So, as is tradition whenever markets start gaining steam, we've started to see folks dust off their old hot takes about how restructuring activity is about to dry up based on the price action in either equities (bad take) or public credit (better take, but lacks some nuance).
First, in terms of equities, the list of reasons why a connection is tangential at best is too long to litigate here. But suffice to say the kind of froth we’ve seen in equities as of late, even if it continues, won't be a harbinger of less restructuring activity in the future because the current froth (if one believes it is froth) isn’t paired with a low rates environment (or the anticipation of a return to one) as was the case in 2020-22.
There's no getting around the fact that SOFR is still over 500bps, and while this is a net positive for those companies that have little to no debt (but lots of cash on their balance sheets) it’s a net negative for those companies with unhedged floating rate debt or maturities that will need to be refi’ed soon that have been hoping for some reprieve from SOFR’s surge since the Fed’s rate hike campaign began.
And when one looks under the surface at the apparent froth in equity markets this bifurcation is being captured (so maybe equity markets aren't quite as irrational right now as some perpetually pessimistic credit investors would like to suggest). For example, Goldman creates custom indices that lump together equities that have the same characteristics, and if one looks to their “strong balance sheet” index it’s up over 10% YTD and if one looks to their “weak balance sheet” index it’s flat on the year (despite NDX and SPX both being up around 7% YTD).
What we’re seeing in equities isn’t risk-on sentiment pervading all corners – what we’re seeing is companies with light balance sheets and high growth prospects being rewarded due to a belief that we won’t see material economic weakness this year (remember that this time last year a recession occurring sometime in the next year was the consensus view) while those with heavy balance sheets and low growth prospects are still stuck in the mud due to the prevailing rates backdrop.
This bifurcation can also be seen through another Goldman index. This one of CCC-rated credit issuers that can then be compared to SPX. Notice when the meme-mania (that involved quite a few stressed public companies) peaked in '21 and when our current rate hike cycle began to be priced in (the temporary uptick in Q4 '23 was due to the rates market getting ahead of itself and pricing in six rate cuts for '24 before pairing that back to around three now).
Second, in terms of credit, there's no doubt that credit markets have moved in sympathy with equity markets in recent quarters. As should be expected since this time last year a recession within the next year was the consensus view and there was still uncertainty over when the Fed would end its rate hike cycle. Whereas now we've seen above-trend growth over the last year, the Fed is firmly on pause, and trend to above-trend growth over the next year is the current consensus view.
As a result, credit markets are more open than they’ve been in a while, and spreads are extremely tight all things considered. For a sign of how things have changed, look no further than Coinbase announcing plans to offer $1bn of convertible SNs. Here's a little historical overview of where CCC spreads are now (well, as of a few weeks ago) and how much they've tightened in over the last few quarters...
However, the hyperventilation over the decline of spreads, and the subsequent decline in the amount of "distressed" inventory (read: the amount of loans / notes currently trading above a certain spread), vis-à-vis future restructuring activity is all a bit much. Sure, this is a (much) better barometer than equity price action (as mentioned above, that's a low bar to clear) but not by as much as some suggest (especially with the rise of private credit, which many ignore in their prognostications because of the opacity there).
Insofar as loans and notes trade up it can remove some companies, that were at the knife edge, from the pool of those likely to restructure (read: the pathway toward a regular-way refi looks more clear, or at least more doable). However, for those still burning cash and / or with maturities they simply can't refi in our current rates environment, even with tighter spreads and lower yields, their capital structure trading up a bit per se doesn't absolve the need to restructure – it simply informs the kinds of transactions that can be done and / or the economics of those transactions (e.g., an amend-and-extend will be easier and less expensive to do, less discount capture will probably be achieved in an exchange transaction, etc.).
It's perfectly reasonable that some stressed and distressed names have traded up and that the HY primary market has reopened over the last few quarters based on i) the Fed pausing and making it pretty clear that this rate hike cycle has come to a close and ii) the fact that (somehow) the most aggressive rate hike cycle in four decades hasn't spurred a recession and now isn't anticipated to do so.
Because much of the price action we saw over the last few years, along with the more or less frozen nature of credit markets, was driven by deep uncertainty over the future – and this led to some that shouldn't have been stressed or distressed based on their fundamentals trading as such because people basically thought, "Well, if the Fed's rate hike cycle continues even further, or if we suddenly land in a recession, then even though this credit doesn't really look that stressed or distressed based on its fundamentals now, in those situations it could be."
Whereas now, as the dust has settled a bit, the draconian downside cases that led to so many being sucked into stressed or distressed territory have been discarded. So, as a result, those credits that were never really stressed or distressed based on their fundamentals have been pulled out of stressed or distressed territory and, in some cases, have even been able to refi upcoming maturities when they wouldn't have been able to a year ago.
To this end, since Nov '23 we've had issuers that traded at stressed (x > 600bps) or distressed (x > 1000bps) levels last year, but no longer are, raise $36bn of new HY funding (almost all to refi upcoming maturities). And over the last few weeks we've had over $10bn of HY deals minted, likewise almost all to refi upcoming maturities (e.g., Clear Channel, CoreCivic, New Fortress, etc.).
However, even though this credit market reopening has been robust - primarily because there was such a backlog due to the primary market being more or less frozen for a prolonged period for any company that looked pretty stressed - it hasn't been broad. Those that are ~8x levered or more through their capital structure are still more or less frozen out, and likely will be for the foreseeable future as folks have internalized that we may see few (or no) rate cuts this year.
In the end, from a restructuring perspective, as long as rates stay elevated we'll still see plenty of activity as those that have waited with bated breadth for the cut cycle to commence (e.g., lots of sponsor-backed companies) run out of time and are forced to bite the bullet and do something. It’s still all about (base) rates, and right now the rates market is pricing in only around three cuts this year – and there are some, like Torsten Slok at Apollo, that have made the (bold) call in the last few days that we'll have no cuts this year at all.
I'll perhaps save a longer rant for another time. But looking at broad secondary market price action – whether in terms of equities (bad) or public credit (better, kind of) – and making inferences about future restructuring activity sounds sensible enough.
However, one has to be careful about what broad pricing is actually telling you (especially in the midst of a volatile rates environment) and what nuance is displaced when looking at a line chart or a few numbers on a screen that take into account such a wide universe of companies (some of which were never liable to restructure to begin with unless the primary market remained frozen for a prolonged period).
In other words, when you hear about spread tightening across a certain credit rating, or how much distressed inventory has fallen, or see a chart like the one below it's important to not construct a narrative that overinterprets what's really happening. Because, for example, one could construct a narrative based on the chart below that the credit market has turned red hot, that we've closed the chapter on this distressed cycle, and that restructuring activity will probably be much more muted moving forward.
But, in this instance, the real story this chart is telling you is largely one of the hunt for yield that's taken place over the last year as rates have reached their crescendo and the belief among credit investors that, based on the diminished likelihood of a recession happening relative to the consensus this time last year, if one's high enough up in the capital structure then one will be well covered even if a restructuring of some kind occurs (and will be well compensated along the way due to our current rates environment).
So, sure, this chart does signal that we'll probably have less restructuring activity moving forward than one would've thought even a few months ago – but the signal vis-à-vis future restructuring activity isn't as strong as the sharp up-and-to-the-right line would perhaps suggest because it's been driven primarily by the factors mentioned above. In other words, it's not that charts like this have no directional value, it's just that they're prone to overinterpretation as people look at a sharp upward movement in pricing and think there'll be a similarly sharp decline in restructuring activity. But that's not the case here.
Ultimately, even those that are most bullish on credit acknowledge that the default rate probably hasn't peaked quite yet (although some see a peak in 2H 24). Further, those that sound the drumbeat the loudest vis-à-vis calmer restructuring activity in the future based on the price action in public credit tend to outright ignore private credit where everything is famously marked to par until suddenly it isn't – and due to the outsized role of private credit over the last few years, especially vis-à-vis buyouts, that's likely leaving at least half of the story untold.
So, what we've seen over the last few quarters in credit, similar to a certain extent to what we've seen in equities, is a bifurcation develop – one that could deepen, remain stagnant, or reverse itself – where those that were probably unlikely to restructure, but that some might have taken a bit closer of a look at last year due to where their debt happened to trade, now look even less likely to need to restructure.
Whereas the core universe of companies that everyone knows will need to do something at sometime - unless there's a remarkable turnaround in their fundamentals or we see a rapid rate cut cycle commence - remain resigned to the same fate even if their debt has traded up a bit and they've thus contributed to the spread tightening seen in some of the charts above. For this core universe, it's still a matter of when, not if, they take action and what they do – and the longer rates stay higher the more companies that'll be sucked back into this universe.
This is all much different than late-2020 to 2022 where we had a bunch of companies that seemed destined to restructure leverage (actual) hot credit markets driven by zero rates - or even hot equity markets - to avoid having to restructure (at least for a while). We aren't there now, and won't be even if rates normalize a bit over the rest of '24.
Note: If you don't find reading Howard Marks too tedious, I've uploaded his memo from Jan 2024 on rates, credit, misallocation, and what a new normal could, or should, look like.
Note: I wrote all the above last week, but as it happens a few days ago a new episode of Bloomberg's FICC Focus came out that has an interview with Tuck Hardie (MD at HL) that's excellent and worth a listen. He echoed much of the above re: the bifurcation, the impact of rates, how many (especially sponsor-backed) companies are on the sidelines in a vain (?) attempt to withstand the rates storm and deal with their capital structures in a better environment, that we're still very much in a distressed cycle irrespective of how tight credit is right now, etc. Hardie also enters into a nice little rant about how liability management exercises (LMEs) are nothing more than a "new buzzword for out-of-court transactions" which exactly mirrors my (much lengthier) rant about the acronym in the 2023-24 Bonus Guide (where I said it's hard to imagine there's a turn of phrase, or an acronym derived therefrom, that could be more boring, vague, and devoid of explanatory power – why some insist on using it at every possible juncture is beyond me).
I haven’t had much free time over the last few months, so haven’t had the chance to cook up some longer post (e.g., a double-dip debrief or non-consensual third-party release rant). Although, I did carve out some time over the holidays to write a long 2023-24 Bonus Guide with a bunch of interview questions (some that came up in full-time or lateral interviews – then a bunch of more difficult ones that I dreamt up to explain certain concepts). So, here are some of those questions from the 2023-24 Guide...
We’ve talked (a lot) about drop-downs vis-à-vis Serta and also a bit vis-à-vis Trinseo in the Double-Dip Guide. Here’s a nice little overview as a refresher...
The reality is that preventing a drop-down, similar to preventing a double-dip, is a bit harder to do than preventing a non-pro rata uptier because the crux of the transaction is utilizing the investment capacity that’s outlined in the debt docs (as I touched on a bit in a postscript within the Serta Postmortem Guide).
I mean, sure, these could be prevented by taking a more sledge hammer approach and providing less investment capacity in the docs at inception – but the company wouldn’t be as interested in this as the investment capacity is critical for other business uses too and would heavily restrict its flexibility (remember that all debt docs are heavily negotiated and a company, all else equal, will opt to go with lenders that are willing to agree to docs that put them in less of a straight-jacket – sometimes even if that results in a slightly higher rate).
Since the “classic” drop-down involved the transferring of intellectual property, and since IP is the crown jewel for many types of companies, the classic J. Crew blocker has been aimed at preventing companies from shifting material IP from the restricted group down to an unrestricted sub (which, if allowed, would then enable the company to incur fresh debt at the unsub and give those new unsub lenders a structurally senior claim on the material IP residing there).
This kind of blocker, to be clear, doesn’t prevent drop-downs from occurring writ large – other material assets could still be transferred down. Rather, it prevents one specific type of drop-down that is (was) most common, especially among retailers where the IP is a critical part of the business (in other words, where the brand really is the business). So, it’s a bit more surgical and something that companies have been more liable to go along with.
There are some different formulations of J. Crew blockers and some are a bit easier to side-skirt than others. But the most traditional basically says, “The Company shall not permit any of its Restricted Subsidiaries to sell, convey, transfer, or otherwise dispose of or license its Material Intellectual Property to any Unrestricted Subsidiary.” (There can also be prohibitions on transferring IP to non-guarantor restricted subs since even though they are bound by the negative covenants of the pre-existing debt docs they don’t guarantee the pre-existing debt, so holders of the non-guarantor restricted sub debt would have a structurally senior claim on the IP located there.)
J. Crew blockers have become more common and are in a majority of new loan deals (read: in most quarters a little over 50% of all deals will have some kind of J. Crew blocker). Although it’s worth mentioning that there’s a bit of selection bias here. The healthiest companies (in other words, those that at issuance are least likely to do a drop-down) or those who are least set up to do a drop-down (in other words, those where IP is less central to the business) are those most liable to include it as the company basically has the attitude of, “Well, lenders seem to care about this, so whatever we’ll make the concession.”
Note: The term “J. Crew blocker” is used as a catchall for drop-down protection of any kind – even if that protection is protecting against transactions that are different than the original J. Crew drop-down (e.g., involving material assets of any kind, not just material IP).
Note: In the past we’ve seen a few J. Crew blocker formulations that prevented restricted subs that held IP from being designated as an unsub but that didn’t otherwise limit the transfer of IP to an unsub. I touched on designation devilry in the Double Dip Guide, so the loophole in this style of blocker might be immediately obvious to you: the company could simply designate a random (empty) restricted sub as unrestricted and then transfer the IP to it after (so, in this case, a restricted sub that held IP would never have technically been designated as unrestricted).
Note: There have been a few credit agreements that have adopted so-called Envision blockers that, like J. Crew blockers, are meant to prevent drop-downs but that take a different approach and are named after a different contentious transaction (Envision) that involved a Frankenstein-esque multi-step drop-down and uptier which I've brought up briefly in earlier posts. These blockers seek to limit the dollar amount of assets, not the type of assets, that can be transferred to an unrestricted subsidiary, and this is often accomplished through only allowing the company to tap the dedicated “investments in unrestricted subsidiaries” basket as opposed to tapping all the broader set of investment baskets (e.g., investments in unrestricted subsidiaries basket + general investments basket + leverage-based investments basket, etc.) in the docs to effectuate an unsub transfer. Although, in case it's not already clear, this is all well beyond what you need to know.
So, here we’re thinking that if the transaction occurs the YTM will tighten (fall) a bit because we pushed out a maturity and, if we assume the company’s FCF situation doesn’t become too dire, the probability of filing has been lowered. Plus, if we assume the credit agreement was pretty loose beforehand, through tightening up the credit agreement the possibility has been diminished that the company will do something that could eviscerate the position / recovery of the pre-existing holders through a more creative transaction (e.g., a non-pro rata uptier or drop-down) or just threaten their recovery through lots of additional 1L incurrence that would reside pari to them (so, this doc tightening would be a net positive for pricing as it reduces downside risk to holders).
Needless to say, the pro-forma YTM is a guesstimate and you’d want to look at how the transaction would look at various pro-forma levels (e.g., 16%, 18%, 20%, etc.). However, if we assume that the YTM will tighten to 17%, and that the TL trades at 80 after the transaction, we can figure out what the immediate “return” would look for holders (of course, most will have bought the TL at much higher levels so it’s not like their real return will suddenly be positive by dint of the transaction – the “return” here should be thought of as what a holder has “made” as a direct consequence of the transaction being done).
So, first, we know pre-transaction that there’s $500mm of the TL outstanding and it’s trading at 75. Therefore, the market value of the TL is $375mm. Second, we know holders will receive their pro-rata share of a 4% paydown of the face value of the TL, in cash, that amounts to $20mm in total ($500mm * 0.04). Third, we know the new market value of the TL will be the pro-forma amount of debt ($480mm due to the $20mm paydown) and we’ve been told that the TL will trade around 80 post-transaction based on a pro-forma YTM of 17%. Therefore, if we assume the TL will trade at 80 then the market value of the TL will be $384mm (higher than before, even with the lower face value amount!).
So, we can think about the return to holders as being the $20mm in cash plus the new market value of the debt that they still hold minus the current market value of the TL, or $20mm + $384mm - $375mm = $29mm. Thus implying an investor pickup (return) of around 7.7% ($29mm / $375mm) due to the transaction.
Note: This will probably never be asked, but if it is then the interviewer will throw out round numbers or want a rough approximations for the return to keep the mental math gymnastics to a minimum. In the real world, the numbers will all be a bit messier but in the below I chose dates such that the implied trading price based off the round YTM (17%) will also be a round number (80). (In the Bonus 2023-24 Guide I used a more real-world example where the current market price is a touch below 75 and the implied trading price, if we assume a YTM of exactly 17%, is a touch below 80 too – I’ll probably change it to use rounder numbers to avoid confusion, but it's all the same approach).
So, since we know that the recovery of HoldCo’s SNs will probably be influenced by the residual equity value flowing from one of the OpCos, let’s start with one of them. For OpCo1, we have an EV of $50mm and, after dealing with the $30mm of SSNs that’ll receive full (100%) recovery, we have $20mm in distributable value left against $50mm of unsecured claims (the $10mm of SNs and the unsecured $40mm intercompany loan). Therefore, the recovery for both will be 40% or $4mm for the SNs and $16mm for the intercompany loan. And, of course, there’ll be no residual equity value that’ll flow to HoldCo.
For OpCo2, we have an EV of $80mm and that more than covers both the $40mm of SSNs and the $20mm of SNs, so both receive a 100% recovery. This leaves $20mm of value that’ll then flow to HoldCo since HoldCo holds 100% of OpCo2’s equity.
Given this, if we think about HoldCo there are $100mm of SNs outstanding and two sources of value: the $20mm from OpCo2, and the $16mm from the intercompany loan. Since remember that the intercompany loan was made from HoldCo to the benefit of OpCo1 – so the recovery of the intercompany loan we determined in OpCo1’s waterfall is recovery that “belongs” to HoldCo, and we haven’t yet determined what creditors will benefit from this intercompany loan recovery. So, the waterfall at HoldCo is straight-forward: there are $100mm of SNs and there’s $36mm of distributable value, so HoldCo’s SNs will receive a 36% recovery.
Put another way, if we think about HoldCo it has $100mm of liabilities (the SNs) and three assets: 100% of OpCo1 equity (that we’ve determined is worth $0mm), 100% of OpCo2 equity (that we’ve determined is worth $20mm), and a $40mm intercompany loan receivable (that we’ve determined is worth $16mm). Therefore, we have $36mm in value against $100mm of claims, thus the 36% recovery for HoldCo’s Senior Notes.
Note: This kind of question hasn’t been asked before (although EVR asks a similar one sans the intercompany loan component). But I figured I’d add it since it’s a simpler interview-style waterfall question that involves an intercompany loan receivable relative to the (real-world) waterfall involving an intercompany loan receivable that I went through in the Double-Dip Guide vis-à-vis Wheel Pros that’s a bit more complicated.
I’ve talked a lot over the last few months about Serta’s saga and the chill that the Fifth Circuit appeal has cast over these kinds of transactions. This has only been compounded by the travails of Incora, who filed back in June of 2023, and their adversary proceeding which has turned into a bit of a mess (I talked about Incora’s aggressive non-pro rata uptier a few times back in 2022 and 2023 before they bit the bullet and filed).
For a time, in the halcyon days of mid-2023, it looked like non-pro rata uptiers would be rubberstamped and that there wouldn’t be an attempt to unscramble the decidedly scrambled egg that these transactions represent. In fact, the perception that these kinds of transactions would be rubberstamped in-court, after Serta seemed to be well on track, was by in large why Incora filed when and where they did (although they’d be loath to admit it for obvious reasons).
It’s no secret about my views on all of this, so I won’t inject a defense of these transactions here. But the mood does appear to have shifted over these last few months, and the aforementioned Incora adversary proceeding may have more of a gloss of legitimacy than if Judge Jones was at the helm but it's also stretched on and on and on. (Remember we’ve moved from Judge Jones overseeing all of this – for reasons we’ve discussed before vis-à-vis his, uh, undisclosed living situation – to Judge Isgur who has made his views from the bench much less clear to most ears.)
To this end, a little over a week ago we had hearings in Incora’s adversary trial with testimony from a number of those involved in the transaction. I won’t invoke any names here, and I won’t talk about the specifics too much. But in a bizarre exchange we saw Judge Isgur raise his “concern” over possible inconsistencies between what was said on the stand by an advisor to Silver Point and PIMCO and his earlier deposition. This advisor said on the stand that he was aware that a minority group of holders were negotiating with Incora at the same time as Silver Point, et al. but was unaware of the specifics of their proposal on a certain date before the transaction occurred. This mirrored what he said in his deposition.
But then he was shown an email from an MD at Silver Point. This MD told his Silver Point colleagues that their “advisors” had learned the specifics of the minority group proposal (well, that it would involve a drop-down and then some extremely rough numbers).
It was never specified who the advisors were, nor would anyone reasonably think that real proposal specifics were provided from what was described in the email (although actual specifics around the majority group proposal were already pretty well publicized at this time – and, once again, how the minority group learned of the majority approach to begin with, which set off the chain of events I talked about back in 2022, was through a Debtwire article).
In light of this email, the advisor was pressed on the stand about whether he knew of the specifics outlined in the email (he wasn't a recipient of it). Then he was asked if he told the truth in his deposition, despite there being no proof to the contrary, to which the advisor said he did. This led to a bit of back and forth before we had Judge Isgur say, when a lawyer objected to a follow-on question, “That is not an objection. I heard the witness’s testimony today, and I think it’s totally inconsistent with what I’m seeing here. So, I’m very concerned about what we’re hearing. We’re going to let him continue to answer questions.”
This whole line of questioning should be much ado about nothing, but it’s troubling by dint of being treated as a bit ado about something. What the advisor said is that he didn’t know when he became aware of the general concept of the drop-down that the minority group was mulling over, but that he did know about the concept – because of course he did. Everyone knew a drop-down was a viable (albeit inferior) option for Incora, and one that a minority group could opt for in response to the non-pro rata uptier pitch of the majority group.
Knowledge of the specifics never mattered and wasn't determinative. Anyone with access to the docs (read: an advisor to the majority group) could envision what the rough contours of a drop-down proposed by the minority group would look like or at least put an upper bound on it to ensure that the majority proposal was more enticing – as it was, and it wasn't too close.
Anyway, I don’t want to start a rant about the cross-examination, as this isn’t the place to do it. But it does seem like the worst arguments, and the most tangential of tangential issues, are getting the most airtime in Incora. And it does seem that how this transaction came together could inform, whether explicitly acknowledged or not by Judge Isgur, the permissibly of it (something Judge Jones refused to contemplate and which I defended him on despite all his cringe-inducing talk about "financial titans" that engage in "winner-take-all" battles).
The whole situation last week was bizarre, and made all the more bizarre by the specific elements of the transaction that were focused on. For example, there were frequent, torturous discursions into the rationale for the springer when the answer is self-evident. Likewise, lawyers treated it as a bit of a "gotcha" that Silver Point, et al. wouldn't do the same transaction, on the same terms, if it were pro-rata – because of course they wouldn't, that'd be a fundamentally different transaction. Anyway, I'll just say that I admire the restraint (read: self-control) of the witnesses involved and leave it at that.
With all that said, even with all this litigation and the somewhat unfavorable climate for these transactions, we’ve seen a few more uptiers (that we can call quasi-pro-rata, I suppose) either be consummated or kind of unravel over the last few months – desperate times calls for desperate measures.
First, there’s Robershaw which, uh, is a complete and unmitigated mess. So, let's do a quick and dirty overview of what happened (I'll link all the complaints below if you want to read all about it). At first blush, the fact that Robertshaw is such a mess could seem a bit surprising because there weren’t a bunch of neophytes involved here – we had Invesco and Eaton Vance back together again, as they were in Serta, joined this time around by Canyon and Bain.
The transaction itself was simple enough. Robertshaw was bought out by One Rock for $900mm in 2018 and had a $50mm ABL, $510mm 1L, and $110mm 2L. In May of 2023 – around the time that Incora filed – the company faced liquidity constraints and EBITDA was imploding (down a smidge at -74% YoY in Q4 2022).
So, Invesco, Eaton Vance, Canyon, and Bain – that held, in total, 76% of the 1L and 59% of the 2L – completed an uptier that had them invest $95mm of new money into a new First-Out Term Loan; exchange $370mm of their 1L TL, at par, into a new Second-Out Term Loan; and exchange $65mm of their 2L TL, at par, into a new Third-Out Term Loan.
Then, having learnt the lesson of Serta, they decided to be equanimous and offer non-participating lenders the opportunity to exchange their holdings into a mix of Second- and Third- and Fourth- and Fifth-Out TLs (but, of course, in exchange for this equanimity they asked these holders to do them the small favor of not litigating the transaction – although some non-participating lenders still sued, so truly no good deed goes unpunished).
Anyway, this is all is pretty textbook stuff, and if this were where the story ended it'd hardly be worth bringing up. However, a few months after the transaction closed an inglorious series of (absurd) events took place.
The impetus for the circus that would ensue was Invesco, in the near immediate aftermath of the transaction, beginning to buy up, in the secondary market, a simple majority of the First-Out Term Loan and Second-Out Term Loan (in the end, before the brouhaha all began, Invesco had $73.8mm of the First-Out Term Loan, $183.2mm of the Second-Out Term Loan, and $59.2mm of the Third-Out Term Loan).
This was all done on a hush-hush basis, and Canyon, Bain, and Eaton Vance were late to realize that the four firms weren’t all more or less bound together in the capital structure – but instead that Invesco, through now having this simple majority, was alone in the driver’s seat and that the returns of Canyon, Bain, and Eaton Vance were at risk.
This is because through holding a simple majority across the First- and Second-Out, this then allowed Invesco to amend (most of) the terms within the applicable credit agreement and, for all intents and purposes, control the future of Robertshaw unless there was some turnaround in the business that made them no longer need to rely on lenders for support (in other words, if waivers, additional capital, etc. were needed by the company then Invesco was now able to, for all intents and purposes, dictate terms irrespective of what Canyon, Bain, or Eaton Vance thought).
But, as Invesco knew with near certainty, there would be no turnaround in the business: so, in Nov of 2023 after an event of default that Invesco maybe, kind of, sort of forced to happen Invesco, Robertshaw, and One Rock agreed to the contours of a pre-pack (the degree to which they agreed depends on who you believe) that’d have Invesco provide the DIP and stalking horse bid when they filed in Jan of 2024 (read: Invesco would parlay their uptier participation, and secondary market purchases, to own Robertshaw post-reorg through credit bidding the eventual DIP, ABL, and First-Out Term Loan).
But then Robertshaw and One Rock – after having engaged in some level of negotiations over what an eventual filing would look like with Invesco – went to Bain, Canyon, and Eaton Vance to save themselves from having to file (I'm being a bit tongue in cheek here as the fact they’d have to file was all but certain – it was more about which creditors would drive the in-court process and how One Rock could preserve some kind of upside, although that's saying the quiet part out loud).
Recognizing that they needed to land back in the driver’s seat – and that to do so would require kicking Invesco out of it – Canyon, Bain, Eaton Vance, and someone else I'll mention in a minute provided $228mm of new money to a newly spun up entity that wasn't technically a Robertshaw subsidiary and thus not bound by the negative covenants under the pre-existing debt docs. This $228mm was then immediately sent from this newly spun up entity to Robertshaw who used it, in part, to take out (prepay) almost all the pre-existing First-Out TL (inclusive of Invesco's entire stake).
It was expensive to take out the First-Out TL with the make whole, but desperate times call for desperate measures and this did result in Bain, Canyon, and Eaton Vance getting back in the driver’s seat that Invesco previously enjoyed alone due to this group now possessing a simple majority (50.05%) across the small stub of First-Out TL left ($93,000) and the Second-Out TL. This then (depending on your perspective) allowed this new simple majority to amend the credit agreement and incur – wait for it – $228mm in incremental First-Out, and a bit of Second-Out, debt the proceeds of which were used to prepay (take out) the $228mm at the aforementioned newly spun up entity.
So, this was all a bit of musical chairs with the end result being that Invesco was out of the driver's seat and there was now $228mm of new First- and Second-Out TLs. (This is a quick and dirty overview, for the step-by-step mechanics, inclusive of how all the proceeds of this $228mm were used, see the adversary complaint linked later. Here's Invesco's shorter summary...)
Invesco wasn’t too pleased about any of this (it’d be one thing if they only held the First-Out and were taken out of the capital structure as that’d still net them a nice IRR for a few months of work, as they did receive $92mm for their $74mm of First-Out TL – but they still held a non-trivial amount of other parts of the capital structure, plus were obviously going to lose out on getting post-reorg control of the company). So, of course, they sued in state court over the “sham” transaction in Dec 2023 (say a prayer for those that had to deal with this over the holidays…).
Note: I’ve joked before that lawyers secretly love writing these complaints because it provides them full license to show off their literary flare and let loose their existential angst against the world – and this complaint was no different. Here are the alleged consequences if Canyon, Bain, and Eaton Vance are allowed to get away with all this: “...there will be no limit to the sophistry and deceit that will infect the distressed debt market for syndicated secured loans. No amount of thoughtfully negotiated credit agreement covenants can ever effectively prevent other transaction parties from nefariously circumventing contractual rights to garner the controlling votes in credit facilities.” This can seem a bit like the pot calling the kettle black, but I'm pretty sympathetic to Invesco on this here.
Now, one might think all of this rearrangement of the deck chairs on the Titanic kind of makes sense from the company’s perspective if they felt that they were being strong-armed into filing by Invesco (as, let’s be honest, they very much were) and if the end result of all of this rearrangement was that Canyon, Bain, and Eaton Vance became reliable partners in the company's capital structure (working together, hand-in-hand to side-skirt filing and enabling the company to grow into their new capital structure.).
But, uh, around two months after Invesco sued over the transaction Robertshaw filed (in the Southern District of Texas, of course, because SDTX still offers debtors the best shot to have contentious uptiers rubberstamped even if Judge Jones isn’t around anymore). And their current RSA contemplates the sale of their assets to Canyon, Bain, and Eaton Vance through a credit bid. So, it’s more or less the exact same concept that Invesco envisioned in their contemplated Jan 2024 pre-pack – but instead of Invesco credit bidding, we have the rest of the original uptier group doing so.
However, in the above I omitted one little detail: that One Rock participated in the December 2023 Bain, Canyon, and Eaton Vance transaction (to the tune of providing ~$42mm of the aforementioned ~$228mm at the newly spun up entity, which transformed into $32mm of the First-Out TL and $10mm of the Second-Out TL), and will credit bid its new claims alongside the other three. So, the rearrangement of the deck chairs may have not made a difference to the company's prospects, which were more or less set in stone back in late-2023, but if this second transaction stands then it'll have made a big difference to the sponsor's returns. And, in the end, isn't that all that really matters?
Note: Robertshaw is a mess, and to be honest there’s no lessons to be learned from it right now (at least not lessons that should be learned). No one covered themselves in glory here although I don't see an issue with Invesco’s approach (albeit a bit of bad sportsmanship involved) and I'm generally sympathetic to (most of) their position on the “sham” transaction – the Canyon, et al. transaction does seem a bit too clever by half, and would be easier to unwind without touching the uptier issue, although if it stands then it would provide another interesting tool in the tool box...
Note: For the other side of the coin, see the initial complaint in the adversary proceeding after Robershaw filed where Robershaw, One Rock, Bain, Canyon, and Eaton Vance make their case. You have to admire them basically saying, "For the life of us, we can't figure out the issue here. Invesco earned a nice return on their First-Out TL, and then they turned around and sued us. All we did was what the credit agreement allowed us to do, no different than what we did with Invesco in the original uptier. Not sure what all the complaining is about. We just operated within the bounds of what the docs allowed."
Second, in less contentious news, there’s Apex Tools (PJT debtor-side, PWP with an ad hoc group of lenders) that did a nice little quasi-pro-rata (everyone can participate but not on the same terms) transaction a few weeks ago. It was all traditional and most of those that could participate on the inferior terms did do so – although, of course, Robertshaw’s transaction was traditional too until Invesco decided to venture off on its own and the comedy of errors discussed above began to unfold.
]]>And, I mean, that's all true enough and there is a certain monotony (by design) to the in-court process. However, this line of thinking elides the fact that bankruptcy courts are courts of equity, and that the Code endows bankruptcy courts with a broad latitude to move both within and beyond the explicit text of the Code insofar as it’s necessary or appropriate to orchestrate an outcome.
This is because Congress understood that it would be impossible – even in their near infinite wisdom – to craft a Code that envisioned every possible case that would fall at the feet of bankruptcy courts and every possible plan that would need to be crafted to maximize estate value and creditor distributions. Sometimes extratextual elements would need to be added to plans that Congress did not and could not envision at the time and thus may not find explicit statutory support within the Code.
However, if these extratextual elements don’t conflict with other aspects of the Code then they’ve been considered (more or less) acceptable due to a catchall provision placed within the Code by Congress that’s been interpreted to be limited, first and foremost, by what the Code disallows, not what the Code allows (in other words, an inversion of the cannon of construction expressio unius est exclusio alterius that we talked about vis-à-vis Serta some time ago).
This idea, in some loose form, stretches back centuries as the Supreme Court observed vis-à-vis the Bankruptcy Act of 1841 in a 1845 decision, Ex Parte Christy: “[I]t is manifest that the purposes so essential to the just operation of the bankrupt system, could scarcely be accomplished except by clothing the courts of the United States sitting in bankruptcy with the most ample powers and jurisdiction to accomplish them; and it would be a matter of extreme surprise if, when Congress had thus required the end, they should at the same time have withheld the means by which alone it could be successfully reached.”
This is all reasonable enough as it’s somewhat self-evident that bankruptcy isn’t really about finding a perfect outcome, it’s about finding an outcome – and sometimes even an outcome, never mind one that everyone is happy with, requires creativity being employed and, if push comes to shove, endowing someone with the right to ring the bell, call the squabbling to a halt, and cram down the best possible plan on everyone.
In bankruptcy justice, in a more ephemeral sense, is subordinated both practically and philosophically to feasibility. Bankruptcy courts are not here to right the ills of the world, they’re here to reorganize debtors and maximize the recovery of creditors within the broad contours of the Code.
To this end, it’s been recognized by real (Article III) courts that when an issue flows up to them a certain benefit of the doubt should be extended to the judges who have lived with the case day in and day out and have, for lack of a better turn of phrase, a better intuition on what should be done. Not least because contentious or controversial plans often are like a Jenga tower after many turns have been taken – remove one wrong piece and it all comes crumbling down which could redound, in the end, to everyone's detriment (in not only the case at issue but also in future cases). Be careful about opening Pandora's Box.
Note: The above all sets up, as best as I can, the foundation for the actual arguments we’re about to discuss. But before any rx lawyers email me, the above is all a bit (or more than a bit) tongue-in-cheek as Article III courts have, uh, become a bit tired of how much latitude bankruptcy court judges have availed to themselves (as I mentioned in the conclusion to my last post vis-à-vis the Fifth Circuit being quite unlikely to find Judge Jones’ vibes-based approach to determining what “open-market purchases” means compelling even if, as I believe, it's the only sensible outcome).
Note: Since every post needs a little Serta digression, remember that back in 2020, in the wake of Serta's transaction, the Apollo, et al. complaint stated front and center that, "If permitted to stand, it will not only strip Plaintiffs of the collateral protecting their loans, but will cause havoc in the corporate loan market. If majority lenders can conspire with borrowers to subordinate the minority, there are billions of dollars of loans that are at risk of having value stripped away in an instant." We're now three years removed from this prediction and we've seen only a handful of similar transactions and, more importantly, the market has erred on the side of caution, assumed that non-pro rata uptiers or their ilk would be upheld in the end, and Serta blockers are now just another among a long list of bargained-for elements in debt doc negotiations with around 50% of all new lev. loans this year containing them. (Notice how the doomer-ism has been dropped from the Fifth Circuit appeal and we're back to the same tired arguments being trotted out.)
Note: It should be somewhat self-evident that bankruptcy court judges have a significant amount of latitude in how they handle cases. If this weren’t the case and they were more or less indistinguishable from each other due to the confides of the Code or whatever, forum shopping (the bête noire of many academics) wouldn’t be a thing. But there is a reason that the Southern District of Texas turned into the hottest venue in bankruptcy both literally and figuratively in only a few years, and there’s a reason that Judge Jones handled 17% of all cases with over a billion dollars in liabilities since 2020 – and the reason isn't because Kirkland, et al. wanted an excuse to fly down to Houston for some Tex-Mex and to take in the Houston Livestock Show and Rodeo.
Anyway, back in August – before I discussed disqualified lender lists and mustered a defense of Apollo – we talked about (nonconsensual) third-party releases: an extratextual element to be sure, but one that has been accepted by most (not all!) Circuit Courts for decades because of the recognition that they enable the creation of plans in certain situations that would otherwise have little chance of coming together.
The reason for bringing them up then was that the knock-down, drag-out fight over the permissibility of nonconsensual third-party releases in Purdue’s case was set to be decided once and for all: because after the Second Circuit’s opinion reversed the Southern District of New York’s decision that reversed the bankruptcy court’s approval of Purdue’s plan, SCOTUS took up the case to make a final decision with oral arguments taking place on Dec 4 of 2023.
As I wrote back in August, “Given the extratextual nature of third-party releases and the textualist majority now ruling the roost at SCOTUS, this could shape up to be the end of third-party releases as we know them. If this is the end, it’ll be a mess. And it’ll all be because a common practice – rooted in pragmatism and past precedence, but not much else – managed to raise the ire and indignation of enough people to get it in front of SCOTUS. The nail that sticks out gets hammered.”
It's important to never read too much into oral arguments, and a decision won’t come down until the first half of 2024. However, sometimes oral arguments leave little to the imagination: it was already baked into the cake that some (e.g., Justice Thomas and Justice Gorsuch) would take issue with nonconsensual third-party releases on more constitutional grounds and that some (cough, cough Justice Roberts) would invoke the major questions doctrine because that needs to be shoehorned into almost every case these days.
The real fight was always going to be over the squishy middle of the Court (of which there remains few) who could perhaps be swayed by more pragmatic considerations such as the fact that nonconsensual third-party releases in Purdue were supported by almost everyone with an economic interest in the case, the fact that nonconsensual third-party releases stretch back decades with most Circuit Courts approving their use in limited circumstances, etc.
But, as Patel of Akin, representing the UCC, recognized in his exasperated final pleas before the Court the squishy middle seems to think - in concert with the media, politicians, and the public - that these third-party releases are a way for the Sackler family (a nebulous collection of dozens of people criss-crossing the world) to skirt responsibility for their actions and shortchange creditors when this will likely prove to be quite the opposite.
Not to ruin the story before it even begins but it’s almost assuredly the case that the Second Circuit’s opinion upholding Purdue’s use of nonconsensual third-party releases will be reversed. I’d personally bet on it being 8-1 with Kavanaugh in dissent, or at best 6-3 with Kagan and Roberts hopping on board too. (I think that Justice Jackson could go either way, but there aren’t many who agree on this, so I’ll bow to the court watchers here).
If the Second Circuit is reversed, this will all be a bit of a mess. First, Purdue’s case will drag on for even longer and those most harmed (the opioid victims themselves) any honest commentator would, or should, acknowledge will almost assuredly be left worse off (there will per se be no recovery from the estate, and a default to the tort system or multi-district litigation will be retread that will have their own challenges). Second, it’ll fundamentally impair the ability to use chapter 11 as a way to efficiently, effectively, and equitably come to fulsome resolutions around mass tort claims – especially when the amount of claims are orders of magnitude in excess of what the debtor and those who’d otherwise be beneficiaries of releases can provide (the recent 3M / Aearo settlement isn’t much of a counterpoint to this). Third, it could throw a wrench into the ability of some sponsors, in some circumstances, to secure global peace through the use of third-party releases when one of their PortCos files (although I’m a bit unfazed on this – it shifts leverage a bit, sure, but should only make the price of peace in limited circumstances a bit more than it otherwise would be).
Instead of bludgeoning you with my views here – that, like all my views, have some obvious biases although less so here than with more “core” restructuring issues such as the permissibility of non-pro rata uptiers, double-dips, etc. – I’ll do a quick and dirty overview of some interesting points, and leave lots of links for you to read up on the case from those who know more than me, and make better arguments than I can, in case it’s of interest over what remains of the Holiday Season.
Note: Keep in mind that this is a case, like all other mass tort cases, that for most exists on the periphery of restructuring – a case that’s of interest, but that almost no one has an interest in. PJT is debtor-side with HL and Jefferies having creditor-side mandates. But this isn’t a case where restructuring bankers make much of an appearance (except in being called out for fees, which is unfair in this instance), and there are no distressed fund shenanigans going on. As in most in-court cases, the fees earned to-date help tell the story, and that story is one of a legal fight that’s dragged on for years (to-date fees are set to surpass $700mm in toto, with a relative pittance going to PJT, et al.). (You can read PJT’s fee breakdown here if for some reason that’s of interest.)
There’s no sense rehashing the rise and fall of Purdue Pharma here – the briefs that I’ll link to in a moment offer a nice play-by-play of the history that’s sufficient for our purposes (if more sensational or salacious accounts are what you’re after then there are countless books, Netflix series, etc.).
