for existing secured loans more severely than collateral transfer transactions. A sampling of the major asset drop-down transactions over the past few years, shows the average debt put ahead of the original first lender works out to about 21% of the new loan structure (see table 1). For a similar sampling of the major uptier loan exchanges over the past few years, the priming percentage is higher, more than double, at 46% (see table 2). Viewing the data from another angle, the amount of priming debt exceeded 50% of the post-exchange total loan exposure in four of the seven priming loan transactions but only in one of seven collateral transfer transactions.

Table 1

Table 2

The most apparent consequence is the disparity in recovery expectations for the primed debt after an uptier priming loan transaction versus a collateral transfer. The difference in recovery expectations between winners and losers is much more stark with uptier loan exchanges. And what we have seen in these transactions so far is that the rolled-up portion--being the impetus for increased recovery prospects for lenders participating in the exchange--is usually larger and more damaging to nonparticipating lenders. GTT Communications Inc. and Renfro Corp., a double-dipping priming borrower, are the exceptions (see the "Outliers--Nearly Full Participation" section for a recap of the Renfro deal).

An Illustrative Example: How Priming Roll Up Tranches Impair Recoveries

For now, to illuminate our point, consider a transaction where a borrower with a $1 billion outstanding first-lien term loan and a recovery point estimate of 50% ($500 million enterprise value in a default scenario, which does not change) borrows an additional $200 million (new money) in priming term loan, and 51% of the lenders agree to roll up $300 million of their share of the original $1 billion ($510 million) into the priming position at par. The participating lenders on the new priming debt would likely expect a full recovery on that priming debt after a default. The remaining $210 million of debt ($510 million less $300 million) from the original loan owed to the participating lenders not rolled up would see a negligible recovery, bringing their average recovery down to 67%. The nonparticipating lenders on the remaining debt ($490 million) will likely also recover a negligible amount. However, if we were to remove the rolled-up portion of that hypothetical transaction, recovery prospects for the original loan improves to approximately 30% (see chart 1). The chart shows how the recovery prospects change for participating and nonparticipating lenders in the same hypothetical uptier exchange scenario explained above. The rollup amount decreases from the original $300 million to zero.

Chart 1 

The recent priming loan transactions we've seen so far have been put together by groups representing far less than all of the lenders on the original loan, because the requirement to make the requisite amendments to the credit agreements to allow for priming is typically a simple majority of lenders by amount. And as demonstrated, recovery prospects for participants and nonparticipants change according to rollup size. Below, we use the same hypothetical from before ($1 billion original loan; $200 million new money priming loan; constant $500 million distressed enterprise value; 1:1 par rollup exchange; 51% participation) to take a closer look at the mechanics of the transfer of value (see chart 2).

Chart 2 

From this perspective, we can see again how important the rollup is to the increased recovery prospects for the participating lenders. These charts also show how the increased recovery prospects for participating lenders comes at the expense of nonparticipating lenders. This is the other key to these transactions.

At The Expense Of Nonparticipating Lenders

All but one of the uptier loan exchanges we looked at was executed at par, meaning existing debt was exchanged for new debt without any discounts on the existing debt, even though all of these loans were trading at significant discounts at the time of the transaction. This further explains the increased weighted average recovery prospects that most of the participating lenders on these transactions saw. They received a better-than-market price for the existing loan and were able to solidify that new value by placing the new loan in a priority position.

Serta Simmons Bedding LLC was the exception. In its deal, first-lien lenders exchanged at a discount of 26%, meaning these lenders needed to exchange $1.35 of the existing loan to get $1 of the rolled up priming loan. Likewise, second-lien lenders exchanged at a discount of 61% into the same rolled-up priming loan (second out to $200 million in new money). After the participating lenders exchanged approximately $992 million of first-lien loans and $300 million in second-lien loans, together they instantly realized a loss of approximately $441 million because of the discounted rate (first lien: $258; second lien: $183)--a sum they would have to make up on the rest of the transaction. The losses incurred by the participating lenders through the exchange discount benefits the borrower by reducing its debt burden and could benefit the nonparticipating lenders if this helps the company avoid an eventual default.

