The surge in aggressive out-of-court loan restructurings in recent years has been a frequent topic of interest in our investor discussions, at industry conferences, and in the financial press. These restructurings are often referred to as liability management transactions (LMT) or exercises (LME). Restructurings that benefit certain existing lenders at the expense of other investors in the same loan are often referred to as "lender-on-lender violence".

The disparate impact on investors in the same loan is a key source of investor frustration with LMTs. Accordingly, our focus with regard to LMTs has been on restructurings that disadvantage existing lenders and where all lenders are not offered the chance to participate in the restructuring on the same terms.

Given the debt market's ongoing and widespread interest in LMTs, we address frequently asked questions to provide perspective and transparency on these restructurings and their credit implications.

Frequently Asked Questions

How does the surge in aggressive out-of-court loan restructurings affect recovery prospects for institutional first-lien lenders, and what is driving this trend?

The proliferation of LMTs in the past few years (Chart 1) has dramatically increased the risk of loss for broadly syndicated loan (BSL) investors. With the threat of these restructurings by distressed entities, lenders can no longer rely on realizing average par recoveries of 75%-80% (and more than 90% on a median basis) by virtue of their position at the top of the capital structure, with liens on substantially all assets.

As the investor base for institutional loans expanded and became more diversified (like the high-yield market) over the past decade, syndicated loan documents became more bond-like and flexible. As a result, most now provide companies with numerous options to restructure their balance sheets in ways that can dramatically reorder the relative priorities of existing first-lien lenders (and other creditors), while shareholders retain their equity positions.

Aggressive restructuring tactics include transferring assets or collateral away from lenders, allowing new tranches of debt with higher-priority repayment status, subordinating repayment rights of certain (previously equal) lenders, and using various techniques to enhance the protections provided to the lenders that supply new capital (at the expense of existing lenders). These restructurings often produce winners and losers from the same group of lenders.

Considering this risk, existing lenders may approach distressed borrowers with proposals to provide much needed liquidity (and/or relief from pending debt maturities) in exchange for enhancing their position in the post-restructuring capital structure and to preemptively ensure they avoid being the disadvantaged party. The impact on disadvantaged lenders can be significant, including wiping out their recovery prospects in a subsequent default scenario.

Chart 1

Are these LMT restructurings helping companies adequately resolve their capital structure problems?

In our view, the LMTs that we've been tracking generally have not solved the capital structure problems that forced these companies to restructure in the first place (Table 1). In these 38 loan LMTs by 35 companies from mid-2017 through August 2024 (with some undergoing multiple transactions), 13 firms subsequently filed for bankruptcy (37%). Of the 22 that avoided bankruptcy, only five (14%) staved off a subsequent default or are rated higher than 'CCC+'. Issuer ratings of 'CCC+' or lower connote our expectation that an eventual default is more likely than not. This means that another nearly 50% of the dataset has either subsequently defaulted (outside of bankruptcy) or is viewed as at risk of doing so.

The five exceptions: PetSmart LLC, which we rate 'B+'; Renfro Corp., and Boardriders Inc., which repaid their loans in full when these companies were subsequently acquired; and Rackspace Technology Global Inc. and City Brewing Co. LLC, which we rated 'B-' after they completed LMTs that boosted liquidity and reduced total debt (since existing creditors took a sizable haircut to par). An issuer rating of 'B-' or higher means we believe the new capital structure is sustainable.

Table 1

How have these LMTs affected the recovery prospects for existing first-lien lenders?

The impact is complex. Total first-lien debt generally increased for most of these LMTs because these transactions were more focused on improving liquidity than reducing debt to more sustainable levels. Consequently, they generally suppressed overall recovery prospects for first-lien lenders as a group (including first-lien, first-out through the first-lien, last-out tranches). Of course, the impact on lenders varied from LMT to LMT (Table 1), as did the impact on individual lenders in many LMTs since they sometimes produced multiple outcomes among the previously equal lenders. (These cases generally show the change as varied in the table.)