There’s no doubt that Purdue’s the most infamous filing since the financial crisis. Purdue’s story captured the public’s imagination, and, for most, Purdue has become the posterchild of the entire opioid crisis. This is all understandable since the script pretty much writes itself. There was a profit-maximizing firm that was hell-bent on peddling highly addictive drugs with seemingly reckless abandon. There was a secretive family - full of social climbers, literal climbers, and assorted creative-types - that were the sole beneficiaries of the firm’s billions in profits and ensconced those profits in difficult-to-breach trusts in difficult-to-reach locales. There was even a cameo from McKinsey who seems to have taken the mantle of the “great vampire squid wrapped around the face of humanity” from Goldman in the public’s mind (absurd article, fantastic turn of phrase).
Anyway, by the late 2010s the need to file became self-evident as the level of litigation from individuals and, eventually, states piled up to an unprecedented degree (most states were notable by their absence prior to the opioid crisis becoming a more politically sensitive issue, and make no mistake that the states have diminished victim payouts from what they otherwise would be due to their inherent leverage in the case, but we’ll leave that aside for now). In the end, Purdue filed in 2019 in the Southern District of New York and, as of today, there are an estimated forty trillion in claims against both the Sacklers and Purdue (so, most creditors won’t be getting a full recovery here...).
No different than in any other case, upon filing all litigation against Purdue was stayed. However, since Purdue and the Sacklers were so impossibly intertwined (Purdue distributed around $11b to the Sacklers over the two decades prior to filing and Sackler family members had served as co-CEO, president, and held six board seats at various times) there was parallel (duplicate) litigation against the Sacklers pre-filing.
So, even though none of the Sacklers filed personal bankruptcy, the litigation against them was also stayed when Purdue filed. This was for several reasons not least of which is that everyone understood at the time that any eventual Purdue plan would involve a sizeable contribution to the estate from the Sacklers in return for third-party releases, so allowing litigation to proceed against the Sacklers would allow some creditors to jump the line and, by extension, lower the amount available to the rest of the creditors of the estate due to diminishing the value that the Sacklers could contribute to Purdue. (The backstory isn't terribly important for our purposes here but the filing occurred because, after Purdue's MDL trials and tribulations, bankruptcy became viewed by the Sacklers, rightly, as the only way for there to be an actual global resolution for all parties involved - most importantly themselves.)
Note: It’s also important not to lose sight of the fact that the “Sackler family” is often thrown around as if it’s, like, a few siblings who ran and controlled Purdue. In reality, there are dozens that are considered, for our purposes here, members of the Sackler family. Some were intimately involved in Purdue, and some were more or less disinterested parties that had an economic stake in the company. Likewise, not all the Sacklers are residents of the US and, as I alluded to back in August, the vast majority of their wealth would not be accessible in a personal bankruptcy proceeding to begin with.
Note: I can’t write 10,000+ word posts every month, and this is a rabbit hole not worth venturing down too far, but millions were spent prior to the plan being developed determining how much of the Sacklers’ assets are collectible and what other forms of settlement, outside the bankruptcy context, could look like. So, take it as an article of faith, read the Purdue and UCC briefs, or read through the docket: not all that wealth, or even a majority of it, would be accessible to claimants outside of it being voluntarily offered as part of a comprehensive settlement. This is one of those things that was self-evident in 2020 and 2021, but somehow is an issue of debate now. Here's Judge Drain, almost in tears, trying to make this case that there's a central unfairness here but the realities must be dealt with as they are...
In the end, after much back-and-forth, in Sept. of 2021 Judge Drain (now retired) confirmed Purdue’s Plan – the result of pain-staking negotiations that almost entirely revolved around a $4.325b contribution coming from the Sacklers in return for (nonconsensual) third-party releases. (The Sacklers’ also agreed to exit the opioid business worldwide and make Purdue’s records public for future study on the causes of the opioid crisis).
Now, as I wrote back in August, third-party releases can come in many flavors – with some being tightly tailored, and some being extremely expansive. The simplest explanation of third-party releases is that they prevent the beneficiaries of a release (non-debtors, such as directors or lenders or subsidiaries or in this case the Sacklers writ large) from being sued by existing creditors or (sometimes) relevant other non-debtors for their actions either directly or (sometimes) indirectly related to filing. The nonconsensual descriptor comes into play when even those that aren’t in favor of the releases within a plan are nevertheless bound by them due to a majority being in favor and the plan being confirmed (in Purdue in excess of 95% of all creditors voted for the Plan, including between 95.7-98.0% of personal-injury claimants who, for obvious reasons, have no love lost for the Sacklers or Purdue).
To be clear, from the outset of Purdue’s case the fact that there would be third-party releases was taken for granted by almost all involved: the only question was how tightly tailored they would be and how much the Sacklers would pay for them. So, as you’d expect, the initial salvo by the Sacklers after Purdue filed involved them agitating for extremely expansive releases that would encompass, well, pretty much everything they could ever be sued for. However, over time the releases were whittled down and down to the core of the issue that brought Purdue to filing in the first place – in fact there was even a last-minute amendment before confirmation by Judge Drain to make the releases even more narrow than what was originally agreed to.
So, here’s a basic overview: the releases at issue here would enjoin all creditors from i) pursuing current claims against the Sacklers, either directly or indirectly via the investment vehicles they control, as long as those claims are based on the debtor’s (or the estate’s) conduct and are opioid related and ii) initiating future litigation against the Sacklers, either directly or indirectly via the investment vehicles they control, as long as those claims are based on the debtor’s (or the estate’s) conduct and are opioid related. In other words, these releases would resolve, in one fell swoop, all current and future claims against the Sacklers connected with the conduct of Purdue in the context of opioids. This includes all direct claims (harm to individuals by the non-debtors) and derivative claims (harm to the estate by non-debtors, such as fraudulent transfer, deceptive marketing, negligence, etc.). But these releases don’t cover claims that are i) not held by a creditor of Purdue ii) not opioid-related or iii) opioid-related but not dependent on Purdue’s actual conduct.
If a visual helps, then here’s one from Purdue’s brief that was done in an attempt to drive home the point that these releases don’t absolve the Sacklers of all responsibility but rather absolves them, in return for billions, of claims that are inextricably intertwined with the actions of Purdue (with Venn diagrams like these, don’t say that the hundreds of millions in legal fees are all for not – look at the attention to detail with the red and blue mixing into purple within the intersection...).
Note: I’ll circle back to this later, and I don’t want to repeat myself too much. But, since this is a point that seemed to elude some, I’ll touch on it here. Without these nonconsensual releases creditors could still pursue claims against the Sacklers. However, because the claims at issue here per se revolve around the Sacklers conduct through Purdue as a kind of conduit, it would trigger claims by the Sacklers for indemnification or insurance coverage against the estate and start a whole new front of internecine legal fights. And because the total claims here are in the trillions, far in excess of the amount Purdue or the Sacklers can come up with, one or two individual creditors could i) drain the estate of its value and/or ii) drain the Sacklers of funds that’d otherwise go to the estate and be distributed, of course, equitably. This is the rationale behind almost all creditors insisting on these releases being nonconsensual – they weren’t foisted on creditors, they were demanded by them. Because it was understood by almost all creditors that to allow a few creditors to enter the backdoor, cut in the queue, skip to the front of the line, etc. would be to the direct detriment of all other creditors with similar claims who didn’t.
There was never a doubt that there would be an appeal over the Plan’s confirmation. True, most states, and most claimants, were on board. But there was still a sizeable number (eight states and DC, along with 2,683 individual claimants) who weren’t. So, the Plan’s future was punted up to the US District Court for the Southern District of New York. This is where the trouble began, and is the reason why we’re over two years removed from the confirmation of the Plan without a dollar having flowed to victims and hundreds of millions more in legal fees having been racked up.
Judge McMahon – a faster writer than I am, as she somehow delivered a 142-page decision in a few months – ruled that a bankruptcy court can’t, on a nonconsensual basis, bar third-parties from asserting direct claims (e.g., harm to individuals) against a non-debtor (the Sacklers). In other words, nonconsensual third-party releases aren’t permissible under the Code.
This was a decision that struck at the heart of the Plan and rendered it unsalvageable because the vast majority of the Plan’s value stemmed from the Sacklers’ contribution for these nonconsensual releases. So, the District Court’s decision was appealed to the Second Circuit that hadn’t previously offered a full-throated opinion on nonconsensual third-party releases (four other Circuit Courts had ruled they were permissible with three Circuit Courts having held that they aren’t on narrower grounds).
Unlike the District Court, the Circuit Court took, uh, a bit more time. Enough time that while the appeal was pending, the Plan was revised: in return for the Sacklers’ upping their total contributions to $5.5-6.0b, everyone outside of the US Trustee who has no economic interest in the case, a few Canadian First Nations, and a small subset of individual claimants approved of the Plan. And there’s no doubt that this reality – that those who most loathed the Sacklers were now in almost unanimous support of the Plan – weighed on the Second Circuit in their decision.
The Second Circuit issued its opinion – that reversed the District Court and affirmed the Bankruptcy Court – in May of 2023. In my view – for however much value you want to ascribe to it – the Second Circuit’s opinion is still the most compelling take on Purdue’s predicament. It confronts the reality that there can appear to be somewhat shaky statutory support for nonconsensual third-party releases, but that, in a bankruptcy context, it shouldn’t be dismissed as irrelevant that near unanimous support exists for the current Plan and it shouldn’t be dismissed that other avenues for resolution are almost assuredly going to lead to inferior outcomes for those most harmed here (the opioid victims themselves).
But just as it was baked in that the District Court’s decision would be appealed, so too was it baked in that the Second Circuit’s opinion would be. So, with there now being an even larger split between the Circuit Courts and with Purdue being such a high-profile case, it was all but certain that SCOTUS would take up the case and decide the issue of nonconsensual third-party releases once and for all.
In August 2023 SCOTUS granted cert and scheduled oral arguments for December 4. The (narrow) question before the Court is as follows: Whether the Bankruptcy Code authorizes a court to approve, as part of a plan of reorganization under Chapter 11 of the Bankruptcy Code, a release that extinguishes claims held by non-debtors against non-debtor third parties, without the claimants’ consent.
Thus far I’ve been mum on the actual statutory arguments here. Why did the District Court think that nonconsensual third-party releases are not permissible? Why did the Second Circuit disagree? Why do (some) Circuit Courts disagree with the Second Circuit? What, like, are the arguments that SCOTUS will need to wrestle with?
I figured it’d be better to save all this until we talked about oral arguments, because oral arguments laid bare the most important aspects of the case (although some, like Justice Sotomayor, used oral arguments to enter into disorienting discursions on definitional matters that left everyone, not least of all Sotomayor herself, a bit dazed and confused).
On December 4, we had three people argue before the Court. First, the Deputy Solicitor General, Gannon, arguing on behalf of the US Trustee. Second, Garre, of Latham, on behalf of Purdue. Third, Shah, of Akin, on behalf of the UCC (remember: almost all creditors, including those represented by the UCC, approved of the Plan and, by extension, the releases contained within).
Note: You can read the briefs filed by the US Trustee, Purdue (excellent), and the UCC that lay out their full views – something that’s worth doing to really understand the issues here since oral arguments are often used by justices to test out the limits of arguments, throw out half-baked hypotheticals to see how they’re handled, etc. It’s also worth reading the Second Circuit’s decision since that’s kind of the base case the fight centers around (there were also an insane number of amici briefs filed – lots from academics trying to have their moment in the sun, but there are some like from The American College of Bankruptcy that grapples with the broader ramifications of a reversal of the Second Circuit in a more dispassionate sense and tries to make sure consensual releases aren't disrupted).
In the end, since textualism – always in all ways – is the modus operandi at the Court now, most of the argument centered around two snippets of the Bankruptcy Code: 1123(b)(6) and 105(a). The Fourth and Eleventh Circuits believe that 105(a), on its own, authorizes nonconsensual third-party releases, and the Sixth, Seventh, and (now) Second Circuits believe that 105(a) and 1123(b)(6), when read together, authorizes these kinds of releases.
Section 1123(b)(6) says that “a plan may... include any other appropriate provision not inconsistent with the applicable provisions of [the Code]”, whereas Section 105(a) says that a bankruptcy court can “...issue any order, process, or judgement that is necessary or appropriate to carry out”.
The thinking of the Second Circuit – that was mirrored by the Sixth and Seventh circuits, along with Garre and Shah in this case – is basically that 105(a) endows a bankruptcy court with the authority to take actions that are necessary or appropriate to get a plan across the finish line, and 1123(b)(6) allows the inclusion of what I’ve called “extratextual elements” in a plan so long as they’re appropriate and not in contradiction with any other part of the Code. This draws on United States v. Energy Resources Co., Inc where SCOTUS held that 1123(b)(6), when read together with 105(a), granted bankruptcy courts a “residual authority” that’s consistent with “the traditional understanding that bankruptcy courts, as courts of equity, have broad authority to modify creditor-debtor relationships”. In other words, 105(a) superglued to 1123(b)(6) allows for the inclusion of plan provisions that find no direct support within the Code so long as these plan provisions are appropriate and not expressly disallowed elsewhere in the Code (per the Second Circuit, 105(a) can't be relied on alone and must be tied to some other section of the Code).
This is what I was alluding to – without getting into the legal underpinning – in the preamble: there’s been a long history at the Court of appreciating that bankruptcy courts need broad latitude, and that Congress understood that not all plan provisions could be envisioned and thus explicitly expressed in the Code. So, when it comes to the Code, there aren’t really elephants hiding in mouseholes. Rather, there are elephants, in this situation, hiding in elephant-sized holes that Congress explicitly and deliberately placed into the Code.
But – and there’s a big but here – the above is more or less uncontroversial vis-à-vis the modification of creditor-debtor relationships. But what we’re talking about here is the relationship between creditors of a debtor (Purdue) and non-debtors (the Sacklers) that haven’t filed bankruptcy themselves (the Sacklers have, as we’ve discussed, been lumped into this case because of how inextricably intertwined to Purdue they are).
So, sure, sure, 105(a) and 1123(b)(6) can be read together to modify creditor-debtor relationships – that kind of, like, is the heart of what bankruptcy is all about, is why bankruptcy courts are courts of equity, etc. But can we extend this to stripping a non-consenting creditor’s right to their day in court against some non-debtor that (per se) hasn’t filed? Does the fact that duplicate claims were filed against both Purdue and the Sacklers, since the two are so inextricably intertwined, make a difference here? If we’re saying that the Sacklers are de facto debtors – but aren’t, like, actual debtors – then why shouldn’t they have to put “all their assets on the table” and have them divided up among creditors as Purdue itself is doing here? Is the fact that non-consenting creditors can have their say in a bankruptcy court context sufficient, or must their day in court against non-debtors come outside the bankruptcy context if they so choose? What if it’s in the best interests, in the view of the bankruptcy court, of all creditors to force releases, and the associated settlement amount attached to them, on everyone – inclusive of the few creditors who refuse to capitulate?
Note: Due process and Seventh Amendment concerns were something (surprise, surprise) that Justice Gorsuch kept circling back to because he seemed flabbergasted that claimants could have their due process and Seventh Amendment rights stripped away without their consent when the Sacklers didn’t file themselves. See, pp. 74-77 of the transcript – I think Garre handled it well, but no line of argument will be persuasive to Gorsuch on this.
Look, the optics here overall aren’t fantastic. Because it sure looks like the Sacklers are using Purdue as a conduit, once again, to skirt justice as somehow, with over forty trillion in estimated claims, the Sacklers under the Plan would still be walking away from all of this as billionaires (at least in a collective sense). It sure looks like they’re getting the benefits of bankruptcy but aren’t shouldering the costs (read: putting all their assets on the table). And this is all due to the fact that Purdue, as a standalone entity, is so deprived of assets, partly because of the Sacklers sweeping billions out of Purdue over the last few decades, that the only way any recovery can reach down to victim classes is through a Sackler contribution of their “ill-gotten” gains – so, even though the Sacklers aren’t putting all their assets on the table, they’re able to strongarm creditors into begging for them to be given releases that eviscerate the litany of (civil) litigation against them.
But Purdue, the UCC, et al. have argued that No True Textualist would buy what the US Trustee is trying to sell (some ejusdem generis gobbledygook in relation to 1123 that is meant for short, tight list of items not separate provisions as is the case here). 1123(b)(6) is a catchall that is limited by what the Code doesn’t allow, and the Trustee can’t point to any other area of the Code disallowing these. Them's the breaks.
Further, sure, 1123(b)(6) is most often invoked when the creditor-debtor relationship is the only operative one (since in most cases there isn’t a non-debtor issue of consequence in play). But the whole reason these releases are so essential is that the Sacklers and Purdue are so intertwined that the absence of these releases will impact actual creditor-debtor relationships. Because without these releases – that, once again, are limited to claims against the Sacklers that depend on Purdue’s conduct – creditors could pursue claims against the Sacklers that would trigger indemnification / insurance claims against the estate should these claims depend on Purdue’s conduct (whether these are of merit or not, the cost to litigate will be absurd, even by the lofty standards already set by the case to-date, and deplete the estate of even more value).
In other words, these releases do have an impact on creditor-debtor relationships, if one believes that’s relevant to 1123(b)(6) by departing from a "stricter" textualist reading of it, because their absence or presence fundamentally shifts not only the recovery that’s due to various classes, but the relationship of the debtor to the Sacklers that’ll have knock-on ramifications on all creditors. As Purdue said in its brief, “Resolving those claims [between Purdue and the Sacklers] to maximize the value of the estates for all creditors directly impacts the creditor-debtor relationship. Indeed, without the releases, there is no settlement, the Debtors likely would be forced into a Chapter 7 liquidation, and ‘unsecured creditors would probably recover nothing from the Debtors’ estates’”. (This wasn’t elaborated much because, I mean, it is a bit of connect the dots but the creditor-debtor relationship must be, in some sense, modified when the absence of a plan provision, even if it's to the benefit of non-debtors, turns a case into a liquidation instead of reorganization and when a class of creditors goes from getting something from the debtor to probably getting nothing.)
The other major line of argument – that most didn’t think would feature quite as prominently as it did – surrounded whether these releases, in effect, constitute a discharge. Under Section 524(a), in bankruptcy a debtor can be released, through a discharge, from liability relating to any pre-petition debt so long as the debtor complies with the Bankruptcy Code (the proverbial, “putting all your assets on the table” as was frequently invoked by the justices in oral arguments).
The Fifth, Ninth, and Tenth Circuits have said that nonconsensual third-party releases are not permissible under 524(e) because they conflate third-party releases with discharges. However, the Second Circuit departed from this interpretation because the third-party releases at issue here, due to how tightly tailored they eventually ended up being, do not, in their view, constitute a discharge.
Per Gannon the releases here are a “functional” discharge. In other words, a discharge in all but name. But this functional discharge is being granted, unlike in a classic bankruptcy context, without the Sacklers putting all of their assets on table (as mentioned before, it’s important to note that Gannon is eliding the fact that most of the Sacklers assets wouldn’t be eligible for a personal bankruptcy, and it’s not altogether clear what Sacklers would be filing, where they would be filing, and what actions they could take against the smoking wreck of Purdue’s estate sans-releases). But if one thinks that these releases are indistinguishable from discharges then all this 105(a) and 1123(b)(6) talk is moot: if these releases are just discharges dressed up in different garb, then these releases aren’t permissible.
Here I think Garre did as well as he could – at least given the predisposition of the majority of his audience:
Note: Some have become a bit preoccupied with Section 524(g) that explicitly allows for an injunction of claims between non-debtors in asbestos cases (with lots of caveats). This was added to the Code in the 1990s after the Johns-Manville case and some have basically said, “If Congress intended that nonconsensual third-party releases could be permitted in any mass tort case, then they would have said so when they added 524(g). Instead, they crafted a very narrow exception to the implied prohibition of these releases, with lots of caveats, for asbestos related cases.” However, Congress made it clear at the time that no one should read 524(g) to infer other limitations within the Code. Further, this argument strikes Purdue, et al. as a bit backwards: nonconsensual releases were in the ether before 524(g) was added, and have been used thereafter. If Congress believed there was a general prohibition against nonconsensual releases, but wanted to create a defined carveout for handling asbestos cases, then they would have added language to that effect to preclude nonconsensual releases being used in other cases in the decades to come – or, at the very least, revisited all of this after realizing their error.
So, the US Trustee’s argument boils down to, “Look, Section 1123(b)(6) and 105(a) can’t expand the bankruptcy court’s authority to extinguish claims, without consent, between two non-debtors (claimants and the Sacklers) unless the Code expressly allows it with clear language (as it does in asbestos cases). Because to allow this is to rob nonconsenting claimants of the ability to exercise their rights and, if that isn’t enough, these releases are tantamount to a discharge, in all but name, to those that haven’t earned the right to that discharge by putting all their assets of table. In short: the Sacklers are getting the benefits of bankruptcy without incurring the significant costs – they’re having their cake and eating it too.”
From a more practical perspective, the natural consequence of affirming the Second Circuit, per Gannon, is that it will provide “...a roadmap for corporations and wealthy individuals to misuse the bankruptcy system to avoid mass-tort liability. Such releases deprive tort victims of their day in court without consent. And they erode public confidence in the bankruptcy system.”
An uncharitable reading of this is that Gannon seems more preoccupied with public perception – since the public, as we all know, has deeply held views on how expansive of a catchall Section 1123(b)(6) really is – than with the perspective of the opioid victims, the overwhelming majority of whom support the Plan and, by extension, the releases contained within sans a few “nut-case holdouts” (Justice Kagan’s words from a hypothetical question, not mine!).
In contrast, Purdue and the UCC, the latter representing those most harmed by the Sacklers actions, are saying, “I mean, c’mon, the most active Circuit Courts have allowed nonconsensual third-party releases for decades, and the Second Circuit here has implemented a seven-factor balancing test to ensure that these releases can’t be abused by ‘wealthy individuals’. Section 1123(b)(6) is a catchall and, when read with 105(a), has two limitations i) what’s being done must be appropriate and ii) not inconsistent with other provisions of the Code. So, what’s a better definition of “appropriate” here than what almost all creditors, inclusive of those who most despise the Sacklers, deem by dint of their approval of the Plan to be appropriate? What have these other Circuit Courts missed in the Code that expressly disallows these? Isn’t the truest textualist reading here that if you can’t point to a part of the Code that disallows these, then these releases are allowed? The US Trustee is suggesting that the Second Circuit is playing policy maker – but that’s backwards. If Congress wanted to exempt these, then surely they would’ve done so when crafting 524(g). Since they didn’t, then tossing out nonconsenual releases would be the real act of policy-making (something that, as all faithful followers of the major questions doctrine can attest, is best left for the hallowed halls of Congress). Further, this isn’t a classic discharge, and it’s not a functional equivalent to one: these releases are only binding on the intersection of Purdue-related and opioid-related conduct (look at our color-coded Venn diagram!) and doesn’t absolve the beneficiaries of these releases from allcurrent or future legal liability (criminal, tax, non-opioid-related, etc. liability can still be pursued!). These releases were negotiated with creditors in the driver’s seat, over a period of years, and represent the single biggest contribution (by far!) to the estate. It’s a settlement, based on the fact that identical claims exist against Purdue and the Sacklers, and is additive to the estate value in more ways than one: if the Sacklers didn’t agree to the releases then they’d have claims against the estate themselves that at a minimum would lead to even more litigation cost, even more delays in creditor distribution, and drain the minimal estate value of Purdue that would exist sans a Sackler contribution. In other words, the addition of the releases adds $6b, and the negation of the releases won’t just get the estate value back to neutral, it’ll all but ensure there’s not a dime to distribute to victims or to run abatement programs. And, when it comes to these constitutional concerns that the Trustee is playing footsy with purely because of the composition of this Court: c’mon, there are often modifications of debtor, creditor, and non-debtor relationships in bankruptcy. These ‘nut-case holdouts’ were notified well in advance of the Plan, we explained the releases in excruciating detail, and they have had lots of time to have their fair say within a court, albeit a bankruptcy court. They’ve been heard, but so have the other 95% of those that voted in favor of the Plan who will have justice as they see it ripped from them so that a small minority can pursue justice as they see it to the detriment of the overwhelming majority and almost assuredly of themselves too.”
I’m not a SCOTUS spectator, and some were a bit nonplussed about how oral arguments went. But I think most in favor of nonconsensual third-party releases listened to the first eighty or so minutes with a feeling of increasing exasperation.
Gannon did a masterful job of paying homage to textualist arguments then sidestepping Justice Thomas’ obvious question on how third-party releases of any kind are consistent with his line of argument; leaving an indelible impression that, of course, this was a sweetheart deal for the Sacklers and a better one would be on offer if SCOTUS reversed the Second Circuit but then was fleet of foot when asked, like, what the contours of some hypothetical better deal would look like; etc.
Garre, on behalf of Purdue, and the second to step into the batter’s box, was then forced into a more defensive position on issues that are better covered in the briefs: on direct vs. derivative claims, on discharges vs. releases, etc. And then there was Justice Gorsuch who seemed more preoccupied with drawing laughs from the cheap seats than much else (per Gorsuch, there’s “a lot going against” Garre here – something that, at a minimum, is dismissive of all the Circuit Courts who think these releases are permissible and in some cases have thought this for decades).
Anyway, the increasing exasperation among many listeners that the core arguments in support of these releases weren’t coming to the fore and that the justices weren’t at ease with the issues here seems to have been shared by Shah too (the head of Akin’s SCOTUS practice, arguing on behalf of the UCC that overwhelming approved of the Plan).
It’s hard to say what Shah’s gameplan was at the start of the day – but it’s almost certainly the case that as he watched Gannon and Garre he felt he needed to say his piece: that the Court would be overturning what has been viewed, for three decades, as the most equitable way, sometimes the only way, to handle these narrow types of cases; that the Court would be defying the wishes of almost all opioid claimants; and that the Court would be getting hoodwinked by the US Trustee and their implied argument that the bluster of Purdue, the UCC, the states, etc. is all for show and that if the Second Circuit is reversed some better settlement will come to the fore and that, no, victims will not be devastated in this case or any similar ones to come (there's a reason that Boy Scouts of America filed an amicus brief here in support of nonconsensual releases).
This is something that Justice Kagan seemed to understand, and an argument she wanted to hear made in full. So, when the opportunity presented itself Shah let loose in what may not move the needle, but I’m sure proved cathartic in the moment (it’s worth listening to this section of oral arguments, as the heartfelt frustration doesn’t bleed through in the transcript and, for someone that’s before the Court often, it’s not in Shah’s best interest to be so exasperated about the justices not quite getting it...).
The frustration above is borne out of the fact that there is little doubt about the outcome should the Second Circuit be reversed: there will be a liquidation, there will be no renewed global settlement, there will be no reconstituted Purdue as a public-benefit company, etc. Instead, there will most likely be, per Shah, a mad dash to the courthouse and whoever strikes it lucky first (one of the states, most likely) will reap all the rewards. The inherent equity of the bankruptcy process – with the split of the spoils within a class occurring without discrimination – will be tossed and a few (at best) winners, after millions more of legal fees, will hit the jackpot with the rest left in the wake.
Note: Here I think Shah is laying it on a bit thick to his own deteriment. What will happen to Purdue should the Second Circuit be reversed is more or less a known quantity, and that isn't non-trivial as Purdue being reconstituted as a public-benefit company, etc. would be a good thing. However, while it's impossible to envision what the contours of a consensual settlement outside of bankruptcy would look like there'll need to be one of some kind at some point. (What percent of claimants are brought in, what the distribution will look like, etc. is anyone's guess.) But Shah's tact of not giving an inch on the idea of a (somewhat) broad settlement outside the bankruptcy context - since he was probably worried that the justices would misinterpret him as saying that there's a possibility of a similar (maybe better!) settlement being reached if they reverse the Second Circuit - made him look a bit slippery and weakens his broader argument that in a non-bankruptcy context there will per se be those, after much more time and expense, that are left behind completely or left with a modicum of what's in their hands now (this could be nearly all creditors or it could be a somewhat small percent – it's all unknowable now). In other words, it's pre-ordained that whatever is to come, should the Second Circuit be reversed, is going to be less equitable from a distribution perspective and (maybe, maybe not!) dollar perspective – but that doesn't mean the only possibility is a much larger distribution to a handful of creditors as he suggested. (This is a possibility, and the worst possibility thus why Shah invoked it, but not the only possibility. However, that doesn't mean that the best possibility, on balance, isn't the Plan as currently constituted.)
Unfortunately, Shah – before reaching his crescendo where he’d explain how the incentive structure of the current settlement would be inverted on its head by a reversal of the Second Circuit’s decision – was cut short because he was going too fast and being too “dramatic” for Justice Sotomayor’s taste.
Thus ensued an elongated back-and-froth that illustrated why the aforementioned squishy middle of the Court – those most predisposed to equity-style arguments, or at least those who care about outcomes as opposed to only statutory issues – are so apprehensive: a failure to understand what Shah called the “collective action problem”.
Justice Sotomayor, and later Justice Jackson, seem to think, “Well, there’s already a settlement here between almost everyone – all the states, almost all the victims, etc. So, what’s the issue here? Just settle here with almost everyone based on the current terms without making it binding on those who don’t consent. Then settle or litigate with the sliver of claimants who don’t consent thereafter. Sure, that’ll mean the Sacklers will have to pony up a bit more money to deal with these holdouts but no one should shed a tear over that and we all know the Sacklers have more than $6b of assets. So, again, what’s the issue here?”
The issue here is that the incentive structures, without the ability to force the releases on the few “nut-case holdouts”, become inverted. Without nonconsensual releases, there will not only be no global peace, there will be no immediate peace of any kind. Instead, we’ll probably be back to square one. This is because there’s limited incentive for the Sacklers to contribute nearly as much for consensual releases, even if it involves 97%, because with trillions in estimated total claims even a few “nut-case holdouts” could win an amount that exhausts their total assets and will come, at a minimum, with millions more in legal fees. The settlement value to the Sacklers was based on the presumption of global peace not piecemeal peace – and for what should be intuitive reasons the value of a settlement with 97% is far less valuable to them than with 100%. That’s why they have no interest in going forward with these releases on the current terms if they’re not binding on everyone.
Likewise, without nonconsensual releases the incentive structure of individual claimants, opportunistic contingency-fee lawyers, and non-federal entities (e.g., states, municipalities, etc.) shifts too: now there’s the possibility, remote or not, of extracting orders of magnitude more for themselves if they happen to be the first to win a case or settle with the Sacklers before their assets are exhausted. This is a classic collective action issue: no one wants to sign onto something when the returns to being a holdout, from an expected value perspective, can appear much higher. So, as Shah argued, even if the Sacklers offered the same deal but with the releases not being binding on holdouts – which wouldn’t happen but let’s suspend our disbelief – there wouldn’t be 97% that’d take it to begin with. Most creditors and the Sacklers will, with the Second Circuit’s decision overturned, have their magnetic poles flipped. Instead of being tightly bound together – as they are today with both arguing in favor of the Plan and its releases – they’ll be repelled from each other with global peace being relegated to an aspiration.
The briefs from Purdue and the UCC may be to blame for a lot of the confusion here as both offer scant discussion of the incentives at play. So, it's understandable that Justice Sotomayor, for example, seems to be under the impression that the states – irrespective of the Court’s decision – will be more than happy to go along with the current deal if it’s reconstituted to be consensual (e.g., kind of similar to the 3M situation). But Shah says that’s not what the states have said, and that’s not what will happen.
As with most of the issues that arose in oral arguments, this issue was beat to death in bankruptcy court years ago – and perhaps that's why Garre and Shah seemed so exasperated by the line of questioning coming from the Court. They thought these battles had already been fought and won and didn't think that they'd have to be fought again (or erred in presuming that the justices would delve beyond the briefs and into the lower courts' findings to see how these battles were won to begin with...).
Anyway, in a bizzarro-world twist, one of the central pillars of the bankruptcy system, the equitable distribution of recovery among similarly situated creditors, may be bowdlerized here due to the hold out problem that the bankruptcy system is meant to be a solution to. As the UCC brief states, “Critically, the Release provided in exchange was demanded ‘as much, if not more’ by the Official Committee and other creditor groups exercising fiduciary duties, JA 348, to prevent the Sacklers from ‘exhaust[ing] their collectible assets fighting and/or paying only the claims of certain creditors with the best ability to pursue the Sacklers in court’”. In other words, the nonconsensual aspect of the releases isn’t only something that the Sacklers wanted, it’s something that almost all creditors wanted to maximize (read: protect) their own recovery from others.
Since Shah’s soliloquy was cut short, Justice Kavanaugh stepped in with some leading questions that he knew would illicit answers that allowed Shah to layout his full argument but without fear of interruption this time. This could have been partly out of pity for Shah who clearly had more to say. But it was liable that Kavanaugh understood by this time that he was the lone one in favor, without reservation, of nonconsensual third-party releases. So, this was his opportunity to use Shah as a mouthpiece for himself – asking questions that he already knew the answers to in order to encourage the aforementioned squishy middle over toward his position.
This was followed by some Justice Jackson questions that – in contrast to her questions to Garre – showed perhaps some movement toward the notion that, no, there’s not liable to be some broader settlement outside of bankruptcy that is better for (almost all) creditors than what's on offer here.
Unlike the future of non-pro rata uptiers or drop-downs or double-dips, it doesn’t matter too much to me what the future holds for (nonconsensual) third-party releases in a narrower sense.
So, since I don’t have a vested interest here and haven’t followed every twist and turn in Purdue, I’ve tried not to be too one-sided and to explain the main issues here (at least as I see them) to give you some things to chew on. For a broader (read: better) perspective, the paper by Casey and Macey (In Defense of Chapter 11 for Mass Torts) is excellent and it’s largely informed by own views on all of this as I do believe chapter 11 should be able to play a role in (most) mass tort cases.
I’ve heard a few theories for how a (narrow) decision by SCOTUS that cuts against the Second Circuit could be worked around within a bankruptcy context. However, the most liable outcome here – especially in the early years before lawyers test out some workarounds – is a default to the tort system (more or less handling litigation on a case-by-case basis leading to the “race to the courthouse” issue that Shah was so emphatic about along with inconsistent outcomes for those that do manage to reach the courthouse) or multi-district litigation (that likewise comes attached with some thorny issues of its own but would at least be a bit more equitable; although there's a reason why we're here with a Plan that's so broadly supported to begin with and with few pining for the "simpler" days of Judge Polster's MDL).
There’s no doubt that there’s a shakier statutory basis for upholding nonconsensual third-party releases than one would hope for. It all comes down to whether or not one thinks 105(a) duck-tapped to 1123(b)(6) is so expansive as to allow for non-debtors to be released without the consent of all in certain (tightly controlled) situations.
It’s fair enough for Gannon to say there’s no issue with these kinds of releases should Congress amend the Code to expressly allow for them. But, needless to say, there’s precisely zero chance of Congress stepping in no matter how many victims in mass tort cases, now or in the future, wish that they would. The optics would be terrible, and the outraged op-eds from onlookers would come in fast and furious.
Back in August I mentioned that nonconsensual releases are one example of an “extratextual element” that has become common practice in certain situations, but that rests on a foundation of pragmatism and precedence and not much else. This uneasy status-quo was always going to be challenged at some point – and Purdue was the perfect case to knock these releases off their precarious precipice.
There couldn’t be a less sympathetic group that these releases are to the benefit of, and there couldn’t be a less sympathetic entity than a defunct opioid manufacturer. But lost in all of this, as Shah was so exasperated to make clear, is that those who find the Sacklers least sympathetic and Purdue most odious are precisely those that most want these releases – but this is deemed to be of little consequence to the US Trustee who decided to assert itself here to protect the right of creditors to, in the end, almost certainly achieve an inferior outcome to what is in their hand today.
So, whether Justice Kavanaugh stands alone, or Justice Kagan and (maybe) Justice Roberts hop on board, it seems that we’re at the end of the line for nonconsensual third-party releases, and we’ll see what the future of releases writ large holds based on how the opinion is crafted. It’s not the end of the world, but it’s an end of an era. Even if one is sympathetic to the constitutional concerns raised or the supposedly shaky statutory support here it should be recognized that, even if one is right on the law, it’ll almost assuredly be an unfortunate outcome for victims in this case and I believe future cases.
Perhaps the most frustrating part of oral arguments was that the Court seemed skeptical of Garre and Shah vis-à-vis their claims of what is to come should nonconsenual releases be relegated to the dustbin of history – perhaps assigning their views even less credibility than Gannon’s.
However, it’s not their views that were on offer – it’s the views arrived at after millions were spent in court on countless independent experts, mediators, etc. who determined the Sacklers wealth, it’s collectability, the alternatives available to creditors large and small, and how a Plan could be constituted not to reverse the harm of the actions of Purdue and, by extension, the Sacklers but how a Plan could be constituted to at least somewhat mend the damage done through the creation of a public-benefit company, an archiving of most Purdue materials for future use, and the distribution of billions of dollars to victims abatement programs. As Judge Drain said the creditors led the creation of the Plan and tens of millions of documents were reviewed – it was an exhaustive, extensive, and hugely expensive process that culminated in a Plan that, now, appears all for not.
In the opening lines of the Second Circuit decision, Judge Lee wrote that, “Bankruptcy is inherently a creature of competing interests, compromises, and less-than-perfect outcomes. Because of these defining characteristics, total satisfaction of all that is owed—whether in money or in justice—rarely occurs. When a bankruptcy is the result of mass tort litigation against the debtor, the complexities are magnified because the debts owed are wide-ranging and the harm caused goes beyond the financial. That is the circumstance here.” The reversal of the Second Circuit will allow everyone to attempt to achieve more satisfaction in what is owed in both money and in justice – the issue is that almost nobody wanted to, and almost 100%, if not 100%, will find such an attempt illusory on both counts. But at least it’s not like hundreds of millions were spent on a Plan that is liable to become a handful of dust that can’t be, and won’t be, reconstituted...
Happy Holidays!
]]>In the case of both drop-downs (e.g., J. Crew, PetSmart, Neiman Marcus, Revlon, Envision, etc.) and non-pro rata uptiers (e.g., Serta, Boardriders, TriMark, Incora, Envision, etc.) this indirect impact comes through ushering in a reimagining of how permissible debt docs can really be, and how much the boundaries can really be bent before courts begin pushing back (this latter point still mostly being an unknown vis-à-vis non-pro rata uptiers and suddenly much more uncertain with the unfortunate downfall of our old friend Judge Jones who I spent so much time talking about in relation to Serta).
In all of my writing on Serta, Incora, etc. this is something that I’ve tried to get across: that these two types of solutions have caused a meaningful shift in the Overton window. Today, you’re invariably going to pay more attention to if pro-rata sharing provisions can be amended by a simple majority, how much value can be shifted to an unrestricted subsidiary, etc. in assessing the potential solutions available to a company – and, importantly if you’re on the buy-side, if you could be caught on the wrong end of a solution.
The new normal is thinking about these solutions in the back of your mind, and this leads to their impact being felt in situations where there’s just the possibility that they could be effectuated (e.g., leading to more cooperation agreements being signed as creditors eschew undergoing an arms race to offer companies the best non-pro rata solution in favor of working together on more vanilla out-of-court solutions, leading to companies more easily getting amend and extends done through being able to offer lenders valuable non-monetary consideration in the form of tightening up credit agreements to preclude drop-downs or uptiers from occurring in the future, etc.).
Additionally, it’s inarguable that the rise of drop-downs and non-pro rata uptiers has inspired the search for other creative solutions – ideally some that, at least superficially, look a little less abrasive to non-participating creditors and thus results in companies incurring less immediate litigation costs. And this search has only been accelerated by the current rates backdrop that has led to a proliferation of stressed companies that need an infusion of liquidity or the ability to refi existing debt coming due but also need to find ways to keep down their cash interest expense – since S + 800 feels a bit different when SOFR is north of 5% as opposed to south of 1%.
Anyway, a new solution has been found – one that, over the past few quarters, has been reproduced with a few tweaks multiple times just as Serta’s non-pro rata uptier was reproduced with a few tweaks by Boardriders and TriMark shortly after it was announced.
However, unlike drop-downs or non-pro rata uptiers the solution found isn’t really that novel. Rather, it’s a retrofitting of an old concept – initially popularized a few decades ago by distressed funds – that has been given a new lease on life and will join drop-downs and non-pro rata uptiers as being yet another tool in the toolbox (assuming that it holds up in court once tested, something that only time will tell but that most are bullish on as this “new” solution doesn’t hinge on a creative reading of the debt docs or harm non-participating creditors quite as much – at least initially).
Note: If you’re currently preparing for interviews it’s important to keep in mind the essentials: the accounting questions, the waterfall questions, the structural subordination questions, the bond math questions, etc. Those are the kinds of questions that will dominate your interviews. It’s certainly impressive to be able to explain (roughly) what drop-downs, non-pro rata uptiers, or this new solution are in an interview if the opportunity arises. However, as I've stressed before, knowing the granular specifics is far beyond any interviewer’s expectations and, more importantly, not something that'll organically crop up. So, focus on the important stuff first and don't become too lost in the sauce here for no reason.
Note: I’ve tried my best to create a nice little introduction here that covers the essentials and ventures down rabbit holes on an as-needed basis. To this end, there are some smaller details I've avoided discussing because I don’t think they're essential to telling the story of this solution and would just result in us getting dragged into debt doc deliberations over considerations that are of limited practical consequence (e.g., considerations surrounding the designation of an unrestricted subsidiary but designation isn't the real issue that can present itself with using an unsub here, considerations surrounding investment capacity vis-à-vis the new-money guarantees and the intercompany loan but if there’s sufficient debt and lien capacity then sufficient investment capacity is liable to be available, etc.).
