US leveraged finance: The road ahead
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Distressed companies open the liability toolbox to avoid full-blown bankruptcies

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  • Announced US corporate bankruptcies climbed to 630 cases in 2020, according to Standard & Poor's—up from 2019 levels, but still lower than expected
  • Bankruptcies ticked higher early in 2021—from 14 cases in January to 23 cases in March, before dropping to 11 in June—but are still well below 2020 levels according to Debtwire Par
  • Covenant relief and uptiering, as well as drop down deals and other liability management structures have offered companies a variety of levers to pull to avoid entering bankruptcy situations

Bankruptcies in the US climbed from 14 cases in January 2021 to 23 in March, but are still below the levels seen in 2020

Management teams and private equity (PE) sponsors have successfully deployed a range of liability management tools to steer companies through the COVID-19 downturn and avoid both bankruptcies and full-blown restructurings.

According to Standard & Poor's, US corporate bankruptcies climbed from 580 in 2019 to 630 in 2020. Although volumes did rise, the number of bankruptcies came in significantly lower than anticipated, and well down from the 819 recorded in 2010 in the aftermath of the global financial crisis.

Although Debtwire Par figures show an uptick in bankruptcy filings from 14 cases in January to 23 in March 2021, volumes are still low year-on-year. Monthly bankruptcy totals consistently exceeded 25 in the first half of 2020, pushing to as high as 40 cases in July 2020 and 37 cases in May 2020.


Holding firm

The relatively benign levels of bankruptcies reflect a combination of factors that have favored distressed companies, giving them time to manage their liabilities without resorting to bankruptcy.

One major factor that has helped borrowers navigate COVID-19 volatility is that the lion's share of outstanding debt has been issued with covenant-lite terms. A covenant-lite loan has fewer covenants to protect the lender and fewer restrictions on the borrower regarding payment terms, income restrictions and collateral (e.g., no maintenance covenants that default due to deterioration of financial performance alone).

According to Standard & Poor's, more than 80 percent of the S&P/LSTA Leveraged Loan Index (which tracks the performance of the largest US institutional leveraged loans) is composed of covenant-lite loans—compared to a share of just 15.5 percent at the end of 2008. This offered much-needed breathing room to companies that saw earnings flatline and leverage multiples mushroom during the pandemic, developments that would have tripped financial maintenance covenants if not for covenant-lite terms.

Even debt instruments that continue to have financial maintenance covenants—primarily pro rata revolving credit facilities and amortizing loans that are held by banks post-syndication—have been able to obtain covenant relief from lenders to help them through this volatile period. But this relief has often come at a cost.

According to Standard & Poor's, by the end of April 2021, there were 15 covenant relief deals, which is consistent with pre-pandemic levels. Although less than half the number of covenant relief deals observed over the same period last year, the option has remained open for borrowers even as capital markets have rebounded and, in fact, thrived post-pandemic.

When borrowers have pushed up against potential breaches of financial maintenance covenants, lenders that agreed to offer covenant relief typically did so in return for newly inserted liquidity-based covenants that required borrowers to share cash-flow projections of up to 13 weeks with lenders, as well as hold lender calls to outline financial performance expectations, and maintain certain minimum liquidity levels.

Even borrowers that have been running out of cash and have not been positioned to raise additional capital have used innovative tools to avoid bankruptices, de-lever their balance sheets, reduce their overall interest expense and extend their debt maturity profiles



Dropping down and uptiering

Even borrowers that have been running out of cash and have not been positioned to raise additional capital have used innovative tools to avoid bankruptices, de-lever their balance sheets, reduce their overall interest expense and extend their debt maturity profiles.

Companies facing various pandemic, industry and other headwinds have taken advantage of flexibility in documentation through so-called "asset drop down" and "uptiering" deals.

Asset drop down transactions (which often use flexibility found through using unrestricted subsidiaries) have seen borrowers use flexibility present in their existing debt documentation to transfer valuable assets and collateral out of the restricted group that benefits the senior secured creditors. In these deals, assets (often intellectual property) have been transferred into new "unrestricted" subsidiaries that can raise additional debt using those assets as collateral, or can be sold without the restrictions imposed by existing debt documentation.

Lenders have been moving, as and when opportunities arise, to shut down this flexibility through unrestricted subsidiary blocker terms, which provide that certain "core" assets are prohibited from being transferred to unrestricted subsidiaries. But, over the past 12 months, borrowers have nonetheless been able to bring in additional liquidity by using drop down flexibility.

In uptiering deals, meanwhile, borrowers have structured transactions pursuant to which they offer certain existing senior creditors the opportunity to exchange some debt instruments (often at a discount to par) for new instruments that layer into new structurally senior positions in the capital structure. This has proven an effective way for borrowers to reduce leverage and improve their liquidity profiles by reducing debt service, while also extending their debt maturity profiles to provide additional runway to navigate challenging industry landscapes. However, in some instances, this has triggered litigation in US courts by lenders that were excluded from this uptiering.

As has been the case with asset drop down deals, lenders are zeroing in on terms in new deals, and in the context of amendment and waiver discussions, to block uptiering.

Uptiering and drop down deals have proven valuable tools for borrowers but, as capital markets have recovered, borrowers have not had to turn to these options as frequently. Borrowers that have not benefited from this recovery, but whose tools have been locked away through blocker provisions, continue to seek ever-more creative options to raise liquidity—which may account for the recent rise in interest for preferred equity structures.

A big rebound in secondary prices for debt has reduced the opportunity to capture discount through uptier transactions.

In June 2020, the average price for debt in the secondary loan market was trading at 85.51 percent of par. In June 2021, prices averaged 97.95 percent of par. High volumes of refinancing activity have also given borrowers greater flexibility to extend maturities and lower financing costs.

Innovative structures that use the flexibility found in debt documentation have provided, and will continue to provide, valuable tools that distressed companies can deploy to manage their balance sheets through challenging market backdrops.


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US leveraged finance: The road ahead


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