The asymmetry in outcomes fluctuated for each LMT depending on key terms, such as the amount of new money raised, lender participation rates and terms, and how aggressively the restructuring benefits were tilted toward ad hoc lenders working with the company on the transaction. In many cases, ad hoc lenders ended up with better recovery prospects after the LMT because they traded existing debt into more senior tranches in the revised capital structure, with other lenders relegated to junior positions. Conversely, disadvantaged lenders were given a less favorable position in the new capital structure and bear most (or all) of the risk of loss in a subsequent default.

To put this in perspective, the data on 38 LMT restructurings we've tracked since 2017 show first-lien recovery expectations for the most disadvantaged lenders were cut by nearly 70 percentage points on average (roughly 40% of par), with the lenders' recovery expectations wiped out in 14 of these cases. These calculations use our estimated recoveries embedded in our recovery ratings on the debt.

For LMTs with a varied impact on existing lenders, the hit was somewhat less severe on non-ad-hoc lenders that participated in the restructurings than on the most disadvantaged lenders (nonparticipants). While the magnitude of the gap varies considerably on a case-by-case basis, the outcomes for participating non-ad-hoc lenders were still notably worse than those realized by the ad hoc lender group.

How does LMT risk factor into our recovery ratings?

While the risk of an aggressive loan restructuring can pose significant event risk to the recovery prospects of institutional loan investors, effectively factoring this into our ratings at the debt-instrument level is another matter.

To start, the documentation flexibility that enables these transactions is pervasive in BSL documents. Still, not all distressed companies take this route. Even sponsor-owned companies that restructure may do so in a more traditional manner by filing for bankruptcy, negotiating outside of bankruptcy with lenders on a pro rata (or equal) basis, restructuring at the expense of junior creditors, or relinquishing their equity. This type of default and restructuring (with outcomes that reflect the relative priorities of creditors in a company's current capital structure) is effectively what we evaluate with our recovery ratings.

Further, even if it were possible to predict which companies would take this route, quantifying the potential impact is another problem. These transactions are often very complex and rely on the combination of multiple baskets and provisions in the documents. And they may depend on undisclosed company calculations of capacity (based on estimated future synergies, for example), unknowable third-party assessments (valuations on the assets being transferred, for example), or the potential resetting of capacity if sufficient lenders agree to amend the existing document to allow a transaction. The table indicates the impact on impaired lenders can vary substantially depending on myriad factors (not limited to the amount of new capital raised or whether some lenders elevate their claims above other existing lenders).

Lastly, the challenge of reflecting this risk in an issue rating is further complicated with priming loan exchanges that typically create winners and losers among lenders in the same debt instrument, and in some cases multiple layers of winners and losers. For example, there can be different outcomes among the ad hoc lender group, participating non-ad-hoc lenders, nonparticipating lenders, first-lien bondholders, and so on. We indicate restructurings with multiple layers of disadvantaged lenders after the restructuring recovery in the table as "varied".

While we understand that LMTs can substantially impair first-lien recovery prospects, we don't see an effective way to capture this risk in our issue or recovery ratings on a prospective basis. Further, we don't believe that rating to a worst-case scenario would be reasonable or helpful to investors. As a result, we capture the impact as part of our ongoing ratings surveillance once the specifics of a restructuring are known. Of course, we also continue to interact and engage with the market to solicit feedback and ideas and to ensure that our approach and rationale are clear.

What are the primary LMT types, and how do they function?

LMTs are typically grouped into four primary categories: drop-downs (or collateral/asset transfers), uptierings (or priming loan exchanges), double-dips, and pari-plus transactions, but a given LMT may involve features of multiple categories. (We refer to drop-downs as collateral/asset transfers and uptierings as priming loan exchanges because these labels provide a clearer description of what these maneuvers achieve.)

