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Let’s talk about knife fights in the world of distressed credit

I’ve previously talked about how the chickens have come home to roost following a decade of weak credit docs in broadly syndicated loans (BSLs). At a high level, a liability management exercise (LME) is a transaction where the borrower uses loose credit documentation to move assets away from borrowers, and then use those assets to gain financing from a new capital source. If you want a bit of an intro on what I’m talking about in this newsletter, I’d refer to that prior piece. I did a 2nd deeper dive on LMEs here as well. But ultimately, the deterioration in credit documentation, and PE groups putting their well paid and sophisticated army of lawyers to work, led to insanely loose credit documentation which has allowed for trapdoors and loopholes for borrowers to move collateral around. This euphoria from the 2010s and early 2020s is now leading to some serious problems for lenders just trying to get par back.

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There was always possibility of financial engineering as a Company gets distressed, but the “traditional” path to distress used to be pretty different. A company would gradually, and then suddenly, enter distress and then within a certain amount of time would have an out-of-court restructuring or file for chapter 11 bankruptcy. These traditional methods would result in the equity holders taking a financial hit. This is natural right? Equity is the highest risk, highest reward part of the capital structure. But we’re entering a perverse trend in the market where creditors are being asked by the borrowers to take a hit, “or else”. By that I mean collateral may be stripped and moved around as collateral for a new group of lenders.

Lender-on-lender is largely preferrable to Sponsors and Borrowers over writing a large equity check; or having to file for bankruptcy. Might as well play lenders off each other so they can live to fight another day right?

More than two years of high interest rates have significantly impacted the cash flow and refinancing ability or several borrowers. Additionally, other borrowers that levered too aggressively in 2021 are now dealing with higher financing costs. Despite those borrowers not being at LME level quite yet, you can just tell on some names that they’re an eventual 2028-2032 restructuring candidate and it’s a question of how cute you as a lender want to get.

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