(Bloomberg) — First it was “drop downs.” Then came “priming.” Now, hedge fund titans have a new weapon of choice in the distressed debt battleground.
Sometimes referred to as “non-pro rata uptiering,” companies facing financial trouble including Rackspace Technology Inc. and Apex Tool Group are inking restructuring deals that provide select creditors with better terms on debt swaps than others.
It’s the latest in a wave of maneuvers — often masked by banal legalistic terminology — that distressed funds and others managing billions of dollars are deploying to clean up at their rivals’ expense. The new deals are typically structured as below-par debt exchanges at a variety of different price points. Creditors that negotiate the proposals usually provide new money and receive the smallest haircuts on their holdings. Those that choose not to participate risk being stripped of their collateral and covenants, while also getting pushed down the repayment priority line.
With the supply of troubled bonds and loans limited as the US economy manages to avoid tipping into recession, market watchers say some money managers are pitching these sorts of transactions to struggling companies earlier than ever before as they look for opportunities to profit.
“With fewer true recovery investing opportunities in the market, distressed investors and private capital providers have been aggressive about playing offense and offering deals to companies for their own benefit, but at the expense of others,” said Scott Macklin, head of US leveraged finance at Obra Capital.
Among the most controversial recent transactions was a proposal from Bain Capital’s Apex Tool Group. Creditors including Angelo Gordon & Co., Anchorage Capital Group and Elliott Investment Management-backed Elmwood Asset Management took part in a deal that saw them swap first-lien debt into a newly created higher-priority term loan — which is effectively second in line — at around 90 cents on the dollar. Those that weren’t part of the negotiating group could exchange their debt for a mix of the new loan and a lower-ranking obligation at roughly 73 cents.
The value of the original debt plunged following the exchange offer, and some creditors banded together with lawyers to assess their options. But ultimately, holders of more than 90% of the company’s first-lien loan agreed to the deal. Not going along with the plan would have seen them fall well back in the line for repayment.
In a similar move, Apollo Global Management Inc.’s Rackspace last month proposed a deal that would hand a group of negotiating lenders 83.5 cents on the dollar for swapping into new debt. Other lenders would received between 70 cents and 78 cents.
Software firm GoTo Group landed $100 million of new capital from some of its existing lenders in February, and agreed to open a bond and loan exchange to all creditors as part of the deal. Still, terms were better for negotiating lenders: they were eligible to swap debt at 85 cents on the dollar, versus 77 cents for other creditors.
“The practical problem is that many lenders are concerned about the liability management exercises — it’s almost secondary to how the business is performing,” said David Orlofsky of global consulting firm AlixPartners. “The fear of being left behind is now causing some lenders who don’t like the proposed LME transaction to support it anyway. They would rather be part of it than being left out and adversely impacted.”
Representatives for Bain, Angelo Gordon and Anchorage declined to comment. Apex Tool, Elmwood, Apollo, Rackspace, GoTo and Francisco Partners Management, GoTo’s main private equity owner, didn’t respond to requests seeking comment.
In years when the leveraged buyout machine was booming thanks to ultra-low interest rates and yield-hungry investors, many private equity owners added language in bond documents to permit deals that favor some creditors over others, giving them extra ways to negotiate if their portfolio companies ran into trouble.
Historically, many creditor clashes have ended up being litigated, although judges have largely deemed the moves permissible or the suits have settled before a ruling. A group of left-behind lenders are again suing as part of a bankruptcy of appliance maker Robertshaw, which before filing for court protection cut a deal with select investors that gave it new money and pushed a left-out group from first or second in line for repayment to sixth or seventh.
Robertshaw and its private equity backer One Rock Capital Partners didn’t respond to requests for comment.
“We are seeing that senior secured debt is not what certain lenders bought into,” said Scott Zemser, a partner and global head of the leveraged finance practice at Mayer Brown. “A lot of this language was put in by sponsor’s counsel to give flexibility when you have 50, 60, 70, 80 lenders in the lender syndicate and you are headed towards a restructuring situation.”
While the latest transactions may anger creditors, companies argue that out-of-court restructurings provide better outcomes than filing for bankruptcy. A Fitch Ratings review of 2023 Chapter 11 emergences found that on average, first-lien lenders recovered just 53 cents on the dollar, and even less when companies had undergone previous liability management transactions.
More non-pro rata uptiering deals are likely on the way, thanks to a key contingent of the loan market. At the same time that private equity sponsors were tweaking credit documents to make it easier to pitch such deals, many collateralized loan obligations — the largest buyers of loans — were reworking their own documents to give them more flexibility to participate in liability management deals.
“We are entering the next chapter, resulting from many years worth of trends; companies and lenders are looking to resolve issues way in advance of potential insolvency,” said Douglas Mintz, co-chair of the business reorganization group at Schulte Roth & Zabel. “What we’re seeing are individual creditor groups working alone to impact their own recoveries.”
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