Collateral/asset transfer:   In this type of LMT, assets are transferred from the collateral package provided to existing lenders by the obligors (the borrower and guarantors) on the existing debt to a nonobligor entity and used as security to raise new debt. The entity to which the assets are transferred can be an unrestricted subsidiary or a nonguarantor restricted subsidiary under the existing credit agreement. Unrestricted subsidiaries do not provide guarantees and security for the existing loans and are generally not subject to covenants in the existing credit agreement. Nonguarantor restricted subsidiaries also do not provide guarantees and security, but (like other restricted subsidiaries) are subject to such covenants. In either case, the new debt is structurally senior to the existing loans with regard to the value at this entity.

Historically, the transferred assets have often consisted of intellectual property. The transfer can be effected either through an actual transfer or by designating a restricted subsidiary that owns the assets as an unrestricted subsidiary. These restructurings may also involve the exchange of some or all of the existing loans held by the lenders that provide the new money debt for one or more tranches of new debt to the new borrower. This debt can rank pari passu with or junior to the new money debt. Prominent examples of collateral transfers include LMTs by J. Crew Group Inc. and Revlon Inc.

Priming loan exchange:   In this type of LMT, the existing borrower incurs new debt that is senior to the existing loans with respect to payment or collateral. The debt is provided partially or in full by the majority lenders that meet the required lender threshold under the existing credit agreement (typically 50.1% of the loans and loan commitments) to amend most of its terms without the consent of the remaining lenders. If the new debt is a new tranche under the existing credit agreement, these lenders amend the waterfall provisions in the agreement to give the new debt priority. If the new debt is documented separately, the agreement is amended to permit it to have priority (and to reflect this in an intercreditor agreement).

Existing lenders providing the new money then exchange some or all of their existing loans for new debt (sometimes at a discount to par), typically into a tranche junior to any new money tranche but senior to existing loans held by investors that don't (or weren't offered the opportunity to) participate in the restructuring. The majority lenders may also make additional amendments to the credit agreement that are unpalatable to other existing lenders, such as stripping the covenants, which can provide a significant incentive for existing lenders to participate. Examples include LMTs by Serta Simmons Bedding LLC and Trimark (TMK Hawk Parent Corp.).

Double-dip:   New debt is raised by an affiliate of the existing borrower that is not an obligor on the existing debt, and the new debt is guaranteed and secured by the obligors on the existing debt on a pari passu basis with that existing debt. This provides the new lenders with a direct claim against the obligors' assets. The proceeds are then lent by the new borrower to an obligor as an intercompany loan that is also guaranteed and secured pari passu by the obligors on the existing debt and the resulting receivable held by the new borrower is pledged as security to its lenders. This provides an indirect claim against the obligors' assets. As a result, lenders to the new borrower will have two claims, instead of one, against the value of the obligors in a bankruptcy. LMTs by At Home Group Inc. and Wheel Pros Inc. are examples.

Pari-plus:   This approach typically involves borrowing money at a nonobligor affiliate of the existing borrower and getting secured guarantees from other nonobligors that have assets of value (for example, foreign nonguarantor subsidiaries). Proceeds are then lent to an obligor as an intercompany loan that is guaranteed and secured pari passu with the existing loans (and pledged as security for the debt of the new borrower). This provides the new debt with an indirect pari passu claim against legacy obligors (the "pari" part) and a structurally senior claim to the value of the new borrower and its exclusive guarantors (the "plus" part). The Sabre Corp. transaction is an example.

Unsurprisingly, as borrowers and lenders have become more familiar with LMTs, such transactions have increasingly blurred the lines between these categories. For example, the Trinseo PLC transaction incorporated aspects of both a collateral transfer and a pari-plus LMT. In our view, this mix-and-match trend is likely to continue and accelerate, with future LMTs employing new, as yet unseen, tactics.

What terms and conditions allow LMTs to be executed?

Borrowers have relied on a host of provisions commonly found in credit agreements, and any given LMT will involve several such provisions. Without intending to be comprehensive, we highlight a few broad areas of focus and other notable terms.