In the real world, thanks to George Constanza’s chip dipping proclivities, the term double-dip has taken on a negative connotation. However, in the world of restructuring the term has anything but a negative connotation. In fact, it has been used for decades to refer to something that, at first blush, seems a little bit like alchemy.
The term “double-dip” refers to a situation where a creditor holding debt that’s been issued by a non-guarantor restricted subsidiary or unrestricted subsidiary can end up having a recovery upon the company filing that’s around double (or more) that of pari debt issued by some other entity (although the total recovery, in dollar terms, of a creditor benefiting from a double-dip is capped at payment in full – typically just meaning par although there could be a make whole, accrued interest, etc. nudging the total recovery above par).
Functionally, the way this potential doubling of recovery occurs is through the subsidiary-issued debt holders establishing two independent allowed claims against the company (ergo, the term double-dip). The first dip arising from an entity, or a series of entities, where value resides providing a guarantee of the subsidiary-issued debt. The second dip arising from the subsidiary upstreaming the proceeds from the subsidiary-issued debt, in the form of an intercompany loan, to an entity where value resides and often where some or all of the company’s existing debt has been issued out of in return for an intercompany loan receivable that’s then pledged to the double-dip creditors as security for their debt.
So, upon filing, there are two independent allowed claims that redound to the benefit of the subsidiary-issued debt holders: the direct claim arising from the guarantee(s) provided and the indirect claim arising from the subsidiary separately being able to enforce the intercompany loan against the debtor with any recovery then flowing to the subsidiary-issued debt holders.
Note: The above description is trying to retain as much generality as possible – something that’s impossible to do perfectly since double-dips have many permutations as we’ll soon discuss. If things seem a bit murky now, it’ll all (hopefully!) be cleared up as we move forward. For now, just keep in mind the basic principles: you could find yourself getting a recovery that’s around double that of pari creditors upon filing – although the dollar amount of your recovery will be capped at payment in full – and this arises through establishing two independent allowed claims against the debtor (each one of these allowed claims being a “dip”, ergo the double-dip name).
Anyway, to avoid ourselves getting too lost in caveats before we even get going, let’s put a bit of meat on the bones through a little example. Imagine that we have an entity called ParentCo. It holds all of the company’s assets and is the issuer of the company’s only debt: a $200mm 1L TL. Because of regulatory reasons or tax reasons or some reasons the company created a non-guarantor restricted subsidiary that we’ll call SubCo. SubCo then issued $200mm of Senior Secured Notes to some creditors and, as you might expect, the creditors demanded a secured (first-lien) guarantee from ParentCo to make the subsidiary-issued Senior Secured Notes pari with the ParentCo-issued 1L TL.
Now, SubCo was just a shell that was created for some reason, and it had no use for the $200mm raised there. In fact, the debt docs governing this $200mm in debt specifically precluded SubCo from engaging in any business activities other than more-or-less servicing its debt.
Therefore, SubCo immediately upstreamed the proceeds from its debt issuance to ParentCo through an intercompany loan that was also secured on a first-lien basis and thus resides pari with ParentCo’s 1L TL. In return, SubCo received an intercompany loan receivable to the tune of $200mm and this receivable was pledged to the Senior Secured Noteholders as security for their debt. Therefore, SubCo, the erstwhile shell company, now has $200mm in assets (the intercompany loan receivable) and $200mm in liabilities (the Senior Secured Notes).
So, to be clear, before filing ParentCo – the entity in this example that’s the issuer of the company’s pre-existing debt, has all of the company’s assets exclusive of the intercompany loan receivable, etc. – will be regularly paying the intercompany loan and those proceeds will be used by SubCo to pay the Senior Secured Notes. It all just flows through and the rate on the intercompany loan will be exactly the same as the rate on the Senior Secured Notes. (Remember: the only real reason this debt was incurred at SubCo to begin with was for some reason that precluded it being incurred as secured debt at ParentCo.)
However, if filing occurs down the road then things get a bit interesting because all of a sudden we’re looking at a double-dip situation...
Think about it from the Senior Secured Noteholders’ perspective: if filing occurs then the Senior Secured Notes, that have a secured guarantee from ParentCo, will reside pari to the 1L TL at ParentCo. However, the SubCo can separately enforce the intercompany loan against ParentCo that’s also been made pari to the 1L TL residing there and the recovery stemming from this will, obviously, flow to the creditors of the SubCo – and the only creditors residing there are the Senior Secured Noteholders.
Therefore, we have two independent allowed claims here that both redound to the benefit of Senior Secured Noteholders but one being direct and one being indirect. First, the direct claim arising from the secured guarantee of the Senior Secured Notes. Second, the indirect claim arising from SubCo’s intercompany loan receivable that’s been pledged to the Senior Secured Notes. So, effectively, the Senior Secured Noteholders have two bites at the ParentCo apple.
Put another way, if we were to do a little waterfall there would be $600mm of claims that are all residing pari to each other arising from the $200mm 1L TL, the $200mm Senior Secured Notes, and the $200mm Intercompany Loan. It just so happens that $400mm of these claims, in the end, benefit one group of creditors: the Senior Secured Noteholders.
Now, to turn this into more of an interview question, although it would never be asked, let’s imagine that the company files and that we apply a 6x multiple to their LTM Adj. EBITDA of $40mm (don’t worry about deficiency claim stuff). In other words, let’s pretend that there’s $240mm in distributable value for waterfall purposes. If there weren’t a double-dip, and instead the Senior Secured Notes had only the secured guarantee, then you’d say there are $400mm in total first-lien claims. So, there’d be a 60% recovery ($240mm / $400mm) for both the 1L TL and the Senior Secured Notes (in other words, $120mm of recovery for each).
However, as mentioned, with the double-dip there are really $600mm in first-lien claims. So, the 1L TL would receive a 40% ($240mm / $600mm) recovery or $80mm. However, the Senior Secured Noteholders would benefit from a 40% recovery on the Senior Secured Notes residing pari to the 1L TL and a 40% recovery on the Intercompany Loan residing pari to the 1L TL that’ll flow to them through SubCo. Since both of these are $200mm claims, the recovery from each will be $80mm and the total recovery, in the end, for the Senior Secured Noteholders will be $160mm or 80% of the amount initially lent. Therefore, even though the ParentCo-issued 1L TL and SubCo-issued Senior Secured Notes have identical face values and reside pari to each other, the Senior Secured Notes are getting double the recovery due to their multiple (two) allowed claims. Magic.
In the preamble I alluded to there really being two phases to the history of double-dips. The first phase, encompassing the better part of two decades, is one where the only double-dips that arose did so organically – they were merely a natural consequence of certain companies having cavernous capital structures borne, usually, out of a need to issue debt out of foreign subsidiaries for tax or regulatory reasons (e.g., Lehman, General Motors, etc.).
In other words, it wasn’t really the intention of these companies to create a double-dip when they were raising debt at some SubCo and most of the holders at the subsidiary level were entirely unaware that there was even the possibility of being able to multiply their allowed claims if the company were to file.
Given this, in the past twenty years many of the old guard of the distressed world (e.g., Appaloosa, Elliott, Redwood, etc.) have tried to find these relatively rare double-dip opportunities out in the wild and take advantage of them.
And there’s an obvious reason for doing so: if no one else recognizes that the debt issued by some SubCo could have around double the amount of claims and, by extension, could have around double the potential recovery it otherwise would have then the market is probably pricing the debt as if it has only a single-dip (e.g., pricing based on the assumption of a thirty-cent on the dollar recovery, not up to a sixty-cent on the dollar recovery, etc.). It’s been a good trade if you can find it and execute it in size – neither being easy to do.
Anyway, I’ve talked a bit before about how the announcement of Serta’s non-pro rata uptier, to the surprise of many within the industry, caused incredulous indignation outside the industry. It struck many outsiders as fundamentally unfair, on its face, that a simple majority could radically reorientate the priority of those in the minority. It was tantamount to bullying – even if those being bullied weren’t the most sympathetic cast of characters.
I can imagine that some reading this may look at double-dips the same way and are wondering how this has all stood up in court over the years. What were the arguments in favor? What were the arguments against? What are the rules of the road, the boundaries that can’t be broken? Surely, if there’s been a number double-dip situations over the past two decades, someone has litigated all of this and some precedence has been set. It’s not like these are benign situations where no one loses – we just saw in our little waterfall example that the gains in recovery of one party in-court (SubCo’s Senior Secured Notes) are per se the losses in recovery of another (ParentCo’s 1L TL). This is claim dilution and, just like with all kinds of dilution, if you’re the one being diluted you won’t be happy! Especially if you didn’t realize you would be diluted!
However, last month we discussed how many issues in restructuring that are controversial, contentious, and continually litigated tend to languish in a legal limbo – coming close to the brink of being ruled on, but never being so. And this is because, just as occurred with Apollo’s complaint surrounding Serta’s use and abuse of their DQ list, the issue gets settled before a court has the opportunity to weigh in one way or the other.
This has more-or-less been the case with direct double-dip litigation. There’s been a few decisions from courts around the margins but, in the end, settlements usually end up occurring at the eleventh hour. For example, the most famous double-dip involved Lehman Brothers. To reduce a mountain to a molehill here, Lehman Brothers Treasury Co. (LBT), a subsidiary domiciled in the Netherlands, issued around $35bn of Notes that were guaranteed by Lehman Brothers Holdings Inc. (LBHI). Immediately upon issuance, LBT upstreamed the proceeds to LBHI.
Upon filing the LBT Noteholders claimed they had a double-dip with a direct claim arising from the guarantee of the LBT Notes by LBHI and an indirect claim arising from the intercompany loan that was the result of LBT upstreaming the debt issuance proceeds to LBHI. This set off a fire storm and led to LBHI holders advocating for substantive consolidation to, in part, void the double-dip and it looked like this mess was going to be decided by the court.
However, before the final reckoning a settlement was reached. There would be no full double-dip, and there would be no substantive consolidation. Instead, both LBT claims were allowed in the Plan but a portion of the LBT Noteholders’ double-dip recovery would be allocated to LBHI holders.
So, when it was all said and done, those who timed their entry into LBT prior to the double-dip becoming well known, and those who timed their entry into LBHI before they regained leverage in the case through the substantive consolidation push, made historic windfalls (although in Lehman the biggest winners were arguably the advisors who risked nothing and gained nine figures – not bad work if you can get it).
Anyway, it’s unfair to say that these organically arising double-dips are entirely untested. There may be a paucity of precedence but there is a kind of tactic approval from bankruptcy courts stemming from PORs getting confirmed that contemplate certain creditors getting the benefit of a double-dip (even if, as in Lehman’s case, those creditors don’t get quite as much recovery as they were initially jockeying for due to a settlement occurring vis-à-vis the double-dip).
For example, in LatAm, a pandemic-era case, a number of distressed funds (e.g., Redwood) successfully argued that they had a double-dip that boosted the recovery of their holdings above pari creditors holding debt that didn’t benefit from a double-dip. It’s perhaps not surprising then that it would be Redwood that spearheaded the evolution of double-dips this year – sparking an onslaught of transactions with many of the big names in distressed rushing in to participate...
In Northern Italy finding white truffles is done the old-fashioned way: you get a hound with a good nose, go marching through the forest for days on end, and, after many false positives, end up finding a few hunks that are worth their weight in gold. It’s laborious, inefficient work.
In the last few decades, finding double-dip opportunities has been roughly similar – just swap out the hound with a good nose for a distressed analyst with a masochistic relationship to their work, the old-growth forest of Northern Italy for a stressed company’s corporate structure, etc.
Given the relative rarity of double-dip opportunities and how tricky identifying them can be it seems natural to think that if the concept of double-dips has been at least tacitly supported by courts then why go through the rigmarole of finding them out in the wild to begin with? Why should it matter if they arose organically or not? Why not just, like, create them out of thin air?
This can seem to be an obvious thought in light of the drop-downs and non-pro rata uptiers that have occurred in recent years. But this is the rationale behind me going through my whole song and dance about the Overton window in the preamble. There is no reason the evolution of double-dips that we’re about to discuss couldn’t have happened earlier. It’s just that there’s been, for lack of a better turn of phrase, an attitudinal shift that’s allowed this evolution to occur now -- and, as with all things in finance, once one person does something then everyone piles on.
So, as you’ve guessed, the evolution of double-dips that began this summer involves companies manufacturing double-dips as part of a new-money transaction – something that participating creditors, obviously, love as it provides better downside protection if the company files in the future (through benefiting from a total claim size that’s around double, depending on the transaction structure, the face value of the debt that has the benefit of the double-dip).
The transaction that spurred this evolution was At Home, a sponsor-backed retailer of hokey home décor. They were acquired by Hellman & Friedman a few years ago and pre-transaction their capital structure consisted of a $425mm ABL with $321mm drawn, a $600mm 1L TL with $593mm outstanding, $300mm in Senior Secured Notes, and $500mm in Senior Notes (the 1L TL and SSNs were pari).
Sadly, it appears that the inflatable pumpkin, etc. market has seen better days. This year At Home had modestly negative EBITDA and, through the magic of addbacks, slightly positive Adj. EBITDA. But that’s a far cry from the $300mm of both that they did two years ago (although they’re expecting that both will rebound next year to over $100mm as freight-disruptions abate, cost reduction initiatives take hold, etc.).
Anyway, they needed some fresh liquidity and to dream up some ideas for doing so they brought in Kirkland & Ellis and PJT. In the end, they settled on a transaction that involved manufacturing a double-dip on a $200mm new-money investment – and it’s somewhat natural that they did considering that one of those providing the new liquidity, Redwood, was more than familiar with taking advantage of double-dip opportunities in the wild.
Similar to the first drop-downs and uptiers that occurred, this first manufactured double-dip was relatively straight-forward – not having the bells and whistles that double-dips that have come in the wake of At Home’s transaction (e.g., Tinseo and Wheel Pros) have had.
So, let’s work through the steps that At Home took to effectuate the transaction. As you go through these steps, keep in mind that we’re literally just trying to re-create a “traditional” double-dip that you’d find in the wild – therefore, we’re really just working backwards from the end goal of providing creditors participating in the transaction multiple allowed claims if filing occurs.
STEP 1: CREATING THE SUBSIDIARY
First, a subsidiary needs to be created. In At Home’s transaction, a non-guarantor restricted subsidiary was created, based in Cayman, that we’ll call SubCo. To be clear, it was a shell – having no assets and no liabilities. The “restricted” descriptor means that SubCo had to comply with the negative covenants underpinning At Home’s existing debt docs, whereas the “non-guarantor” descriptor means that SubCo wasn’t a guarantor of any of At Home’s existing debt.
You’ll recall that I’ve talked about unrestricted subsidiaries many times before – especially in relation to Serta’s transaction and the drop-down that was unsuccessfully pitched. Unlike a non-guarantor restricted subsidiary, an unrestricted subsidiary doesn’t need to comply with the negative covenants underpinning a company’s existing debt docs and doesn’t have to guarantee any of a company’s existing debt – it’s fully outside the restricted group thus the name.
Ideally, you’d rather be spinning up an unrestricted subsidiary to do one of these transactions instead of a non-guarantor restricted subsidiary – and in some cases like Sabre and Trinseo that’s been the case. However, the reason you’ll see non-guarantor restricted subsidiaries used is due to the underlying debt docs: more specifically, some debt docs precluding restricted group entities from guaranteeing the debt of an unrestricted subsidiary or, more generally, allowing unrestricted subsidiaries to incur debt that is recourse to assets residing within the restricted group (in most situations the restricted group entities are those that have issued most, or all, of the company’s existing debt and contain most, or all, of the company’s existing assets – so, if you’re looking to do a double-dip, you want access to those assets!).
STEP 2: ISSUING THE SUBSIDIARY DEBT
Second, with the subsidiary created it now needs to actually issue the debt. In At Home’s transaction this was $200mm of 11.5% Secured Private Placement Notes maturing in 2028. Redwood led the way in providing the funding along with a cohort of others that, like Redwood, were pre-existing Noteholders (we’ll circle back to this point in a few minutes).
Now, backing up for a second, all debt docs are heavily negotiated and try to strike a balance between restricting the company from taking actions that could diminish recoveries for holders while ensuring that the company has the flexibility to manage its affairs. This can most clearly be seen in the capacity that debt docs provide for a company to incur additional debt (e.g., the priority it can be incurred at, the purposes it can be incurred for, the type of entity that can incur it, etc).
Therefore, to effectuate a double-dip, the company’s existing debt docs must allow it to incur the new debt at the subsidiary level and guarantee that new debt at the subsidiary level (thereby providing the first dip) and permit the intercompany loan from the subsidiary to the operating company that’ll be using the funds (thereby providing the second dip). In other words, the existing docs must permit all three of these things to manufacture a double-dip.
So, getting back to our second step, we know there needs to be existing capacity under the existing debt docs to incur debt at the subsidiary level. If the subsidiary is an unrestricted subsidiary, then there’s no issue with this step as the subsidiary isn’t subject to the negative covenants of the existing debt docs. Practically this means you can raise as much debt at an unrestricted subsidiary as folks are willing to give you – the trick is figuring out how to provide sufficient value at the unrestricted subsidiary level such that people will actually want to put money there. (It’s not too enticing to lend to an empty shell that has no recourse to any value!).
This is how many drop-downs fail at the planning stage because the existing docs don’t allow enough value to be transferred down to an unrestricted subsidiary to make it worthwhile to pursue. Not to get too off track but this is, in the end, how Apollo, et al. got our maneuvered in Serta: there was only around $675mm in value that could be transferred to an unrestricted subsidiary, so there was a natural binding constraint on how much new-money could reasonably be lent to an unrestricted subsidiary and the amount of debt it’d make sense to exchange over.
Anyway, in At Home’s transaction the SubCo was a non-guarantor restricted sub. This means, as discussed, it is subject to the negative covenants under the existing debt docs. Therefore, to incur debt at the subsidiary there must be sufficient debt and lien capacity, and this capacity must be able to be tapped specifically for the purpose of incurring debt at a non-guarantor restricted subsidiary. The most common baskets that can be tapped are the general debt and lien baskets along with foreign or non-guarantor debt and lien baskets (although others can be available).
This is a huge rabbit hole that I’ll try to not go down too far. But think of baskets as being like little carveouts in the debt docs that allow additional debt to be incurred at some priority, at some type of entity, for some purpose. Some baskets will be a flat amount, some will expand or shrink as total assets or EBITDA or some other metric expands or shrinks, some will permit an amount of debt up until some ratio such as leverage or FCCR. The point is that in assessing the viability of most out-of-court solutions, you need to turn to the debt docs and figure out if there’s the capacity to do what you want. Some of the baskets won’t be applicable to the specific thing you’re trying to do, and some of baskets can be added together to get to the capacity desired.
So, if someone is asking, “How much additional debt can a company incur?” it’s far too general of a question to really answer. Is the debt going to be secured? Is it going to be structurally senior? Is it going to be used to repay existing debt? Depending on the answer, how much capacity the company has can be wildly different.
Knowing the ins and outs of tallying up capacity, or specific baskets that should be looked to in certain situations, is, to put it mildly, well beyond the scope of what you need to know in interviews. It’s just important to bring this all up to reinforce the point that most out-of-court solutions are going to be constrained by the debt docs, and this is true of double-dips too. Although, it should be noted that eventually you’ll learn the ins and outs and be putting together slides breaking down the capacity in the docs – albeit with “subject to review by counsel” emblazoned on them since it’s counsel that will have the final say, perhaps with some creative interpretation à la Envision.
Note: To maintain the integrity of the double-dip that’s being put in place, the debt docs governing the subsidiary-issued debt should ideally be heavily restrictive – precluding additional borrowing at the subsidiary, transferring its sole asset of the intercompany loan receivable, or otherwise doing any business beyond servicing the debt that resides there. The double-dip is predicated, obviously, on diluting the claims of other creditors through establishing multiple allowed claims – but double-dip creditors need to be mindful of the tables being turned on them and having value leak from their own subsidiary. You can’t just play offense; you need to play a little defense too.
STEP 3: GUARANTEEING THE SUBSIDIARY DEBT
In order to create the first “dip” a subsidiary’s newly issued debt needs to be guaranteed by entities where (obviously!) some actual value resides. In most situations this will mean a guarantee coming from one entity (or many entities) within the restricted group.
So, for example, in At Home the newly issued Private Placement Notes were guaranteed on a first-lien basis by the At Home ParentCo (At Home Group) and some of its domestic restricted operating subsidiaries thereby making them pari to the pre-existing 1L TL and SSNs.
Philosophically, if we think about what a guarantee really is, it’s functionally similar to regular-way debt being incurred by the entity providing the guarantee. This is the rationale behind nearly all debt docs treating guarantees as the assumption of additional debt – and, as we discussed above, when you’re trying to determine if debt can be incurred at some priority, at some type of entity, and for some purpose you need to turn to the debt docs and look for capacity.
Typically, the debt and lien capacity relied on will stem from the general debt and general lien baskets, guarantee-specific baskets (only if the guarantee is to the benefit of a restricted group entity, such as a non-guarantor restricted subsidiary), and the incremental debt basket (although, to be clear, all debt docs are unique snowflakes with a mix of baskets – these are just commonly used here).
Importantly, to create a secured guarantee you need both debt and lien capacity. The lien capacity being necessary to make the guarantee secured and, as you can imagine, in any double-dip transaction where the company is per se stressed you’re going to want a secured guarantee to make sure your new-money is pari to the company’s existing secured debt, as was the case in At Home and Wheel Pros.
(Alternatively, double-dip creditors can have secured guarantees from non-guarantor restricted subsidiaries where value resides, thereby giving themselves structurally senior claims on the value residing there relative to the company's pre-existing secured debt, as was the case in the Sabre and Trinseo double-dip transactions -- but I'll leave that discussion for the Double-Dip Guide to avoid muddying the waters here too much).
STEP 4: CREATING THE INTERCOMPANY LOAN
In order to create the second “dip” the funds raised at the subsidiary-level need to be upstreamed, in the form of an intercompany loan, to some entity (usually that has issued the company’s pre-existing secured debt) with the subsidiary then receiving an intercompany loan receivable that, in turn, is pledged to the subsidiary’s creditors as security for their debt.
Once again, this requires debt and lien capacity under the debt docs with the lien capacity being necessary insofar as you want the intercompany loan to be secured and thereby residing pari to the company’s existing secured debt (e.g., in At Home the Intercompany Loan was from At Home Cayman to At Home Group and was made pari to At Home Group’s existing first-lien debt).
Therefore, in determining if capacity exists, you’ll go back to the same well: looking at general debt and lien baskets, the incremental secured debt basket, etc. if there's remaining capacity there. However, in many double-dip transactions (e.g., Sabre and Trinseo) the intercompany loan proceeds are used specifically to repay existing debt – and, in this case, permitted refinancing baskets can be used that, to simplify, allow debt to be refinanced by similar debt (e.g., secured debt being refinanced by a secured intercompany loan à la Trinseo).
In the end, the lynchpin of making one of these Double-Dip 2.0 transactions work is making sure that the intercompany loan resides pari to the company’s pre-existing secured debt. Technically, if you wanted, both the double-dip debt guarantee and the intercompany loan could be unsecured and in that case you wouldn’t need the existing docs to provide lien capacity (they’d just need to provide debt capacity, and this is invariably more ample). But if you’re looking at a stressed company that’s desperate for liquidity or can’t do a regular-way refi of its existing debt then you’re not liable to get much recovery if your claims are behind a wall of pre-existing secured debt.
Remember: it’s fantastic to benefit from around double the claims of similarly situated creditors through having a double-dip – but if those similarly situated creditors are getting pennies on the dollar, or nothing, then all of those claims you have aren’t going to help you earn much of a return.
WRAPPING UP THE AT HOME TRANSACTION
So, we’ve briefly covered the mechanics of manufacturing double-dips and how, in the case of At Home, Redwood, et al. have turned a $200mm new-money investment at SubCo into $400mm of first-lien claims if filing occurs (although remember that the maximum recovery of the PPNs is capped at payment in full). Here’s how you can visualize things...
But let’s take a wider lens here and bring things full circle. You’ll recall that I mentioned some of the new-money participants were pre-existing Senior Noteholders – residing pre-transaction behind a wall consisting of the $321m ABL, $593mm 1L TL, and $300mm Senior Secured Notes. Now, if you’re providing new money to a struggling company, and you also happen to hold some lower part of the capital structure that’s inline for a de minimums recovery, then you’ll want to try to salvage some value – and one way you can do that is through trying to roll up your holdings as part of the transaction to a higher position in the capital structure.
So, that’s exactly what was done here. In conjunction with the $200mm new-money financing, $447mm of the pre-existing Senior Notes were exchanged into $413mm of new Senior Secured Notes that reside pari to the other At Home first-lien claims. The rate on the Senior Notes and these new Senior Secured Notes is the same (7.125%) but there is the ability to toggle the new Senior Secured Notes to PIK at 8.625%. Therefore, this little exchange created a bit of discount capture, since the exchange happened below par, and in the future At Home will be able to conserve some cash if they want to utilize the PIK toggle.
So, if we’re thinking about the waterfall, there’s the $321mm ABL; the pre-existing $300mm Senior Secured Notes, the $593mm 1L TL, the $200mm Private Placement Notes, the $200mm Intercompany Loan, and the new $413mm Senior Secured Notes that are all pari; and then there’s the lowly $53mm of left-behind Senior Notes that weren’t allowed to participate in the exchange.
Put another way: pre-transaction there were $893mm of first-lien claims and now there are $1,706mm – not something that the pre-existing 1L TL and SSNs are too happy about, even if the reason for the claim dilution is, in part, the new-money investment that was desperately needed.
Similar to drop-downs and non-pro rata uptiers, double-dips won’t be able to be done by every company under stress. It all comes down to the docs: if there’s not sufficient basket capacity to incur the debt at the subsidiary and guarantee that debt on a secured basis and put in place the secured intercompany loan then the double-dip will be a non-starter (unless the transaction is being done by a majority of existing lenders, so the docs can just be amended to effectively add in the capacity as was done in Wheel Pros...).
Regardless, many will be able to do a double-dip, and there’s been a narrative develop over the summer that they’ll somehow replace drop-downs and non-pro rata uptiers. However, this is overstating the case for them. There will be times when a double-dip makes the most sense, and there will be times when a drop-down or non-pro rata uptier makes the most sense. Additionally, there will be times when a combination of these three solutions makes the most sense (e.g., Tinseo’s combined drop-down and double-dip, Envision’s combined drop-down and uptier, etc.).
But, to be clear, there are undoubtably benefits to double-dips, so let’s talk about a few of them...
First, there’s a certain innocuous quality to double-dips. Unlike in drop-downs or non-pro rata uptiers where the full weight of the transaction is immediately felt by non-participating creditors, in double-dips the impact is primarily felt by those “harmed” only upon filing – when suddenly they find themselves diluted down by the multiplicative claims arising from the double-dip.
The natural extension of double-dips appearing to be more innocuous when they’re executed is that there’s less immediate litigation costs. This stands in sharp contrast to drop-downs and non-pro rata uptiers where – as we’ve discussed ad nauseam in relation to Incora, Serta, etc. – there’s nearly always going to be some level of immediate litigation coming from those creditors who’ve been left out in the cold (although this isn’t always the case, Envision was a masterclass in doing follow-on transactions to diminish the amount of litigation that would eventuate).
Additionally, since most (not all!) doing these more “creative” transactions are sponsor-backed, this lack of litigation is valued not just from a cost-savings perspective but from a reputational perspective. This isn’t because sponsors are benevolent but because many creditors in one PortCo’s capital structure are going to be in other, or future, PortCo capital structures. So, all else equal, sponsors would rather not make creditors too mad as that could result in a slightly higher cost of debt in future buyouts (e.g., the so-called Apollo premium). Personally, I think this is all heavily overstated as a rationale for doing a double-dip as opposed to a more aggressive alternative but this is a narrative you’ll often hear, so now you’ve heard it too.
Second, in theory there’s no need for a new-money lender in a double-dip to be an existing creditor. The new-money at the subsidiary level could be funded by anyone so long as they liked the terms of the debt and felt comfortable with their enhanced downside protection (in other words, the enhanced level of recovery they’d get upon filing through having the double-dip).
This stands in contrast to non-pro rata uptiers where, by definition, you need a simple majority of the relevant existing creditors in order to amend the docs to effectuate the transaction. So, there’s not that much leverage for the company as the only ones who can do the uptier are some combination of existing creditors that can form a simple majority. In fact, the only real leverage of the company comes through threatening to try to do another type of transaction, instead of the uptier, if those pitching the non-pro rata uptier don’t agree to a lower exchange rate or better terms (from the company’s perspective) on the new super priority debt.
Third, the pricing of the double-dip debt (e.g., the subsidiary-issued debt that benefits from the double-dip upon filing) is usually pretty favorable considering the stressed nature of the company. For example, At Home’s Private Placement Notes have an interest rate of 11.5% and ended up pricing at around a 13% yield. Not exactly cheap. But considering that the pre-existing Senior Secured Notes had a yield well into the 20s pre-transaction (remember: they have a first-lien claim too) the pricing was about as good as could be hoped for from the company’s perspective.
The rationale behind the double-dip debt being relatively cheap for the company is pretty straight-forward: the downside risk to holders of this debt is significantly diminished due to having around double, give or take, the allowable claims relative to the amount lent if the company files.
Think about it this way: imagine you’re looking at a piece of debt and think the company could file in the next two or three years. Now let’s imagine that through your genius analysis you think the recovery you’ll get upon filing is around 30-40%. In this case, the size of the coupons you’re clipping over these two or three years pre-filing better be large or, alternatively, the entry point you’re getting into the debt at better be pretty low in order to make a reasonable return. But if there’s a double-dip then the recovery you’re assuming that you’ll get if filling occurs will be significantly higher (by virtue of the multiplicative claims) than it otherwise would be so you don’t need the coupons you’re clipping to be quite as large, or the entry point into the debt to be quite as low, to arrive at the same level of return or better.
Therefore, for a company struggling in the current rates environment, the double-dip is a valuable non-monetary form of compensation to give holders. In other words, the company doesn’t need to provide holders the same upside pre-filing (through high coupons or a low entry point) because the company is manufacturing a better downside for holders through a higher recovery than pari creditors post-filing.
Fourth, in the same way that drop-downs and non-pro rata uptiers can result in significant discount capture through having existing holders exchange their debt below par, so too can double-dips as part of the broader transaction (or as a direct part of it, à la Wheel Pros). In At Home this occurred, as we’ve already discussed, through $447mm of the Senior Notes rolling up into $413mm of the new Senior Secured Notes – thereby netting a nice little discount capture.
Additionally, it’s important to keep in mind that a company may look toward a more creative transaction not only to bring in new liquidity but to effectively refi or otherwise reconstitute debt through an exchange. For example, in Trinseo the blended double-dip and drop-down transaction was used to take out its remaining $660mm TLB due in 2024 and over three-quarters of its Senior Unsecured Notes due in 2025. Thereby pushing back maturity walls and giving itself some much needed breathing room (although it’ll still have to deal with those Unsecured Notes left behind but there's a plan for them...).
In At Home the challenge was less about maturity walls and more about the need to bring in liquidity and, if possible, keep cash interest expenses as low as possible. To this end, the Senior Notes exchanged into Senior Secured Notes had an identical cash rate. However, unlike the Senior Notes, the SSNs included a PIK toggle thereby providing more cash interest breathing room if needed in the future. So, this effective reconstituting of the Senior Notes into a PIK instrument as part of the broader transaction provides the company a bit more optionality moving forward.
Whenever a new type of solution comes along a familiar script occurs: the first transaction is relatively vanilla and then, as the transaction is digested, a slew of similar transactions occur that are expanded and enlarged in increasingly novel (read: aggressive and/or complicated) ways.
If you’ve read all my writing on non-pro rata uptiers over the years, then this script will be familiar. Serta’s PTL Lenders exchanged their existing holdings well below par, thereby creating a huge discount capture for the company. But then, just three months later, Boardriders decided to push the envelope a bit more through announcing their own transaction that was similar in style but with participating holders exchanging their existing debt at par (a better deal for participating holders and causing much more indignation among non-participating holders given that the debt being exchanged was trading well below par).
More recently, if you’ve read my posts on Incora, you’ll recall that things were taken a step further with some of the Unsecured Notes rolling up above pre-transaction Senior Secured Notes at par – despite the Unsecured Notes trading way below par – to the direct benefit of the sponsor that had been buying up some Unsecured Notes themselves. Now that’s aggressive.
Anyway, the same script has played out vis-à-vis double-dips. Something that shouldn’t be too surprising given that double-dips, unlike drop-downs or non-pro rata uptiers, are a bit more flexible and can be more easily combined with other types of solutions.
Note: In the Double-Dip Guide that I’m putting the finishing touches on the below transactions are discussed in much more detail although, to be clear, the specifics of these are lightyears beyond what you need to know for interview purposes.
Immediately following At Home, we had Sabre that involved a larger new-money component and a bit more complicated of a structure (there was another proposal from existing lenders on the table, but the company opted to go the double-dip route after the double-dip proponents upped the size).
The transaction involved a group led by Centerbridge – with Oaktree, Oak Hill, and JPM tagging along in much smaller size – providing a $700mm Term Loan to an unrestricted subsidiary that the company had spun up. There’s still a recognizable double-dip here (e.g., the new-money creditors are going to have two independent allowed claims if the company files in the future). However, there are a number of things that make it distinct from At Home’s transaction including the secured guarantees coming from a smattering of non-guarantor restricted subsidiaries being capped at $400mm due to debt doc constraints and the terms of the Centerbridge, et al. Term Loan and the resulting intercompany loan that resides pari to Sabre's existing secured debt being, uh, a classic Centerbridge concoction (read: extremely aggressive, we’re talking a max rate of 17.50% for cash interest and 19% if PIK is elected).
In Trinseo the new-money became even bigger, and the transaction structure much more complicated. Ultimately, the transaction crafted was a blended double-dip and drop-down with a new lender group – consisting of Oaktree, Apollo, and Angelo Gordon – providing a $1,077mm Term Loan that benefits from a double-dip and that was used, net of fees, to take out the entire $660mm TLB coming due in September of 2024 (done at par) and $385mm of the Senior Unsecured Notes coming due in September of 2025 (also done at par).
Trinseo is a bit of a grab bag because, given the size of the Term Loan, the company didn’t have the basket capacity to do a “clean” double-dip (e.g., just have a non-guarantor restricted subsidiary or unrestricted subsidiary issue a $1,077mm term loan, have that debt guaranteed on a secured basis by restricted group entities, and then put in place a secured intercompany loan that would also reside pari to the company’s existing secured debt).
So, it was a bit of a mess with the intercompany loan being broken into multiple tranches and the proceeds being flung in different directions, the secured guarantees coming from a smattering of non-guarantor restricted subs at a capped amount, and the drop-down of the valuable Americas Styrenics business only being possible due to the elevator-style movement of the proceeds from one of the aforementioned intercompany loan tranches that opened up the necessary basket capacity to drop the business to an unrestricted sub to the benefit of double-dip creditors. (I’ll save all the gory details for the Double Dip Guide).
Finally, we have Wheel Pros where the double-dip isn’t to the benefit of the new-money component of the transaction (the $235mm FILO facility). Rather, the double-dip is to the benefit of those participating in the exchange component of the transaction – something that was open to all $1,154mm of 1L TL lenders and three-quarters, or $272mm, of Senior Noteholders to participate in. To complete the exchange and effectuate the double-dip, a new non-guarantor restricted subsidiary was spun up and a new $1,014mm 1L TL was created alongside a $272mm 2L TL. The first dip arises from these new term loans benefiting from secured guarantees from Wheel Pros Inc., the borrower of the company’s pre-existing secured debt, and all its wholly-owned subsidiaries. The second dip arises from the term loan proceeds, totaling around $1,286mm, being sent, through an intercompany loan, up to Wheel Pros Inc. and being secured and guaranteed by Wheel Pros Inc. and all its wholly-owned subsidiaries.
The proceeds of the $1,286mm intercompany loan were then used by Wheel Pros Inc. to execute open-market purchases on the participating holders’ existing 1L TL and Senior Notes positions (at 85% and 100% exchange rates, respectively). So, this just amounts to an exchange (at a discount) of the existing 1L TL at the ParentCo into a 1L TL at the SubCo with the benefit of a double-dip, and an exchange of the existing Senior Notes at the ParentCo into a 2L TL at the SubCo with the benefit of a double-dip.
In the end, Wheel Pros really demonstrates how existing creditors – staring down the barrel of a stressed company they don’t really want to put new money into – can structure a transaction with a double-dip component to buy the company more breathing room to implement a turnaround without it to being too risky and make sure that no third-party comes in to do a transaction that suddenly strips value from them (drop-down) or dilutes their existing claims (double-dip). So, of all the double-dips that have occurred, this is the most defensive-minded transaction.
It seems like my (extremely minimal) spare time is inversely correlated with the length of these posts. But there are a few housekeeping notes that are worth spending a few minutes on.
First, in last month’s post we talked about Serta’s use and, in my view, abuse of their disqualified lenders (DQ) list in relation to Apollo. This may have seemed like a relatively niche thing to focus on since, relative to the overall Serta case, it was a sideshow and was settled before Judge Jones had the opportunity to opine on it.
However, the reason I spent so much time talking about it – beyond the fact that I clearly have trouble keeping these posts short – is that Serta’s DQ list shenanigans are a harbinger of what’s to come. To this end, in recent months there’s been a number of distressed funds that have had their trades in certain stressed PortCo’s languishing in limbo – with some situations breaking out into public view like the battle brewing between Blackstone and Strategic Value Partners over SVP’s unsettled trades in a Blackstone PortCo (Packers Sanitation Services).
Just as there was an attitudinal shift that led to the evolution of double-dips suddenly occurring, there’s been an attitudinal shift that’s largely led to this DQ list mess suddenly occurring. And part of that attitudinal shift is a realization that even if the sponsor doesn’t have much of a legal leg to stand on (e.g., the distressed fund should have their trades settle) it’ll take time for it all to pan out. However, in the meantime tying up the trades of one distressed fund will have a chilling effect on all other distressed funds looking at building a position – so, insofar as a sponsor wants more control over who’s in the secured part of their capital structure and wants to send a warning shot, mission accomplished.
Note: The more worrying issue, as we discussed last month, that’ll rear its head in the future are the DQ provisions in some credit agreements becoming bewilderingly broad (some more-or-less stipulating that all funds of a certain ilk are persona non grata). Today, we're seeing (in my view) an abuse of still somewhat boiler-plate DQ provisions but, in the future, similar antics won't necessarily be an abuse as it'll align with the text of the credit agreement. Anyway, I won't belabor this point any further but moving forward there will be many breathless articles about how these expanded DQ provisions, and the DQ lists arising out of them, are gumming up secondary loan market liquidity – so, don’t be surprised when you see them.
Second, we need to talk about Judge Jones because, as mentioned in the preamble, he’s resigned due to, uh, an undisclosed living situation that really should’ve been disclosed. I’ve written about Judge Jones a fair amount in recent months because he’s had a truly outsized impact: turning the Southern District of Texas into the hottest venue in bankruptcy both literally and figuratively and tackling some of the most contentious cases. This includes current cases with far-reaching implications, like Incora, where the battle is still in full heat and that will now be reassigned. In fact, Judge Jones was actually hearing summary judgement arguments in Incora’s case after his living situation became public but resigned shortly thereafter – causing more than a few heart palpitations over at Platinum, I’m sure.
In my writing on Serta I think I made it pretty clear that Judge Jones is a divisive character – with the more uncharitable thinking that he’s an unserious self-promoter who is deferential to debtors to the detriment of case outcomes because to be known as debtor-friendly is to ensure that the largest and most controversial (read: consequential) cases continue coming to his court (and, like, he has handled over 10% of all cases with over $100mm in liabilities since 2016 and around 17% of all cases with over $1,000mm in liabilities since 2020 for a reason).
However, there are some – not just those at Kirkland! – who would defend Judge Jones as being someone whose eccentricities belied a seriousness of purpose, and who stood athwart those who would rather see cases shrouded in uncertainty because that may bear out organic compromises even if it prolongs the debtor’s time in-court. Judge Jones believed that in the most controversial and contentious cases, expediency is a form of equity, that cases must be dealt with as delivered, and that preserving business value should be sacrosanct even if this requires sometimes rubberstamping some dubious debtor behavior.
In the end, this is where much of the resentment toward Judge Jones comes from. For example, everyone knows that his real reason for upholding Serta’s non-pro rata uptier boils down to him more-or-less thinking, “If I unwind this transaction it’ll unleash chaos. There’s no doubt that it’ll be value destructive for Serta itself, since it’ll languish in-court longer, but it’ll also be value destructive for all the other companies that have done a non-pro rata uptier over the last three years. It’s not my issue that this wasn’t all decided by an Article III court in the three years prior to coming to me. So, it’s plausible to me that this transaction is permissible. Plus, it’s not like every credit agreement in the aftermath of Serta blocked these kinds of transactions from occurring. In other words, it’s not like Apollo, et al. are the unlucky few here who’ve been blindsided by this in a way that no one else ever will be. Therefore, on balance, it’s better to try not to put the toothpaste back in the tube – it would unquestionably be a negative for these businesses and their employees and could even end up being a Pyrrhic victory for non-participating creditors if unwinding these destroys enough business value.”
