Where a corporate borrower defaults on its debt terms, distressed debt investors are often presented with opportunities to acquire the debt at a discount. The strategy of investing in distressed debt presents investors with a number of opportunities, including gaining control of the debtor company via a restructuring process (the so-called loan-to-own strategy) and/or using its position to control the restructuring negotiations with a view to generating significant returns on its investment (e.g., selling the debt at a premium).
Distressed debt investors have become accustomed to arbitraging restructuring negotiations by negotiating terms which allow them to maintain effective control over the debtor businesses, even in situations where the business has defaulted on its debt terms.
During the past several years, however, sponsors and borrowers have exploited red-hot credit markets to fight back.
Sponsor and borrower protections, which are manifesting themselves more frequently in large cap and upper mid-market European leveraged loan documentation, have the potential to change the dynamics of restructuring discussions going forward.
Looser terms
Sponsors may argue that, in the past, covenants were drawn too tightly or were artificial, causing borrowers to default in circumstances where there was little or nothing wrong with the underlying business. They may further argue that such covenants were simply a mechanism for creditors to transfer equity to themselves via loan-to-own strategies at a point in time where there is still value in the business.
Recently, sponsors and borrowers have capitalised on the increased liquidity and competition in debt capital markets to curtail such predatory tactics by lenders. A detailed exploration of the full range of ways sponsors and borrowers have been able to limit such behavior is beyond the scope of this article, but includes pressure on pricing, non-call protection, the return of equity cures, expansive permitted baskets ("grower and builder baskets"), "most favoured nation clauses and "cov-loose" structures. These types of structure are beginning to affect the timing of when a company in distress might need to approach its lenders, the dynamics of those discussions and the options available to borrowers and lenders who seek to successfully rescue or rehabilitate the debtor business.
Liquidity stress rather than pressure on covenants is becoming a more prevalent driver to initiate discussions between lenders and borrowers.
Restrictions on transfer
As a result of looser terms, transferability remains a key issue for lenders. If a lender does not like what it is seeing but there is no default under the loan documentation, then trading out of that debt becomes a real possibility. Traditionally, from a borrower's perspective, once its debt became liquid through trading in the secondary debt market, its ability to control the identity of a new lender was extremely limited. As a consequence, in the event that the borrower faced the possibility of a debt restructuring and/or insolvency process, its new lender may have had investment objectives different from those of the originating lending bank.
The recent changes in negotiation dynamics in the European leveraged loan market have resulted in sponsors and borrowers further restricting a lender's ability to assign or transfer its rights under loan documentation (including via synthetic structures such as sub-participations or trusts). Reflecting recent market practice, on November 18, 2016, the Loan Market Association (LMA) updated its precedent documents for use on leveraged transactions to include provisions which only allow the transfer of loans, which are not subject to a continuing event of default, to entities on a pre-approved list (sometimes called a whitelist). There have also been, albeit extraordinary, reported instances in which sponsors and borrowers have been successful in negotiating away the event of default exception such that lenders were restricted from transferring loans at all times.
One of the consequences of sponsors and borrowers limiting the pool of secondary investors is that distressed debt investors are effectively shut out of directly investing in certain deals. While, on the face of it, this may work to a sponsor's or borrower's advantage, it remains unclear whether excluding such distressed investors may be short-sighted: they may have much more flexibility and appetite to provide funding to a borrower during a period of uncertainty.
Sponsor purchases of debt
Another defensive mechanism which appears to be coming to the fore is the acquisition of debt by a sponsor when the debtor business is facing distress. Prior to the financial crisis in 2007/2008, the LMA leveraged loan documentation did not expressly contemplate borrowers and related parties (including sponsors) purchasing outstanding loan commitments. As a result, when the financial crisis hit, sponsors and borrowers alike capitalised on deficiencies in loan documentation to purchase loans in the secondary market at values which were trading well below par.
In late 2008, the LMA, prompted to address the issue of debt buy-backs by borrowers and related parties (including sponsors), published new recommended-form documents. The revised LMA leveraged loan documentation provided two alternatives: the first was an express prohibition on "debt purchase transactions" and similar transactions by members of the group; the second, as an alternative, permitted such transactions but subject to significant restrictions. Both, however, provided for the voting disenfranchisement of any "sponsor affiliate" that purchased an interest in the underlying loan. The net result of the amendments was that where a borrower (or sponsor) was permitted to purchase debt in the secondary market, and where such a borrower faced financial difficulty, the sponsor was effectively sidelined from materially influencing any restructuring negotiations and/or insolvency process (albeit it would still be allowed to join in the economic upside that may result from the restructuring and/or insolvency itself (e.g., via a debt-for-equity swap or being an "in-the-money creditor")). While the disenfranchisement provisions are a standard clause in LMA leveraged loan documentation, the clause can, like all others, be negotiated and amended (including to incorporate an extensive list of reserved matters) which may ultimately have more impact on the scope of the sponsor (or its affiliate) to participate in restructuring discussions.
The ability of borrowers and sponsors to purchase debt at a discount has advantages. Among them: borrowers purchasing debt at below-par values are afforded the luxury of retiring debt at a discount, and sponsors purchasing debt at below-par values assure themselves that they participate in any economic upside, should the debtor turn itself around. Most recently, however, sponsors are using debt purchase transactions to purchase the debt of holdout lenders in order to implement restructuring proposals (such purchases being made at, above or below par). Notwithstanding the popularity of schemes of arrangement under Part 26 of the UK Companies Act 2006 to deal effectively with holdout lenders, an increase in these types of debt purchase transactions may have the unintended consequence of encouraging lenders to further hold out on restructuring proposals, instead looking to the sponsor to enter into an off-market debt purchase transaction.
Impact on restructuring negotiations
Sponsors and borrowers may have sought to sideline what they consider to be predatory investors by negotiating favourable terms in European leveraged loan documentation and have in the process given themselves the ability to protect their economic interests by purchasing a borrower's debt. However, the protections agreed at origination may adversely affect their interests during restructuring negotiations. Lenders are potentially better equipped to provide financing in distressed situations. Involving them in a timely way in the process, rather than deferring their assistance to the point at which the financial distress of the underlying business has reached critical levels, might provide a better result for all stakeholders.
Market participants will be acutely aware of the dynamics in current European leveraged loan documentation and will be watching closely to see whether these trends persist in all European restructuring situations.