A key source of flexibility is large basket capacity under negative covenants. For example, many credit agreements permit obligors to make investments in nonobligor subsidiaries in reliance on several basket exceptions to the investment covenant, including a ratio basket, an "available amount" basket, a specific basket for such investments, and a general investment basket. The borrower is often also permitted to reclassify investments initially made in reliance on a basket subject to a dollar cap (or a soft cap such as a percentage of total assets) as being made in reliance on a basket without such a cap, such as a ratio basket, if later the investment would meet the requirements of the latter. This allows them to "refresh" basket capacity. Consequently, a borrower can combine and shift capacity among multiple baskets to transfer assets to a nonobligor subsidiary as an investment in connection with a collateral transfer. Capacity under the asset sale, restricted payment, and sale and lease-back covenants can also facilitate collateral transfers.

A similar analysis applies to the debt and lien covenants as they relate to debt incurred by a nonguarantor restricted subsidiary in connection with a collateral transfer, double-dip, or pari-plus LMT, since these subsidiaries are subject to the covenants under the existing credit agreement. Debt and lien capacity available to obligors is relevant in other cases, such as the incurrence of intercompany loans and the guarantees and security provided by them in connection with double-dip or pari-plus LMTs. Capacity under refinancing, incremental, or incremental equivalent debt baskets often figures notably in LMTs.

LMTs have also renewed market participants' focus on lender voting requirements for amendments to credit agreements. Many credit agreements, for example, do not require the consent of all lenders or each affected lender for amendments that change payment priorities in the waterfall, subordinate their security, or permit payments on a non-pro-rata basis. The extent of flexibility afforded by the amendment provisions is instrumental in allowing the amendments to the existing credit agreement made in priming loan exchanges and can otherwise determine terms of an LMT. For example, in exchanging existing loans for new debt in connection with a priming loan exchange (or a debt exchange in connection with a collateral transfer), participating existing lenders may rely on the "open market purchase" buyback provisions of the credit agreement, which are typically the subject of an exception to pro rata treatment requirements, if those requirements cannot be amended without the consent of each affected lender.

Other provisions that have played an important role in LMTs include those requiring that guarantees and security granted by a subsidiary be released when it ceases to be wholly owned and allowing restricted payments in the form of equity of unrestricted subsidiaries, which featured prominently in the LMTs by PetSmart and Neiman Marcus Group Ltd. LLC, respectively. Some credit agreements permit unlimited investments in restricted subsidiaries, including nonguarantor restricted subsidiaries. And as noted above, provisions concerning buybacks and the designation of unrestricted subsidiaries can be a crucial component of LMTs.

Another potentially underappreciated factor is the definition of EBITDA in the credit agreement. EBITDA is often used to set basket capacity and in various ratio tests. Consequently, expansive definitions can increase event risk and make it easier to structure an LMT.

What are lenders doing to help protect against the risk of LMTs, and how effective are these approaches?

The principal approach has been to add "blockers" and other protective provisions to credit agreements intended to cut off some avenues by which LMTs have proceeded:

• A "J. Crew blocker" typically restricts the transfer of material intellectual property (or, sometimes, "material assets") from the borrower or a restricted subsidiary to an unrestricted subsidiary (or, sometimes, from an obligor to a nonobligor) and the designation of any subsidiary that owns or exclusively licenses material intellectual property (or material assets) as an unrestricted subsidiary.
• "Serta protection" language commonly requires the consent of all affected lenders to any subordination of their debt or liens. (Common exceptions include priming debt to the extent all affected lenders are offered the opportunity to participate pro rata on the same terms and debtor-in-possession financing.)
• A "Chewy blocker" may provide that guarantees and security from a subsidiary will not be released as a result of its ceasing to be wholly owned--unless the relevant transaction is with a third party for a bona fide business purpose and not primarily for the purpose of releasing such guarantees and security, together with other requirements intended to prevent opportunistic release.
• More recently, specific language aimed at thwarting double-dip and pari-plus LMTs has begun to appear, but these provisions are infrequent and highly variable.

