The Takeaway: A Q&A With Surbhi Gupta on Liability Management Exercises
What is a liability management exercise, and under what circumstances are they typically employed?
Liability management is essentially just another term for what is commonly known as an out-of-court restructuring transaction. We have seen a recent uptick in that activity because of a few factors—especially looser credit documents in loans issued post-COVID-19—that have created opportunities for sponsors to pit lenders against each other within the same capital structure or allow issuers to transfer assets away from existing lenders’ collateral for the benefit of a third party looking to provide liquidity for the company. All this maneuvering has really facilitated a fairly substantial increase in liability management transactions over the past two years, particularly those focused on low-touch restructuring where the sponsor retains control of the equity.
What is causing that increase?
There are a few factors. Terms in loan documents were previously much tighter, and second, the volume of capital—both syndicated and private credit—is more than triple what it was during the financial crisis. Couple those two elements with a zero-rate environment, where money was effectively free, and many of the latest spate of debt documents have very few controls in place. As an example, financial covenants were much more commonplace even five years ago. There are now fewer triggers for lenders to have a seat at the table if something goes awry. To top it off, in-court restructurings—traditional bankruptcies, in other words—have become cost-prohibitive as financial and legal advisory fees have dramatically increased. So, take the combination of “loose” documents, exponential increase in capital, and an elevated-rate environment (versus just a couple of years ago), and then juxtapose that with the heightened cost of a bankruptcy process, and you have this uptick in LMEs as a result.
Do these transactions involve or focus on a specific part of the capital structure as opposed to addressing the whole stack, as would happen in a traditional restructuring?
No, they don’t. It depends on what you’re trying to accomplish in a liability management transaction. The business case for the issuer can involve several different factors. It could be that the company wants to extend its maturity runway or reduce its current debt service requirements in order to reinvest in the turnaround of the business. The latter has become very critical for some of these players ever since the rate increase, where we went from a zero-rate environment to SOFR at its peak of 5.4%. As a result of that increase, for issuers with floating-rate debt, you’ve potentially doubled your debt service costs compared to when you first issued that debt.
Another potential reason for engaging in an LME is that some issuers want to capture discount on their debt. If your debt is trading at substantially less than par, there may be an opportunity to reduce both leverage and debt service costs through discount capture. Capturing discount has become more important for issuers trying to manage their overall quantum of debt as the LME transaction is often accompanied by new money needed to reinvest in the business, which further increases leverage.
Lastly, to the extent there are any financial covenants, that can be a trigger to engage in an LME. So, when you talk about the different factors for the business case, for an issuer to pursue a liability management transaction, it can really target several areas of the capital structure—and some of these factors can be coupled together. They’re not mutually exclusive. So, you might want to raise capital, capture discount, and reduce your cash debt service burden at the same time.
Given the range of potential goals an issuer is trying to achieve in an LME, are you seeing any specific trends within the space? Are you seeing more of one particular type of transaction, or is it somewhat across the board these days?
I think in the first iteration of some of these liability management transactions, which took place during COVID-19, the goal was really more about raising new money as bridge capital to fund the turnaround of the business in what was an unusual time of turmoil for companies. The new money was accompanied by an uptier, non-pro-rata transaction (i.e., lenders within the same tranche of debt having their liens and priorities changed post-transaction). If you look at some of the more recent transactions, they are largely still focused on new money but also on reducing debt service—and coupling that with discount—so that you can really at least try to get some sort of net deleveraging transaction out of it. Perhaps more importantly, these transactions are increasingly done on a pro rata basis, which allows 100% of lenders in the same class to participate in the LME but creates a sliding scale for the economic consideration provided.
What will be interesting is that there have been dozens of these liability management transactions over the course of the past 18 months, and the rate environment hasn’t improved much over the same period. There are a lot of sponsors who took companies private in 2021 through mid-2022 at very lofty valuations accompanied by significant leverage, given the low-rate environment at the time. It’s not hard to imagine why a gradual 25- or 50-basis-point reduction doesn’t move the needle when you were servicing debt at SOFR of 5.4% to currently 4.5% (but starting at SOFR of nearly 0% until 2022). So, I think what will be really interesting is how many of these issuers come back to the well for either a second round of liability management or more of a traditional restructuring transaction.
What about the claim that LMEs merely temporarily stave off the inevitable and that it is a short-term fix? Is it a matter of the health of the company at the outset or a matter of making sure the transaction involves the right participants?
There’s a lot to unpack there. I would say there are a lot of businesses that are decent quality credits and/or recent LBOs, and the sponsor isn’t going to just throw in the towel; as economic animals, they want to maximize their equity return or, at the very least, preserve their option on the equity. And, because some of the documents are so loose, so to speak, the sponsors actually have a real threat and bargaining power vis-à-vis the lenders. They can simply tap one of the dozens of private credit providers for new money, strip collateral away from current lenders, and leave them worse off than if they’d worked with the sponsor. This is the carrot and stick approach that drives lenders to ultimately come to a hopefully reasonable resolution with the sponsor.
Given the serial nature of these LMEs, lenders are beginning to ask: Does this business really just require a low-touch LME as a bridge to something else (e.g., turnaround and growth of the business, ultimate sale, or other exit), or is there something more holistic needed, like a complete deleveraging of the entire capital structure? Asking themselves that question results in the realization that they, in conjunction with advisors, need to do a lot more diligence about the quality of the business. The actual liability management transaction can be structured, negotiated, and consummated in a matter of weeks. So, there’s a renewed emphasis on due diligence and the quality of the business: Is this really the right path, or should I be doing something more comprehensive here?
Lastly, I would be remiss if I didn’t ask you about cooperation agreements, as they are a hot topic in the context of LMEs these days.
Cooperation agreements are essentially a glorified term for, “Let’s hold hands and be a unified voice against the sponsors so that they can’t pick us off and establish a 50.1% group against our 49.9% group.” Some are even pushing these levels: “Let’s get two-thirds of the group inside the co-op, or even 90%.” This hampers the ability of the sponsor to negotiate with an existing lender without speaking to the whole co-op group and, therefore, forces the use of third-party capital as a credible alternative. Similarly, these agreements can also stop a third party from coming in and buying up some of that debt, unless that new party becomes a signatory to the co-op agreement. So, the carrot and stick approach works both ways; sponsors and lenders can have varying points of leverage during the course of structuring an LME transaction.
