Restructuring

Liability management exercises are facing increased legal scrutiny, with recent rulings from federal and state courts reshaping the boundaries of permissible transaction structures.¹

LMEs by Better Health Group and Oregon Tool Inc., in January and February, respectively demonstrate that lenders, borrowers and sponsors are not slowing down when it comes to executing non-pro rata deals and underscore the embedded flexibility in many credit documents for reshaping capital structures. These LMEs employed extend-and-exchange strategies to achieve non-pro rata outcomes while side-stepping the open market purchase concerns raised in Excluded Lenders v. Serta Simmons Bedding LLC, which was decided by the U.S. Court of Appeals for the Fifth Circuit on Dec. 31.

At the same time, the rise of private credit financing is changing the dynamics of LMEs, as alternative capital sources introduce new covenant constraints and strategic considerations. These developments highlight the evolving nature of LMEs in the U.S.

From the early days of exit consents and coercive exchanges to dropdowns and now post-Serta uptiers utilizing extend-and-exchange structures, LMEs have never stood still. They are shaped as much by litigation and judicial interpretation as by lender, borrower or sponsor creativity and market pressures. Understanding that history helps explain how the playbook keeps adapting — and why the next move is always just one ruling or transaction away.

Much has been said about the current state of LMEs, which can be best described as complex, highly negotiated transactions that allow a borrower to restructure or refinance its outstanding debt obligations where a conventional refinancing is not feasible.

In recent years, LMEs have become increasingly sophisticated and often controversial, as borrowers look for creative ways to avoid an in-court restructuring within the confines of their existing debt documents and legal precedent. Yet despite the recent proliferation of these complex transactions, LMEs are nothing new, having been around for decades.

We take a look below at the various forms of liability management in decades past, and track its evolution into its current form to predict how the next development might take shape.

Liability Management Eras

The Early Years

The 1980s and 1990s were characterized by financial instability stemming from the savings and loan crisis, high interest rates and deregulation, alongside a surge in high-yield bond activity and leveraged buyouts spurred by the creation of the junk bond market a decade earlier.

As distressed companies explored ways to manage leverage, LMEs took early forms through exchange offers and consent solicitations designed primarily to lower principal, extend maturities or modify interest rates.

Such structures resulted in the emergence of early case law in the realm of liability management, such as the Delaware Court of Chancery’s 1986 ruling in Katz v. Oak Industries, which blessed the use of exit consents in an exchange offer or consent solicitation, notwithstanding the coercive effects of this now-common technique.

In the 2000s, LMEs remained front and center amid the burst of the dot-com bubble and the Great Recession as borrowers struggled under the weight of unsustainable debt loads. Borrowers continued to use structured exchange offers and so-called “amend and extends” as part of broader refinancing initiatives to increase liquidity and extend runway during the financial crisis to stave off the disruptions — and expense — of Chapter 11.

Flexible covenant and so-called covenant-lite terms proliferated in both bond debt and credit facilities, giving borrowers more flexibility to restructure outstanding debt obligations. Out-of-court restructurings gained in popularity as an alternative to filing for Chapter 11 and laid the foundation for a more aggressive approach to liability management as an alternative.

Leveling Up

Beginning in the 2010s, the landscape of LMEs changed forever. Borrowers began taking advantage of a historically low interest rate environment through proactive refinancings of their outstanding debt.

Extended periods of low interest rates fueled intense lender competition, leading to unprecedented borrower-friendly debt documents with weakened protections for creditors. Such terms, collectively, resulted in loosened covenants and new technology that provided flexibility for distressed borrowers to maneuver around restrictive covenants in pursuit of creative capital solutions.

Such solutions are embodied today by three general transaction types — or some combination thereof: dropdowns, uptiers and double-dips.

Dropdowns are typically structured so the borrower can move material assets to an unrestricted subsidiary or nonguarantor restricted subsidiary, which results in the assets being removed from the existing collateral package. After this initial step, those assets are used as credit support to issue new, structurally senior debt, i.e., debt that has a higher priority in repayment due to its position within the company’s capital structure, rather than explicit contractual seniority.

Dropdowns are unique in that they generally do not require existing creditor approval so long as the borrower can find third-party capital sources willing to provide the new debt and fit the dropdown within their existing covenant package.

In 2016, J. Crew Group Inc. implemented a dropdown transaction by transferring material intellectual property assets to an unrestricted subsidiary, which subsequently used those newly acquired assets as collateral support for new financing. J. Crew moved the assets outside the creditor group by leveraging flexible investment baskets to raise new money without needing to obtain creditor consents notwithstanding that the transferred IP would no longer benefit the existing creditors.

Uptiers are two-step transactions where a majority or supermajority of participating existing creditors amend their debt documents to subordinate the liens on existing collateral to a new issuance of superpriority debt, and then exchange their subordinated debt for such new debt at the expense of nonparticipating creditors; this may be done in the same credit agreement, a so-called sidecar with intercreditor arrangements, or on more of a synthetic basis by pairing with the dropdown, described above.

In 2020, Serta executed an uptier transaction with the consent of two of its creditor groups by amending its existing credit agreements to modify lien priorities and allowing participating creditors to exchange into new superpriority debt.

Boardriders and Incora were other notable examples of uptiers that followed Serta, in 2020 and 2023, respectively. Litigation followed each of these transactions as nonparticipating creditors challenged the transactions on various grounds. That said, we continue to see non-pro rata uptiering transactions in the market.

Double-dips are structured transactions that allow distressed borrowers to raise new capital while leveraging their existing capital structure for enhanced collateral coverage. In these deals, a borrower, often an unrestricted subsidiary, incurs new debt secured by its assets and guaranteed by the credit group — this is the first dip. The borrower then uses the proceeds to fund an intercompany loan to the existing group, e.g., for purposes of buying back the existing debt likely at a discount, which creates a receivable for the borrower that is pledged to the lenders as additional collateral.

This gives the new lenders a second claim against the group, in addition to any “exclusive collateral,” improving their position relative to other creditors. In 2023, several distressed borrowers executed double-dip transactions, including At Home Group Inc., Trinseo and WheelPros LLC, signaling the growing adoption of this liability management strategy.

Importantly, these three general categories of LMEs are not mutually exclusive, meaning some deal structures may blend elements of each.

The Next Era

It may be that the next era of liability management takes a more collaborative approach in an effort to avoid the burden of litigation associated with the more adversarial strategies embodied by the tactics of some previous LMEs — a so-called LME 2.0 — but this remains to be seen. While we have seen some transactions trend toward a more collaborative approach, we are also still seeing LMEs that continue to push boundaries and leverage new technologies.

We are also beginning to see the growing influence of private credit markets on traditional lending structures, as alternative sources of capital become available to borrowers. At the same time, private credit solutions may come with tightened covenants and less flexibility in debt documentation to be leveraged in downside scenarios as well as smaller groups of lenders who are potentially less interested in in-group versus out-group dynamics as repeat players.

LMEs will continue to develop and adapt to market conditions and results of recent litigation, however it is clear that borrowers will need to consider these solutions — or even more creative ones — when facing distressed conditions. We anticipate that we will continue to see LMEs both with existing creditors, but also leveraging off of the potential for a deal away with lenders that are not currently in the capital stack.