The effectiveness of these provisions has not yet been meaningfully tested in courts. At a more basic level, effectiveness may vary depending on how they are drafted and exceptions included. For example, a J. Crew blocker may be less effective if it addresses only unrestricted subsidiaries and not nonguarantor restricted subsidiaries, or if it applies only to transfers under the investment covenant and not to transfers under the asset sale, restricted payment, and sale and lease-back covenants.

In addition, there has been a less-pronounced trend toward tightening of lender voting requirements for amendments to the pro rata and waterfall provisions of credit agreements (by requiring consent of all lenders or affected lenders), sometimes accompanied by the addition of catchall language requiring consent to any amendment that would affect pro rata treatment. Nonetheless, J. Crew and Chewy blockers can usually be amended by majority lenders.

Generally speaking, the market has not seen systematic overhaul of baskets or carve-outs under negative covenants in response to LMTs. "Envision blockers" (Envision Healthcare Corp.), which require that only the specific basket under the investment covenant for investments in unrestricted subsidiaries be used for such investments, are uncommon. Terms governing loan buybacks are also largely unchanged.

Do covenant-lite term loan structures affect the ability to execute LMTs?

The dominance of these term loan structures in the BSL market makes it easier to execute LMTs because companies generally do not need to comply with financial maintenance covenants on a pro forma basis to complete a restructuring (Chart 2). While companies typically still have financial maintenance covenants on their revolving loans, they are generally only tested if revolver draws exceed a preset threshold (typically 25%-40% of the facility size). So, it is easier to either avoid these tests (by having post-restructuring borrowings below the testing threshold) or to get the revolver lenders to go along with a restructuring that enhances their position.

As a result, companies are largely free to use the flexibility widely embedded in various baskets not subject to an incurrence test (which may allow them to add debt, transfer assets, etc.) to execute LMTs.

Chart 2

Are LMTs a problem in the direct lending market?

So far, LMTs seem to be almost exclusively a problem for the BSL market. As of now, the Pluralsight LLC restructuring in June is the only notable private credit LMT to our knowledge. As we understand the situation, Pluralsight transferred certain intellectual property to a restricted nonguarantor subsidiary and raised new capital with a priority position against this value (as well as that entity's existing assets/operations). Even so, these proceeds were modest and used to fund interest payments to existing lenders while the company and its sponsor continued to negotiate with them in hopes of reaching a mutually agreeable solution. Ultimately, this was unsuccessful. Shortly after completing the LMT, the sponsor transferred its equity to the lenders and walked away from its investment. This outcome more closely resembles a traditional lender workout of a troubled loan than the LMTs we've observed in the BSL market.

There seem to be a few key reasons that LMTs have not developed into a significant risk in the direct lending market the way they have in the institutional loan market.

Most loans in the private debt market have much better document protections (as highlighted in "Documentation, Flexible Structuring Continue To Reign In Private Credit," published Sept. 17, 2024). This includes financial maintenance covenants on roughly 90% of private term loans in our sample of 1,404 direct term loans (Chart 3). While covenant-lite term loan structures are becoming more common in direct loans to larger companies (39% of our sample), the frequency is still well below the over 90% rate in the institutional market.

Financial maintenance covenant violations can serve as an early warning and force borrowers into negotiations with lenders before operating results deteriorate more significantly. Such negotiations may come before a sponsor's equity investment is underwater and make the sponsor more willing to inject new equity if that helps the portfolio company reach an acceptable restructuring agreement. In turn, the restructuring can allow lenders to tighten document terms to limit risk if operating performance remains weak. More importantly, private credit documents generally start with much tighter restrictions on the ability to add debt, transfer or sell assets, or create or designate subsidiaries as unrestricted, as well as specific protections (including various blockers) to protect against the loan terms that have allowed LMTs to proliferate in the BSL market.