Note: I think it's fair to say that I view Judge Jones in a more sympathetic light than many although, I mean, that's really not saying much. However, there's no doubt in my mind, or in Apollo's, that he would have readily rubberstamped the DQ list issue we've talked about, likely making a few remarks along the way about how he doesn't see what the issue even is, and I would have vehemently disagreed with that.
Anyway, there’s no defense of the actions of Judge Jones that led to his resignation – it was as clear of a failure to disclose as there could be, and he knew it. However, the announcement of his living situation and his subsequent resignation was met with a certain level of triumphalism that, well, I don’t know if it was per se surprising but it was a bit much.
Remember that most in the industry are not in favor of these more creative transactions – and non-pro rata uptiers are especially loathed. So, the jubilation here is, in part, a reflection of the belief that non-pro rata uptiers now rest on a much shakier foundation with Incora still in-court and Serta's issue at the Fifth Circuit on appeal – and there’s no getting around that this is true.
Rest assured, Apollo and Angelo Gordon have continued making their arguments that non-pro rata uptiers are an afront to all that is decent in this world at the Fifth Circuit. Immediately following Judge Jones’ resignation they filed a reply brief stating that their appeal should be reversed, remanded, and moved to the Southern District of New York.
Meanwhile, both Apollo and Angelo Gordon last month led the combined drop-down and double-dip in Trinseo that saw them hack and saw at Trinseo’s debt docs to manufacture the ability to allow one of the most valuable parts of the business to be stripped away from existing creditors and simultaneously diluted down the first-lien claim pool at RemainCo (although, to be fair, the trading levels of Trinseo's secured and unsecured debt were slightly higher post-transaction, so it wasn't like the transaction had the immediate negative impact that Serta's transaction had on Apollo and AG's positions).
Now, Serta and Trinseo are two different kinds of transactions, etc. and it’s fine, or at least not inconsistent, to argue that non-pro rata uptiers are a blight on the industry and that drop-downs and double-dips are as wholesome as apple pie. But it's important to remember that the moralizations in these briefs aren't a reflection of what anyone at Apollo or Angelo Gordon truly believes – and Judge Jones, in his classily curt and cantankerous way, made it known that he at least understood this much. However, don’t be so sure that other judges will – especially if this does ends up back in the Southern District of New York. In the end, someone needs to decide what "open-market purchase" means (we can't just have judges say it's "ambiguous" forever!) and that decision will be one informed by the perceived fairness of the transaction even if it's wrapped up in a much longer dissertation on these six syllables than Judge Jones provided.
Note: In much of the financial press, as you can read in the above links, there’s very much a court-thrown-into-disarray narrative surround Judge Jones’ departure. But that’s all heavily overstated. It’ll all be fine. The current cases will be reassigned and the prior cases won’t be opened up unless there’s a clear and compelling reason for doing so. This is all a mess but it’s not that bad – well, I’ll reserve final judgement on that until we see how Serta and Incora do.
]]>You may think this murky mix just involves the permissibility, or lack thereof, of relatively novel types of transactions – in other words, situations where desperate companies bend the boundaries, try their luck with some new-ish style of transaction, and then prepare for litigation to see if courts will let what they’re trying to do fly. Nothing ventured, nothing gained.
This is certainly true, and we’ve seen this script play out many times over the past few years. Including right now with a circuit split developing regarding the permissibility of the Texas Two-Step as a strategy for companies grappling with, in some cases, tens of billions of mass-tort claims. If you read my post explaining the Texas-Two Step last year then you know my feelings here: bankruptcy is an appropriate venue for handling mass-tort claims and is the most equitable way to handle these situations from both the company and claimant perspective when an otherwise healthy company, with a diverse line of businesses, appears predestined to be dragged under by the weight of ever-escalating claims.
Regardless, the Third Circuit’s latest view is that our old friends at LTL Management initially filed in bad faith because, uh, they weren’t under enough “financial distress” – so, they purposefully tried to make themselves look, uh, more distressed and filed again but that filing was batted down too. This is the difficulty of circuit courts eschewing pragmatism in favor of navel-gazing “standards” that they’re so fond of cramming down, no pun intended, on bankruptcy courts – but we’ll save that talk for another day.
Note: If you’re curious, you can read Judge Kaplan’s opinion dismissing LTL’s second attempt at filing here that came down in late July (it has lots of great context setting and background info on both the case itself and mass tort cases more broadly). Importantly, Judge Kaplan did not dismiss LTL’s first attempt at filing when it came before him, as his views on bankruptcy being the appropriate venue for resolving all of this largely align with mine – so, obviously, he has the correct views. But the Court of Appeals for the Third Circuit disagreed and dismissed that first filing attempt in January 2023, and Judge Kaplan did the respectable thing of dismissing LTL’s second attempt to file utilizing the “financial distress” standard the Third Circuit laid out earlier this year. It would have been bittersweet for Judge Kaplan to write his latest opinion, especially after his initial support of LTL’s filing was excoriated in academic and judicial circles, so he deserves credit for earnestly engaging with the Third Circuit’s jerry-rigged standard, instead of passive aggressively poking holes in it.
Note: In case you’re even more curious, the circuit split referenced earlier is between the Third Circuit (dismissing LTL’s case) and the Fourth Circuit (upholding Bestwell’s asbestos-related case). Don’t look now, but SCOTUS could be making the final call on all of this.
Anyway, restructuring doesn’t just enter a murky mix when it comes to novel transactions and their permissibility. There are also many, for lack of a better turn of phrase, common practices in restructuring that courts haven’t really laid out clear and broadly agreed upon frameworks for handling – instead, these common practices are governed more by nebulous norms than bright-line rules and, as you can imagine, this can lead to scenarios where perceived violations of these norms can lead to bitter fights.
To make one final digression before getting into the meat of this post, this latter point regarding common practices can be seen in the never-ending, back-and-forth issue of the permissibility of third-party releases for the Sackler family in Purdue. These releases have become the definition of common practice in many chapter 11s: an extratextual appendage to the Bankruptcy Code, sure, but one that’s arisen and become accepted by some (not all!) circuits because it facilitates more efficient, expeditious, and effective reorganizations.
Note: There's a wide diversity of third-party releases -- some tightly tailored, some extremely expansive. But the simplest way to explain third-party releases is that they prevent non-debtors who have been given a release (e.g., officers, lenders, directors, guarantors, subsidiaries, etc.) from being sued by existing creditors or (sometimes) non-debtors for their actions either directly or (sometimes) indirectly related to the filing. The rationale invariably being that these releases are a necessary precondition of the debtor being able to reorganize in line with the plan of reorganization. So, in Purdue’s case the non-debtors at issue are the Sackler family, and the plan contemplates that in return for contributing $6.0 billion to support the plan they’ll receive third-party releases that will have the effect of releasing them from all current and future liability for opioid-related and derivative claims (e.g., deceptive marketing, fraudulent transfer, etc.).
Note: It’s worth briefly mentioning the distinction between consensual and non-consensual third-party releases – both varieties, upon plan confirmation, are binding on all creditors. The Purdue third-party releases are non-consensual as they release the Sackler family from all current and future liability for opioid-related and derivative claims and will be binding on even those who did not vote on the plan.
Anyway, Purdue’s filing has taken on a life of its own given that its rise and fall has become the subject of bestselling books, docuseries, etc. And this has resulted in the pragmatism of third-party releases in Purdue being subordinated to more lofty considerations – namely, that it’s unjust that a family that built their fortune largely off of opioids is being released from further liability in return for contributing $6.0 billion of their personal funds to the plan (contributions that obviously would not be forthcoming were it not for being granted the releases in the plan).
In other words, the view of many is that it should be the prerogative of those harmed by Purdue’s actions to continue extracting every pound of flesh from those enriched by Purdue’s actions – even after Purdue exits bankruptcy, and even if that flesh resides in locales that can’t be easily extracted from – and taking the family off the hook, regardless of how much they contribute to a plan in exchange for the releases, smacks of injustice.
And, I suppose, it is unjust. But that’s bankruptcy, as the Court of Appeals for the Second Circuit’s Judge Lee stated perfectly in a recent majority opinion upholding the bankruptcy court’s approval of Purdue’s third-party releases: “Bankruptcy is inherently a creature of competing interests, compromises, and less-than-perfect outcomes. Because of these defining characteristics, total satisfaction of all that is owed – whether in money or in justice – rarely occurs.”
I’ll probably write a post on third-party releases sometime in the coming months given that Purdue’s utilization of them – a prerequisite to getting the plan put together, as it was a prerequisite to getting the Sackler family to pony up billions of dollars – may result in their downfall. Because the aforementioned Court of Appeals for the Second Circuit’s decision that upheld the bankruptcy court’s approval of Purdue’s third-party releases reversed the ruling from Judge McMahon of the Southern District of New York. This left folks clamoring for SCOTUS to step in and make the final call, and they were more than happy to oblige: last week they granted cert and arguments will commence in December of this year.
Given the extratextual nature of third-party releases and the textualist majority now ruling the roost at SCOTUS, this could shape up to be the end of third-party releases as we know them. If this is the end, it’ll be a mess. And it’ll all be because a common practice – rooted in pragmatism and past precedence, but not much else – managed to raise the ire and indignation of enough people to get it in front of SCOTUS. The nail that sticks out gets hammered.
In last month’s post I took you through a deep-dive on Serta – bringing the story full-circle from when we first talked about Serta’s transaction nearly three years ago. In typical fashion, the length of the post got completely out-of-hand. However, there was one thing that I wanted to touch on that I decided to save for another day: the disqualified lender list and how it was used and abused to Serta’s benefit and to Apollo’s dismay.
In the original adversary complaint, plaintiffs sought determination not only that the uptier transaction was permitted under the Credit Agreement and didn’t violate the implied covenant of good faith and fair dealing, both of which we discussed at length in last month’s post, but also that Apollo was a “disqualified institution” under the Credit Agreement.
In most credit agreements for syndicated loans there will be disqualified lender provisions that allow the borrower to put together a disqualified lender list – basically, a list of institutions that the borrower (company) does not want, in any context, holding their debt in the future.
Note: The terms “disqualified institution” or “disqualified lender” are a bit of a misnomer, as the reality is that any entity, or affiliate of an entity, that’s disqualified can purchase debt if they get the written consent of the company and administrative agent beforehand. But that’s relatively rare as the borrower, obviously, has the disqualified lender on their list for a reason.
The rationale for creating disqualified lender (DQ) lists is pretty straight-forward and entirely sensible. First, they make sure that a borrower’s competitors, assuming that the borrower is private, can’t just buy up some of the borrower’s debt and thus get a sneak peek at their financials. Second, they allow the borrower to preclude more “aggressive” funds from holding their debt if it’s believed those funds wouldn’t be, to use a euphemism, overly constructive if the borrow falls on hard times and needs to begin working collaboratively with its current lenders.
Given this, it won’t surprise you to know that sponsors typically put together the most comprehensive (read: aggressive) DQ provisions and put together the most comprehensive DQ lists. Because, obviously, if you’re a sponsor you don’t want other sponsors getting a peak at your PortCo’s financials and you definitely don’t want certain kinds of distressed funds mucking around in your PortCo’s capital structure if it begins to creak and crack under too much leverage.
The DQ provisions in credit agreements – like much else of the standard language in credit agreements – mostly align with the guidance of the Loan Syndications and Trading Association (LSTA). The idea behind the guidance is to ensure that all DQ lists have a relatively uniform structure and are limited to a reasonable number of entities as to not gum up secondary market liquidity. Additionally, the stipulates, among other things, that the administrative agent should promptly provide any prospective lender the list and make sure they keep the list up-to-date.
In practice you’ll see a wide swath of DQ provisions – some short and sweet, some long and lugubrious. For example, we’re increasingly seeing DQ provisions in sponsor-backed credit agreements that, to put it generously, are aspirational in spirit: sometimes trying to broadly disqualify swaths of funds instead of specific entities, or not making it overly clear if an institution can be added to the DQ list after it’s been created.
More importantly, there are limited hard and fast (read: enforceable) rules vis-à-vis the day-to-day usage of disqualified lenders lists – instead there’s a set of norms for how they’re used that have a tendency to be ignored or sidestepped. And in recent years we’ve seen a number of examples of this, with DQ lists having been used and abused much to the consternation of those on both the sell-side (e.g., loan trading desks at GS, JPM, etc.) and the buy-side (e.g., Apollo, King Street, etc.).
This is because, in practice, secondary trades happen in a competitive environment typified, to put it lightly, by lackluster liquidity. So, if DQ lists aren’t immediately accessible – either by the sell-side trading desk or by the buy-side buyer – then you end up in a situation where the prospective lender needs to undertake a leap of faith hoping that they aren’t on it. Then if it turns out, in retrospect, that the prospective lender was on the DQ list – but no one realized it – some kind of resolution needs to be reached.
When you add on top of this the aforementioned aspirational (read: vague) wording often present in DQ provisions – especially regarding what happens when a buyer on the DQ list manages to purchase debt – it can become a mess. So, much like third-party releases, DQ lists have become a common practice despite their limits still being an unanswered question – thereby opening the possibility for bitter battles when things go sideways and a resolution needs to be found.
So, with that quick and dirty overview of DQ lists out of the way, let’s get back to Apollo and Serta. Apollo, as happens occasionally, was purportedly on Serta’s DQ list because they’re a sponsor themselves and they may or may not have a bit of a rabble-rousing reputation.
If you read through the complaints, opinions, etc. linked in last month’s post, you’ll see an oscillation between folks mentioning North Star or Apollo. Apollo is North Star’s parent entity and because of this were also, by extension, purportedly on the DQ list.
Technically, in every document North Star should probably be exclusively referenced with it just being footnoted that Apollo is the parent entity. But invoking North Star doesn’t quite generate the same implicit understanding that invoking Apollo does. If you say that Apollo is a disqualified institution, everyone kind of nodes their head and says, “sure, sure, makes sense they’re always up to something and I wouldn’t want them poking around my PortCo either.”
Anyway, in March of 2020, as the drop-down was being dreamt up, North Star began buying up the 1L TL to the tune of $192mm. Because Apollo was purportedly a disqualified institution and purportedly didn’t get the requisite consent to effectuate the purchase, the purchase was, after much dilly-dallying, rejected.
However, Apollo says they made the purchase fair and square...
So, let’s talk about what happened here. Because, as you’ll see, there’s a reason why in my writing on Serta over the years I’ve been more defensive of Apollo. Serta played their leverage extremely effectively throughout the process of (ultimately) effectuating the uptier. But their dealing with Apollo wasn’t standard operating practice and, in my view, sets a bad precedence...
Somewhere in the bowels of one of the guides, there’s reference made to the distinction between “assignment” and “participation” when buying a term loan on the secondary market (e.g., calling up a trading desk at GS or Barclays or wherever and purchasing $Xmm of ABC 1L TL.).
But let’s do a quick recap. With assignment, a purchaser effectively has the rights they would’ve had if they had bought up the term loan at issuance. In other words, the purchaser becomes the lender of record, has the right to vote, etc. With participation, a purchaser gets the economic rights (e.g., the interest payments and limited voting rights) but doesn’t become the actual lender of record. Instead, the actual lender of record will remain whoever sold the economic rights.
If you’re at Apollo and are looking at doing a more “creative” transaction – or think one could occur and want to participate – you want to (obviously) become the lender of record (e.g., have full voting rights). So, mechanically, here’s a rough outline of what happens…
Note: Importantly, it’s really the job of the administrative agent to keep an up-to-date copy of the DQ list and to act as a gatekeeper (e.g., not allow those on the DQ list to become an assignee). However, almost all credit agreements specify that there’s no liability for an administrative agent not, like, having an up-to-date list or even looking at the list prior to signing off.
So, here’s where things get a bit interesting. Apollo was on Serta’s DQ list originally but was removed in October of 2016. Then, over the next two years, they bought and sold millions of Serta’s 1L TL. So, in other words, the administrative agent, UBS, was constantly dealing with Apollo and Serta was, as a formality, signing off on their trading in and out of their 1L TL position.
Then on March 12 2020 Apollo reemerged for the first time in a few years: executing trade confirmations with Barclays (the assignor) in the 1L to the tune of $192mm. Apollo reached out to UBS in the days following the trade confirmations to confirm they weren’t on the disqualified list and were told twice that they were not (once verbally, once in writing).
Note: Again, notice the timeline here. They reached out after the trade confirmation, because if you’re actively trying to buy up loans you’re operating in a competitive environment – this is doubly so when other distressed funds are sniffing around the situation and are also trying to weasel their way into the capital structure. So, if you know the administrative agent is going to take time to get back to you, then you feel compelled to act now – and Apollo had good reason to believe, based on their previous trades, that they weren’t erring here.
Following the typical process, Apollo sent over the executed assignment agreements – between themselves and Barclays – to UBS. By April 14, with no response from Serta coming forth, its Apollo’s contention that consent was granted by omission of objection due to i) them being told they weren’t on the disqualified list by UBS and ii) the company not objecting within fifteen days.
But alas the trade didn’t settle, and the excuses from UBS began to pile up. UBS initially told Apollo that they were, like, being ghosted by Serta, so that’s why they couldn’t get the requisite sign off. And, per Apollo, with their suspicions now raised they confirmed multiple times again in mid-April, a month after first executing the trades with Barclays, that they weren’t on the DQ list.
Apollo is nothing if not persistent, and on April 24 Serta finally communicated an ostensible rationale to UBS for the delay: because of the pandemic, getting signatures was proving difficult. But they allegedly assured UBS that they would provide their consent for the purchases.
Several days later, in a bizarre whiplash of events, UBS executed the assignment agreements before, just hours later, retracting them saying it was done in error (to be fair, administrative agents making baffling errors isn’t exactly unprecedented – see Citi mistakenly paying $900m to lenders and then having to litigate to get it back).
Then the dilly-dallying all became clear, in case it wasn’t before. On April 30 Apollo signed an NDA to explore doing a drop-down, and in this NDA Serta acknowledged Apollo’s loan holdings (e.g., the $192mm 1L position we’ve been discussing above). But the next day they threatened to reject Apollo’s assignments – as they had still never actually consented in writing to them – unless Apollo allegedly made “a new money investment in Serta” (e.g., participated in a drop-down).
This would’ve been all water under the bridge if the drop-down had actually occurred, as it seemed likely that it would in those days. The hard-balling by Serta rankled Apollo, sure, but it was obviously a petty leverage play that was made possible due to the ambiguity inherent to DQ lists.
However, as you know from last month’s post, the PTL Lenders swooped in – offering something, to the surprise of everyone else, that couldn’t be matched by the Non-Participating Lenders. So, with that offer now in hand, the leverage Serta had on Apollo vis-à-vis the assignment consent was suddenly moot.
Anyway, the reason why this whole saga wasn’t discussed last month – beyond the fact that I can’t be writing 10,000 word posts every month – is that during the evidentiary trial a resolution to the Apollo disqualification was announced. So, the only question really remaining from the original adversary complaint was if the transaction breached the implied covenant of good faith and fair dealing – and, as you know, Judge Jones made his views clear on all that.
You can read the brief agreement here. The gist of it is that 50% of Apollo’s purchases will be consented to (e.g., they’ll actually have a $93mm position in the original 1L TL) and the remaining 50% of purchases will “be deemed null and void” (e.g., remain owned by the assignor, Barclays).
And, importantly, the agreement does not preclude Apollo (North Star) from continuing to litigate the uptier issue moving forward.
In the end, this agreement may seem a bit uncompelling from Apollo’s perspective. But it’s important to remember the alternative: leaving it in the hands of Judge Jones who, based on his rumblings and ruminations in the prior few months, was likely to side with the debtor’s view that all that matters here is that Apollo’s purchase was never consented to by either the company or the administrative agent – case closed.
So, in this instance, the issue surrounding Serta’s DQ list ended with a whimper not a bang. However, the issue highlights an important point that for all the superficial rigidity that credit agreements can appear to have, there exists a murky mix residing just beneath the surface. Not only as it pertains to the interpretation of language in credit agreements (e.g., the open-market purchasing language we spent so much time talking about last month) but also as it pertains to the practical ramification of language in credit agreements (e.g., how DQ provisions are actually put into practice).
Today, we’re seeing sponsors increasingly expand DQ provisions – seeing it as a way, if nothing else, to maximize leverage down the road should the need arise. This expansion includes providing borrowers more tools if someone ostensibly on the DQ list manages to slip through the cracks: making it clear that they may be provided a more limited set of information, that their entitlement to vote and have enforcement rights may be rescinded, and even that they may be forced sell their loans back at par, what they paid, or the current market price.
Under the expanded DQ provisions in some credit agreements there’ll be situations in the future where borrowers aren’t too perturbed if someone does slip through the cracks and ends up in their capital structure: for example, if the new lender’s voting rights get crimped if they were on the DQ list then it could make it easier for the borrower to push through a more “creative” transaction that leaves the new lender on the outside looking in. The less nay votes, the better.
The aforementioned quote from Judge Lee – stating that bankruptcy is inherently a creature of competing interests, compromises, and less-than-perfect outcomes – can be extended to how credit agreements or indentures come to be in the first place. The things that really matter in debt docs, and the things that can cause an uproar down the road, are the result of the borrower and initial lenders reaching some kind comprise on their naturally competing interests.
It just so happens that often borrowers and lenders have different interpretations of what things in the credit agreement really mean and what they really allow for – both at the time the debt docs are drafted and thereafter. This is really what Serta’s saga boiled down to and it’s this murky mix of issues, whether it be the open-market purchasing language or the DQ list shenanigans, that keeps things interesting and keeps bankers, lawyers, and those on the buy-side well-fed or at least well-medicated.
]]>It’s been a pretty hectic few months, but let’s do a little blast from the past and talk about Serta. They’ve just had their Plan of Reorganization confirmed, and Apollo, et al. have found themselves on the wrong end of a decision that they’re now appealing to the Fifth Circuit.
There are a few reasons, beyond nostalgia and self-interest, that it’s worth talking about Serta...
First, because the resolution of Serta’s case matters for those who’ve done more “creative” transactions over the past few years that haven’t panned out – setting a precedence, or the perception of precedence, for how courts, or a singular court, will handle these cases regardless of the specific type of “creativity” employed by debtors.
Second, because the question of how Serta’s non-pro rata uptier would be ultimately resolved was the cause of much spilt ink over the past three years – primarily surrounding the open-market purchase language in Serta’s credit agreement and, more philosophically, if the uptier breached the implied covenant of good faith and fair dealing. These issues, along with the arguments on either side, are something that I wrote about and prognosticated on in the twenty-three-page Serta Guide a few years ago (needless to say, the guide was written when credit markets were quieter, and I had much more free time!).
Third, because it gives us a chance to talk about Judge Jones who is, objectively, a hilarious character. But the level of self-assuredness he demonstrates – paired with his literary stylings and his clear love of “financial titans” who are engaged in “winner-take-all” battles – has rubbed some the wrong way.
Personally, I think many have been unfair to Judge Jones; taking his arguments less seriously by dint of their delivery and failing to engage with the substance behind them. If this were a longer post it’d end up being more of a defense of how he’s handled the Serta case overall and expressio unius est exclusio alterius – but that’ll have to be saved for another day.
Note: To say this is a far longer post - at well over 6,000 words - than I planned on would be a massive understatement. But I wanted to give a bit of background, context, etc. so here we are. The post bounces around a bit when it comes to the timeline. However, in the end you'll (hopefully!) have a good feel for things.
Note: Also, needless to say, the finer details here aren't things you'll need to know for interviews. However, as discussed in the Serta guide and Incora posts, it's a good idea to know generally what uptiers, drop-downs, etc. involve and it'd be fantastic to have a general idea of how Serta's shenanigans have unfolded. So hopefully you enjoy this post!
Serta Simmons is one of the largest bedding manufactures and distributors in North America, and in November of 2016 they secured a new $1.95b 1L Term Loan, $450mm 2L Term Loan, and $225mm ABL.
But the rise of DTC mattress options, increasing manufacturing costs, etc. began to weigh on Serta even before the onset of the pandemic. So, to try to retain leverage before the business deteriorated too much, they engaged Evercore in late-2019 to begin exploring alternatives that could enhance liquidity, extend out some maturities, and (hopefully) capture some discount on its increasingly cumbersome capital structure.
Note: If you’re interested in more background, you can read the declaration from Serta’s Linker after they filed that touches on why the business deteriorated, etc.
In the end, as discussed ad nauseum in the Serta Guide, they ended up completing an uptier transaction in June 2020 whereby certain holders (e.g., Eaton Vance, Invesco, etc.) provided $200mm of new money in a new super-priority first-out tranche; exchanged ~$1000mm of existing first-lien loans, at a 74% exchange rate, and ~$300mm of existing second-lien loans, at a 39% exchange rate, into a new $875mm super priority second-out tranche; and created a third-out tranche for future incurrence, although it remained unfilled.
The reason for the kerfuffle that ensued in the wake of the uptier was that it was non-pro rata: not open to everyone, including some more notable players (e.g., Apollo, Angelo Gordon, etc.). And those left behind – around $895mm of first-lien debt and $128mm of second-lien debt – effectively became third-lien and fourth-lien, respectively. (Assuming that the empty super-priority third-out tranche wasn’t filled!)
Looking back, especially with how many drop-downs and uptiers have happened since, it’s difficult to remember fully how much of an impact the announcement of the transaction had.
It’s one of those relatively few times that a restructuring transaction causes a meaningful stir outside the industry. And it was certainly among the (very) few times that Apollo was on the receiving end of some sympathy, as the reflexive view among many, especially outside the industry, was that the transaction somehow went a step too far.
It was viewed as the opening of Pandora’s box, and many less active credit market participants began to worry that if even Apollo and Angelo Gordon could get outmaneuvered, then what chance do they have.
But let’s wind back the clock...
In 2020 the pandemic took hold and Serta’s already precarious prospects looked increasingly shaky. So, on April 7 2020, a somewhat ragtag group of holders – the PTL Lenders – banded together and reached out to the company to discuss potential options. Not hearing back, and thinking something was amiss, they reached back out on April 24 with a bit more meat on the bones: sending a proposal that outlined a solution to provide the company with additional liquidity that, importantly, would be open to all lenders.
The next week, after still not hearing back, it was discovered why: another group of holders – that we’ll call the Non-Participating Lenders, including Apollo, Angelo Gordon, etc. – presented the company with a drop-down (unrestricted sub transfer, think J. Crew) proposal back in March of 2020.
For this group, the impulse to do a drop-down was obvious: there was clear precedence for this style of transaction, the company had valuable assets that could be transferred to an unrestricted sub, and the company had ample basket capacity to effectuate the transaction.
So, the Non-Participating Lenders would simply lend new money against the unsub that now housed the valuable assets, and then exchange their existing debt into new debt at the unsub level. And, needless to say, this would all be non-pro rata (e.g., all existing holders wouldn’t be given the opportunity to participate).
There was an ideal set-up here and the Non-Participating Lenders had been methodically building up their position within the 1L tranche to $575mm. They figured that any ragtag group of other holders that formed wouldn’t have the requisite size or sophistication to come up with a compelling proposal for the company, and this reality gave them the leverage, or so they thought, to exchange their debt at a higher rate (in other words, get a better deal).
The final deal put together by Apollo, et al. involved lending $200mm in new money and exchanging $630mm of existing 1L and 2L debt into approximately $470mm of new debt. This wasn’t too steep of an exchange discount given the increasingly precarious situation of Serta and would have actually raised Serta’s overall debt by $38mm along with its cash interest by $37mm.
But, like I mentioned above, it was the belief of Apollo, et al. that they were the only real game in town. So, if Serta wanted an infusion of new money to stay afloat longer, as they desperately did, they’d have to settle for the transaction terms being offered. Beggars can’t be choosers.
And, importantly, the Non-Participating Lenders were right to think this! The first few proposals from the PTL Lenders were uncompelling, and the reason why EVR didn’t engage with them was precisely because they pegged the chances of them ever offering something compelling, relative to the Non-Participating Lenders' offer, as minimal! (Hopefully I’m not sounding too defensive here...).
But on May 26 the PTL Lenders dropped a new proposal, taking advantage of their still larger and more diverse level of holdings of the 1L and 2L tranches. Within just nine days, the deal was wrapped up. There would be no drop-down, instead there would be a non-pro rata uptier.
In the wake of Serta’s decision to go with the PTL Lenders’ offer, the Non-Participating Lenders circulated an email that stated the obvious:
“Advent [Serta’s sponsor] has played our two groups [the Non-Participating Lenders and the PTL Lenders] off of each other and continues to do so… We concede that the Gibson/Centerview group [the PTL Lenders’ advisors] has outmaneuvered our group.”
This is an important piece of context because the litigation that followed had the Non-Participating Lenders feigning shock and indignation – pretending to be blindsided by the transaction and appalled at the company effectively allowing them to be primed by $1075mm of debt (with the capacity to incur further debt in a third-out tranche that was unfilled!).
But this was all performative to try to curry favor with the courts. In reality, the Non-Participating Lenders misjudged how much leverage they had until it was too late – when a new group, larger in size and incensed by the backroom dealings they were left out of, offered Serta something they couldn’t refuse.
The Non-Participating Lenders soberly assessed the situation in the immediate wake of Serta’s decision and, recognizing the perilous position they were in, tried to come up with an alternative deal at the last minute (e.g., tried to saddle up to the PTL Lenders, do a deal together, and buy some of the PTL Lenders’ holdings at a premium to current market pricing).
But the leverage had shifted and the PTL Lenders weren’t interested in détente. It was only then that the Non-Participating Lenders pursued litigation because it was a bit of a call option. In other words, there’s asymmetric upside as the worst that’d happen is they lose some legal fees, that pale in comparison to how much their 1L and 2L holdings would erode under the PTL Lenders’ transaction, but the best that can happen is the transaction gets unwound and their holdings return to roughly where they were before.
With the conciliatory advance of the Non-Participating Lenders being rebuffed by the PTL Lenders, the Non-Participating Lenders did what anyone would do after a novel transaction: sued for an injunction over the “unlawful transaction” to kill it in the crib (in other words, stop the transaction from moving forward).
Judge Andrea Masley of the New York State Supreme Court denied the request, believing the transaction did not appear to violate the Non-Participating Lenders’ sacred rights and thus didn’t require their consent (despite the Non-Participating Lenders’ protest to the contrary).
Many were surprised when Apollo, et al. appeared to drop their pursuit of unwinding the transaction after Judge Masley’s denial. It seemed a bit against type, and many chalked it up to the fact that Apollo, et al. would be happy to do non-pro rata uptiers in the future so there’s no sense fighting it. And, indeed, Apollo has been on the right side of a few uptiers over the past few years.
But, in reality, they were just biding their time to perhaps relaunch their litigation. Because, as anyone would have thought, upon Serta’s transaction occurring a few other similar transactions quickly followed (e.g., Boardriders and TriMark). This then allowed folks to see how the inevitable litigation from non-participating lenders in those cases panned out.
It’s not the time or place to go through all this litigation – or else this post will balloon even further – but in March of 2022 Judge Katherine Failla denied Serta’s motion to dismiss a challenge against their uptier transaction brought by other non-participating lenders, and in October of 2022 Judge Masley denied Boardrider’s motion to dismiss a challenge against their uptier transaction brought by non-participating lenders.
Sensing the judicial mood had slightly shifted – along with concerns rising about Serta filing and their position in the capital structure potentially becoming crystalized – on November 3 2022 the Non-Participating Lenders (e.g., Apollo, Angelo Gordon, Contrarian Capital, etc.) took another kick at the can to try to unwind the transaction.
You can read the complaint here, and below you can see the heart of the argument (e.g., that the “Unlawful Exchange Transaction” was not an “open market purchase”) along with the reference to the other Serta case that spurred Non-Participating Lenders to try, try, try again...
Anyway, we may be getting a bit ahead of ourselves, but with Serta filing the question of whether or not this was really a prohibited transaction or not took center stage. For obvious reasons: if the transaction was upheld the Non-Participating Lenders would stand to get a pittance – just 1% of the post-reorg equity of the company given their lowly location in the capital structure.
Therefore, this was one of the last opportunities for the Non-Participating Lenders to give themselves the chance, however slim, to foist themselves back up the capital structure and get some meaningful recovery in the now seemingly inevitable filing.
So, let’s turn to the Credit Agreement and talk about the sections that Judge Jones – the presiding judge in Serta’s chapter 11 – refers to in his opinion that (spoiler alert!) upholds the transaction.
As mentioned earlier, in November 2016 Serta secured a new $1.95b 1L Term Loan, $450mm 2L Term Loan, and $225mm ABL. The Credit Agreement in question was relatively loose at the time it was written, a reflection both of the relative health of the company and of credit markets at the time.
But it’s important to keep in mind that this was a more innocent time in credit markets, well before drop-downs and non-pro rata uptiers firmly entered the lexicon and became seared into the minds of bleary-eyed lawyers when reviewing credit docs.
There’s been much ado about the looseness of the Credit Agreement, and the slightly sloppy wording of it. It’s true that the insertion of a line or two could have prevented the transaction from occurring, but it’s always easier to play offense than defense in these situations (e.g., take advantage of loose docs as opposed to anticipating how loose docs could be taken advantage of in the future). But even with that caveat, the Credit Agreement was “loose” in more traditional ways (e.g., it had no anti-subordination clause).
Note: This is going to be a quick and dirty breakdown, so if you’re unclear on the linkages I’m making just pop open the links above and CTRL + F the sections noted below. Just be mindful that the way anyone discusses these sections is through the lens of their preferred outcome!
So, first, there’s the question of additional debt incurrence: namely, does the Credit Agreement actually allow for additional debt to be issued? This isn’t really a point of contention, as Section 6.01(z) expressly allows for $200m of additional incurrence – and those now litigating the transaction pitched Serta on a transaction that’d also result in $200m of additional incurrence.
Second, and more importantly, we get to the issue of if Serta can repurchase, at a discount, existing loans from lenders on a non-pro rata basis. Here’s what Section 9.05(g), in part, says...
So, per Judge Jones, this means the Credit Agreement allowed for Serta to repurchase their debt from existing holders through a standard auction process that’s open to all holders, or through open-market purchases that could be non-pro rata (e.g., not open to everyone).
Expressio unis est exclusion alterius: if open market purchases must be similarly “open to all lenders” then it would have been, or should have been, specifically stated as it was for Dutch Auctions. The silence speaks volumes, at least per Judge Jones.
Third, we have the issue of amendments. In order to effectuate the transaction, certain amendments to the Credit Agreement needed to be made. And, per Section 9.02(b), amendments can be made so long as more than 50% consent with the exception of a small selection of “sacred rights” – among them the pro-rata sharing provision.
These sacred rights require the consent of each lender directly or adversely affected by the amendment – both of which would be true in any non-pro rata transaction where you’re on the outside looking in. However, Section 9.02(b)(A)(6) contains an explicit carve out for non-pro rata open market purchases. Here’s what that Section, in part, says along with some adversary complaint commentary that we’ll touch on more later...
Finally, there’s Section 2.18(c) that, in part, states that pro-rata sharing does not apply to “...any payment obtained by any Lender as consideration for the assignment of or sale of a participation in any of its Loans to any permitted assignee or participant, including any payment made or deemed made in connection with Section 2.22, 2.23, 9.02(c) and/or Section 9.05.”
Given these linkages, the transaction being prohibited or not boils down to what the meaning of the term “open-market purchase” really means and if this transaction really represents an open-market purchase. Thus, in a hearing that we’ll discuss shortly, attention was turned toward narrowly nit-picking this issue in every conceivable way given the term isn’t defined in the Credit Agreement.
But the suspicion of counsel to the Non-Participating Lenders was that Judge Jones already had a meaning in mind, and that this meaning would be consistent with the transaction being permitted. Either way, if you’re arguing before someone who you think is already pre-disposed against your argument, this isn’t an ideal way to start ingratiating yourself no matter how much backpedaling you then do...
Evercore’s creative out-of-court rejiggering bought some time – but the mattress market is merciless, and the turnaround Serta was hoping for never quite materialized (if you’re curious, you can read the aforementioned Linker declaration for more details on why they filed).
Serta ended up entering into a restructuring support agreement earlier this year that contemplated the business delevering from around $1900mm pre-reorg to $315mm post-reorg, and then filed on January 23 in the Southern District of Texas down in Houston (the hottest new venue in the world of restructuring literally and figuratively).
The next day, January 24, Serta, Invesco, et al. filed an adversary proceeding against the Non-Participating Lenders seeking a declaratory judgement that i) the uptier was actually permitted under the 2016 Credit Agreement and ii) they didn’t violate the implied covenant of good faith and fair dealing.
Exactly a month later, the Non-Participating Lenders filed their answer, counterclaims, etc. seeking the uptier be unwound, money damages be paid for breach of contract, etc. This then set off a tit for tit, none of which we really need to get into, prior to Judge Jones conducting a hearing on the summary judgement motions on March 28 that was briefly mentioned in the prior section.
This is where things got interesting, as Judge Jones granted Serta’s motion for summary judgement on the open-market issue at the end of the hearing – and did it with a level of panache that made some smirk and some simmer. (He left the good faith and fair dealing issue for a trial we’ll discuss shortly).
In his oral ruling Judge Jones said that the uptier was “very clearly” consistent with the open-market purchase language – in fact, he seemed bemused at the very idea someone could think otherwise saying the decision was “very easy” for him because he deals with credit agreement disputes “every single day” and “Sophisticated parties know what words they want to choose [in credit agreements] ...”.
I mean the Non-Participating Lenders built up the vast majority of their position in the run up to pitching the drop-down, so they didn’t choose any words and self-evidently didn’t foresee the transaction that ended up eventually occurring. But, as you’ll soon see, we need to pick our battles on what pontifications from Judge Jones we discuss, so we’ll let that slide.
Judge Jones clearly thinks that all the litigation – pre-filing and post-filing – about whether the uptier was permissible was just Apollo, et al. trying to extract empathy from some judicial rube who would fall for their faux outrage. And, like, he’s not completely wrong here.
But Judge Failla’s aforementioned prepetition ruling was that the phrase “open-market purchase” was too ambiguous to rule for Serta on, and there has been countless hours of commentary, on both sides, regarding the validity of Serta’s transaction.
When Judge Jones swats away any notion of this being a thorny question, it is a bit of a disservice to everyone – even those that agree with the outcome. It strikes me that Judge Jones is fastidiously focused on not appearing naïve – he wants to make it clear to everyone that he’s wise to the games that these “financial titans” (his words, not mine!) play with each other and he’s not going to be hoodwinked.
But suggesting in his oral ruling that these financial titans “…do these transactions all the time”, when he’s referring to a relatively novel transaction is showing another kind of naïveté – just not one that Apollo, et al. in this instance can take advantage of.
Note: Rest assured, given the outcome here, when Apollo, Angelo Gordon, etc. are on the other side of the table down in the Lone Star State they will be sensationally sycophantic, saying basically: “The transaction at issue here is just a few financial titans battling for priority, as has been happening since time immemorial – and those on the other side are pulling out the old playbook of trying to relitigate their loss, hoping against hope that a judge will be moved by their insincere indignation.”
Anyway, the oral ruling from Judge Jones more or less set in stone the outcome here: the Non-Participating Lenders wouldn’t be given an inch, and Serta’s Plan would get confirmed. But it still needed to be wrapped up, so a joint trial was set on May 15 to consider confirmation of the Plan and to resolve the remaining adversary claims (e.g., the good faith and fair dealing question).
The evidentiary trial took place the week of May 22 with closing arguments on May 25. The Seconded Amended Plan of Reorganization was filed on May 23 after Serta ironed out some issues with the Unsecured Creditors’ Committee and after Judge Jones requested that the death trap provision be removed from the Non-Participating Lenders’ class.
Note: To be honest, it was a bit of insult to injury to add the death trap provision to the Non-Participating Lenders’ class (Class 5). So, don’t say that Judge Jones is invariably debtor-friendly – sometimes he throws a bone to down-and-out creditors!
But the vast majority of the Plan stayed intact from the beginning: the FLFO (First-Lien First Out) Claims get their pro rata share of New Term Loans post-reorg; the FLSO (First-Lien Second Out) Claims get 100% of post-reorg equity subject to dilution and the remaining New Term Loans after distribution to FLFO holders (total New Term Loan size is $315mm); and the Non-PTL (Non-Participating Lenders) Claims get a pro rata share of 1% of post-reorg equity. (If you’re curious, you can read the full Plan here starting on page 64 of this PDF).
Many have suggested that the evidentiary hearing was tantamount to a (very expensive!) show trial, as Judge Jones was clearly going to confirm the Plan, regardless of what objections manifested, and decide the good faith question in favor of the debtor.
But this strikes me as a “head I win, tails you lose” kind of argument – although Judge Jones may have regretted having such a drawn out trial, as the Non-Participating Lenders stepped back up to the batting box talking about how unfair it was that they weren’t invited to participate in the uptier. Something Judge Jones was not amused with, since the open-market kerfuffle was supposed to be settled back in March...
To his credit, he didn’t really provide any hints about how he’d come down at the end of closing arguments. In fact, he hinted at there being a glimmer of hope for the Non-Participating Lenders in his delivery of a kind of therapy-on-the-bench style monologue saying, “I have a lot of issues that have been raise that I haven't thought about. I have the responsibility to think about those issues. I'm doing everything I can do, I've cancelled my vacation, none of my staff is allowed in next week. There's some things I need to reread. There are some things I need to check on. Whether I grant confirmation, enter a declaratory judgment, deny confirmation, or do it in parts, the outcome is irrelevant to me. I just care about one thing, I just want to get it right.”