However, if the company eventually defaults, then we estimate the nonparticipating and/or excluded lenders will receive a negligible recovery of 5% after the transaction compared with our previous estimate of a 55% recovery (based on the rounded recovery estimates that are part of our recovery ratings). On a dollar basis, this reflects a reduction in recovery given default of nearly $450 million ($895 million in exposure times the 50% reduction in estimated recovery). Conversely, we estimate participating lenders would receive a full recovery on the $200 million in new capital provided and a recovery on their existing (rolled up) loan exposure of 95%. On a dollar basis, this represents a net gain in recovery given default of about $262 million (see table 3).

Table 3

The nonparticipating lenders were the source of the increased recovery prospects that participating lenders saw. Thus, the Serta transaction and most other uptier loan exchanges can be viewed as "recovery transfers," whereby participating lenders modify loose credit agreements (perhaps with a simple majority of 51% of lenders by amount) to allow for priming loans that reset the waterfall and put participating lenders in position to receive most, if not all, of the borrower's value in bankruptcy, while nonparticipating lenders (who were pari passu pre-modification) receive little to no value from the borrower in bankruptcy.

That $262 million in additional recovery from the rollup is coming directly from the diminished recovery nonparticipating lenders will receive. The recovery or no recovery line moved from a first-lien versus second-lien split to a participating lender versus nonparticipating lender split (see tables 4).

Table 4

Outliers--Nearly Full Participation

One interesting case has sidestepped much of the significant damage to nonparticipating lenders. Renfro, the North Carolina-based sock manufacturer, took a different approach in its first and second priming transactions. The company received near unanimous consent in its priming transactions from the lenders to borrow additional priming funds--the second priming loan tranche was a delayed-draw facility that primed the original priming loan. The motivation for the Renfro transactions appears to be the desire to provide liquidity to help the company avoid an imminent bankruptcy filing.

Each transaction involved new money and a rollup portion in the priming tranche, albeit a modest rollup. This is most likely because with most lenders participating, there is no real priming taking place. Since there was near universal participation among the lenders, the recovery prospects for all lenders on their existing debt declined somewhat. Is this what the uptier cashless loan exchange looks like when it's offered to all lenders? Perhaps a fear of missing out played a part for some lenders. Perhaps some lenders believe that with the liquidity provided the company can grow and restructure itself out of its current distressed state. So far, we expect the priming debt to receive a full recovery (partially because of the modest rollup). But we question what will happen when the super-super (super-duper?) priming transaction comes along to prime the "superpriority" and "priority" priming transactions.

The Big Picture—What Lenders Can Expect

Fortunately for traditional loan investors, these extraordinary tactics (priming and collateral transfers) are rare because they can have a devastating impact on loan quality for existing lenders. This is especially true if the transactions are not sufficient to enable a company to avoid insolvency. To date, loan investors have had limited success in revising loan documents to block asset transfers (see our report on J.Crew Blocker, published Sept. 23, 2019, for a discussion on efforts to reduce collateral transfer risk), given their limited negotiating power, although such efforts are ongoing.

Similar efforts from investors to limit flexibility for priming loan transactions also appear to have had limited success as it is widely believed the majority of credit agreements continue to be set up in a way that allows a majority of lenders to amend the contract to permit new money priming debt and the rolling up of existing debt into a priority position.

End note

*The value differs from the actual recovery estimate of 5% for newly subordinated debt because the recovery value expected to be available to the general pool of unsecured creditors is from unpledged equity in nonguarantors rather than from loan collateral.

Related Research

• A Look At “J. Crew Blocker” In Loan Agreements, Sept. 23, 2019
• The PetSmart Case: A Deep Dive into Its Equity Transfer of Chewy Inc., Nov. 8, 2018
• J. Crew’s Intellectual Property Transfer: An Update For Distressed Lenders, Sept. 12, 2017