The direct lending market is also fundamentally a relationship business with strategic and often long-term relationships among the lender groups and private equity firms that own the borrowers. As such, a lender is less likely to seek to enhance its individual position at the expense of other lenders and sponsors are less likely to be able to play lenders against each other to complete a restructuring. In addition, direct loans are a hold-to-maturity investment among a small group of lenders in which all parties have invested in the debt at par. This common starting point means that lender incentives are better aligned than in the syndicated markets, where investors may have a significantly different cost basis in the same loan and therefore different views on acceptable restructuring outcomes.

Ultimately, the combination of a unified lender group and stronger documentation provides lenders with a strong negotiating position. Consequently, restructuring outcomes should primarily reflect their best interests rather than a compromised settlement made to prevent the borrower from exploiting documentation flexibility that may disadvantage them.

The flood of money and new entrants into the private credit market have prompted concerns that loan protections will weaken amid heightened competition. This bears watching, although direct lenders tell us they are committed to maintaining robust documentation protections, even if they become more permissive on spread premiums or financial maintenance covenants. They say this holds true even in the upper end of the private credit market, where competition with the BSL market is more intense.

Chart 3

How is private credit/direct lending involved in LMTs?

Private credit is often a source of capital for LMTs given the substantial amount of dry powder raised in recent years. Direct lenders are more likely to offer companies bespoke terms and seen as more comfortable lending to distressed borrowers using LMT tactics (such as collateral/asset transfers, pari-plus, and double-dips) that give them enhanced protections relative to existing lenders. The new capital is at times used to repay pending debt maturities at par, which may be welcome by many lenders even if recovery prospects on their remaining loans are impaired.

While spreads on direct loans are often higher than for institutional loans, this disparity is often narrow (or nonexistent) for distressed firms, which typically have trouble raising money from institutional investors. Private lenders are also generally more willing to offer payment-in-kind options to help stressed companies get the liquidity and flexibility they need to reduce the risk of an imminent payment default or bankruptcy.

Trinseo's September 2023 refinancing provides a case study in one such transaction (see "Leveraged Finance: Creative Structuring Helps Trinseo PLC, Comes With Lowered Recovery Prospects And Higher Costs", published Sept. 19, 2023).

Are there discernible changes in the secondary market response to LMTs as institutional lenders have become increasingly aware of this risk?

Changes in the behavior of syndicated loan investors reflect efforts to limit the downside risk posed by LMTs. Investors are now even more keenly focused on downgrade risk for lower-rated firms, especially those we rate 'B-' or below. While vigilance for default risk and exposure to 'CCC' rated issuers is not new, the importance of proactively managing these risks is heightened by the damage that LMTs can inflict.

After identifying at-risk credits, investors will consider selling these loans, even at a discount to par, if doing so helps avoid a larger loss down the road. At the same time, they often explore a cooperation agreement with other like-minded investors to try to prevent an LMT or influence the restructuring terms to limit their downside risk. Cooperation agreements are widely cited by lenders and their advisers as an important tool to limit LMT risk. Conversely, large holders of a given loan may look to create a cooperation agreement with other large investors to get a majority position and negotiate directly with the borrower (and sponsors as applicable) on a restructuring that benefits both parties, generally at the expense of other lenders.

Our conversations with managers of collateralized loan obligations and data on their performance suggests that smaller managers are more likely to sell at-risk credits early (when discounts to par are smaller), even if this locks in a loss. If they don't sell, smaller managers also seem more likely to pursue cooperation agreements that offer the same (or similar) terms to all investors. Even so, having a large position in a loan does not guarantee an investor won't be disadvantaged by an LMT. Serta Simmons is an example of two separate large lender groups competing to structure an LMT and some of these lenders ending up on the wrong side.

While demanding better documentation protections seems like an obvious and critical way to limit LMT risk, various blockers and documentation changes designed to limit these risks are not widely or consistently implemented in institutional credit agreements. Ultimately, this reflects the limited negotiating power of individual BSL investors.