Anyway, a few weeks later we got the goods, and you can read his post-hearing opinion running through, and dismissing, the objections from the US Trustee, Non-Participating Lenders, etc.
<Note: In his written opinion he revisits his thinking regarding the meaning of "open market purchase" with a bit more depth - although some would say that's a low bar - by citing dictionary definitions, the context of the Credit Agreement, etc.
There was never much doubt about any classic confirmation considerations being roadblocks – the point of the prolonged trial was really to address the good faith and fair dealing question and, with that resolved, confirm the Plan.
So, here’s the crux of the good faith and fair dealing question...
Per the thinking of Judge Jones, a court “...should provide a level of deference in reviewing agreements negotiated and executed by sophisticated parties” and “may not insert contractual terms where none exist”.
The natural implication of this is that since this situation could have been avoided with the addition of a line or two – or perhaps even a few well-chosen words – it’s not the job of Judge Jones, or anyone else, to come to the defense of holders who were on the wrong side of a transaction. You live and you learn.
There is an underlying issue – never addressed by Judge Jones directly – that this is all well and good, but the nature of the transaction was not something envisioned (no pun intended re: Envision) at the time of drafting, or at the time that holders took their positions.
The reality is that nearly all credit docs, relative to twenty years ago, are loose: but there’s a difference between existing creditors complaining about something like additional pari incurrence, something that’s explicitly allowed for or not in the docs, and more “creative” solutions where even those designing and implementing them aren’t entirely sure about their legality.
This is the blind spot of Judge Jones that I’ve alluded to before: his belief that this transaction is just another iteration, with perhaps a novel wrinkle at best, in a long string of transactions involving “financial titans” going tit-for-tat in “winner-take-all” battles.
And this explains his seeming animus towards the Non-Participating Lenders. Basically saying, “I can’t believe you had the audacity to keep coming back to me, and to appeal my prior decision, when you clearly just have sour grapes because you didn’t get your way in doing the drop-down.”
In his final salvo, Judge Jones unleashes the line that will live in infamy about “financial titans engaged in winner-take-all battles” and reiterates his findings as if there were any doubt: the uptier is consistent with the Credit Agreement, and no breach of the implied duty of good faith and fair dealing occurred.
Note: PET here refers to “position-enhancing transaction”, an acronym coined by Judge Jones to describe uptiers, drop-downs, etc. in a (potential) power play to make lawyers grovel by both repeating and extending it in increasingly cringe-inducing ways. I won’t attribute this quote to the lawyer who spoke it into existence in the closing arguments of the trial, but I’ll leave it here for you to contemplate: “My argument is that this transaction is more like an emotional support peacock than a dog or a cat, and it shouldn't be allowed.” God help us all.
Anyway, power-play acronyms aside, this strikes me as self-evidently the right outcome. The core thesis of Judge Jones is merely that it’s not the role of a court to depart from a strict reading because an outcome seems inequitable. In a case involving sophisticated parties, whether they’re financial titans or not, the onus is on them to ensure they know what they’re signing up for and to see around corners – especially those more shadowy corners involving undefined terms.
Additionally, it’s telling that in the wake of Serta there was much fanfare about closing “loopholes” in existing credit agreements that’d allow for a Serta-style transaction. But now, three years on, there isn’t unanimity: many existing credit agreements, and newly drafted ones, still allow for this style of transaction to occur. It’s now, just like any other aspect of a credit agreement, a bargaining chip. If lenders want it omitted, they need to make concessions.
It would be one thing if, in the wake of Serta’s transaction, the “loophole” was closed for every existing credit agreement and every new one precluded a similar transaction from occurring. Perhaps then it’d signal that Non-Participating Lenders were the unlucky few – taken advantage of in a way that no one else will be moving forward and thereby signaling that what occurred to them was somehow beyond the fray in its inequity.
But this isn’t the case, and context surrounding how this transaction came to be matters to Judge Jones. The Non-Participating Lenders were initially in the driver’s seat (remember: the PTL Lenders couldn’t even get anyone to return their calls at first!) but then, suddenly, they weren’t. And, as the Non-Participating Lenders conceded in the wake of the uptier being announced, they were simply outmaneuvered by Serta, the PTL Lenders, and their advisors.
In my view – for however much value you want to ascribe to it – on the critical issues (e.g., the open-market purchase language and the good faith breach) the reasoning of Judge Jones is reasonable, albeit light on details, and the outcome is right. And if you were to pump sodium pentothal into those irked over the way he’s handled the case, they’d begrudgingly agree that he got it right where it mattered most.
The issue is that Judge Jones has a habit of appending commentary – where none is necessary, and no one is asking for it – that tends to betray the very kind of naïveté he’s trying to demonstrate that he doesn’t have.
I’m not talking about more innocuous lines like the one about financial titans. That isn’t my cup of tea, but whatever. I’m talking here about the line that shortly follows: “The risk of loss is a check on unrestrained behavior.”
It’s one thing to lose a case, as Apollo, Angelo Gordon, etc. were anticipating they would here, but having a line like this thrown in does rub one the wrong way. I haven’t heard of anyone having an aneurysm after reading this line, but there were surely some bumping up their blood pressure medication.
To read this line charitably, it’s saying Apollo, et al. played a stupid game and won a stupid prize. The PTL Lenders initially wanted to do a deal open to everyone, were rebuffed, found out about the drop-down, and then used their larger holding size to offer something even better to Serta that the Non-Participating Lenders couldn’t match.
So, the thinking goes, presumably, that distressed funds will think twice before doing these kinds of transactions (“unrestrained behavior”) because someone else could find out their plan and put together a deal that undermines them. Ergo, the risk of loss being a check.
But Serta is relatively unique. It’s not the norm to see two groups – that, when taken together, represent the vast majority of holdings within a given tranche – pitching true non-pro rata solutions against each other. The point of these transaction is you can offer the company more new money, or more discount when exchanging your current holdings, by dint of being placed in a better position within the capital structure where few others reside – the “value” you’re getting circuitously comes partially through the destruction of value of your (former) compatriots in the capital structure.
Therefore, you want to find the minimally viable number necessary to get a deal done. It can’t be too small, as maybe another group will form leaving you on the outside, and you’ll need a majority for any amendments. But it can’t be too big or else the economics may start making less sense (e.g., taken to an extreme, exchanging at a discount and providing new money along with 95% of existing holders, leaving just 5% behind, isn’t going to be overly enticing).
If you’re a sophisticated holder, and you’re looking at credit docs that allow for a more creative transaction, when evaluating “the risk of loss” you’re naturally going to think about some other group preemptively doing something to you. So, ironically, you have an incentive to do “unrestrained behavior”, sometimes the most “unrestrained behavior”, and hope that litigation pans out in your favor or that you can craft follow-on transactions, at worse terms but that require participants consenting not to pursue litigation in order to participate, that makes litigation never materialize in a meaningful way (see: Envision’s very well executed strategy).
Here's another way to put it: Random CLO LLC that holds 0.05% of some tranche isn’t going to get a seat at the table in any context. They’re per se engaging in no unrestrained behavior, and likely aren’t too familiar with the unrestrained behavior others could get up to. They’re just minding their business and clipping their coupons. But yet it’s exactly this kind of holder that’s at the greatest risk of loss in these transactions or, put another way, the only one who is definitely not going to win (at best they’ll be given scraps through a somewhat coercive follow-on transaction).
I don’t know. I’ve heard many interpretations of this line over the past few weeks, most shot through with expletives. It doesn’t matter, and it’s a throwaway line. Perhaps it’s a Zen Koan. A sentence for all of us to carefully contemplate, with its meaning never quite revealing itself but through which we’ll all find enlightenment.
Regardless, if you’re a lawyer on Incora, now before Judge Jones with its own adversary proceeding, you better be relentlessly repeating, “The risk of loss is a check on unrestrained behavior.” Don’t worry about what it means, for there’s only one person who needs to know what it means – and rest assured he most assuredly does.
Note: In the adversary complaint filed by Wesco (Incora) it took just six pages before we got a reference to Serta and how Judge Jones handled it – a prelude of what’s to come as they seek to have Judge Jones rubberstamp their uptier that we’ve discussed several times.
Note: The most charitable reading is perhaps that Judge Jones is referring to the unrestrained behavior of the company in creating the credit agreement to begin with. In other words, the risk of loss to lenders, if a company were to utilize the flexible language contained in the credit agreement, should be a check on allowing this loose language to be inserted. It’s a stretch.
In the past few months we’ve seen a spat of companies that have pursued more “creative” out-of-court transactions bite the bullet – some, like Incora and Envision, suspiciously soon after completing their transactions and suspiciously soon after the various preliminary proclamations and pronouncements of Judge Jones on Serta that signaled his support of the transaction.
This has led to some cheekily calling this the new Texas two-step process: you do an uptier or drop-down, or in the case of Envision both, and then file soon after with the highest classes in your capital structure now being full of creditors more amenable to getting through court quickly.
The undertone of disapproval – that this is all, in some handwavy way, not right – is something I wrote about (read: ranted about) a bit in last month’s postscript, so won’t relitigate here. But it’s a bit hard for me to pinpoint what exactly everyone seems so scandalized over.
The reality is that Serta, facing an increasingly precarious situation, chose the transaction structure that bought them the most time and there’s no doubt that it did. That was, undoubtably, the primary aim of the transaction and they played two groups, both of whom held significant amounts, against each other perfectly to extract the best deal that’d maximize their runway moving forward.
But, insofar as the secondary aim of the transaction was to make any eventual filing, should one occur, more seamless through more easily signing up a restructuring support agreement, especially one that delvers the company more than they would’ve been able to with their pre-transaction capital structure, then that strikes me as entirely rational and reasonable.
When it comes to the PTL Lenders, the primary motive in the moment was, obviously, to provide a compelling enough offer that it’d be accepted – thereby ensuring the current value of their holdings didn’t get decimated by the Non-Participating Lenders doing a drop-down. The natural consequence of being higher up in the capital structure is then being able to get a higher recovery in-court and potentially extract some additional economics (e.g., through providing the exit financing, etc.).
But it’s not preordained – at the time of the transaction or now – that those recoveries will be better than just having clipped those FLFO and FLSO coupons. The PTL Lenders have self-evidently won the battle, but they haven’t yet won the war (read: earning a relatively healthy return over the duration of their holding period!).
Anyway, the thrust of Judge Jones argument, even if the delivery could use some work, strikes me as right. Although the appeal to the Fifth Circuit makes it clear that they really didn’t appreciate how Judge Jones divined his views...
Somehow I don’t imagine Judge Jones cares too much. He has Incora, GenesisCare, Instant Brands, and Diebold to deal with now – enough to delay many more of his vacations, and enough to make many more lawyers contemplate their life decisions, leave the world of restructuring behind, and retire to little hobby farms in Vermont in pursuit of quieter lives far removed from Houston.
]]>This reality occasionally leads to slightly unsavory headlines in the financial press – as you can imagine, it tends to rile up the general public when they hear that hundreds of millions are spent on professional fees, especially in cases like Purdue or Boy Scouts of America where the money spent on bankers and lawyers is per se money that can’t be spent compensating victims. It seems that the general public sadly doesn’t appreciate that bankers are doing God’s work.
Anyway, the eye-watering costs of filing haven’t been lost on creditors, and this is partly why pre-packs have been steadily on the rise over the past decade. Because even if a creditor thinks they could potentially squeeze out a higher recovery in a free-fall, the possibility of a case stretching on for a year or two, and professional fees steadily churning higher, could make winning an argument for a higher valuation or a more advantageous mix of consideration a pyrrhic victory.
In the upcoming restructuring cycle, you’ll likely notice a continued bifurcation whereby sponsor-backed companies with sophisticated creditors holding majorities across the capital structure are much more likely to come together, pre-filing, and try to work out at least the contours of a Plan to avoid the uncertainty of filing with no Plan in place. This will continue to give sponsors quite a bit of leverage to push the bounds, without much to lose, in trying to achieve some level of recovery on their buyout.
For example, back in the dog days of the pandemic Chisholm Oil and Gas (sponsor backed: 58% Ares, 42% Apollo) filed with an RSA in place with holders of 99.6% of their prepetition RBL. The proposed Plan contemplated prepetition equity holders (read: the sponsors) getting back 1% of post-reorg equity and warrants for an additional 11% of the post-reorg equity despite holders of the term loan and general unsecured claims getting just pennies on the dollar in recovery.
This, understandably, wasn’t initially received well by the term loan and general unsecured holders and they objected. But the Plan contained death trap provisions and the impacted creditors – understanding that their recovery would only decline the longer the case dragged on and that Apollo isn’t exactly known for their equanimity – came to a settlement in a few months that provided holders modest concessions while still providing the sponsors with their post-reorg equity.
The Plan was then subsequently approved, and the debtor exited bankruptcy just four months after filing. For their efforts, Evercore, who were debtor-side, would earn around $4m, as laid out in their fee (retention) application, primarily stemming from a $3.25m “completion fee” (in the ninety-days prior to filing, covering most of the timeframe between when EVR was retained and when the debtor filed, they accrued fees of ~$550k).
Additionally, showing that bankers are nothing if not generous, after filing EVR was nice enough to revise its fees down from the original engagement letter thereby saving the debtor probably around $1-1.5m in fees.
Joking aside, the total fees contemplated by the fee application – at around 0.8% of the total pre-reorg debt – is in the ballpark of similarly sized cases as you can see in the excellent little analysis Reorg did breaking down the fees paid to investment bankers across different types of cases...
As you can imagine, there’s quite a bit of dispersion when it comes to the total amount of fees in a given case based not only on the size of the case, but also on whether it was a pre-pack or pre-negotiated case, whether significant asset sales occurred while in court, and other complicating factors (e.g., tort claim issues, a complex capital structure with many disparate creditors dragging the case out, etc.).
In the end, the larger and more complicated the case is, the more refined the fee structure in the fee (retention) application will generally be to account for the uncertainty over how exactly the case will unfold – if you’re a banker, you don’t want to be missing out on any potential fees!
So, you can end up with a situation where you have a dizzying number of different fees: a flat monthly fee, a flat overall restructuring (success) fee, an asset sale fee based on a percentage of any potential asset sales that occur, and a wide assortment of financing fees that’ll be struck at various percentages (e.g., a relatively low fee for advising on exit secured debt, a relatively high fee for advising on exit unsecured debt).
This can lead to situations where creditors object to retention fees, a number of hearings take place, and the fee structure is (potentially) rejiggered. For example, after a number of hearings Judge Drain told Evercore in the Frontier case that, among other things, their restructuring fee should be 14bps, not 16bps, of the total dollar amount of debt restructured – a number divined not through some deep analytical model, but rather loosely based on precedence and his view in the moment.
Like everything in finance, precedence generally wins the day so that’s why you (curiously) tend to see cases of like-kind having roughly the same overall level of fees as a percent of prepetition debt outstanding despite the fee structures potentially being quite different.
It’s also why in more complex cases, where different fees can begin to add up on top of each other quickly, a “fee cap” will be put in place to avoid raising the ire of either creditors or the court as they begin to contemplate just how high the fees could go depending on how the case unfolds.
Anyway, it’s been a crazy past few months, so I haven’t had too much time to dedicate to posts. But I figured this would be a fun little post – albeit not overly relevant to actual interviews – and I’ll drop plenty of links so you can poke through some final fee applications that you may find interesting.
As mentioned earlier, pre-packs come along with many benefits – if, and it’s a big if, you can get enough creditors to agree on what to do pre-filing – including lowering the total amount of fees that’ll be incurred or at least providing more cost certainty.
Carestream Health, that had HL debtor-side, was a great little pre-pack done last year. It didn’t set any records for speed – like the CWT pre-pack, that also had HL advising, getting done in just a day – but its Plan was confirmed in around a month. You can read the Plan / Disclosure Statement here if you want.
Given that smallish pre-packs are typically pretty straight-forward, the fee structure matches with the vast majority of fees comprising a flat amount for successfully completing the restructuring. Here’s HL’s final fee application – for $6.89m – that breaks down what they were retained to do, what they did, and includes the original engagement letter (as you can see, HL was engaged far before filing to explore a potential sale, but this then got amended to include a potential restructuring).
Anyway, here’s an overview of all the (potential) fees...
And here’s HL’s calculation of the actual fees owed...
Note: In any final fee application you’ll notice there are fees, as we’ve discussed above, and then expenses (e.g., travel, meals, access to certain tools or research, etc.). However, the true expenses are often systemically understated – optically it’s never ideal when you’re claiming thousands in small meal expenses, etc. So, even though you’ll use a certain deal code when ordering $35 of lukewarm sushi at 11pm sitting at your desk that may not ultimately be reflected in the final fee application to keep expenses relatively low.
It’s seldom that a company files in a vacuum (e.g., without significant work having been done prior to the ultimate filing). So, whenever you're looking at the fees paid while in-court, it’s important to remember that those engaged would’ve typically been racking up at least some fees pre-filing either to prepare for filing, explore alternatives, or possibly to effectuate an alternative solution (e.g., an out-of-court restructuring) that didn’t end up preventing the need to more comprehensively restructure in-court.
By way of example, McDermott International engaged Evercore in May of 2017 to explore options and eventually filed in January of 2020 with a pre-pack that was confirmed a few months later. Given the complexity of McDermott, a significant amount of groundwork was done in the year prior to filing. This included raising ~$1.7b of prepetition debt with the plan to roll most of it into the DIP facilities upon filing, along with preparing for the sale of their Lummus Technology business with a stalking horse bid of ~$2.73b.
Further, given the relatively weighty capital structure of McDermott – totalling nearly $5b – along with the complexity in what was planned to be done, the in-court fee structure, as outlined in the initial fee (retention) application, was significantly more complex with a flat monthly fee, flat restructuring fee, sale fee for the Lummus unit, financing advisory fees that fluctuated based on the type of security raised, financing placement fees that fluctuated based on the type of security raised, DIP financing fee, flat amendment fee, and an exchange fee.
In the end, since so many of the fees were triggered while in-court, the total fees, as outlined in the final fee application, totaled $51.7m. However, there was a fee cap that lowered the amount down to a healthy $27.5m.
But the above just covers the fees from what was done while in-court. Prior to filing, as mentioned earlier, a significant amount of groundwork was laid to allow for the pre-pack to go relatively seamlessly.
In total, McDermott paid $59.9m in total fees to Evercore in the year prior to filing – with $43.1m of that coming in the three months prior to filing for arranging the prepetition financing, preparing the sale process, etc.
The fact that EVR earned over double the fees pre-filing vs. post-filing may strike you as being a bit counterintuitive – but in more complex cases splitting fees like this isn’t abnormal to see given the desire to not raise the ire of creditors or the court too much with eye-watering fee applications. And, when it was all said and done, the total fees brought in by EVR, as a percent of total prepetition debt, isn’t overly out of line with cases of similar size and complexity.
It’s understandable that from the outside looking in restructuring fees can seem untenably high – and this perspective is likely why there are a few articles a year talking about fees or expenses that fan the flames and undoubtably generate a lot of clicks (it’s low hanging fruit to talk about expenses related to staying at the Ritz).
In an out-of-court context, restructuring fees are, obviously, dictated by what a company is willing to pay – if they don’t like PJT’s terms, they can shop around. And it’s not like the barrier to entry for starting an advisory shop is overly high – the majority of top shops today started more or less from scratch from those departing elsewhere.
In an in-court context, where one could argue the debtor isn’t as incentivized to scrutinize professional fees as in an out-of-court context, creditors can and do object to fees and courts aren’t shy about weighing in. So, there’s a reasonable check on fees running amuck and draining the estate of value.
With all that said, in this post we’ve just covered the banking side of things. In any case where bankers are involved (e.g., a relatively sizeable case) you’re also going to have financial advisors (e.g., FTI, A&M, etc.) and lawyers involved too.
Reorg did a nice little analysis of financial advisor fees – and, as you’d expect, the results are directionally analogous to the banking side of things...
Reorg also did a nice little analysis of legal fees and, as you’d also expect, if a restructuring support agreement is in place, then the overall level of fees, as a percentage of prepetition debt, are significantly less than if there’s none in place (in the latter scenario the cases are not only longer as consensus needs to be built in-court, but they’ll per se involve at least a bit more contention occurring in-court).
When taking all the banking, financial advisory, and legal fees together in a typical case, there’s no getting around that filing isn’t cheap. But costs can be significantly reduced when creditors are willing to be a bit more amicable pre-filing and, as mentioned in the preamble to this post, that can be one of those hidden points of leverage that sponsors are likely to continue pressing down more firmly on moving forward.
In my post last month discussing Incora, I mentioned that they were very likely to file this quarter or next and, when they do file, the sponsor (Platinum) is likely to get some level of meaningful recovery through their pre-filing maneuvering. Well, this week it became public knowledge that they’re currently talking to creditors in anticipation of filing in the next few weeks with (hopefully!) an RSA in place with a non-trivial number of creditors.
The other company that did the most creative (read: aggressive) out-of-court restructuring last year, that I've briefly referenced in a number of past posts, was Envision. Envision represented a grab bag of trends: involving both an unrestricted sub transfer and a non-pro rata uptier to completely rejigger their capital structure and bring in significant new liquidity (PJT was debtor-side, KKR was the sponsor).
Well, this week they decided to preemptively bite the bullet and file - with $655m of cash still on hand, making a DIP unnecessary - in Houston which has become an increasingly popular (read: debtor friendly!) place to file among those that have done more creative transactions (as evidenced by Serta’s success last month – including the Judge Jones decision that I also briefly mentioned last month).
Note: Envision was able to cobble together an RSA that you can read if you’re curious – attached is a declaration from the Chief Restructuring Officer that lays out its path toward filing, what their 2022 out-of-court transaction involved, and why they decided to file now.
In the coming weeks there will be arguments proliferating that these more aggressive maneuvers out-of-court are spurious – only benefiting a certain set of creditors that were allowed to participate and, of course, those advising on the transaction but not really moving the needle on the company’s probability of having to file in the future. In other words, there’s no real value-add to these transactions – they just represent a shifting of value prior to the still predestined filing.
This line of argument has always struck me as being a simplistic reading. It’s exceptionally rare that any out-of-court transaction can be anywhere near as comprehensive as what’s done in-court (e.g., Envision’s RSA would delever the debtor by ~$5.6b!).
Instead, out-of-court transactions are just about doing something that simply forestalls filing and provides for the enhanced possibility, but not the certainty, of being able to turn things around – and in recent years, due to the continual loosening of credit docs over the past decade, it’s been found that often the maximally viable solution out-of-court, the one that provides the biggest reduction in debt or the largest infusion of liquidity, involves a more creative transaction like we’ve seen with Serta, Boardriders, TriMark, Envision, Incora, etc.
For those pursuing an out-of-court solution, sometimes, oftentimes, it doesn’t work out. But that doesn’t make it wrong or, as an increasing number in the financial press insinuate, somehow underhanded or nefarious to pursue just because filing occurs subsequently.
Additionally, insofar as any out-of-court solution greases the wheels of subsequently filing (e.g., through the pre-filing rejiggering making it easier to get an RSA in place with those now most senior in the capital structure) then the out-of-court solution isn't really a failure as it makes the in-court process quicker, cheaper, and likely will result in a post-reorg capital structure that’s better suited to the company upon emergence.
This is a point that really riles people up but it's a reality that almost any comprehensive out-of-court transaction will fundamentally change the inter- and intra-class dynamics (for better or for worse) if filing occurs relative to what these dynamics would've been pre-transaction. So, proactively thinking about a transaction and how it will potentially inform these dynamics, even though you hope the transaction obviates the need to file in the future, is sensible not scandalous.
Anyway, the real point here is that many (read: most outside the industry and some within) have a Straussian reading of transactions like Incora and Envision: believing they were never really about buying time to hopefully turn things around but were just designed to put more favored creditors, or potentially the sponsors themselves, in the driving seat when the inevitable filing occurs (thereby enhancing their returns relative to non-favored creditors and making the filing process easier).
In other words, these transactions are distinct from out-of-court transactions of the past as they're just a glorified prelude to the inevitable filing not an earnest attempt to obviate having to file.
There’s a grain of truth to some of this but it’s far too absolutist. It’s certainty true that one could envision (no pun intended) an out-of-court solution that provides no real enhanced breathing room to the company (e.g., doesn’t move the needle on the probability of them subsequently filing) but does benefit a certain favored group of creditors upon filing, and makes reorganizing in-court easier, through the pre-filing rejiggering done.
But this, in my view, quite clearly doesn’t describe the full intent behind the Serta, Incora, Envision, et al. transactions. In all these transactions significant new liquidity injections occurred and the companies were put in a better position than they otherwise would have been – although non-participating creditors have obvious, and understandable, gripes with the nature of the transactions.
And if the secondary, but not primary, intent of these transactions is that they make for a more seamless filing through likely being able to cobble together an agreement with some creditors pre-filing – as Serta and Envision were able to, and as Incora is likely to – then that strikes me as reasonable.
However, the fact that Envision and Incora are likely to have an easier time in-court, relative to if they had never done their out-of-court work, is viewed by many as proof positive that these transactions were never about forestalling filing – but were rather done with a single-minded focus on making sure a favored set of creditors reaped the highest recovery upon filing (thus why those who participated in these transactions are more than happy to sign onto RSAs and try to jam the cases quickly and relatively cheaply through court).
Anyway, with Envision filing, and Incora likely filing within the next few weeks, you’ll be reading lots about how these sponsor-backed companies aggressively stripped a minority of creditors of the recovery they’d otherwise be due through these transactions despite the supposed inevitability of their filing. It certainly makes for a better story. However, like many things in life, it’s not quite so clearcut and I very much doubt these cases will get clogged up by courts entertaining this line of thinking.
But there’s no getting around there are some bad optics to Incora and Envision filing so quickly after doing transactions that are so aggressive. And, as discussed at length regarding Incora, there is only so much the bounds can be pushed before the bounds become more clearly defined by the whims of the courts – and that should make everyone a bit wary as no one knows exactly where those bounds would be set.
Note: In a redux of the pre-reorg maneuvering that took place with Incora, Platinum (allegedly) began buying up significant amounts of the senior unsecured notes of their PortCo Cision a few weeks ago. So, they aren't overly fazed by the ongoing Incora litigation we've discussed before.
]]>There were a few reasons why I wanted to talk about Incora back then...
First, there was inherently some novelty to the Incora transaction relative to the other non-pro rata uptiers we’ve discussed in the past since it involved notes, not loans, so the transaction dealt with a fundamentally different set of constraints (e.g., no open-market purchase provisions like we talked about with Serta!).
Second, it really involved two non-pro rata uptiers: one involving some Secured Notes flipping up into newly created 1L Notes and one involving some Unsecured Notes flipping up into newly created 1.25L Notes. With the sponsor holding a non-trivial amount of the Unsecured Notes, and them trading well below par but exchanging slightly above par into a 1.25L position thereby layering over even the Non-Participating Secured Notes, it was a bold move.
Third, the original complaint from the Non-Participating Secured Noteholders was just a hilarious read: full of lawyerly angst and fiery rhetoric surrounding the “Sham Transaction” that was “violently detrimental” to non-participating holders. But it did a great job laying out the transaction, so I thought it’d be a fun read for you and, in conjunction with my explanation, would make for great interview talking points – and I’m glad to hear many did end up talking about Incora with PJT and EVR this past cycle.
Anyway, the gears of justice grind slowly and no amount of angst and fiery rhetoric within a complaint changes that reality. But there have been a few interesting developments with Incora – including a new (separate) complaint dropping from the Non-Participating Unsecured Noteholders – so let’s do a little update…
Note: I haven’t had much free time lately, so I’m not going to spend a few thousand words recapping the transaction – therefore, if you haven’t yet, be sure to read my original post or flip through the original complaint that does an excellent (albeit slightly one-sided!) job recapping the transaction.
Note: Keep in mind that in an interview you're never going to be asked (unprompted) about your thoughts on the merits of various non-pro rata uptier arguments being flung around in court. So, if you're preparing for interviews, make sure to prepare for what will actually come up not deciding whether you're in favor of the integrated transaction argument put forward by the Non-Participating Secured Noteholders (although, needless to say, if you're talking with PJT or EVR about Incora, it's best not to say you agree with the arguments of those suing over the transaction!).
As a quick refresher, the pre-reorg capital structure of Incora – which is an entity formed after Platinum took Wesco private and merged it with Pattonair - contained $650m of 2024 Senior Secured Notes, $900m of 2026 Senior Secured Notes, and $525m of 2027 Unsecured Notes.
Due to the pandemic, supply chain issues, etc. Incora quickly began to find itself stretched thin. And with interest payments on its Notes coming up in May 2022 it needed to devise some plan to raise fresh cash and some (e.g., PIMCO and Silver Point) were more than happy to oblige.
The obvious solution was doing a non-pro rata uptier. But, as was discussed at length in the initial Incora post, the so-called Favored Noteholders (e.g., those allowed to participate in the eventual uptier) didn’t hold the supermajority required in both the 2024 and 2026 Secured Notes to strip their liens. This was a necessary precondition to doing the transaction as the Favored Noteholders wanted to exchange their Secured Notes into new (higher priority) debt that had liens on substantially all the company’s assets (in other words, the liens just stripped from the Secured Notes prior to the exchange).
In the end, the necessary supermajority in the 2026 Secured Notes was manufactured through the issuance of $250m of new 2026 Secured Notes exclusively to the Favored Noteholders. These Favored Noteholders, with their newly minted supermajority, then immediately stripped the liens of the Secured Notes and exchanged their holdings into the newly created (higher priority) 1L Notes.
Those Secured Notes that weren’t allowed to participate were rendered unsecured after having their liens stripped – and, to add insult to injury, were also primed by the majority of Unsecured Notes (some held by the sponsor!) who flipped up into new 1.25L Notes despite not putting in any new money.
This is a (very) quick-and-dirty overview of what happened with the Secured Notes but here’s a nice illustration of the overall transaction...
When I wrote the initial post on Incora there wasn’t much to talk about beyond the initial complaint. It’s still early days but we’ve had a bit of traction – most notably with the Participating (Secured) Noteholders, Wesco, Platinum, and Carlyle providing their side of the story and trying to get the complaint dismissed.
Here’s the overarching perspective of the Participating (Secured) Noteholders (PIMCO and Silver Point) that, for what it's worth, I’m in agreement with. They start by arguing that the Non-Participating Noteholder’s complaint amounts to sour grapes – similar to how Apollo and Angelo Gordon feigned indignation and incredulity in the wake of Serta’s decision to do a non-pro rata uptier pitched by Invesco, Eaton Vance, et al. instead of a dropdown (unrestricted sub transfer) pitched by Apollo and Angelo Gordon.
The Participating Noteholders then go on to say basically, “Look, we’re all big boys and girls here and these Original Indentures use highly specific, and highly bargained for, language. It’s absolutely clear that you just need a simple majority of the Secured Notes to consent to increasing the amount of debt that can be issued under the Original Indentures, and that a supermajority can, if they so choose, remove liens. And that’s exactly what happened here: a majority consented to the additional $250m issuance, and a supermajority then voted to remove the liens. That's all that really matters here.”
This is a bit of clever maneuvering (or, if you prefer not to use a euphemism, obfuscation) as what’s said above isn’t something the Non-Participating Noteholders would necessarily disagree with. This is why they made the argument (that, in my view, is a stretch) that this transaction should be viewed as one big integrated transaction.
In other words, the original complaint argued you can’t divorce the step of additional issuance from the step of removing liens. So, there was never really a supermajority for removing the liens as the additional issuance, used purely to facilitate the stripping of liens, should be impermissible.
To partially support this theory, the Non-Participating Noteholders point to how much the 2026 Secured Notes traded up above the 2024 Secured Notes after the idea of the potential for a non-pro rata uptier first leaked on Debtwire. To their mind, this is proof that the Participating Noteholders, caught off guard by the leak, scrambled to get a supermajority (66.67%) that they hadn't yet locked in while, simultaneously, the Non-Participating Noteholders scrambled to get a blocking position (33.34%).
And then, only when a blocking position was achieved by the Non-Participating Noteholders, did the Participating Noteholders then come up with the plan to use their simple majority to allow for the issuance of $250m additional 2026 Secured Notes.
By these newly issued Secured Notes being invested in exclusively by the Participating Noteholders, this then gave them the supermajority necessary to strip the liens and commence the exchange. But if the Participating Noteholders really believed all along that they could manufacture a supermajority this way, and that it wasn't legally dubious whatsoever, then why the mad scramble to buy up the 2026 Secured Notes?
In other words, the argument goes, the Participating Noteholders knew they couldn't manufacture a supermajority through additional issuance -- that's why they were buying up the 2026 Notes initially! But, when they failed to get their supermajority the "right" way, that's when they pivoted to trying to manufacture a supermajority through additional issuance to avoid having their Sham Transaction fall apart before it even got started. And they just hoped, presumably, that despite how legally dubious the transaction was that any litigation could be quickly settled (a settlement basket, providing for additional 1.25L issuance to settle claims from those left behind, was included for a reason!).
Here's what the Participating Noteholders have to say about that...
There is an undercurrent of exasperation (or, depending on your reading, bemused dismissiveness) from the Participating Noteholders throughout – coming back continually to a plain text reading of the indentures: the majority can issue additional notes, a supermajority can strip liens, and the indentures allowed for “privately negotiated transactions”. That’s what happened, end of story. Every step of the process toward this uptier was expressly allowed and there’s no language in the Original Indentures surrounding judging each step differently if they just so happen to be taken in quick succession.
Further, even if the Participating Noteholders purchasing the newly issued Secured Notes seemed irrational if there weren’t an underlying agreement to immediately vote, as a new supermajority, to strip the liens and exchange their Secured Notes into new (higher priority) notes, the Participating Noteholders argue that’s not proof of any kind of wrongdoing.
Finally, because lawyers can’t resist, there are a few jabs throughout around the fact that the Non-Participating Noteholders were crafting their own transaction, that Participating Noteholders were allegedly unaware of, and that the company simply opted for the transaction that was the best deal for them.
This is a touch unfair as the alleged alternative proposal - that an ad hoc group of minority secured noteholders scrambled to put together after they realized they were about to be left behind - was going to be pro-rata (e.g., open to all secured noteholders, including PIMCO and Silver Point). So, it's not like both proposals were going to inevitably leave some behind in the same way or to the same degree.
In the Wesco and Guarantor Defendants reply in support of their motion to dismiss the complaint (linked above) front and center is their core argument: outside of the more ephemeral issue of whether the transaction breaches the implied covenant of good faith and fair dealing, this all boils down to whether you view this transaction as being an integrated one or whether it involved distinct and permissible steps (e.g., using the simple majority to create additional issuance, using the newly created supermajority to strip the liens, etc.).
The logic of their argument here is more-or-less: the Non-Participating Noteholders want you to believe that the Original Indentures permanently bar holders of newly issued Secured Notes from voting (or at least voting the “wrong” way) to strip the liens of all Secured Notes. But this is per se nonsensical, as the Original Indentures make clear that all newly issued Secured Notes are to be equivalent to those originally issued (e.g., with the same rights to provide consent).
So, the argument continues, if you agree with the Non-Participating Noteholders, then what you’re really agreeing with is the notion that these newly issued Secured Notes have different rights relative to the original Secured Notes – which has no basis in the Original Indentures and would be an idea made out of whole cloth.
Note: In the original complaint there are claims that the transaction represents a preferential transfer to an insider (Platinum) and is a fraudulent transfer. This is something that’s more central to the Non-Participating Unsecured Noteholders complaint discussed below, and it’s why the Non-Participating Unsecured Noteholder’s complaint refers to the transaction an “Insider Exchange” whereas the Non-Participating Secured Noteholder’s complaint calls it a “Sham Transaction”. This past week Platinum did try to take down the preferential and fraudulent transfer claims (linked above) and it’ll likely be the same line of argument relied on when addressing the Non-Participating Unsecured Noteholder’s complaint.
Just a few weeks ago a new complaint dropped from non-participating holders of the 2027 Unsecured Notes against Platinum (the sponsor), Wilmington Savings Fund Society (the indenture trustee), Carlyle (the majority holder of the Unsecured Notes pre-reorg), and Senator (a minority holder of the Unsecured Notes who also participated in the transaction).
In my original post on Incora, it was probably self-evident that I wasn’t overly moved by the “integrated transaction” line of argument at the core of the complaint. It struck me then, and it still does today, that it’ll be very hard to get a court to move away from a plain-text reading of the Original Indentures and adopt something that’ll per se be more handwavy.
But when thinking about just the Unsecured Notes things get a bit more interesting because, as mentioned in the original post, this aspect of the overall transaction really pushed the envelope...
First, there’s clearly, at a minimum, the appearance of a tawdry insider element to what occurred as the sponsor, Platinum, had been buying up Unsecured Notes prior to the transaction and participated in the roll-up into the 1.25L Notes.
Further, Carlyle, who was the former majority owner of Wesco before Platinum took it private, had owned over 50% of the Unsecured Notes since Platinum took Wesco private and their consent was strictly necessary to effectuate the roll-up. This was true not only because Platinum didn’t hold a majority of the Unsecured Notes, but also because they’re an affiliate of the company so their notes aren’t included in any consent calculation to begin with.
So, even though Carlyle is a former insider they did have a prior relationship with Platinum and this transaction per se put Platinum in a better position than they’d otherwise be in – indeed, in the event that Incora files, as it appears inevitable that they will this year, the sponsor’s return will be driven almost exclusively by their 1.25L Note holdings as their equity will almost certainly be zeroed.
Second, the Unsecured Notes exchange didn’t occur at a discount, despite the Unsecured Notes trading at around sixty cents prior to the transaction, but rather at 101.125 plus fees and accrued interest. But unlike the Participating Secured Noteholders, who also exchanged their debt slightly above par, there was no meaningful additional consideration given by the Participating Unsecured Notes (e.g., the Participating Unsecured Notes didn’t kick in $250m of new cash as the Participating Secured Noteholders did!).
Third, the Participating Unsecured Noteholders (Carlyle, Platinum, and Senator) didn’t jump over just the Non-Participating Unsecured Noteholders, they also jumped over the Non-Participating Secured Noteholders (who, you’ll recall, are now unsecured due to having their liens stripped – so they’re just secured in name only). This, as it just so happens, puts the Participating Unsecured Noteholders in the part of the capital structure where value is likely to break (in other words, where they’ll likely get some significant recovery!).
Coincidently, this is similar to what has played out with Serta after they did their non-pro rata uptier in 2020 but subsequently had to file earlier this year. Those that were allowed to participate in the transaction are in line for a significant recovery, including the vast majority of the post-reorg equity, while those who weren’t given the opportunity to participate (e.g., Apollo, Angelo Gordon, et al.) are getting a pittance.
Anyway, here’s how the complaint starts off...
The complaint goes on (as any complaint will) to give a litany of reasons why the transaction shouldn’t be permissible. This includes a series of arguments, many of which resemble those in the Secured Noteholders complaint, that fall a bit flat: the indenture trustee not carrying out the transaction in a “fair and appropriate manner”, the deletions made to the Original Indenture just prior to the exchange occurring being improper, the transaction violating sacred rights, etc.
When reading the complaint you can almost tell that some of these arguments are made a bit meekly. Because, when you don’t know what will stick, you throw out everything in the hopes that something does. Especially since you don’t know what decisions will be made, after the complaint, in other non-pro rata cases winding their way through courts.
But to my mind the most interesting aspect of the complaint given Platinum's involvement – more as a thought experiment, as it’s unlikely that it’ll end up being persuasive – surrounds whether this all constitutes a preferential transfer given the unique factors in play.
Here’s how the Non-Participating Unsecured Noteholders partly lay it out...
The obvious retort to this is that the Unsecured Notes weren’t trading at pennies on the dollar prior to the transaction: they were around sixty cents and it’s simply a statement of fact that the transaction did buy the company a bit of breathing room (although likely to no avail). Plus, as part of the transaction, a $25m promissory note from Wolverine (the HoldCo through which Platinum owns Incora) was rolled up into the 1.25L Note and thereby had its maturity deferred.
In other words, it may have been true that the company would have had to file if this transaction did not occur, but that’s the whole point of most out-of-court transactions: to buy the company time to turn things around. Sometimes it works, sometimes it doesn’t. And, unfortunately in this case, it appears not to have worked based on how much the Unsecured Notes have traded down over the past year.
But the real argument from the Unsecured Notes is that this transaction was done despite insiders knowing that the fate of Incora was sealed. They knew the transaction wouldn't move the needle. They just wanted to make sure, when the inevitable filing did occur, that they held a more senior part of the capital structure that would ensure them some level of recovery (as opposed to being more passive and just holding their equity that’ll inevitably be worthless upon filing).
In support of the contention that this transaction was done not so much to buy time, as it was inevitable the company would have to file, but rather just to get Participating Unsecured Noteholders into a better position prior to filing there are a few indirect factors one could point to...
First, the Unsecured Notes traded down significantly to around 40 cents after the transaction and continually traded down thereafter (e.g., there was never a bump in pricing reflecting optimism that this transaction could turn things around). Further, today, just a year later, the Unsecured Notes are trading under ten cents – making it clear that not only is the market pricing in that a default is in the offing, but that the value of Incora will break above the Unsecured Notes (in other words, they’re unlikely to get any recovery).
Second, the overall transaction was done a year ago due to interest expense coming due in May. Well, it’s almost May once again and the position of Incora isn’t ideal: as of last quarter, they had around $140m in liquidity and will need to shell out around $100m in interest expense next month. So, unless there’s a significant new infusion of cash or a sudden turnaround in the business, then filing is likely in Q3 or Q4 of 2023. Perhaps, if you want to be generous to the Non-Participating Unsecured Notes, this indirectly illustrates that insider(s) knew the transaction was just going to stall things out for a year, but was never going to remedy the situation.
Third, the 2024 and 2026 Senior Secured Notes are also trading more-or-less around ten cents on the dollar. Meaning that the market thinks the value of Incora breaks more at the 1.25L Notes level – conveniently the level that Platinum, Carlyle, and Senator exchanged into (in other words, above the Non-Participating Unsecured and Secured Notes). This, once again, being an indirect signal that the Participating Unsecured Notes possibly knew where in the capital structure they roughly needed to land to secure some recovery in the evitable filing.
As part of the complaint, the Non-Participating Unsecured Noteholders talked through a little illustrative waterfall...
The Non-Participating Unsecured Noteholders are really trying to suggest that this transaction was done under false pretenses. That ostensibly it was done to provide the company with additional time to try to turn things around through an aggressive transaction that, unfortunately, did come at the expense of the Non-Participating Unsecured Noteholders.
But, in reality, the Non-Participating Noteholders believe the company was insolvent at the time of the transaction, and that the insider(s) knew this and also knew the transaction wasn’t going to change the trajectory of the company. Instead, the transaction was done merely to enhance the recovery of Platinum, Carlyle, and Senator by bumping them up in the capital structure – along with buying them just enough time (a year or so) so that it doesn't look too on the nose when they end up filing.
If this theory sounds like a heavy lift – as it’s predicated partly on imputing motives through a series of indirect factors or signals over the span of a year – then I'm inclined to agree. It’s unlikely that this line of argument will go far even though, optically, there's no getting around that the Unsecured Notes element of this transaction does look particularly aggressive.
But it does raise the question of just how much any sponsor, who’s staring down the barrel of their PortCo equity being wiped out in a seemingly inevitable future filing, should be thinking about aggressively rejiggering the capital structure to potentially end up with a non-trivial amount of post-reorg equity if filing does occur – a circuitous reward for driving the pre-reorg equity value down to zero. It sure beats pumping fresh cash in pre-filing themselves.
When it comes to non-pro rata uptiers, there haven’t just been developments with Incora since my last post. There was also a fresh complaint dropped regarding Mitel’s transaction last month, which is a transaction I briefly mentioned in my post on the next restructuring cycle.
Additionally, with Serta having filed after buying a few years of breathing room with their non-pro rata uptier several years ago, the question quickly became whether the new priorities set by the uptier would be respected in court. If they were, then those that participated would end up getting a fantastic recovery, including the vast majority of post-reorg equity, with those left behind getting a sliver of recovery (something akin to what is most likely to happen if and when Incora files, assuming this transaction stands).
The answer, coming down from Judge Jones a few weeks ago, was that the open-market purchase provisions in the docs made the transaction unambiguously permissible. In fact, in some ways he seemed offended this was even a question he had to resolve, “I sit with these matters everyday… Sophisticated parties know what words they want to choose… this is very easy for me”.
Note: Judge Jones did leave the door ever-so-slightly ajar on the implied covenant of good faith and fair dealing line of argument (something you’ll notice is an almost boilerplate part of every complaint regarding non-pro rata uptiers now). And it was made clear that this ruling didn't speak to whether the transaction complied with all aspects of the credit docs -- just the open market provision aspect.
Anyway, it goes without saying that in an interview you’re never going to be expected to know all the arguments being flung around in court or provide some cogent analysis of them. But it was really fantastic to see how many enjoyed my original Incora post and put it to good use in interviews, so I just wanted to do a little follow-up on where we are today (hopefully discussing so many disparate threads so quickly hasn't been too confusing!).
If you want to keep track of the Secured Notes litigation, go here and search by index number 654068/2022. If you want to keep track of the Unsecured Notes litigation, search by index number 651548/2023.
]]>So, since recruiting season is upon us, I figured that I’d take a break this month from doing slightly more complicated posts on uptiers, cramdowns, death traps, etc. to discuss yields more generally and try to help build up your intuition a little.
Because even though there typically won’t be a wide variety of bond math questions in an interview, it’s never a bad idea to have a bit more of an intuitive understanding in case your interviewer wants you to eschew doing any math (e.g., using the estimated YTM formula) and explain things more extemporaneously.
To that end, I’ve put together a few questions below that will hopefully help prompt your thinking in the right direction and have tried to explain things in a more generalized way even if that’s at the cost of glazing over some nuance.
However, if you’re short on time and long on interview-related stress, the primary question that routinely comes up is the second question below, and you can answer it with either the estimated YTM formula or the more “intuitive” shortcut discussed in the answer here.
Just keep in mind that whenever you have a bond math question in an interview you’ll never actually be expected to do any convoluted calculations or need to explain any more cumbersome concepts (e.g., convexity). Instead, everything will usually be kept quite surface level and your interviewer is usually just looking for you to demonstrate a handwavy, directional understanding of what’s going on.
Anyway, to set the stage a bit, there are a number of different ways you can think about framing what a YTM is really saying. The most common (academic) framing is that it’s the rate at which you can discount the future cash flows (coupons and principal) of a bond so that the present value of those cash flows ends up aligning with the current price.
So, for example, if you have a bond with four years to maturity, a 5% coupon, and a yield of 7% then you know the current price should be 92.23. Below you can see that if you just discount the cash flows you’re getting (e.g., $5 in coupons a year, $100 at maturity) using the yield as your discount rate then you’ll end up with a PV of 93.23. Alternatively, if we pretend the coupon is equal to the yield (e.g., both 5%) we get a PV of 100 as we’d expect.
Note: If we’re holding the bond to maturity and reinvesting the coupons clipped at the YTM rate then our return (IRR) should equal the YTM, which is also what we find below.
This is all well and good. But it perhaps doesn’t build that much of an intuitive understanding – beyond illustrating how as the YTM increases the price decreases – so let’s see if we can circle around a few more creative ways of thinking about all this.
This isn’t the kind of question that’d actually come up in an interview but since you’ll occasionally get more conceptual bond math questions – that get beyond just using the estimated YTM formula – let’s use this question as an excuse to take a step back for a second, eschew doing any real math, and think about bond pricing more intuitively.
Whenever you depart from relying on real math and begin trying to explain things more generally, you’ll inherently lose some nuance. But here’s one way you can think about yield in relation to bond pricing at a (maybe!) more intuitive level: it’s reflecting the amount the bond needs to return in a given year, based on its current price in a given year, to get it on a pathway towards being worth par at maturity.
This is something that many initially overlook, even though it’s obvious in retrospect: if you have a bond trading below par with a number of years until maturity and we say the yield is X%, then the value of that bond must increase as maturity approaches if the yield is to stay static through the period. Because if the bond weren’t to increase in value then the natural consequence would be for the yield to inch upwards as maturity approaches.
To put some meat on the bones, in our little example here we’ve been told a bond has four years to maturity, a coupon of 5%, and a yield of 7%. Consequently, the price of the bond will be around 93.2 assuming a par value of 100 (assume annual coupons).
If we were to plot the four years until maturity, what we should observe is that the price of the bond increases incrementally each year as we approach maturity until it reaches par while the actual yield stays static.
The obvious question then is how much should we theoretically expect the bond to increase each year. To answer that, let’s think about what yield is representing once again: it’s the return of the bond necessary to get it back to being worth par at maturity. Therefore, for a bond trading below par, that’ll necessitate there being a return in excess of the coupon rate because the price of the bond needs to “catch up” to the par value.
So, the theoretical amount the bond should increase in value in a given year should be reflective of the dollar (not percentage) spread between the return of the bond in a given year, based on the current price, and the coupon (which will obviously be a static value).
If this all seems a bit fuzzy, think about the little table below...
We begin by taking our purchase price of 93.23 (based on there being a coupon of 5%, a yield of 7.0%, and four years to maturity). Applying the yield of 7.0% to the purchase price, that means the bond itself, in year one, “earns” a return of around 6.53. Stripping out the coupon component paid, this means the bond has 1.53 of price appreciation, and should theoretically be worth 94.751.
Now if you were to go use a yield to maturity calculator and type in a coupon of 5%, three (not four!) years to maturity, and a current trading price of 94.751 you’d find the yield to maturity is, as you’d guess, equal to 7.0%. Likewise, if you just play around with a YTM calculator and try to get a YTM of 7.0% by rejiggering prices around, you’ll hone in on, for example, 96.384 if you put a coupon of 5% and say there are just two years to maturity.
If you then tally up what I’m calling here the “appreciation spread” for all four years (e.g., the spread between the amount of return in a given year after stripping out the coupon component) you’ll get 6.77. And, since our initial purchase price was 93.23, adding these values together gets you 100 at maturity which must be the value of the bond at maturity.
Therefore, we’ve proven in our own circuitous way that the final value of the bond should be par (100) if it grows by 7% a year and, from an investor’s perspective, each year your effective return from owning the bond is per se going to be informed by having bought the bond below par.
So, glossing over some nuance, the takeaway here is that one way to think about yield when a bond is trading below par, from a slightly different perspective, is that it’s reflecting the return necessary for a bond to reach a par value at maturity and that it will, obviously, be an amount in excess of the coupon rate as it’s trying to “catch up” to par.
Here we have all the ingredients needed to use the estimated YTM formula and, if we were to use it, we’d end up quickly getting 14 / 90 or 15.56%.
But let’s pretend that your interviewer balks at your utilization of the estimated YTM formula and says they want you to give a more “intuitive” answer. In this case, hopefully the rather lengthy question above helps prompt your thinking in the right direction.
Because what we found through the prior question is that a simplified way we can think about a bond trading below par is that its YTM is being informed by two components: the coupon component and the price appreciation component.
So, the way your interviewer will want you to answer this question is by thinking about these components separately…
First, we know that our YTM will be driven partly by the coupons we’re clipping (in this case, $10 a year). But how favorable those coupons look is inherently contingent on the price that the bond is currently trading at (e.g., what you’re paying today to get this future stream of cash flows).
Therefore, a way to think about the portion of our YTM being driven by the coupons we’re clipping, and their subsequent reinvestment until maturity at the YTM rate, can be represented by the current yield (C / P) or, in this case, 10/80 = 12.5%.
Second, we know that our YTM will be driven partly by the price appreciation that’s occurring since we’re buying the bond below par and assuming it returns par in five years. As we saw in the prior example, the amount the bond will increase per year won’t be constant, but the amount of price appreciation each year, when tallied together, will equal the spread between the purchase price and par. In other words, the bond will reach par at maturity, it just won’t be going up each year by the exact same amount.
Therefore, a simplified way we can estimate the portion of our YTM that’s being driven by price appreciation is that it’s just the spread between par and the purchase price divided by the number of years until maturity.
In this case, it’ll be (100-80) / 5 = 4. So, we can say that we’re getting roughly 4% worth of principal pickup (price appreciation) per year.
Adding these two YTM components together we get 12.5% + 4% or 16.5%. Needless to say, this approach isn’t really much quicker than using the estimated YTM formula – but it does allow you to show a more intuitive understanding of what’s driving the YTM.
The real YTM here is 16.126% (assuming annual coupons) and, if you’re curious, you can get a feel for how this bond changes as maturity approaches by revamping our quick-and-dirty analysis from the prior question...
If we use our strategy from the question above – eschewing the “real math” of the estimated YTM formula in favor of a more “intuitive” approach – then we’ll find that the first bond has a YTM of 16.5% while the second bond has a YTM of 17.5%.
In both cases the current yield (C/P) is identical. But in the case of the former we’re getting $20 of price appreciation in five years, whereas in the latter we’re getting it in just four years.
So, it makes perfect sense that the shorter-duration bond should have a higher YTM because, all else being equal, it’s obviously better to get the same amount of cash sooner rather than later.
This wouldn’t be asked in an interview context as it’s a little too conceptual. But working through this question will (hopefully!) allow us to put a bow on all of this yield talk and give you a reasonably intuitive understanding of the basics.
Note: In the future maybe I’ll put together a few questions on thinking through duration and convexity. But we’ll save that for a later day since no one is going to ask you the intuition behind convexity declining as yields increase in an interview.
Anyway, one way to show a coupon-reinvesting-skeptic the error of their ways would be to lay out the cash flows: take your coupons each year, compound them at the YTM rate for the relevant number of years left until maturity, tack on the principal you’re getting at maturity, and sum up the proceeds.
Then you could compare the total proceeds found to if you had just placed an amount of money, equivalent to the current trading price of the bond, into a bank account that promised to pay you an annual rate equivalent to the YTM for the number of years until maturity.
In both instances you’ll find that the total proceeds are equivalent and that their present value (when using the YTM as the discount rate) will bring you back to the current price.
Further, your return (IRR) will be the same whether you’re assuming you get the coupons each year and par at maturity or if you’re assuming you get no coupons and a lump sum of all the proceeds at maturity (keep in mind with the lump sum strategy that you’re assuming that you’re taking the coupons each year and immediately locking them into an investment paying the YTM rate for however many years until maturity – consequently, all proceeds arrive effectively only at maturity).
In the end, the YTM must assume that the coupons are being reinvested at the YTM rate. Because if the coupons weren’t reinvested at all, or were done so at some lower rate, then the PV of our total proceeds in Strategy B would be lower than the current price and the proceeds from Strategy A would be higher than the proceeds from Strategy B.
Note: Both of the IRR figures found below are equivalent to the YTM that we used (as they should be since the YTM should equal the IRR if you’re holding the bond to maturity and reinvesting coupons at the YTM rate).
Just as a point of reference, if we assume that we have a bond trading at par – meaning that the coupon rate and YTM are the same – then, as you’d expect, we get an IRR that’s 10% regardless of if we do the lump sum method, or assume coupons are paid annually.
Hopefully this has helped flesh things out a bit for you. It can be easy to fall down the conceptual rabbit hole with bond math questions, but it’s important to remember that what folks refer to as “bond math” for interview purposes is a bit of a misnomer.
Rest assured, no one is going to be testing your mathematical limits in an interview. Instead, you’ll either get quite straight-forward quasi-math questions (e.g., finding the YTM as we did above) or you'll just be asked more conceptual questions where your interviewer will want you to give a more intuitive answer that eschews doing any real math.
So, for example, if you were asked if your return would be higher, lower, or the same if coupons were reinvested at a lower rate than the YTM then you now have a little mental model for explaining your answer. Because just think about the table from the prior question: the total proceeds would be lower if the coupons were reinvested at a lower rate than the YTM, so you’d expect the PV of the total proceeds to be lower than if coupons had been reinvested at the YTM.
Anyway, given that bond math questions will make up a relatively small part of an interview – as most interviewers want to focus on more restructuring-specific questions – it’s good to know the building blocks but you shouldn't spend an irrational amount on it.
Note: If you have upcoming superdays make sure to spend a little bit of time (but, just like with bond math, not an irrational amount of time!) developing answers to more general questions around if you think there will be a meaningful upswing in restructuring activity, what the impetus for increased activity will be, etc. In the members area there are a few research reports you can draw excellent talking points from, and there’s also the post I did several months ago on what will inform the next restructuring cycle that is still 100% applicable.
]]>But, to my mind, the major factor informing the first half of the year – and what really explains why so few companies ended up filing – was a kind of temporal oddity that I’ve talked about before regarding what will contribute to the next restructuring cycle. The first half of the year, for most companies, was the best of both worlds: the excess savings of consumers allowed companies to raise prices with relative ease, but the consequences of the Fed’s rate hike cycle (e.g., higher debt servicing costs for companies with unhedged floating rate debt, consumers curtailing spending due to economic uncertainty, etc.) hadn’t yet bitten.
Regarding debt servicing costs, here's a great recent chart from LevFin insights touching on this: for those that haven't hedged their floating rate debt, the rate hikes are beginning to bite...
In other words, the first half of the year saw companies have their cake and eat it too. They benefited from the inflationary environment (e.g., the ability to raise prices more easily without destroying demand) but didn’t yet feel the consequence of what the Fed was doing to do to try to tame inflation (e.g., raise rates at the fastest pace in the last four decades).
However, as we ventured into the second half of the year the Fed’s hiking cycle began to bite: capital markets activity slowed to a crawl, earnings began to show early signs of cracking, and those industries that benefited most from the easy money era of the prior two years began to have companies falling in rapid succession into bankruptcy courts.
While the past year was slow by historical standards, the last quarter of the year saw the most activity in two years -- and it wasn’t just driven by one industry due to idiosyncratic factors but involved a relatively wide swath of companies biting the bullet.
With a paucity of cases and a relatively strong economic backdrop for most of the year, there weren’t any sectors that saw an aberration in filing to the upside. Rather, the notable sector trends involve those that saw a sharp contraction from historic norms.
In any given year over the past decade, two of the sectors that produced the most filings were consumer discretionary (including retail) and energy. However, the past year saw consumers still burning through the excessive savings they built up through the pandemic while also getting outsized wage gains in nominal terms -- consequently, it was a great year for consumer discretionary with surprisingly few filings (and, as you’d expect, many of those that did end up filing were on distressed radars for a long time like Cineworld).
Meanwhile energy posted one of its best years on record. With strong energy prices not only being informed by the war but also by diminished investment in capacity -- a natural consequence of the lessons learned from how many energy companies through the mid-to-late 2010s over levered themselves in a sprint to build up capacity and then wound up needing to restructure during a tougher pricing environment (e.g., a classic example that’s gone full circle from over levering itself to build out capacity, filing due to a massively over levered capital structure, and now once again being a publicly traded company that’s erring on the side of being much more conservative would be Chesapeake).
Anyway, here's a breakdown from Reorg of the year that was, sector-by-sector…
Even though the number of Chapter 11 filings ended last year roughly flat from the year prior – itself a very muted year – it wasn’t until the latter half of the year that we saw a meaningful number of cases over the $1b mark and began to see a trickle of $10-50b cases.
Note: For context, whenever you hear someone refer to a case size as being $1b or $5b or whatever, what they’re referring to is the amount of liabilities the company has.
As you can see in the graph below from Reorg, the number of very small cases (e.g., $10-100m) isn’t that far removed from where it was pre-pandemic. But the number of larger cases (e.g., those that would require restructuring bankers getting involved) is still well below the historic average.
This is why if you’re ever reading a story on Bloomberg, etc. and they say something like, “there’s been a notable uptick in Chapter 11 cases recently”, you can’t take it as per se meaning that restructuring bankers are much busier (although directionally it’ll likely be true).
With that said, even though last year saw only 21 cases over the billion-dollar mark, 15 of those came in the last half of the year which is more inline with historic norms (so we’re moving in the right direction – at least for our purposes!).
The silver lining of 2022 was that we had a return of cases in the $10-50b range after having none the year prior (the two most notable being FTX, advised by PWP, and Cineword, advised by PJT).
Below is a list of some other notable in-court cases from the past year over the $1b mark:
And, of course, there’s been the smattering of large crypto cases that are talked about ad nauseam in the popular financial press (e.g., Bloomberg) such as BlockFi, FTX, Celsius, and Voyager. From a restructuring perspective, there are some interesting elements to these cases by dint of their lack of traditional capital structures, their unruly or unnavigable corporate structures, etc. but these cases are quite divorced from regular-way cases and aren’t as interesting as the amount of coverage in the financial press would indicate.
With that said, given their lack of meaningful capital structures and the number of depositors who are now creditors, there is a very robust claims market that you can follow in real time on Xclaim that will move substantially as the cases progress and more clarity is achieved on potential recoveries.
Something that I’ve written about many times is the continued rise of pre-packs over the past decade (especially for sponsor-backed companies). Per Reorg, just shy of 40% of all $100m+ cases were pre-packs which is roughly in line with the average over the past two or three years.
Note: In the guides I’ve always recommended that if you’re going to talk about an in-court case in an interview, then choosing a pre-pack is an obvious choice as there’s per se less twists and turns occurring in court given that everything is buttoned up pre-filing. As a result, reading through the disclosure statement and skimming certain parts (Article III) of the Plan or Reorganization will tell you more than you’d ever need to know for interview purposes.
Some notable pre-packs from the past year are Carestream and Lumileds, the former taking just over a month to get done and the latter taking just over two months. There weren’t any clean cut pre-packs that got done in a day like Belk or CWT in years past -- however, there’s the slightly more nuanced case this year of Seadrill New Finance that was confirmed in a day but that was part of the broader Seadrill restructuring. So, I’d shy away from talking about this in an interview as you don’t want to open up the can of worms of the broader Seadrill restructuring which was relatively complicated -- offshore drillers are always a pain, partly because of how they’re structured as I obliquely touched on by way of example in my post on upstream guarantees.
Note: Just to provide a little example, here’s a link to Carestream’s combined disclosure statement and Plan. If you flip to page seven, you’ll see that the table of contents of the disclosure statement provides a quick-and-easy overview of everything you need to know when discussing a deal in an interview (e.g., who the company is, how they got into trouble, how various classes are being treated, what the company will look like post-reorg, etc.).
In any given year there’s normally an overarching theme or trend that bleeds through. In terms of out-of-court transactions, we continued to see progressively bolder – for lack of a better word – unsub transfers and non-pro-rata uptiers occur last year (e.g., Envision and Incora) that everyone loves talking about (these are gently introduced in the Serta guide).
However, in terms of in-court activity there weren’t any meaningfully innovative tactics tried that will have long standing implications. Sure, there were all the crypto filings, a sharp decline in cases from sectors that are normally well represented, etc. but that’s just sector-related stuff.
For example, we talked previously about the Texas-Two Step strategy for handling mass tort litigation that became notorious in 2021 – now that is an innovative and controversial in-court theme or trend.
Personally, it was my view that we’d see more pushing of the bounds of how tort claims were being handled last year -- with debtors basically adopting the "nothing ventured, nothing gained" mindset. But despite some of the biggest cases of last year surrounding mass tort issues (e.g., Aearo, Endo, and TPC) the Texas Two-Step – or any new novel permutation or offshoot of it designed to handle tort claims in-court – wasn’t meaningfully attempted (due to a fear the strategy could be upended in court, which seems increasingly prescient as a federal appeals court just rejected J&J's strategy). Here's what the 3rd Circuit said in their decision...
In many ways, the activity of last year wasn’t that surprising. The residual ramifications of how loose monetary policy was in the years prior, how much activity was pulled forward by the pandemic, and the margin expansion most observed for the better part of the year made for a more muted year typified by a ragtag group of cases.
In reality – if you look at the cases that were above $1b – it was a pretty wild smattering of crypto cases, tort-related cases, and a few other idiosyncratic cases (e.g., Reverse Mortgage Investment Trust).
There just wasn’t really that much in the way of large “classic” or regular-way cases like you normally have with a few exceptions like the pre-packs previously discussed (e.g., Carestream) or cases like Revlon or Cineworld that were circling the drain for years (with Revlon trying nearly every out-of-court option possible prior to biting the bullet and finally filing).
But the good news (again, for our purposes) is that the tide is turning -- and it’s doing so quite quickly. In just the first month of this year (2023) we’re getting plenty of regular-way cases coming down the pipeline (e.g., Bed Bath & Beyond, Serta, Party City, etc.). So this year promises a return to some level of normalcy -- and perhaps a little bit (or quite a bit) more than that.
Note: While it's always a good idea to have an understanding of the general restructuring landscape and what's been happening, if you're getting ready for interviews be sure to make sure you're focusing most of your time on studying what restructuring investment banking really involves and the classic restructuring interview questions that'll come up.
]]>This shouldn’t be any surprise: your job as an analyst or associate will be to read lots of things drawn up by bleary-eyed lawyers. And, while they may may have once had dreams of writing the next great American novel, they’ve long since resigned themselves to ensuring unrestricted subsidiaries are being appropriately defined.
But there does come a time in which these bleary-eyed lawyers get to let loose their pent-up angst, revive whatever literary abilities were laying dormant, and show off their potential as a polemicist – and, for this, we should all be thankful.
In the world of restructuring, where you’ll most often see this is after a contentious restructuring transaction occurs. As those who felt they got a raw deal will then bring suit and their initial complaint will generally take the approach of feigning indignation and incredulity – gobsmacked by the level of injustice brought upon them, unsuspecting as they allegedly are, by the company or other creditors or both.
Anyway, let’s quickly talk about Incora (a.k.a Wesco Aircraft Holdings, Inc.). It’s one of the more interesting restructuring transactions of the year as it’s a non-pro rata uptier similar in style to Serta (that I talked about at length in one of the guides in the members area).
However, there are a few twists with Incora relative to the non-pro rata uptiers of the past – not least being that it involves notes (not loans) which makes it a bit more straight-forward.
Fortunately, on Halloween of this year (spooky!) a suit was filed by the non-participating noteholders over the transaction and the bleary-eyed lawyers who wrote it pulled out all the stops: calling the restructuring a “Sham Transaction” involving “Phantom Notes” that was “violently detrimental” to the non-participating noteholders who were “ravaged” by the sponsor (Platinum) who had “lucrative (and sinister) aims”. While I’m not a psychologist, there seems to have been a lot of non-restructuring-related angst being taken out while writing this complaint – so, I hope it proved cathartic!
As per usual, this is going to be a substantially longer post than I originally intended. So, feel free to click around the links below, or read it through from the beginning.
The First Draft of Incora’s Uptier Transaction
The Issue with the First Draft of Incora’s Uptier Transaction
The Mechanics of Incora’s Uptier Transaction
The Challenge to Incora’s Uptier Transaction
As I wrote a month ago, many of the more aggressive restructuring transactions we’ll see out-of-court over the next year will likely be done by sponsor-backed companies, and Incora fits the bill: it was bought out by Platinum just prior to the onset of the pandemic with slightly over $2b of debt layered over an initial equity investment of only $266m.
The capital structure was pretty straight-forward: $650 in 2024 Senior Secured Notes, $900m in 2026 Senior Secured Notes, and $525m in 2027 Unsecured Notes. As you’d expect, with the Senior Secured Notes residing atop the capital structure, they had a first lien on substantially all the company’s assets.
Since the company is predominantly in the aerospace and defense supply chain space, it was hit hard by the pandemic and, when combined with its heavy debt-load, began facing a liquidity crunch through the latter-half of 2021 and into 2022.
So, for the sponsor, Platinum, the question became two-fold: how do we get some liquidity injected into Incora to stave off having to file and how do we try to salvage some level of return here?
You may think those two questions are one and the same, since if the company were to file that would almost surely result in Platinum having no meaningful return, given that they’re just the equity holder – but, as you’ll see in a moment, there’s a reason I’m separating these two.
In the end, it was thought that Incora probably needed around $200m of fresh capital to give it the breathing space needed to (hopefully!) effectuate a turnaround. Needless to say, this could have come through the sponsor injecting more money itself. But doubling down on an investment that’s already at (effectively) zero after two years isn’t the modus operandi for most sponsors. Especially when creditors are lining up to give the company fresh capital if the company is willing to get a little creative and endure a little litigation…
What I’m going to do here is try my best to run through the restructuring transaction incrementally to hopefully make it more digestible for those less familiar with restructuring. But, if you’re interested, you should read the actual complaint filed by (most) of the non-participating creditors involved here – all joking about lawyerly-angst aside, it’s a very readable account of what happened that shouldn’t take more than a few hours to read.
Anyway, the best way to think about this transaction is that, in the run up to Incora’s restructuring, there were (roughly) four groups of importance…
First, you had the company itself, advised by PJT, who had two primary objectives: get existing creditors to lend it more money since they (obviously) didn’t have the ability to tap the traditional primary market, and keep cash interest expenses down as much as possible.
Second, you had a group holding the bare majority – but not a two-thirds super-majority – of the Senior Secured Notes. This group, comprised primarily of Silverpoint and Pimco, were advised by Evercore (who was also debtor-side on Serta and who is almost invariably involved in these more creative restructuring transactions).
Third, you had Carlyle that held the majority of the Unsecured Notes and Platinum (the sponsor) that had bought up a non-trivial number of Unsecured Notes leading up to the transaction.
Fourth, you had a long list of smaller creditors (e.g., various funds tied to Blackrock, JPM, GS, etc.) who owned smaller bits of the 2024 Senior Secured Notes, 2026 Senior Secured Notes, and/or 2027 Unsecured Notes (e.g., taken together, these smaller creditors didn’t comprise a majority of holders in any of the Notes).
In January of 2022, the state of play was basically this: you had a company (Incora) that needed to do something (raise around $200m of fresh cash, the more the better!) and a few very large players, holding a simple majority of the Senior Secured Notes, who are always looking to get their hands dirty in interesting special situations (e.g., Pimco has a staring role in this case and was also involved in the even more creative and contentious restructuring of Envision Healthcare this year as well). On top of this you also had a few very large players, holding a super-majority of the Unsecured Notes, that happened to now include the sponsor itself.
Given this, it’s not a surprise that initial conversations took place between Incora (a.k.a Wesco) and the majority holders of the Senior Secured Notes regarding what a potential restructuring transaction could look like that would include a substantial new money investment. Both were eager to come to the bargaining table.
And, in the end, it seemed there was an obvious solution: do some kind of exchange whereby the majority holders of the Senior Secured Notes exchange into new (higher priority) notes while also lending the company new money (within this new, higher priority tranche). Thereby leaving those Senior Secured Notes who didn’t participate – or, more aptly put in this case, weren’t given the option to participate – behind them in the capital structure.
Note: Just to be clear, since the Senior Secured Notes (pre-transaction) had a lien on substantially all the company’s assets, to effectuate this transaction that lien needed to be stripped so that it could be given to the new notes that participating Senior Secured Notes were exchanging into (thereby rendering the non-participating Senior Secured Notes effectively unsecured, as we’ll get into much more below).
For the participating Senior Secured creditors, this is an ideal solution as it keeps them in the highest position within the capital structure, ensures there’s less debt pari to them, and since the exchange was done at par that’s just an added benefit. Sure, you’re putting more money in. But if there’s going to be some kind of out-of-court deal done, it’s better for you to be steering it and to be in a relatively better position (from a priority perspective) than other creditors you were previously pari with (as opposed to the opposite).
The question then became what to do with the Unsecured Notes, which were majority held by Carlyle but with the sponsor also holding a non-trivial chunk. In the end, it was decided that certain holders would be given the opportunity to just roll-up their holdings into newly created notes that would be behind what the participating Senior Secured Notes exchanged into, but in front of the pre-existing Senior Secured Notes who weren’t given the opportunity to participate in the exchange.
So, to recap this first draft of the restructuring transaction, the majority holders of the Senior Secured Notes would exchange into new notes, while simultaneously also lending new money to the company, while the majority of the Unsecured Notes would exchange into new notes sitting above the non-exchanging Senior Secured Notes (e.g., jumping in front of them). Those in the minority of the pre-existing Senior Secured Notes and Unsecured Notes would then be bumped back in the capital structure (into, effectively, third and fourth position) behind all of this newly created debt.
If you’ve read through the guides, this looks like a pretty classic out-of-court restructuring dynamic. But what makes it unique is the non-pro rata nature of it. Meaning, only the pre-ordained majority holders of these tranches had the opportunity to participate in the exchange. For the minority holders, even though they almost surely would have participated if given the opportunity, they were simply left out in the cold – and, in this example, behind over a billion dollars of newly created debt.
When discussing Serta’s non-pro rata uptier, I spent a significant amount of time discussing specific verbiage within the docs around open-market purchasing language and all that fun stuff because, in that case, we were dealing with term loans.
What makes the case of Incora (Wesco) unique among the smattering of non-pro rata uptier situations we’ve seen over the past few years is that we’re dealing with bonds with their much more straight-forward governing docs (indentures).
As the complaint lays out, you have three basic kinds of consent thresholds with notes: those requiring a bare majority of 50%+1, those requiring a super-majority of 66.67%, and those requiring unanimity (e.g., for anything involving changes to the “sacred rights” of the notes).
In order to effectuate the non-pro rata uptier Pimco, Silverpoint, et al. needed to have enough of the Senior Secured Notes to release the liens the Notes held on collateral (since the Notes were secured by substantially all of the company’s assets) which required having a super-majority.
But, on February 7 of 2022, a Debtwire article was released describing the early discussions that had been taking place between the majority of the Senior Secured Notes and the company (e.g., describing the plans, as outlined in the prior section, for some kind of non-pro rata uptier, even though the exact details weren’t hammered out yet).
This set the minority holders of the Senior Secured Notes into a frenzy. They knew what was coming: if they weren’t given the opportunity to participate, they would go from having a first-priority position to holding Notes that were entirely unsecured (not to mention behind potentially in excess of a billion dollars of new debt!).
So, this rag-tag group of minority holders coordinated themselves with a singular goal in mind: to create a blocking position that would ensure that this kind of uptier couldn’t take place without this minority group’s consent. It was quickly realized that it was possible to potentially create a blocking position within the 2026 Senior Secured Notes, so a bidding war quickly ensued between the two sides (e.g., the majority creditors and this rag-tag group of minority creditors).
As the complaint illustrates, this created bizarre price action after the Debtwire article was released whereby the 2026 Senior Secured Notes went from trading around 85 to well over par. Further, since only a blocking position could be created in the 2026 notes, a large spread opened up between the trading levels of the 2024 Notes and the 2026 Notes (despite, obviously, the 2024 Notes having the same claim on the company while also maturing two years earlier!).
In the end, by late February of 2022, this rag-tag group had firmly established a blocking position, and a collective sigh of relief was no-doubt released. However, that’s when the real creativity of this transaction began.
After having established a blocking position, this group of minority lenders began (trying) to engage with the company on a few different solutions in early March of 2022. The contemplated transactions were more classic out-of-court stuff: providing new cash while also converting the existing Senior Secured Notes into PIK Notes – all of which, needless to say, would have been open to everyone to participate in (e.g., not be something that only an exclusive group of creditors could participate in, as the non-pro rata uptier per se was).
But the proposed transaction wasn’t quite as appealing to the company from a new-money perspective and it’s not entirely clear how seriously the company even took the offers placed on the table by this rag-tag group of minority creditors.
So, in the end, just a few weeks later and without warning to minority creditors on March 28 the non-pro rata uptier took place and the company announced it had completed its restructuring on March 29.
Here’s how the restructuring transaction worked, and how the blocking position that was so hard-won was casually side-stepped along the way…
As previously discussed, the binding constraint on doing the non-pro rata uptier was the blocking position that had been developed by this group of minority creditors in the 2026 Senior Secured Notes.
While the non-pro rata group (e.g., Pimco, Silverpoint, et al.) held a majority of the 2026 Notes, they didn’t have the supermajority necessary to strip the Notes of their liens. But, obviously, they wanted to exchange their existing holdings into newer, higher priority debt that would have liens on substantially all the company’s assets, so it was strictly necessary to strip the liens from the Senior Secured Notes.
While this put them in a bit of a quagmire, they dreamt up a solution: if you can’t get a supermajority by (allegedly) hoovering up all the 2026 Notes you can get your hands on in the open market, maybe you can just manufacture a supermajority of your own.
On March 28 the company executed the “Third Supplemental Indenture” that allowed the company to issue $250m of additional 2026 Senior Secured Notes. However, these Notes weren’t offered to all existing holders on a pro-rata basis (e.g., all existing 2026 Noteholders couldn’t just buy their pro-rata share), nor were they made available to purchase on the open market.
Instead, they were issued to a select group of existing noteholders: namely, those that wanted to do the non-pro rata option. With this non-pro rata group now holding $250m more of the 2026 Notes, they now had a supermajority position (as, obviously, the blocking position that had been carefully built up by minority creditors was diluted by this new issuance).
The complaint called these Phantom Notes, which is a reasonably accurate description because on the same day, March 28, this newly created supermajority consented to the “Fourth Supplemental Indenture” which released all the liens the 2024 and 2026 Senior Secured Notes had on their collateral.
With the liens now released, the company could pursue the non-pro rata exchange. So, the non-pro rata group – which included holders of the so-called Phantom Notes – exchanged their Notes for $1.27b of newly issued 1L Notes that, obviously, ranked senior to the now-unsecured 2024 and 2026 Senior Secured Notes.
To add insult to injury the 2024 and 2026 Senior Secured Notes – who could do nothing but watch as this all unfolded – the Unsecured Notes were exchanged for $473m of newly issued 1.25L Notes that, obviously, also ranked senior to the now-unsecured 2024 and 2026 Senior Secured Notes.
Here’s a great illustration from the complaint that outlines the transaction. As you can see, the Phantom Notes and the non-pro rata group’s Senior Secured Note holdings were exchanged into roughly $1.27b of new 1L Notes that reside atop the capital structure.
Then Carlyle and Platinum exchanged their Unsecured Notes into new 1.25L Notes, jumping ahead of the remaining Senior Secured Notes ($539m) and the remaining Unsecured Notes ($104m).
So, effectively, the old 2024 and 2026 Senior Secured Notes are now third in priority in the capital structure (they used to be first and have a first lien on all the company’s assets!) and the poor Unsecured Notes are now fourth in priority (and, obviously, also have no lien on any of the company’s assets).
As you can imagine, the announcement of the transaction – even though it was quite well forecast for those in the know beforehand – caused a sharp drop in the trading prices of the Senior Secured Notes…
If I get time over the coming months, my plan is to create a little guide in the members area to walk through a few of the more creative transactions we’ve seen this year in a bit more detail – including, importantly, how these kinds of transactions are being challenged in court.
Because many new to the world of restructuring look at these kinds of transactions and think to themselves, “Regardless of what the docs technically permit to be done, this just seems fundamentally unfair!” And this kind of appeal to common sense – as opposed to relying exclusively on a strict textualist reading of the docs – is something that has gained some initial traction in certain courts (although not everywhere!).
To this end, there is an implied covenant of good faith and fair dealing that could be applicable with these kinds of transactions – although its implied nature, obviously, means what is and is not done in good faith, or what is or is not fair, is hotly debated. But, for many, a few large creditors who happen to hold a supermajority stripping all liens from a given tranche of debt and then exchanging their holdings into new debt (at a higher priority and with new liens replicating those just stripped), all without allowing any minority holders to participate, does seem to be something that surely must fall somehow under this covenant (although I don’t really fall into this camp, but that’s partly for self-serving reasons!).
Regardless, as we’ve discussed above, the case of Incora goes a step further than “conventional” non-pro rata uptiers in two major ways. First, by using the Phantom Notes to manufacture the supermajority needed in the 2026 Senior Secured Notes to effectuate the transaction. Second, by allowing the Unsecured Notes to also uptier the original Senior Secured Notes – and to do so when a large holder of the Unsecured Notes is Platinum itself (thus manufacturing a significant economic gain for the sponsor).
If you read the actual complaint, you’ll quickly see that plaintiffs – who represent 75% of the left behind 2026 Senior Secured Notes and over 30% of the left behind 2024 Senior Secured Notes – are taking the approach of throwing out as many arguments against the transaction as they can think of in the hope that one or two stick. So, given how long this post already is, I’ll save a more detailed discussion of the arguments being made for the new guide whenever I’m able to put it together.
However, the main argument made by the plaintiffs is that the “two-step” process utilized by the company to effectuate the transaction (e.g., executing the Third Supplemental Indenture to create the Phantom Notes, and then executing the Fourth Supplemental Indenture to release the liens and allow the transaction to proceed) should be viewed as one integrated or singular transaction.
In other words, even though it was technically possible, from a textualist perspective, for the company to create the $250m in additional 2026 Senior Secured Notes with a simple majority, not a supermajority, the rationale behind creating these $250m in new Notes was purely to manufacture the supermajority needed to strip the liens held by the Senior Secured Notes.
The proof of this, to their mind, is that both transactions occurred on the same day; the Phantom Notes were not made available pro-rata, but were rather made available to those in the non-pro rata group; and the Phantom Notes consented to, and participated in, the exchange into the new 1L Notes (therefore, they only existed for less than a day!).
Nobody disputes that the 66.67% consent threshold to release liens needs to based on the amount of Senior Secured Notes “then outstanding” (e.g., outstanding prior to the period before the transaction occurs). The arguments of the company – along with the non-pro rata group – is that this period is between when the Third Supplemental Indenture was executed and the Fourth Supplemental Indenture was executed (e.g., after the Phantom Notes have been added, thus creating the supermajority which allowed for the liens to be stripped on the Senior Secured Notes).
But plaintiffs are arguing this was all one integrated transaction, so the period that should be looked at is prior to when the Third Supplemental Indenture was executed (e.g., before the creation of the Phantom Notes and when the blocking position was still intact). Therefore, the transaction should be voided as there wasn’t actually a sufficient level of consent to strip the liens.
Here’s the best summation of this line of argument…
And...
Well, there you have it. Incora was one of the more interesting cases of the past year and will be heavily litigated moving forward. This latter point won’t come as a surprise to either Incora or PJT. They specifically included a 1.25L settlement basket to try to get those minority holders “left behind” to exchange their existing notes into the new 1.25L Notes to settle any litigation (this may still end up happening!).
Anyway, hopefully I’ve done a reasonably good job breaking things down in a relatively approachable way. Just keep in mind, if you’re gearing up for restructuring interviews, that no one is proactively going to be asking you about non-pro rata uptiers! For interview purposes, make sure you have a sound understanding of what restructuring investment banking is all about and go through all the restructuring interview questions I’ve put together.
And, as always, if you end up getting an offer anywhere because of the blog and the guides, be sure to let me know. It always absolutely makes my day to get those e-mails, so I really appreciate when people take the time to send them.