Is there a change in how LMTs are structured and the impact on existing lenders? If so, does S&P Global Ratings have a sense of what may be driving these trends?

In 2024, many LMTs they seem to be structured to encourage high participation among existing lenders. This is achieved by offering lenders not directly involved with negotiating the restructuring (or the so-called non-ad-hoc lenders) to participate in the LMT on terms that are better than they would otherwise get. For example, they may get a mix of new second-out and third-out loans rather than being relegated to a third-, fourth-, or fifth-out position if they do not participate. Nonparticipants also generally have other protections removed. Separately, participation may provide non-ad-hoc lenders with an opportunity (but not necessarily an obligation) to contribute to new super-priority debt tranches on a proportional basis with their ownership of the original loan. These new money loans generally have favorable pricing and robust prospects for recovery in a subsequent default.

While these LMTs produce a less extreme gap between winners and losers (excluding lenders that choose not to participate), the outcomes are still tilted toward the ad hoc group. This materializes as allocations in higher-priority tranches, backstop fees on new money tranches, and lower par haircuts on existing debt when debt haircuts are required. Consequently, non-ad-hoc lenders still bear most of the risk associated with a future default. This incremental risk is significant because in our view LMTs typically do not resolve the capital structure problems that triggered the restructurings in the first place.

Additionally, the disparate impact realized by formerly equal lenders remains a fundamental lender complaint. (We don't highlight restructurings offered on a pro rata, or equal, basis in most of our research because they are generally less controversial.) Importantly, the incentive to participate in many of these transactions may be more driven by the desire to avoid an even worse outcome than the fairness of the proposal.

In our view, three considerations drive the trend to incentivize high participation rates by offering less-lopsided LMT terms:

• The use of cooperation agreements can give groups of smaller lenders unlikely to be in the ad hoc group some real negotiating power in certain instances.
• Many more extreme winner-take-all LMTs (Serta Simmons, for example) resulted in time-consuming and expensive litigation that mitigated some breathing room intended by the LMT. This possibility may make significantly lopsided transactions less appealing.
• To a lesser degree, some sponsors (and loan investors) may be wary of potential reputational damage if they are seen as consistently aggressive in these situations.

How is the impact of LMTs captured in aggregate recovery statistics for first-lien debt?

In theory, it seems straightforward that LMTs should generally depress first-lien recovery statistics because these restructurings typically layer additional first-lien debt on top of already overburdened structures. In practice, the impact on aggregate recovery statistics is murky, and the best way to measure this may not be obvious given the complex and idiosyncratic nature of these transactions. For example, with collateral transfers, the recovery rate on the existing first-lien debt gets impaired, but the new class of first-lien debt created in these transactions (with liens on the transferred assets) generally has very strong recovery prospects, which muddies the impact on first-lien recoveries.

With priming loan exchanges, the new super-priority first-lien debt generally has very strong recovery prospects, while the (now subordinated) legacy first-lien debt may be divided into several loan tranches of various sizes with different repayment priorities (first-lien, second out; first-lien, third-out; first-lien, fourth-out; etc.). Most of these now subordinated legacy first-lien tranches have poor recovery prospects and are effectively first-lien in name only. It is unclear whether aggregate recovery statistics will count this debt as first-lien after subordinating the repayment priority, even if this debt still technically has a first-lien security interest.

If not (and only the new super-priority debt is counted as first-lien), priming loan exchanges may perversely boost recovery statistics for first-lien debt notwithstanding the damage these restructuring tactics can have on disadvantaged lenders. Conversely, if the legacy debt tranches are still counted as first-lien, this will drag down first-lien recovery statistics, as one would expect. The best way to capture the impact is still unclear. From a mathematical perspective, calculating first-lien recoveries on a dollar-weighted basis for all first-lien tranches after a restructuring would seem to make the most sense. However, this wouldn't capture the impairment borne by the newly subordinated first-lien lenders nor the benefits realized by lenders that primed them. Similarly, pari-plus and double-dip structures create two classes of first-lien debt with different recovery profiles. The gap between these recovery rates can vary substantially from transaction to transaction.

All of this muddies the impact on first-lien recovery statistics. Loan investors should understand that aggregate recovery statistics are unlikely to effectively capture the impact on first-lien recovery rates given the complex and idiosyncratic nature of these transactions.

Given all of these factors, what are our expectations for first-lien loan recoveries and LMTs?

We expect first-lien loan recoveries to be lower than the historically strong estimates of actual recovery rates. Historical actual average recoveries for first-lien loans in the U.S. are generally cited in the 75%-80% area, with median recoveries exceeding 90%.

Even before considering the impact of LMTs, our recovery ratings (which estimate future recovery rates) on first-lien debt in the U.S. have declined into the mid- to low-60% area the past six years. This has been driven by a combination of increasing total and first-lien debt leverage, shrinking junior debt cushions, and the predominance of covenant-lite loan structures. Our estimates of actual recoveries on first-lien debt also show a notable decline in first-lien recovery rates in recent years under two separate S&P Global Ratings studies using different groups of companies and different methods of estimating recovery after default (see "Are Prospects For Global Debt Recoveries Bleak?", published March 14, 2024). Tellingly, the primary drivers for lower actual first-lien recoveries seem to match the drivers in the downtrend in our first-lien recovery ratings--namely, shrinking debt cushions and the dominance of covenant-lite loan structures in BSLs (Chart 4).

Chart 4

LMTs should exert additional downward pressure on aggregate first-lien recovery rates, with individual lenders often realizing dramatically different outcomes because of these maneuvers. While the number of out-of-court restructurings remains limited, they are becoming more frequent and likely to persist--especially amid credit stress--since the weak protections that allowed them to proliferate remain widespread. While documentation provisions designed to combat some of these risks have existed for many years, they often don't make it into institutional credit agreements due to the limited negotiating power of individual loan buyers in the BSL market.

As aggressive restructurings have increased, the stigma has abated somewhat, with non-sponsor-owned companies sometimes now utilizing these tactics.

Appendix

Related Research

• Distressed Exchanges Underpin Rise In North American Selective Defaults, Oct. 28, 2024
• Debt Restructuring Snapshot: Del Monte Foods Inc., Oct. 8, 2024
• Debt Restructuring Snapshot: Magenta Buyer LLC (dba Trellix And Skyhigh Security), Oct. 2, 2024
• Leveraged Finance: Documentation, Flexible Structuring Continue To Reign In Private Credit, Sept. 17, 2024
• Leveraged Finance: Adding Up: EBITDA Addback Study Shows Moderate Improvement In Earnings Projection Accuracy, March 27, 2024
• Are Prospects For Global Debt Recoveries Bleak?, March 14, 2024
• Leveraged Finance: Creative Structuring Helps Trinseo PLC, Comes With Lowered Recovery Prospects And Higher Costs, Sept. 19, 2023
• Credit FAQ: A Closer Look At Uptier Priming And Asset Drop-Down Provisions In U.S. CLOs, July 26, 2023
• Credit FAQ: Envision Healthcare Corp.’s Two Major Restructurings In 100 Days, Sept. 2, 2022
• Leveraged Finance: Assessing The Damage: How Weakening Debt Structures And Loan Terms Diluted First-Lien Credit Quality, Dec. 7, 2021
• A Closer Look At How Uptier Priming Loan Exchanges Leave Excluded Lenders Behind, June 15, 2021
• Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks, Oct. 13, 2020
• Acosta Inc.’s Modern Day Bankruptcy: A CLO-Distressed Funds Clash, May 7, 2020
• A Look At “J.Crew Blocker” Provisions In Loan Agreements, Sept. 23, 2019
• Credit FAQ: When The Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries, Feb. 19, 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