]]>Through the first half of the year, there were only twenty filings with assets over $100m and the larger companies that did file (e.g., Revlon and GWG) were circling the drain for years prior to finally, mercifully, biting the bullet.
But as economic growth fizzles while inflation remains stubbornly persistent, the credit cycle is unequivocally turning. For obvious reasons: just take a look at this chart from Goldman illustrating how quickly HY bond yields have shot up during this hiking cycle.
Needless to say, the spiking of HY bond yields isn’t an immediate problem for the issuers of these bonds (since the obligations that flow from them are fixed, not floating).
Indeed, if you’re a company that has exclusively issued high yield bonds (so, in other words, have no floating rate debt) then you could look quite prescient. Not only are you not directly exposed – from a debt servicing perspective – to the rapid rise in rates, but you also will now have your capital structure (in price terms) trading at a deep discount.
Therefore, if you have some extra cash, you could buyback some of your debt on the cheap. The only downside here is that when you need to refi your debt, assuming rates are roughly in line with where they are today, then your forward-looking debt servicing costs will be much higher.
As you can imagine, there aren’t too many companies that fit this bill. In the ultra-low rates environment we’ve experienced since the great financial crisis, it’s nearly always made more sense to have a capital structure with at least some floating-rate debt as it’s almost always provided for a lower debt servicing cost (assuming, obviously, that we don’t have the fastest rate hiking cycle since the 1980s occur!).
But there are some companies that do have this kind of throwback capital structure like Bath & Body Works which has its nearest term maturity in 2025. Because of this, it’s not surprising that many are overweight BBWI despite it being a high-yield retail name (not too many HY retail names are favorably viewed these days but having a good capital structure can sometimes make up for being in a lousy sector!).
Anyway, when thinking about the future level of restructuring activity, two things are always of overriding importance: the ability of issuers to refi their debt before maturity and the ability of issuers to service their existing debt.
When looking at the high yield and leveraged loan landscape at a macro level, companies appear relatively well positioned to weather higher debt servicing costs. As of last quarter, coverage ratios have been historically high across the board.
The reason for this current debt servicing strength emanates from two factors…
First, the strong level of nominal earnings growth that’s occurred in the post-pandemic recovery. Remember: insofar as your level of interest expense increases at a lower velocity than your nominal earnings growth – perhaps because of having issued lots of fixed debt – then, all else being equal, it’s going to make your coverage ratios look better! Inflation isn’t always a bad thing if you have fixed debt obligations!
Second, as we’ve discussed before, through the latter half of 2020 and through most of 2021 we experienced a historically hot credit market powered by an ultra-low rates environment. So nearly every leveraged loan or high-yield issuer that could refi part of their capital structure took advantage of the opportunity to do so. Thereby often watering down their debt servicing cost, even if they didn’t reduce down their aggregate amount of debt outstanding.
However, coverage ratios don’t stay static on either side of the divide (the obvious caveat being that there are relatively rare situations in which there is an entirely, or almost entirely, static denominator).
As we enter into a likely earnings recession – with perhaps a real recession to follow that will have scant fiscal and monetary policy supports – we’ll almost certainly see a compression of the numerator. Further, since the ultra-hot credit markets, mixed with ultra-low rates, of the past few years pushed many into more top-heavy (e.g., floating rate) capital structures, the impact of rising rates will drastically change debt servicing costs for the vast majority of issuers moving forward.
When the Fed reaches its terminal rate – that GS, for example, is predicting will be 450-475bps – that’ll make the annual coupon rate of leveraged loans go from just 3.8% in 2020 to slightly over 8% in 2023.
The above chart is worth always keeping in the back of your mind when thinking about restructuring activity moving forward – especially for those highly-levered sponsor-backed companies with top-heavy capital structures (many having exclusively, or almost exclusively, floating rate debt).
The reality is that the vast majority of the pain – both from a debt servicing perspective and an earnings compression perspective – has yet to have been realized. Because so much market commentary is focused on where the terminal rate will end up, it can be easy to forget that most of the pain to be felt by issuers on the debt servicing side hasn’t yet fully materialized. We’re still in the early innings.
Now it’s important to keep in mind that some issuers – especially those that are larger and more sophisticated – will have hedged out at least some of their interest rate exposure. For example, Aramark Services has hedged out about 96% of their more than $3b in floating rate debt outstanding.
However, other large companies, like PetSmart, don’t appear to have any interest rate hedges and will see their TL, for example, go from costing $103m in interest expense in 2021 to ~$190m in 2023 using current rate forecasts. As an aside, you may remember PetSmart (backed by BC Partners) from their controversial unrestricted sub transfer years ago.
With the primary markets largely closed today, when looking at the leveraged loan and HY landscape the question becomes whether issuers will even have the capacity to roll over (refi) their debt when it comes due. Because even if the primary market awakens from its slumber, debt will be pricing much higher just off the pure rate effect – never mind if spreads materially widen (increase) due to a recessionary environment taking hold.
However, the pandemic distorted many things – not least of which being the aggregate maturity walls of leveraged loan and HY bond issuers. Given just how hot the debt markets were, and just how low rates were, maturity walls were materially pushed back by nearly all of those that could.
While normally aggregate maturity walls have a slightly positive-skew, with the peak usually around three years from present, what we’re seeing now is much different.
Here are the aggregate maturity walls for leveraged loan issuers...
And here are the aggregate maturity walls for HY issuers...
Most notable is just how few maturity walls exist in 2023, as normally you’ll have a non-trivial number of companies who have been desperately trying to push out maturities for a few years but have failed to do so. Instead, there are more HY issuers with maturities in 2035 than there are in 2023.
As I mentioned at the outset, monetary policy works with long and variable lags. Given how few maturity walls are coming due over the next two years, the bulk of increased restructuring activity in the near-term won’t be driven as much by the inability of corporates to refi their upcoming maturities as they come due (despite how unfavorable an environment it is for that currently!).
Rather, it’s far more likely that as we enter into an earnings recession and the cost of servicing debt for many corporates grows significantly, we’ll begin to see meaningful balance sheet distress crop up across the board. Thereby forcing corporates to take some level of action as their capital structures become untenable in its current composition.
As you think about this credit cycle, keep in mind the chart above from Goldman illustrating coverage ratios being at historical highs. This is fundamentally why we’ve seen the lag in restructuring activity both in- and out-of-court: corporates still look good on paper, but this is a bit of a chimera.
While it can seem counter intuitive, what we saw in last quarter’s earnings for most leveraged loan and high yield issuers is the positive impact of an inflationary environment: higher nominal earnings, driven by an ultra-tight labor market with robust wage growth and built-up consumer savings, alongside debt servicing costs that only nudged up as higher rates hadn’t yet begun to fully feedthrough.
In other words, the environment that we’ve been in – that is now turning – was a bit of a temporal oddity. In coming quarters we’ll see the full implications of rising rates come home to roost, causing compression of coverage ratios, increases in leverage ratios, etc.
While some expected the fastest rate hiking cycle in the last forty years to begin an almost immediate cascade of restructuring activity, this was always a bit foolhardy. There needs to be an impetus for companies to begin engaging in restructuring activity whether in- or out-of-court.
As we move forward, we’re likely to see some enhanced level of in-court restructuring. Indeed, we have already seen a non-trivial uptick over the last quarter (although many were circling the drain for a long time, like Cineworld, so you can’t really attribute these exclusively to the rates environment of today).
However, what we’re likely to see much more of is the return of out-of-court restructuring activity. This is because most believe – rightly or wrongly – that the Fed is going to raise rates to their terminal rate and then be forced into cutting rates toward the latter half of next year (e.g., as of this writing there are three 25bps cuts priced in before the end of 2023).
The implications of the Fed quickly cutting rates significantly – perhaps in response to a recession taking hold – is that refi costs will come down significantly assuming (big assumption!) that credit spreads don’t blow out. Further, many are assuming that with the amount of dry powder in private credit markets, it won’t be the case that all funding markets will be as closed during a recession as they would’ve historically been when there will fewer non-bank lenders.
So for those that begin to face material distress within the next year, they’ll be much more likely to try to take pre-emptive action out-of-court under the assumption that if they can just get through 2023 they’ll be able to more fully right the ship in 2024 or 2025 in a more normalized (e.g., positive growth, low rates, open credit markets) environment.
This is already manifesting itself a bit with the rise of amend-and-extends we’ve been seeing as those relatively few companies with near-term maturities try to kick the can down the road by working with their existing lenders on extending out maturities – while paying hefty consent fees to get them onboard (e.g., Augusta Sportswear amending and extending its TL and revolver this week).
However, in the coming months where I think we’ll see the most significant and interesting out-of-court action play out will be with sponsor-backed companies. Given that they are (by definition) relatively highly levered, have significant floating rate debt, and are backed by sophisticated players who will try to take pre-emptive measures to salvage some level of return from their struggling investments.
For example, just last week we saw Mitel – backed by Searchlight Partners – do a simple non pro-rata uptier akin to what occurred in Serta, Boardriders, and TriMark (if you haven’t yet, be sure to look at the Serta case study in the members area where I walk through how this works in detail).
Basically what happened is that the majority of the first-lien term loan lenders (L+450, Nov 2025, $884m) and second-lien term loan lenders (L+675, Nov 2026, $260m) consented to providing $156m in new money via a super-priority term loan while uptiering (exchanging) their holdings into new second-out and third-out tranches, respectively.
The second-out tranche is $576m in size (SOFR+680bps, 95% exchange rate) and the third-out tranche is $125m in size (SOFR+935bps, 82% exchange rate). Both are due in October of 2027.
What makes the transaction non pro-rata (as the name implies) is that not all existing first-lien and second-lien lenders were given the option to participate. So, there’s effectively now $857m in new debt ahead of those who were left behind – around $281m of the original 1L, now effectively the 4L, and $108m of the original 2L, now effectively the 5L.
Anyway, the reason I bring up this transaction is because Mitel didn’t have maturity walls on its pre-existing 1L or 2L coming up for several years. However, this transaction allows them to get new money and push out their maturity walls further. More importantly, from Searchlight’s perspective, this transaction gives them enhanced optionality. While their equity in Mitel may not be worth much now, maybe Mitel will be able to turn things around even under the enhanced debt load and debt servicing cost that this transaction created. Ultimately, for Searchlight, there’s limited downside to doing this (beyond having to deal with some disgruntled and likely litigious lenders who weren’t given the option to participate in the transaction).
Moving from out-of-court to in-court, we’re also seeing an increase in sponsors trying to salvage a sliver of value in their portfolio companies by doing what I’ll call “pre-emptive pre-packs”. Here’s what I mean…
When a portfolio company having to file chapter 11 becomes a foregone conclusion, there’s naturally a tension between lenders and the sponsor. The lenders know that the earlier the company files and the quicker it gets through the process, the more value that the company will retain (or, put another way, the less value the company will bleed). However, the sponsor will want to maintain optionality in their existing equity position by putting off filing as long as possible on the off chance the company is able to turn things around before filing is absolutely necessitated.
So increasingly you’re seeing cases like Heritage Power where it appears that they’ll be doing a pre-pack chapter 11 and that existing lenders will get the vast majority of the post-reorg equity with the sponsor (SVP) retaining a 5% post-reorg stake.
Note: You may remember me writing about SVP previously when they took a controlling equity stake in Washington Prime Group (which was the second largest filing of 2021) through some clever maneuvering.
Anyway, the point I’m making here is that over the next six months we’re likely going to see increasing levels of sponsor-backed companies taking aggressive out-of-court actions to try to maintain their optionality or more opportunistically filing and trying to retain a sliver of value through the process. In other words, sponsor activity will be the tip of the spear when it comes to increasing restructuring activity.
Despite everyone being focused on the macro factors at play these days, it’s important to remember that restructuring activity doesn’t come to standstill even during the most robust of economic times.
There are always going to be sectors that have been exposed to shocks (e.g., oil and gas in the mid-2010s) or secular declines (e.g., brick-and-mortar retail in the late-2010s).
This year we’ve already seen a few large filings – Celsius and Voyager – come out of the crypto space as the crypto market began falling. Likewise, even though we’ve already had many filings in the brick-and-mortar retail and commercial real estate space over the past few years, these are sectors that are in secular decline and will likely produce many more filings irrespective of how macro conditions evolve from here.
While forecasting future restructuring activity is always a near impossibility, there’s no doubt that there will be an increase over the next year. The only real question is just how much of an uptick we’re going to see.
To my mind, the answer to that question largely hinges on how much earnings deterioration we get and how much debt servicing costs increase for those with top-heavy capital structures.
The former will be informed by whether we have a recession or not – this is hotly debated with GS thinking the odds are below 50%, and Bloomberg Economics thinking it’s 100%. The latter will be informed by just how much companies with floating-rate debt have their debt servicing costs increase – a function of how top-heavy their capital structure is, whether or not they’ve hedged their rate exposure, and how high the terminal rate gets along with how quickly it comes back down.
We’re still several months away from when a significant increase will begin to take place. But restructuring investment bankers are now having many more preliminary conversations and drawing up potential restructuring solutions for those most at risk (plus, there has been an uptick in actual deal activity!).
Today there are some leading indicators signalling what’s to come. The leveraged loan default rate has begun to pick-up steam, downgrades are now heavily outpacing upgrades, and sponsors are becoming more aggressive in trying to complete out-of-court solutions that could bring in new money investments.
Moving forward we’re likely going to see many more interesting and creative forms of out-of-court restructuring as sophisticated and increasingly experienced sponsors try to maintain the optionality of their investments. And with just how loose credit docs have been over the past number of years, there’s a lot of room for pushing boundaries further and further (as we’ve already experienced a bit this year with Envision Health, backed by KKR).
Further, if inflation proves to be stickier than the market currently anticipates – necessitating rates to stay higher for longer, or for there to be an even higher terminal rate – then things will get even more interesting. While relatively dovish sentiment has been prevailing over the past few weeks, inflation being stickier than is currently imagined can’t be entirely discounted, as Apollo nicely points out in the following chart...
Anyway, for interview purposes, it’s always a good idea to have a general view of where you see restructuring activity going and what’s driving it. There’s no objectively right or wrong answer here, but hopefully you’ve enjoyed reading this and can take away a few talking points. I’ve also included the GS research report I’ve been referencing throughout this post in the members area if you want to check it out.
With that said, you should primarily focus your time on typical restructuring interview questions, what restructuring investment banking really involves, and things like structural subordination / upstream guarantees.
If you’ve enjoyed this post, feel free to let me know and I may do a little update every quarter or so (by which time we’ll hopefully see much more deal activity coming down the pipeline).
]]>This balancing act frequently leads to tension. As I’ve written before, many think of chapter 11 as being a system typified by strict rules, procedures, and processes. While that’s certainly true, it’s also a system that has inherent ambiguity built-in and that consequently imbues the judge overseeing the case with the power to, when necessary, render decisions to clear logjams when they develop and keep the case on track.
Nowhere is this more obvious than when it comes to valuation. For chapter 7 cases there’s a certain level of intuitive fairness and objectivity to the way that “valuation” is ascertained: you just liquidate the company and tally up the cash. This cash is then dolled out based on the rule of absolute priority to creditors. So, what you get as a creditor is a predictable result of how much the company was ultimately liquidated for and where you stand in the capital structure. This makes it’s hard to argue you’ve been treated inequitably since the process is all so mechanical -- the results just are what they are.
But when it comes to chapter 11 cases, the debtor needs to place a value on the company moving forward that will inform what each class receives in consideration (if anything) in order to create their Plan of Reorganization. This is obviously a much more nebulous form of valuation than doing a straight liquidation, just as is true when valuing a healthy company for M&A purposes.
Further, the issue of valuation is complicated by the various incentives at play between the debtor and various types of creditors. From the debtor’s perspective, they’ll want as low of a valuation as possible as that’ll mean they can emerge with a slimmer capital structure. Likewise, for creditors who are getting back par via the debtor’s Plan they’d prefer as low of a valuation as possible – as long as it doesn’t crimp their own recovery any – so that the debtor can emerge with a slimmer capital structure that will make the company less likely to get into distress down the road.
However, if you’re part of an impaired class getting just a few percent (or less) in recovery pursuant to the Plan put forward by the debtor, you have an obvious incentive to argue for a higher valuation as any marginal increase in valuation will result in a marginal increase in your recovery. And if you have some likeminded creditors in your class who are equally aggrieved by their proposed recovery and believe the valuation of the debtor should be higher, you can muster up the ability to block the Plan and try to bring the debtor to the negotiating table.
This is where the judge overseeing the case needs to step in. While every judge has a wide degree of discretion in how they manage a case – with some allowing valuation fights to go on for a little while – in the end there needs to be some kind of resolution in order to get the Plan approved by the court and have the debtor exit bankruptcy. Ultimately, if one or more classes are blocking a Plan from being approved - and it appears no one is willing to budge - the judge will need to decide whether or not to cramdown the Plan or not.
Note: Since I’ll be getting into a bit more detail than you’d ever need for an interview in this post, if you have an upcoming interview make sure to focus on the types of things that will come up most (e.g., go through the traditional restructuring interview questions, make sure you have a general understanding of what restructuring investment banking is, know what structural subordination is, etc.).
Since this is another quite long post branching in a few different directions, I’ve broken it down into a few different sections.
What is “unfair discrimination” in the context of a cramdown?
Unfair discrimination and cramdown tests
So, let’s back up a bit. When a company files chapter 11 they’ll need to dream up a Plan of Reorganization that places creditors into various classes, defines how each class will be treated, and then discusses how the debtor intends on implementing the Plan (among many other things).
Which of the debtor's classes are impaired or unimpaired will always be clearly laid out in a table within the debtor's PoR, like as follows:
In order for the PoR to be confirmed by the court, it must meet the requirements of Section 1129 of the Bankruptcy Code. Most importantly, Section 1129(a)(8) requires that each class of claims must either vote to accept the Plan or not be impaired (as only classes who are impaired get to vote to accept or reject the Plan).
However, if this is where the discussion ended then there would be an obvious issue: what if a class of impaired creditors simply holds the case hostage (by voting to reject the Plan) until they get the recovery value they want? This would obviously not only drag out a case, but it’d also put in jeopardy the recovery of the classes above the one blocking the case (as maybe the value of the debtor would deteriorate significantly as it wallows away in court).
With exactly this issue in mind, the Code has Section 1129(b) which allows the confirmation of a plan over the objection (rejection) of an impaired class if all other subsections of Section 1129(a) are met and the plan, “…does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”
Therefore, when a Plan is confirmed by the court pursuant to Section 1129(b) that is what we mean by a “cramdown”. In layman’s terms, if the court deems that a Plan does not “discriminate unfairly” against rejecting class(es), that it is “fair and equitable” to rejecting class(es), and if at least one impaired class has voted to accept the Plan, then the court may force the Plan (cram it down) on those class(es) who have voted to reject it.
Below is some pretty standard language you’ll find in the Disclosure Statement accompanying any Plan of Reorganization regarding what is meant by "unfair discrimination" and "fair and equitable" in this context:
In the end, it’s not the wish of any judge to confirm a Plan via a cramdown after an impaired class has rejected it. They’d prefer for a consensual Plan to be reached that has support from all the impaired classes. However, a judge does bare the burden of knowing that prolonged Plan confirmation fights can create significant economic harm and if the Plan is deemed not to discriminate unfairly and is fair and equitable, then it is in the best interests of a wide set of stakeholders for the Plan to be consummated and for the debtor to be able to exit bankruptcy as quickly as possible.
Part of the reason I decided to write a post on cramdowns – even though it won’t really come up in interviews, beyond it being a good idea to know the definition – is to illustrate a broader point about extra-textual language.
While I suppose I’m biased, chapter 11 of the Bankruptcy Code is really quite an ingenious text and it’s especially impressive when you realize that there was nothing remotely similar to it anywhere in the world when it was adopted.
However, there are many parts of the Code that have superficially clear meaning, but that are a bit more ambiguous when you really begin to think about them. An obvious example of this is the “unfair discrimination” language contained in Section 1129(b), which the Code doesn’t define or provide an approved test for anywhere.
While at first blush the meaning may seem clear, how exactly would you define it in the context of cramming a plan down on a rejecting class? Is there a fair form of discrimination? If so, when does fair discrimination tip into the universe of the unfair?
As the world of restructuring has exploded over the past three decades – beyond the size anyone would have expected when the Code was adopted – there has needed to be extra-textual appendages added to grease the wheels of modern restructurings.
By extra-textual appendages what I’m referring to are, for lack of a better turn of phrase, generally agreed upon ways to do things that are influenced by the spirit Code, but that aren’t per se rooted in the text of the Code itself.
A recent example of this phenomenon that’s currently causing controversy in the PG&E case – far beyond what we really need to get into here – is at what level, if any, post-petition interest should be paid to unimpaired unsecured creditors when there’s a solvent debtor. The Code stays entirely silent on this issue – perhaps because no one envisioned this edge case – so a textualist reading of the Code would lead one to believe that these creditors should never get post-petition interest (as the Code says nothing about it).
However, the issue of original litigation in PG&E's case surrounded not whether these unimpaired unsecured creditors should get post-petition interest, but rather at what rate the post-petition should be at (the contractual or state law rate vs. the federal judgement rate, the latter of which is much lower). This can seem like an incredibly minor distinction, but there’s quite a spread between the two rates and the difference amounts to hundreds of millions in post-petition interest due to the sheer size of PG&E’s outstanding unimpaired unsecured debt.
Anyway, the point is that it was a forgone conclusion - agreed to by both the debtor and the creditors - that even though the Code was completely silent on the post-petition interest question for unsecured creditors, they still deserved something -- it was just a matter of what rate should be utilized. Then in Judge Ikuta’s incredible dissent on the Ninth Circuit she argued that because the text of the Code said nothing about paying post-petition interest to unimpaired unsecured creditors, these creditors deserved nothing at all (which, again, no one was even arguing for to begin with!).
Now this is all very in the weeds. But the point worth keeping in mind for those just joining the industry or those who are about to join is how many generally agreed upon and commonly used conventions (e.g., third-party releases) have no basis in the text of the Code. These things are extra-textual appendages – to use my turn of phrase – and, consequentially, there is always the risk of differences in judicial interpretation wrecking havoc on the way you had anticipated a certain case or situation unfolding.
Anyway, as discussed before venturing on this little digression, cramdowns do have a basis in the text of the Code. But you’ll frequently see arguments from sophisticated creditors within an aggrieved class over whether or not they’ve been unfairly discriminated against because of the unsettled nature of how these two words ought to be defined and the divergent tests courts will use to determine if unfair discrimination has actually occurred (hint: none of these “tests” are quantitative models with objective outputs!).
While there is no universal cramdown test, significant thought has gone into how to determine whether or not to proceed with one when issues of unfair discrimination arise within a rejecting class of creditors.
Ultimately, what’s often first looked at is whether there is any “reasonable basis” for the discrimination and whether the plan could be consummated without the discrimination being in place. Afterwards, a number of different tests could be considered (in the case of Tribune, four separate tests were considered).
Even though there is no universally agreed upon test when it comes to unfair discrimination, an increasingly popular one is the Markell test:
“A rebuttable presumption of unfair discrimination exists when there is 1) a dissenting class; 2) another class of the same priority; and 3) a difference in the plan’s treatment of the two classes that results in either a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments) or b) regardless of the percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.”
With that said, unfair discrimination could be overcome if the court finds a lower recovery as being consistent with what they would have achieved outside of bankruptcy or that another classes higher recovery is offset by some contributions to the reorganization of the debtor.
In the case of Mallinckrodt this year, several subclasses of Class 6 (the General Unsecured Creditors) rejected the proposed Plan of Reorganization on unfair discrimination grounds (although, since this was a quite complicated case, exactly what the unfair discrimination each subclass claimed was different).
In Judge Dorsey’s long opinion confirming the debtor’s plan, he provided a pragmatic overview of cramdowns, how courts have judged matters of unfair discrimination, and why the debtor’s proposed Plan does not unfairly discriminate against rejecting classess and thus satisfies the cramdown requirements of Section 1129(b).
This is how Judge Dorsey opened his opinion on Section 1129(b)…
“Because not all classes of creditors voted to accept the Plan or were otherwise deemed to have rejected the Plan because they are receiving no recovery, Debtors cannot comply with the requirements of Section 1129(a)(8) of the Code, which mandates that all classes of creditors must either vote to accept the Plan or receive payment in full. Therefore, to have the Plan approved, Debtors must show that the Plan ‘does not discriminate unfairly and is fair and equitable with respect to each class of claims or interests that is impaired under and has not accepted the [P]lan. In bankruptcy parlance, this is referred to as a cramdown plan. The Third Circuit has recognized that cramdown plans ‘are an antidote to one or more classes of claims holding up confirmation of an otherwise consensual plan’”.
Ultimately, Judge Dorsey found that any unfair discrimination that may arise due to differentials between the Plan’s distribution among classes is rebutted by the fact that each rejecting subclass is receiving no less than the de minimums distribution it was entitled to in the first place (as another class – Class 5, the Guaranteed Unsecured Notes – were gifting recoveries to several classes of junior creditors, albeit not all in pro rata amounts).
To that end the debtor’s (read: debtor’s advisors) put together a waterfall showing that while there’s a disparity in recoveries for Class 6 under the PoR, if the rule of absolute priority were strictly applied they would have received much less or nothing at all.
While Mallinckrodt is an incredibly sprawling case, the takeaway here should be that a level of reasonableness needs to be infused into the situation. As Judge Dorsey said when shooing away one of the subclasses of Class 6:
“Similarly, Sanofi’s argument that it suffers unfair discrimination because Class 7 Trade Creditors are receiving a 100% recovery while Class 6(f) is receiving far less also fails. Sanofi’s argument that Debtors cannot rely on Nuverra and Genesis Health because the gift is coming from Debtors, not Class 5 is plainly contradicted by the record. Both Class 6 and Class 7 are only receiving more than the de minimus recovery to which they are entitled because another creditor group is allocating its recoveries to fund the distribution. Without the gift from Class 5, Class 6 gets next to nothing. The fact that Class 7 gets a greater gift than Class 6 does no harm to Class 6 claimants.”
Just to tie up the Mallinckrodt example, you may be wondering why it is that Class 5 is giving a sizeable "gift" to these more junior classes – only a few of whom are owed anything by rule of absolute priority – to begin with.
Class 5 was entitled to a recovery of $1.37b representing 89% of its original claims of $1.54b due to having guarantees from nearly every entity within the debtor’s sprawling corporate structure. While Class 6 – some of the subclasses of whom argued they were being unfairly discriminated against – are larger in size at $5.5b, most of those comprising Class 6 have few if any guarantees and are entitled to no recovery pursuant to the rule of absolute priority. (Remember that Class 5 are the Guaranteed Unsecured Notes and Class 6 are the General Unsecured Creditors.)
However, as Judge Dorsey said in his opinion: “To avoid litigation with constituents in the other unsecured classes and facilitate settlements, the holders of Class 5 claims agreed to reallocate or ‘gift’ $228.5 million of their Entitled Recovery to Class 6 and Class 7.” The size of this gift was ultimately decided through mediation between the debtor and the Unsecured Creditor’s Committee (UCC).
Something that takes awhile to get your head around can be just how many ambiguous situations arise in a chapter 11 case, especially a complex one like Mallinckrodt, and how those ambiguities can lead to unpredictable outcomes. There’s no per se right valuation for Mallinckrodt that should have been used by the debtor, no per se right amount (if any) Class 5 should have gifted to other classes (before mediation only $100m was offered!), and it wasn’t inevitable (although it was likely) that Judge Dorsey would shoo away the unfair discrimination claims of the rejecting subclasses of Class 6.
But this is what makes chapter 11 cases interesting: while there is a mechanical process at play, there are also always ambiguous situations that arise that can massively influence the direction of the case (sometimes due to the views of the judge overseeing the case, which is partly why venue selection is so important).
As per usual, this post was much longer than I originally intended it to be. However, it struck me as worthwhile to use this post to lightly introduce the concept of extra-textual impact, ambiguities that are going to exist in every chapter 11 case, and the power invested in the court to make final decisions to get cases done as quickly as possible (trying to balance the equitable treatment of creditors with the need to efficiently reach a conclusion that they believe maximizes the value of the estate, and thus the recovery values of all the creditors).
With all that said, it’s important to recognize that for interview purposes this is all well beyond the scope of what you need to know (although you should know the basic definition of a cramdown, which just involves the court approving a Plan despite an impaired class rejecting it). Beyond that, what you should takeaway from this post is that while all chapter 11 processes follow a familiar script, when you dig a bit deeper a number of ambiguities begin to crop up that give rise to many difficult questions (thankfully this is the case, as otherwise the amount of fees that could be charged by restructuring bankers and lawyers would be much harder to justify!).
]]>For example, if I were to ask you whether or not - in a chapter 11 case - you’d expect second lien noteholders to receive a higher recovery than third lien noteholders you may scoff, tut-tut, and say that obviously this would be the case. First comes after second, second comes after third, etc.
However, things mean what they’re defined to mean, and this obviously holds even more true when it comes to actual tranches of debt. Second lien notes, third lien notes, unsecured notes -- they’re all just labels. While you can safely assume a second lien note probably has a second lien on something, without digging into the credit docs you can’t say much more than that.
In the case of Neiman Marcus, their labeling of their 2L notes and 3L notes was directionally correct but didn’t tell the full story. As it turns out, the 3L notes had, as you’d expect, a third lien on many different things but also had a first lien on some real estate assets that pushed their recovery value above the 2Ls in their initially proposed Plan of Reorganization.
Note: While the initial PoR contemplated the 3Ls likely getting a higher recovery, this was before including 2L consideration coming from the non-debtor MyTheresa. But in order to avoid triggering myself with discussions of retail restructurings during the depths of the pandemic, I won’t open that whole can of worms.
Here's another more common scenario that illustrates this point: sometimes you’ll quickly look at a company and see that they have a few different tranches of unsecured notes. However, you’ll then notice that one tranche has a coupon of 6.5% trading at 95, and another has a coupon of 8.5% trading at 70.
A good interview question would involve asking what explains this discrepancy -- after all, not only could you buy one of these similar sounding tranches cheaper, but it also would give you a better coupon!
If you’ve already read the post I did on structural subordination - or read the dedicated structural subordination guide in the members area - then the answer should be obvious right away: the 6.5% unsecured notes must reside at the OpCo level, where the assets reside, while the 8.5% unsecured notes must reside at the HoldCo level. Further, there must not be an upstream guarantee in place giving the HoldCo notes a general unsecured claim at the OpCo level (because if there were then the HoldCo-level notes would effectively be pari with the OpCo-level notes in terms of priority and thus should be trading at roughly similar levels after adjusting for the modest coupon differential).
Since this is a bit of a longer post, you can use the links below to navigate to each section. Given that we've previously gone through upstream guarantee questions in the structural subordination post, the way I'll try to approach talking about upstream and downstream guarantees this time is primarily through a little hypothetical case (which hopefully helps flesh things out without being too confusing!).
What is an Upstream Guarantee?
What is a Downstream Guarantee?
Upstream guarantees are guarantees that are extended by subsidiaries to the parent-level in order to overcome the issue of structural subordination (by giving creditors at the parent-level some form of claim at the subsidiary that has extended the guarantee).
Since this may seem like a bit of an academic definition, let’s clean it up a bit and talk about why upstream guarantees are utilized at all by going through a little hypothetical case.
Let’s imagine that we’re thinking about starting a company in the offshore drilling business. We know that offshore drilling is ever so slightly capital intensive with offshore rigs/drillships costing hundreds of millions of dollars, requiring millions in annual maintenance expense, etc. Further, we know that offshore rigs aren’t exactly commoditized: each is unique in its size, capacity, age, and, most importantly, in its average contractual dayrate.
Another thing we know is there have been many offshore drilling chapter 11 filings over the past few years like Pacific Drilling, Diamond Offshore, Valaris, and Noble. But this reality leaves us entirely undeterred. Despite the fact that we don’t know anything about the mechanics of offshore drilling, we figure that’s entirely inconsequential if only we can craft a perfectly contoured capital structure.
While this latter point is (obviously) written in jest, poor business performance in conjunction with unruly and nonsensical capital structures were the primary drivers of many of the offshore drilling filings we’ve seen over the past few years. It’s not that a perfectly contoured capital structure would have prevented these filing from ever occurring, but they would have provided at least a bit of optionality by leaving the door open to doing clever out-of-court restructurings or finding ways to issue incremental debt.
So, here’s how we’re going to design our hypothetical corporate and capital structure…
If we think about our business conceptually, it’s more or less just a collection of unique offshore drill rigs that are each very expensive and that each throw off a stream of cash flows (assuming they're currently operating). So, what we’re going to do is create a corporate structure that will place each rig into its own OpCo and then establish a HoldCo that will hold 100% of the equity of each one of these operating companies. Here's a little visualization:
What we’re then going to do is issue Secured Notes at each one of these operating companies. The reason for doing so is two-fold. First, we know that credit investors want to have debt housed as close as possible to where the assets of a company actually reside. So, issuing Secured Notes at the operating company (subsidiary) level gives them exactly that. Second, we know each rig is unique and that many credit investors will prefer to be able to get exposure to individual rigs, based on their own analysis and valuation methods, as opposed to getting exposure to all of them lumped together. Remember, these rigs are worth hundreds of millions and produce hundreds of thousands of dollars in revenue a day when operating -- in other words, each is really a non-trivial business in its own right.
Now that we have Secured Notes placed at each of our operating company, the question then becomes what to do (if anything) at the HoldCo level. While in this hypothetical example there are no tangible assets at the HoldCo, they do hold the equity of all of our operating companies which certainly does have value assuming the operating subsidiaries aren't underwater (no pun intended).
So, what we’ll do is issue two large tranches of Unsecured Notes out of the HoldCo. Since both of these tranches of Unsecured Notes will be removed from where the assets reside, we’ll need to provide holders a higher interest rate relative to what the Secured Notes are getting. However, insofar as folks believe that there will be sufficient equity value within the operating subsidiaries - that wholly belongs to HoldCo - then the enhanced yield could be quite enticing to those with a slightly greater risk appetite.
More specifically, the first tranche of Unsecured Notes we’ll issue - that we’ll call the Priority Senior Notes - will have upstream guarantees from all the operating companies which will give the Priority Senior Notes a general unsecured claim at each of them. The second tranche of Unsecured Notes – that we’ll just call the Senior Notes – will have no upstream guarantee from any of the operating companies.
From a recovery perspective, this would mean that value from any given operating company will flow first to their specific Secured Notes, then to the Priority Senior Notes due to the upstream guarantee in place, and then to the Senior Notes (as any value left over at an OpCo would flow to the HoldCo given that it holds 100% of each OpCo’s equity). So, even though HoldCo has issued two tranches of unsecured notes, one tranche is structurally senior due to the upstream guarantees they have from the subsidiaries.
What’s described above is really just a heavily simplified and stylized version of Transocean’s corporate and capital structure. First, they have secured notes that are issued at each rig’s specific OpCo with these secured notes being secured by all the assets and earnings associated with that specific rig. Second, they have tranches of unsecured notes at the HoldCo level with varying levels of upstream guarantees (or none at all). Practically, this means that some of Transocean’s HoldCo unsecured notes are structurally subordinate to other HoldCo unsecured notes.
While Transocean hasn’t filed yet, they did do a contentious out-of-court exchange in late 2020 which invited a lawsuit from Whitebox and PIMCO who believed that Transocean stripped their unsecured notes - which were called Priority Guaranteed Notes - of their structurally senior status because the exchange involved the issuance of new unsecured notes - which were called Senior Priority Guaranteed Notes or SPGNs - that had a higher priority than the Priority Guaranteed Notes.
Circling back to what I wrote in the preamble, this is why you can never rely on labels as being overly informative! Here we have some Priority Guaranteed Notes that were subordinated by Senior Priority Guaranteed Notes.
Note: As you can imagine, everything is a touch more complicated in practice. The new SPGNs had a guarantee from three holding company subsidiaries that each, in turn, wholly own certain operating companies. Importantly, when you hear “holding company” that doesn’t necessarily mean the parent-level holding company (e.g., for Transocean, that would be Transocean Ltd.). As Moody’s put in when they first assigned a rating to the new SPGNs, “The SPGNs are structurally subordinated to the outstanding secured [rig-level] debt and the company's undrawn $1.3 billion secured revolving credit facility. The SPGNs are senior to the previously issued PGNs and the senior unsecured notes, and have a priority claim, because of the guarantees from Transocean's Structurally Senior Guarantors, effectively giving these notes a priority claim to the assets held by Transocean's operating and other subsidiaries compared to Transocean's PGNs and senior unsecured notes.”
Note: Technically Transocean Inc. has issued all the unsecured notes and Transocean Ltd. (the true parent-level HoldCo) has guaranteed them. However, Transocean Inc. is the direct and wholly owned subsidiary of Transocean Ltd. So, to avoid splitting the most microscopic of hairs, we'll call the issuer of the unsecured notes, Transocean Inc., the effective HoldCo for our purposes here.
Let’s imagine that we have a simplified little HoldCo / OpCo structure. The OpCo has $300 in assets and has issued $200 in unsecured notes, while the HoldCo has issued $200 in unsecured notes and holds the equity of OpCo. What will be the recovery values with and without an upstream guarantee being in place?
You can visualize the structure as follows -- keep in mind that the HoldCo should always be drawn on top and that any upstream guarantee should be drawn from the OpCo coming up to the HoldCo.
If there’s no upstream guarantee in place, from a recovery value perspective the OpCo unsecured notes would be made whole as they’re fully covered by the assets at OpCo. The $100 left over at OpCo would then just flow through to HoldCo given that HoldCo owns the equity of OpCo. So, the unsecured notes at HoldCo would receive a recovery of fifty cents on the dollar.
If an upstream guarantee is put in place, things get a bit more interesting. The first question we would need to answer is what kind of claim the upstream guarantee confers to the HoldCo unsecured notes at the OpCo level.
While guarantees can be structured in a myriad of different ways – including being issued on a senior secured basis – you’ll most often see them (especially for interview purposes) providing HoldCo debt with a general unsecured claim at the OpCo level.
So, if the upstream guarantee provides HoldCo creditors with a general unsecured claim at the OpCo level then this would make the HoldCo and OpCo unsecured notes pari. Thus, we have $400 in debt, $300 in assets, and a recovery for both tranches of seventy-five cents on the dollar ($300 in distributable value divided by the $400 of pari debt).
If we change up our example a bit and say that the OpCo debt is now secured by the assets residing at OpCo while this upstream guarantee is still in place, then our outcome changes again. While this upstream guarantee will provide HoldCo creditors with a general unsecured claim at the OpCo level, it won’t change the reality that the OpCo secured debt is still ahead of it in priority at the OpCo-level. So, in this case OpCo creditors would receive full recovery and HoldCo creditors would, once again, receive fifty cents on the dollar. Thus, making them no better off, in this scenario, than if they had no guarantee at all.
Ultimately, corporate structures can become incredibly complex and verge on the point of being internally inconsistent. Part of the reason why the little narrative in the prior section revolved around a hypothetical offshore drilling company is that they are notorious for having difficult corporate structures to get your arms around. This is due to the breadth of geographies they operate across, which comes along with legal and tax issues, in conjunction with the desire to segregate assets so that they can maintain maximum flexibility to raise incremental debt when needed.
Take a look at Valaris’ corporate structure below. They had $7.1b of debt when they filed their Restructuring Support Agreement although, to be fair, their capital structure itself was actually reasonably straightforward with almost everything being issued out of the parent-level HoldCo.
So, in the real-world dealing with guarantees is really an exercise in scavenging credit docs and disentangling who is doing the guaranteeing, what benefit its conferring, and then determining what a given tranches overall priority really is.
Note: To avoid repetition, we'll just go through this one extended example here. There's quite a few more examples in the structural subordination post and many more in the guide in the members area (including some questions with more than two entities involved -- although those never come in interviews, I just created them to help build your intuition).
As you’d expect, downstream guarantees are just the inverse of upstream guarantees. Instead of the guarantee being extended from the subsidiary-level to the parent-level, the guarantee is being extended from the parent-level down to the subsidiary-level.
Or, in other words, instead of the guarantee being extended from the OpCo to the benefit of the HoldCo, the guarantee is being extended from the HoldCo to the benefit of the OpCo.
Now based on the little example in the prior section, a downstream guarantee from the HoldCo to the benefit of the OpCo wouldn’t provide any benefit (since the only value at the HoldCo will be whatever OpCo equity value exists – so we’re getting a bit recursive!).
However, in more sprawling real-world capital structures value from many different subsidiaries will be flowing up to the parent-level HoldCo and the HoldCo itself may have some assets of its own. For example, Transocean Ltd. is the parent holding company of Transocean and all of the secured notes – that are issued at separate rig-level operating companies – include guarantees from Transocean Ltd.
So, it’s entirely common and useful for guarantees to be extended by the parent to debt issued out of an operating company. For example, getting back to Valaris plc (the parent HoldCo) during the First Day Declaration, the following was said about notes issued out of Ensco International Incorporated, “ENSCO International Incorporated is a wholly-owned subsidiary of Valaris plc, and Valaris plc is the full and unconditional guarantor of the Ensco International Notes. All guarantees issued under the Ensco International Notes are unsecured obligations of Valaris plc ranking equal in right of payment with all of Valaris plc’s existing and future unsecured and unsubordinated indebtedness.”
Hopefully this post has been helpful. With my increasingly busy schedule over the past few months, I haven’t had as much time to write as I’ve been hoping for. However, I’ve been dealing with a number of complex corporate structures with lots of guarantees flying around, so I figured I’d write this more conceptual post covering upstream and downstream guarantees. Although, to be clear, you don't need to know all of the details in this post for interview purposes at all.
I also wanted to write this post to hit home, once again, the importance of looking at how things are defined and the need to always read the underlying credit docs -- because what you think things ought to mean is often quite different than what they really mean.
If you haven’t already, you should read the structural subordination post that covers more practical interview-style questions involving HoldCo/OpCo structures that have guarantees involved. There are also the classic restructuring interview questions and, if you’re just getting started, the restructuring investment banking primer that may be helpful to read through.
]]>Just looking at the above answer might make the process sound quite prosaic. In fact, it may all sound entirely mechanical -- as if the chapter 11 process is really just a conveyor belt that every debtor predictably moves along until they re-emerge from bankruptcy.
However, while the conveyor belt analogy isn’t wrong – since every debtor is going to follow more or less the exact same process, there is a defined format for how certain documents should look, etc. – think about how much subjectivity is involved at each stage of the process (e.g., how do we know what the debtor is really worth?).
The strict and sophisticated framework that envelops the chapter 11 process – all overseen by the loving grace of the court – belies the fact that the process all boils down to the debtor and a sufficient number of impaired creditors negotiating an equitable plan for moving forward.
If you’ve ever found yourself taking a step back and asking yourself why restructuring investment bankers are bringing in eight-figure fees for navigating what, at least superficially, appears to be a rather mechanical process, here’s your answer: you have adversarial and aggrieved parties clawing at a limited pool of economic value, and they need to be guided towards some kind of mutually agreed upon solution so everyone can move on (because the longer the debtor is in-court, the more they’ll be bleeding value).
So, a restructuring banker is being paid for their knowledge of the process, their ability to devise an equitable solution, and (most importantly) their ability to get that solution agreed to by a sufficient number of impaired creditors to wrap up the process as quickly as possible.
What tends to complicate matters the most in the chapter 11 process is that there’s no objective answer to what the debtor is really worth. So, if impaired creditors don’t feel they’re getting the recovery they should – based on what they think the company is worth – then this sets up the debtor for potentially getting into a protracted valuation fight.
Unless, of course, the debtor has some more coercive tactics up their sleeve for strong-arming prickly impaired creditors...
As per usual, this is an absurdly long post so I've broken it down into a number of different sections you can navigate to using the links below.
The Problem With Valuations in Chapter 11
The Basics of the Death Trap Provision
What Classes Death Trap Provisions Target
What Compensation "Death Trap Classes" Get
So, here’s a scenario: there’s a company, let’s say they’re in the oil industry, and suddenly there’s an unprecedented global health event that demolishes the price of oil. In fact, for a brief moment oil kind of trades at a negative price (e.g., you’re being paid to take physical oil because no one wants it).
As a result, the company quickly drains its liquidity and is now facing a cash crunch. So, the company engages some restructuring bankers, and they begin reaching out to creditors to start a dialogue about maybe doing some kind of out-of-court solution, but, regrettably, it becomes obvious no fulsome solution is going to avail itself.
With no out-of-court solution possible, the company files chapter 11. Now the aim of the company is to get in-and-out of the process as quickly as possible while right-sizing its balance sheet. After all, the bankruptcy process is expensive and the longer the debtor is in the process, the more value destruction that will occur.
So, the debtor needs to create a Plan of Reorganization that lays out who the classes of debt are and how they’ll be treated. In other words, they need to determine what each class will be getting for a recovery value based on the Plan value that’s been arrived at.
But what should that Plan value be? Obviously, in this scenario, it’ll be relatively tightly correlated to the price of oil. However, having just gone through an unprecedented oil shock due to a global health event, who can say what that will be? Maybe the price will rebound immediately, maybe it’ll languish for years, maybe it’ll go down even further!
As I’ve mentioned many times before, the most contentious part of the chapter 11 process usually comes down to valuation. From the perspective of the debtor, they’d like a relatively low valuation as that will mean they can emerge with a slimmer capital structure. However, from the perspective of impaired creditors getting cents on the dollar, an increased valuation will mean an increased recovery value for them.
If the debtor isn’t careful and tries to force a Plan with too light of a valuation, a class of creditors could start a valuation fight that may then require having to go through a time-consuming and costly cramdown process to get the initial Plan approved. This process will involve the court needing to ascertain the valuation of the debtor and then ensure that those classes higher in priority than the objecting class of creditors aren’t being overcompensated and that those classes that are lower in priority than the objecting class of creditors aren’t receiving anything.
Note: Obviously I'm heavily glazing over the chapter 11 process here for the purposes of setting up the rest of this article -- keep in mind that actual cramdowns are rare and most of the time, perhaps after significant horse-trading and subtle coercion, a consensual Plan is developed.
In order to avoid either getting into a cramdown fight or otherwise getting bogged down in the process with an intransigent impaired class, a so-called “death trap” provision can be utilized to try to preemptively strong-arm an impaired class – that may otherwise want to pick a valuation fight – to vote to accept the Plan of Reorganization (remember that the only classes that will vote on the Plan are those that are impaired).
So, what a death trap provision will do is give a junior impaired class a binary choice: if they vote to accept the Plan of Reorganization, then they’ll be given some small level of recovery, but if they don’t vote to accept the Plan of Reorganization, they’ll either be given nothing or something substantially less than they would’ve if they had initially accepted.
Now obviously death trap provisions can only be utilized when certain conditions are present. In particular, debtors can utilize death trap provisions against a certain impaired class when their Plan value dictates that technically that impaired class isn’t owed anything if one were to strictly apply the rule of absolute priority. The theory that’s underpinning the death trap provision is that because the impaired class isn’t technically owed anything, what's really happening here is that a small amount of value is being gifted from a more senior class to compensate a more junior class to try to entice them to vote for the Plan and avoid delays in confirmation (as avoiding delays avoids value destruction, etc.).
Put another way, the debtor is essentially saying to the impaired class who they’re trying to convince to vote for the Plan: “Look, based on our Plan value we don’t think you should be getting any recovery value at all. However, valuations are always tricky and it’s in everyone’s best interest not to start a valuation fight here and drag this out. So, we’ll give you a little bit of value if you vote to accept the Plan we've devised. But if you don’t vote to accept the Plan, then we’re not going to give you anything. So, take what we’re giving you now and vote to accept the Plan, or be prepared to roll the dice with a potential cramdown.”
As already mentioned, death trap provisions are going to be utilized against classes that are at the margins. Or, in other words, they’re going to be utilized against classes that are technically owed nothing – per the Plan valuation – but for whom a reasonable argument could be made that they could be owed something if the debtor is valued more aggressively.
Note: There's a few wrinkles in here when it comes to past death trap precedence, but we'll glaze over them to avoid muddying the waters. What I've described above holds true for almost all death trap situations.
So, as you’d imagine, death trap provisions usually only target one class of debt (whatever class happens to be most at the margin). There are exceptions though. For example, Chisholm was an interesting case in which they used death trap provisions to coerce their second lien, pre-reorg equity, and general unsecured creditors into accepting their Plan. However, Chisolm was a bit of a unique circumstance as the value of the company was heavily underwater when the Plan was devised due to them being an oil and gas extraction company filing near the height of the pandemic. Chisolm also happened to be backed by Apollo and Ares -- so it’s not much of a surprise that they’d be more aggressive in using death traps than others would.
Most often you’ll see the death trap provision target either the equity or the 2L. However, as illustrated above, there’s nothing that precludes the inclusion of a death trap anywhere else.
An interesting question – which hopefully is reasonably intuitive if I’ve explained things well so far – is whether you think that death traps targeting pre-reorg equity will be more commonly seen with energy companies or retail companies, all else being equal.
What you should immediately be thinking of is that the valuations of retail companies will be relatively range bound and stable. However, since energy companies will have valuations that are much more dependent on volatile underlying commodity prices there’s much more room for argument around valuation with them (in particular, if commodity prices are abnormally low at the time the Plan is devised).
As a result, pre-reorg equity holders in energy companies tend to be much pricklier as they understand that a sudden rise in the underlying commodity price could all of a sudden leave them with a significant recovery value. This is an entirely fair point and many oil and gas companies that filed in Q3/Q4 of 2020 suddenly looked much better – while they were still going through the process – as commodity prices rebounded.
Anyway, the point is that you’ll often see energy companies use death trap provisions targeting equity in order to coerce them into quickly accepting the Plan and to stop them from either fighting for a higher valuation or just trying to draw out the process as much as possible in the hopes that commodity prices rebound in the interim (e.g., Chisholm Oil and Gas, Pioneer Energy, Denbury Resources, etc.).
Thus far we’ve established that death traps are essentially a carrot-and-stick phenomenon – you offer an impaired class some modest amount of recovery (the carrot) if they vote to accept the Plan, but if they vote to reject the Plan you offer them much less or, more often, nothing at all (the stick).
However, we haven’t yet established what exactly the form of recovery being offered to the impaired class involves. While the form of recovery can be structured a number of different ways, most of the time it’ll be a pool of cash, post-reorg equity, or warrants.
The rationale for offering post-reorg equity or warrants is obvious. You’re essentially saying to the impaired class, “Look, you shouldn’t technically get anything according to the Plan value we’ve developed. However, we know that you may think our Plan value is too low. So, what we’ll do is throw you some post-reorg equity or warrants. This way if you’re right and the value of the company is significantly greater than we think it is, then you’ll get uncapped upside value!”.
In terms of the amount of compensation given to classes targeted by a death trap, there’s nothing formulaic here. However, in classic death trap scenarios it’s usually pretty modest and will leave the class with a 1-5% recovery value (which isn't much, but is better than nothing!).
Alright, let’s wrap things up by going through a little example to make this all a bit more concrete. One thing you’ll notice about death trap provisions is that they are often utilized by sponsor-backed companies that have entered into robust restructuring support agreements prior to filing.
Note: When I refer to an RSA as being robust, what I mean is that it has broad-based support from creditors within the largest classes (e.g., a very high percentage of the largest classes have signed on to the RSA).
The reason why you’ll often see death trap provisions crop up in these scenarios is that sponsors are sophisticated and want to get in-and-out of the process as quickly as possible. By entering into a robust RSA pre-filing they’ve done the toughest part, but they run the risk of having a few junior impaired classes with some thorny creditors drag out the process (since they have nothing much to lose by waiting around trying to get a higher valuation).
So, by thrusting a death trap on one or more of these junior classes it puts pressure on them to accept the little bit they’ve been offered - that they may not technically deserve - in order to disincentivize them from throwing a wrench into the process. To put it a bit colorfully: the debtor is barreling down the tracks of the chapter 11 process at full steam and is essentially throwing the junior class a few cents and saying don’t get in our way or we’re going to run you over.
So, let’s talk about CWT. They represent a classic pandemic-case as they were a travel management company that was humming along reasonably well but then were, as you can imagine, devastatingly impacted by the onset of the pandemic.
Given that CWT was sponsor-backed and had a relatively concentrated pool of creditors, they were not only able to enter into a robust RSA pre-filing, they were able to do a full pre-pack. In fact, they were able to do a pre-pack in a day (meaning they were able to get in-and-out of court in a day).
Note: In the restructuring guides I’ve talked about there being a trend toward ever quicker pre-packs occurring. While getting in-and-out of court in a day was unfathomable a decade ago, we’ve had a few sponsor-backed companies do so over the past few years (e.g., Belk).
Anyway, one of the reasons why CWT is a classic pandemic case is that they were forced to file not because of gradually slowing demand for their services but rather due to demand falling off a cliff (which obviously no company is in a great position to handle).
As a result, the Plan value contemplated in their RSA is actually reasonably large because it’s predicated on the pandemic subsiding and business returning to some level of normality in the future -- they just, like so many others, weren't in a position pre-filing to withstand however long it’d take for demand to return to normalized levels. So, according to the Plan, most classes of debt are unimpaired and thus aren’t entitled to vote as they would obviously accept the Plan. Instead, just three classes are impaired as you can see below:
The marginal class in this case – that could potentially be owed some small amount, if you were to make a stronger valuation case – is Class 7. However, clearly the debtor doesn’t think they’re owed much of anything as Class 5 got 100% of the post-reorg equity as part of their recovery and Class 6 got just a few warrants as their recovery. So, Class 7 was targeted with a death trap provision to essentially make sure it wasn’t worth their time to throw a wrench into the prepack and delay getting in-and-out of court in a day.
This death trap involved giving the creditors in the class their pro-rata share of $250,000 in cash if they voted to accept the plan and nothing if they voted to reject it. This equates to a recovery value – since this was a very small class – of a bit more than 2%.
While this may seem like a relatively miniscule recovery value, keep in mind that death traps are always used to coerce acceptance of a Plan for classes at the margin. In this case Class 7 was deemed to be entirely out-of-the-money per the Plan valuation, so technically they were owed nothing unless the valuation was successfully challenged. So, it wouldn’t be sensical for these creditors to receive that much higher of a recovery -- especially if it’s in cold hard cash, not something with more nebulous value like post-reorg equity or warrants.
Part of the reason why I chose to write about death traps is they demonstrate that despite the fact that the in-court process can appear quite rigid and mechanical on the surface, there can be a lot of horse-trading and subtle coercion that happens.
While death traps have become increasingly common, they’re still relatively rare. Further, they, by definition, happen at the fringes of the process and aren’t remotely close to being the centerpiece of any Plan. However, they can be utilized to make sure that a potentially troublesome impaired class can't delay, or even derail, the process.
So, you should really think of death trap provisions as being another potential tool in the toolbox for getting a debtor's Plan across the finish line if the right circumstances present themselves.
Anyway, hopefully this has been relatively interesting to read and helps shed a bit of light on ways debtors can try to set themselves up to get through the process as quickly as possible (to avoid prolonged value destruction, ever-mounting professional fees, etc.).
Needless to say, this kind of stuff isn’t something you need know for interview purposes at all. So, don’t worry about this coming up. Instead, focus on classic restructuring interview questions, learning what restructuring investment banking broadly is, learning about more general terms like structural subordination, etc.
However, if you’re ever researching a chapter 11 case and you notice in the Plan of Reorganization that some class will either get something if they accept the Plan, or get nothing if they don’t, and are a bit confused on what’s going on, now you know!
]]>To put a bit more meat on the bones, the entire edifice of restructuring can really be thought of as trying to create a predictable system by which the economic value of a debtor can be fairly distributed to creditors to satisfy their claims, while also balancing the fact that there won’t be enough to go around and we want the debtor to be viable moving forward.
While most restructurings – whether in-court or out-of-court – will usually result in a bit of litigation around technicalities, it’s rare that you’ll see serious arguments being made at a more fundamental level about the very structure of the restructuring transaction itself being unfair (and thus requesting that it be unwound or precluded from moving forward).
However, over the past five years we’ve seen this occur more frequently as the structure of restructuring transactions have become more novel and more aggressive in terms of what they're trying to do.
For example, over the past few years we’ve seen non-pro-rata uptiers from Serta, Boardriders, and TriMark – along with Incora just a few months ago – in which a simple majority of existing creditors have primed those not in the in-group. Thereby pushing the minority holders back in terms of priority and devastating the value of their holdings.
This all comes after the shock-and-awe of J. Crew doing their IP transfer in 2017 – followed by the likes of PetSmart – that shifted existing assets out from underneath existing creditors by utilizing unrestricted subsidiaries (we’ve seen a slightly more complex iteration of this just last month with Envision Healthcare).
When all the cases referenced above were announced, breathless commentary erupted in the financial press about the seeming unfairness of these transactions. The undertone of the commentary being that these kinds of transactions are just obviously unfair and that if they are upheld by the courts it would speaks to some level of brokenness in the bankruptcy system.
However, part of the reason why I wrote the Serta case study in the members area – that covers both non-pro-rata uptiers and the usage of unrestricted subsidiaries – was to try to show why these kinds of transactions make sense, how credit docs can be amended to prevent them if so desired, and why courts have (mostly!) permitted them.
Note: Mostly is the operative word. Some have unwound their more novel restructurings (e.g., Travelport unwound their attempted IP transfer in 2020), while most that have successfully done these more aggressive restructurings have settled instead of pursuing litigation too far (e.g., TriMark in early 2022). In the future I may write about this a bit more, as there's some interesting strategy behind how a debtor should navigate the wreckage after doing these kinds of transactions.
Anyway, what we’ll be talking about today doesn’t really involve a novel form of restructuring transaction – at least in the way that non-pro-rata uptiers and IP transfers are – but rather involves something that’s a layer above: reshaping the organizational structure of a debtor solely to be able to deal with a large and unknowable amount of future liabilities in a somewhat more efficient way by leveraging the bankruptcy system (without putting the entire company into bankruptcy in the process).
Since the Texas Two-Step is a somewhat novel approach that's been done by just a few debtors, I wanted to use this post to get beyond just the mechanics of how its implemented. Instead, I wanted to also touch on the rationale for pursuing this strategy and touch on how to think about the issue of "fairness" (e.g., why aren't these cases immediately dismissed as bad faith filing?).
Anyway, since this is an absurdly long post I've broken it down into a few different sections that you can navigate using the links below.
The Rationale Behind the Texas Two-Step
The Mechanics of the Texas Two-Step
The Fairness of the Texas Two-Step
Over the past five years a small number of debtors – all of whom have had mass tort liabilities – have perused a so-called Texas Two-Step strategy (e.g., Georgia Pacific / Bestwall, Trane Technologies / Aldrich Pump, and CertainTeed / DMBP). Now, most controversially, we have the ongoing case of Johnson & Johnson (technically Johnson & Johnson Consumer Inc. / LTL Management).
The basic rationale for pursuing this strategy is quite straight forward. Imagine you’re a large company (e.g., Johnson & Johnson) that has thousands of products and over a hundred thousand employees. In other words, you’re a big and diversified conglomerate -- you don’t do just one thing, you do a myriad of different things and have done so for over a century.
But imagine that one of your products, allegedly, has caused cancer among some users due to how it has been formulated (e.g., your baby powder has included talc). As a consequence, you now have tens of thousands of pending lawsuits against you. However, after years of fighting these suits it’s not clear what your liability is really going to end up being. You’re winning almost all of the personal injury cases brought against you – after spending hundreds of millions on legal expenses – but you’ve also lost one case (involving just 22 plaintiffs!) that has suddenly strapped you with over two billion in liabilities.
Clearly this is a chaotic and uncertain situation for everyone involved…
From the perspective of the company, even if they win all the remaining cases they’ll still need to spend billions fighting them and it will take years and years to work through them all. However, given that the company is dealing with a large volume of cases (in the case of J&J, tens of thousands!) there’s always the possibility that they lose some cases and are suddenly on the hook for billions more than anticipated.
From the perspective of those bringing suit, they’ll be waiting years for any kind of resolution and, based on precedence, most are going to lose. But those few that win will be in for an astonishing payday (along with their lawyers, of course).
So, even if the company doesn't believe they’ve done anything wrong and believe they can win every future case it still, on balance, is going to be a massive overhang on the company to continue litigating these claims (investors don’t like having thousands of lawsuits pending!) and they’d rather it all just be resolved. This is especially true when the company is a large, diversified conglomerate -- they have many other things, related to the good functioning of their business now and in the future, to worry about.
Now, if we take a step back, one way to think about the bankruptcy process is that it’s a forcing function. When a company is trying to do an out-of-court restructuring, sometimes it’s impossible to get everyone to the table to agree on something. Sometimes the company just needs to file to get everyone to seriously get down to business, find an equitable resolution that can be agreed upon by a sufficient number of creditors, and move on.
So, what if there were a way to take all these potential future liabilities (the lawsuits) that the company has, concentrate them in one entity, put a pool of money alongside it, and then have that entity file Chapter 11. The ParentCo could still be on the hook for what the final amount of compensation is, if it’s above the money that's already been placed at this severed off entity, but the bankruptcy process would force a resolution of these claims against the company once and for all. In other words, the forcing function on the bankruptcy system would force everyone to come to the table, figure out a dollar amount for existing claims and any future claims, and be done with it.
So, this is where the Texas Two-Step comes in. It’s a way to sever off these legal liabilities into a singular entity, have that entity file, and then utilize the bankruptcy process to come to a final resolution as to what is really owed and distribute that to all the creditors (e.g., the thousands of those that have brought personal injury suits against the debtor).
Now perhaps I’ve framed the rationale for using the Texas Two-Step in such a way that you see no issue with it (because, full disclosure, I largely have no issue with it!).
Certainly one could reasonably argue the Texas Two-Step represents an ideal outcome -- one that illustrates the benefits of having such a robust bankruptcy system. Because what this type of restructuring allows is for the ParentCo to be able to focus on their primary business and gain certainty around their liabilities. Meanwhile the creditors will be able to have a quicker resolution of their claims and all creditors (tort claimants) with a valid claim will get some level of compensation (instead of most getting nothing while a small minority get tens of millions, which is what has happened in the case of J&J over the past few years).
However, there’s no getting around the fact that to a layman – or an enterprising politician who has forgotten their bankruptcy and tort law from their time at HLS or YLS – seeing a company sever off liabilities into an entity and then have that entity file bankruptcy doesn’t look great. Rather, it looks like the company is trying to skirt their financial responsibility by abusing the bankruptcy system.
While Jones Day has made hundreds of millions from architecting the Texas Two-Step and then working with debtors on implementing it, they’ve also created something almost perfectly suited to creating outrage.
In fact, the Texas Two-Step has caused sufficient and wide-spread enough outrage that there have been Senate hearings on it and a piece of legislation introduced – The Nondebtor Release Prohibition Act – to try to prevent this strategy from being utilized moving forward (and retroactively void those that have occurred, which would be a ridiculous mess if it were to occur).
So now that we’ve painted the rationale for why someone would pursue a Texas Two-Step, along with providing a very brief overview of what it is, we should probably cover the mechanics a bit more granularly (e.g., what does Texas have to do with any of this?).
Traditionally when we think about mergers, we think about two distinct entities merging to create a larger entity. However, Texas law has a quirk in that mergers can also refer to a divisional merger whereby an entity incorporated in Texas can split into two discrete entities.
All that’s required is that the merger plan specifies how the company will be broken in two and that, importantly, the liabilities associated with each company must have assets sufficient to cover them.
So, what will happen in a Texas Two-Step is that a company will briefly reincorporate in Texas and undergo a divisional merger, resulting in the creation of what we’ll call GoodCo and LiabilityCo. The pre-merger company, that we’ll call OldCo, will cease to exist.
As the names would imply, LiabilityCo will get all the mass tort liabilities that were previously associated with OldCo along with some assets. The GoodCo will get everything else – essentially looking like the OldCo except without all the tort liabilities and without a few assets.
After this is done, GoodCo will reincorporate in the state that OldCo was previously incorporated in. LiabilityCo will reincorporate in the state that it will file in. This has historically been in North Carolina as the Western District of North Carolina was where the first attempts at the Texas Two-Step occurred so there’s case precedence.
However, after much argument, J&J's case last year was moved from North Carolina to New Jersey – where they’ve been traditionally incorporated and where GoodCo reincorporated – and the case hasn’t been dismissed. So, depending on how the case further evolves, there will likely be less narrow “venue selection” relating to where the filing takes place in future cases involving a Texas Two-Step.
Note: In the case of Johnson & Johnson, their subsidiary (Johnson & Johnson Consumer Inc., or JJCI) reincorporated in Texas. The LiabilityCo – called LTL Management – assumed all talc-related liabilities that JJCI previously had, along with a series of assets. This included a bank account with $6m in cash and equity interests in Royalty A&M, which are valued at north of $360m and will generate roughly $50m per year. However, this isn’t the full extent of how much Johnson & Johnson will contribute as we’ll soon get into. Rather, these are just the assets that LiabilityCo (LTL Management) had from the outset.
Prior to LiabilityCo filing chapter 11, a series of intercompany agreements will be entered into between GoodCo and LiabilityCo. This will include the fact that GoodCo will fund the chapter 11 process of LiabilityCo and, most importantly, that GoodCo will fund a Qualified Settlement Fund (QSF) to cover the mass tort claims against LiabilityCo. However, the QSF will only be assessable as part of an approved Plan of Reorganization with certain strings attached (e.g., releases for GoodCo to ensure that litigation can’t restart against them). In other words, GoodCo is still on the hook for paying settlement dollars, but any deal reached must require that GoodCo is insulated from any future litigation. After all, the whole point of this strategy is to create a definitive resolution instead of stretching it out for years and perpetually draining cash due to never-ending litigation.
Note: In the case of J&J, the QSF was pre-funded with $2b to handle all claims as part of a reorganization. Importantly, the QSF and existing assets of LiabilityCo aren't necessarily the maximum that would be divided among creditors, but rather should be thought of as being the initial starting point or the initial bargaining position. You’d certainly expect J&J to pay in more to LTL if it meant reaching a quick PoR with acceptable releases.
Anyway, after LiabilityCo files an immediate request for an injunction against all pending litigation (against either LiabilityCo or GoodCo) will be requested and it will almost certainly be granted (this is rather formulaic and will almost always be granted unless the court deems a case to obviously be a bad-faith filing). With an injunction granted, this allows GoodCo to go about their business as usual while LiabilityCo works through the lengthy restructuring process and tries to reach a satisfactory PoR.
So, mechanically the Texas Two-Step isn’t really that complicated. You’re just reincorporating a company with lots of mass tort liabilities in Texas – due to their favorable laws on divisional mergers – and then spitting out a GoodCo and LiabilityCo.
The GoodCo then reincorporates back wherever it was previously and can focus on its core business again while being free from the overhang of ongoing litigation. Meanwhile LiabilityCo reincorporates somewhere (in the past it’s been North Carolina but moving forward it may be back to the same state as GoodCo) and files.
After filing an injunction will be granted that freezes ongoing litigation. LiabilityCo then has some breathing room and will seek to work through the bankruptcy process and come to a comprehensive solution that addresses all mass tort claims against it by using the assets it got immediately after the divisional merger, the QSF funded by GoodCo, and likely some additional funding from GoodCo. Eventually a PoR will be reached which will be include releases to ensure that GoodCo can't face future litigation.
While the Texas Two-Step might not sound that complicated mechanically, there’s no getting around the reality that the optics of a Texas Two-Step just aren’t ideal.
Jones Day isn’t really making hundreds of millions due to their brilliant structuring of the Texas Two-Step, rather they're making this money for being able to execute something that has caused such an outrage among the general population, politicians, and even some legal scholars (in other words, Jones Day is primarily earning their keep by convincing courts these aren’t bad-faith filings, that the cases should proceed despite the uproar, and that this approach is not only equitable but fair to all involved).
The reality is that almost immediately after a LiabilityCo files, you can bet on certain creditors asking the court for the case to be dismissed as a bad faith filing. So, since the very structure of these kinds of transactions are being argued from the outset largely based on the fundamental question of fairness, how should we think about the issue of fairness here?
While no one would claim that I’m an ethicist – or that I approach these kinds of questions without bias – if this kind of question interests you, then you should go read through the trial of the talc claimants’ motion to dismiss LTL’s case from earlier this year.
Arguing for dismissal were the two official committees of talc claimants along with several personal injury law firms. These parties were making the case that this is obviously a bad faith filing that was using the bankruptcy system purely to gain some form of litigation advantage (in other words, that the filing was fundamentally unfair to talc claimants). Against them were LTL’s counsel, led by Gregory Gordon of Jones Day and Allie Brown of Skadden Arps.
Brushing aside many more technical arguments, there were three broad arguments that Gordon and Brown were making that get to the heart of why this kind of case is justified and why the case should not be dismissed.
First, Gordon made the argument that the primary “winners” from dismissing the filing would be the plaintiff’s law firms who would be able to continually litigate against GoodCo (JJCI) moving forward. While they may lose most of their cases, as has occurred thus far, they would keep trying while hoping to hit a home run and then reap a nice "40% fee" off the top of it (like with the aforementioned case, with just 22 plaintiffs, that resulted in an award of over two billion).
Gordon’s argument is that surely it's more equitable if everyone gets something. If those in favor of dismissal want the most equitable outcome, how is it more equitable when a few strike massive paydays, while the majority receive nothing? Especially considering it's not the case that there's a hard cap right now on the amount available for claimants. Everyone knows it'll probably be more than the assets of LTL and the $2b sitting in the QSF.
Second, Brown made the argument that there are 38,000 claims outstanding, and the average trial would cost JJCI around $2m to $5m. Extrapolating these numbers out, Brown said it’d cost JJCI up to $190b just to try these cases (leaving aside the potential liability if they were to lose some of these). Further, Brown argued that by any reasonable standard JJCI can only be involved in ten trials a year -- so getting through all the trials individually would take, uh, 3,800 years? So, Gordon's first argument in favor of proceeding centered around equity, while Brown's argument centered around feasibility.
Third, Gordon returned to make the broadest and most fundamental argument. JJCI is a large company with a diverse product line, thousands of employees, and countless suppliers. It simply can’t reasonably compete against competitors with this litigation overhang, and as litigation expenses ramp up as described above – even if all were decided in favor of JJCI – eventually JJCI would need to file chapter 11 itself. However, unlike LTL filing, JJCI itself filing would have a seismic impact -- resulting in mass disruption to thousands of employees, suppliers, etc. and causing significant losses to other pre-existing creditors in JJCI's capital structure and, of course, shareholders.
The unspoken argument from Gordon and Brown is really, “Look, we don’t recognize that talc causes these adverse effects, but we’re willing to try to deal with this issue. However, is it truly in the best interests of anyone (outside of perhaps some personal injury lawyers) to have JJCI inevitably file due to the unceasing litigation that would occur if we didn’t do this Texas Two-Step? What is the alternative end result here? Is it to return to the status quo where a few claimants win tens of millions while everyone else losses? Beyond any equity-related arguments, litigation continued in this way would take, literally, centuries and require up to two hundred billion dollars along the way. So, that’s per se unfeasible, which only leaves the other alternative being that JJCI itself is forced to file chapter 11 after litigation expenses overwhelm it. However, would JJCI inevitably having to file due to the weight of this litigation truly be preferable? Beyond the collateral damage that would occur – to employees, suppliers, other creditors, etc. – it wouldn’t make a difference. The intercompany agreements in place already mean that JJCI is on the hook for funding LTL's chapter 11 process and potentially putting in more money to secure a Plan of Reorganization along with the releases! In fact, one could argue if JJCI were to file the amount of value destruction that would occur – due to additional litigation expense pre-filing, reputational harm, and the prolonged nature of what would be an extremely complicated filing – would result in claimants getting less than they could now by following this process and allowing a healthy GoodCo / JJCI to exist while being unburdened by these mass tort claims. So, while many don’t like the optics of the Texas Two-Step, this is the most efficient way to equitably deal with all of these claims in a comprehensive and timely manner. In short, it ensures that everyone gets something while not destroying the value of JJCI in the process.”
As mentioned earlier, one of the stages of a traditional Texas Two-Step has been to reincorporate LiabilityCo in the Western District of North Carolina. When LTL initially filed there a battle immediately erupted over whether the venue should be moved to where GoodCo reincorporated and where OldCo was previously incorporated (New Jersey). The thinking on both sides was that moving the case to New Jersey would raise the odds of the case being dismissed as a bad faith filing or otherwise cause serious issues with how the case would proceed.
However, Judge Kaplan of New Jersey – who’s overseeing the case – has surprised even those that are most bullish on the utilization of the Texas Two-Step. He’s made it clear that far from the bankruptcy system being a merely adequate place to deal with mass tort liabilities, it’s a superior venue to the alternatives.
As Judge Kaplan said in his opinion denying dismissal: “There is nothing to fear in the migration of tort litigation out of the tort system and into the bankruptcy system. Rather, this Court regards the chapter 11 process as a meaningful opportunity for justice, which can produce comprehensive, equitable, and timely recoveries for injured parties. The bankruptcy courts offer a unique opportunity to compel the participation of all parties in interest (insurers, retailers, distributors, claimants, as well as Debtor and its affiliates) in a single forum with an aim of reaching a viable and fair settlement.”
He then proceeded to write: “Bankruptcy has proven an attractive alternative to the tort system for corporations [facing mass tort claims] because it permits a global resolution and discharge of present and future liability, while claimant's interests are protected by the bankruptcy court's power to use future earnings to compensate similarly situated tort claimants equitably.”
We are still a long way away from any form of resolution in LTL’s case. However, what has transpired over the past few months has further cemented the seeming viability of utilizing the Texas Two-Step to handle mass tort liabilities.
Judge Kaplan’s decision undoubtably rings hollow for many and the usage of the Texas Two-Step still strikes many as being fundamentally unfair and a perversion or abuse of the bankruptcy system.
But, in the end, fairness must be bound by practical realities as they are found. Leveraging the bankruptcy system to handle mass tort liabilities may produce bad optics, but there is no better and more feasible mechanism to ensure that a fulsome resolution is reached, all valid claims are treated similarly and equitably, and that the ParentCo/GoodCo can continue to operate when it would otherwise be swallowed up in litigation and then desperately lurch towards filing chapter 11 itself.
Hopefully this post has been somewhat interesting. I’ve tried to take a broader lens as opposed to just getting into the weeds of the arguments back and forth on the ongoing J&J saga or getting into the other older asbestos cases like Georgia-Pacific / Bestwall.
In case you’re wondering, all of this would never come up in a restructuring interview (unless you decided to bring it up!). So, if you’re gearing up for interviews focus on the basics of restructuring investment banking, classic restructuring interview questions, etc.]]>Given that I’ve had virtually no free time over the past few months – which may give away the answer as to whether there’s at least a tangential connection between heightened inflation and restructuring activity – these will just be a few notes for you to consider.
My underlying assumption is that if you were to ask most people in finance whether they’d expect greater restructuring activity and generally distressed situations to arise in an inflationary environment they would say that this is obviously true and that an impact would be seen quite quickly.
Directionally, this strikes me as being correct. But it likewise strikes me that persistently high levels of inflation, matched by rising yields, won’t result in as immediate and large a rebound in restructuring activity as many think. Further, it will require a shift in mindset regarding what options are really on the table for right-sizing debtors and who to keep your eye on when doing distressed screens.
To that end, let’s briefly cover some ways that inflation can cause an uptick in restructuring activity (one related to dealing with maturity walls, one related to general liquidity).
Over the past nearly two years we’ve had unprecedentedly tight credit markets matched by a massive inflow of capital to private credit and direct lending funds. Predictably, as everyone chased whatever modicum of yield they could get, many out-of-court and in-court situations resulted in debtors maintaining high leverage, while also getting the benefit of looser credit docs and lower cash interest payments.
In fact, you have cases like Pennsylvania REIT that emerged from chapter 11 in December of 2020 with a higher level of leverage than they had pre-filing. SVP – that ended up becoming the majority owner of another REIT, Washington Prime Group, through their chapter 11 process in 2021 – held a relatively small secured stake in PREIT and initially objected to their PoR saying it lacked feasibility and would set them up for having to file again shortly (which seems prescient given that PREIT just recently issued a going-concern warning!).
While more nuanced due to the settlement issue involved, Mallinckrodt will also emerge from chapter 11 with slightly more leverage than it went in with based on their current Plan.
Anyway, what we’ve seen over the past few months is the beginning of a reversal in high yield and distressed debt spreads. For example, CCC-rated spreads have widened ~150 basis points since the beginning of the year (remember this is the spread off the treasuries curve, so the actual yield on distressed paper has risen sharply when accounting for the rise in treasuries in conjunction with the widening spread).
But what’s more interesting than what we’ve seen in secondary market pricing is what’s happening in the primary market.
Just $900m of high yield debt priced last week, bringing the total for the first three weeks of April to just $6b. This is the slowest pace of pricing since April 2008. Further, consensus forecasts for high yield pricing this year are continually being slashed and now stand at around ~$250b (whereas $450b priced a year ago with yields on issuance being at a record low of ~4.8%). What is pricing right now - like the unsecured notes tied to the buyout of Oldcastle - is being done at a steep OID with a yield of 11% (proving that even when things are getting priced, they aren’t getting priced well).
This is all compounded by dealer inventories being incredibly low and with dealers actually being net short high yield. The wariness of banks to hold rate-sensitive paper is also reflected in more general measures like HYG, which has seen outflows of more than a third from its peak (it's now back to early 2019 levels).
Anyway, the point is that no one likes to try to catch a falling knife, and right now we’re starting to see the signs that stressed (or distressed) debtors are no longer going to be able to push back maturity walls as easily as they have over the past few years.
What we’ll likely see moving forward is out-of-court and in-court deals that involve substantially more equitization, higher yield on any new money debt, more aggressive tactics by creditors via looking to do non-pro-rata uptiers or asset transfers, and potentially the return of tighter term sheets (although my personal view is that we’re in a new normal when it comes to term sheets – everyone just cares more about initial pricing).
Where you’d expect to see this first play out is with struggling sponsor-backed companies, which is what we’re now seeing with a few different debtors. For example, right now there’s a battle brewing over Envision Healthcare – backed by KKR and being advised by PJT – over how it’ll move forward even though it has a reasonable liquidity position currently. PIMCO is looking to transfer assets to an unrestricted sub to lend against, which existing lenders are (predictably!) not thrilled about the prospect of (sending assets to an unrestricted sub is explained in the Serta case study in the members area, if you're curious).
Likewise, with Service King – backed by Blackstone, being advised by PJT on the debtor-side and with HL and Evercore advising two different groups on the creditor-side – it looks like we’re going to see an out-of-court deal with substantial equitization and a bit of new money placed.
Ultimately, deals still need to get done, credit funds need to deploy cash, and banks need to make markets. However, to use a very Bloomberg-daytime-television cliché, with inflation starting to bite everyone has suddenly adopted a much more defensive posture. No one likes holding a sizeable, not overly liquid, piece of a debt priced at a yield of 5% that’s now at 8% and rising.
As we’ve observed over the past year, inflation doesn’t touch every industry equally and likewise it doesn’t affect the underlying economics of every company in a given industry equally (see: Talen Energy and their large hedging losses).
For example, most distressed investors will have some healthcare providers prominent on their screens right now -- including names like Envision Healthcare, TeamHealth, Smile Direct Club, and Air Methods.
Recently healthcare providers have been squeezed not only by higher wage pressures than many other industries – for understandable reasons, given the strain on front-line medical workers over the past few years – but also by the rapid uptick in pricing for medical equipment. Further, some healthcare providers also face the uncertainty surrounding the No Surprises Act, which is meant to protect consumers from unanticipated out-of-network costs (although how it'll actually be implemented is still somewhat uncertain).
For companies that don’t have the capacity to manage down their working capital requirements and that don’t have the capacity to pass on higher input costs to consumers, positive free cash flow is quickly turning into negative free cash flow and is beginning to put a strain on liquidity. This is only exacerbated in industries that have some amount of regulation that stymies their ability to price in a somewhat more dynamic or fluid way.
This obviously makes the ability to push back maturity walls when needed more difficult and is further compounded by suddenly being in a tighter credit environment as everyone is concerned about taking on new debt that immediately trades down as yields continue to rise. This is why you’re seeing some sponsor-backed companies that still have significant liquidity, like Envision, trying to be a bit more proactive in extending out their runway by working with creditors earlier rather than later.
Should we continue to have persistently high inflation, there likely will be more idiosyncrasy in what companies end up becoming distressed. So, instead of seeing certain industries dominate this upcoming cycle (like oil and gas did in the mid-2010s and retail did in the late-2010s) we’ll end up seeing companies across industries that have similar structural issues (e.g., companies that that have commoditized products that traditionally only compete on price, companies that have had their working capital blown out by a rapid rise in a given commodity or input cost, and, of course, lots of highly levered sponsor-backed companies).
Note: One thing not mentioned above that is an obvious liquidity drain involves the rising cost of floating rate debt as rates rise to combat inflation. Due to most term loans having a floor of 1%, we’re just now starting to see this have an impact. While LIBOR / SOFR will need to go significantly higher to have a meaningful impact on the liquidity of even quite distressed debtors, it’s something to be mindful of.
Through 2020 we not only saw a large pull forward of restructuring activity, but through the latter half of 2020 and throughout 2021 we also saw quite dubious debtors being able to opportunistically refi upcoming maturities to take advantage of the unprecedentedly tight credit markets.
However, it’s important not to overstate how many maturity walls have been pushed back as every year sees a large swath of maturities coming due and the current inflationary environment will undoubtably have an impact on those.
It strikes me that the impact of inflation on restructuring will be much less immediate than many think and we’ll likely see more preemptive out-of-court solutions or pre-packs being explored as debtors recognize well in advance that they need to act in the face of bleeding liquidity and a likely inability to refi maturities coming due given the kinds of terms the market is now demanding.
If you were forced to have to say how inflation is going to affect stressed and distressed debtors moving forward in one sentence, I would say that it’ll simply reduce down a debtor’s debt capacity. This will necessitate debtors needing to slim down much more during a restructuring than they have over the past few years. Practically, this means more of the consideration in a restructuring that creditors get – whether in-court or out-of-court – will need to be equity to lighten the leverage of reorganized debtors. Further, it will probably mean that creditors will be looking for more floating rate debt as opposed to fixed rate whenever possible (so they can be somewhat insulated from potential rate rises), and creditors will be more apt to engage in aggressive inter-creditor battles moving forward.
With all this being said, you can never discount that we could be in for some cooling of inflation expectations sooner rather than later. With recent news of somewhat lackluster economic growth and a Fed that seems at least rhetorically committed to getting back to a neutral rate no matter what, we could see cracks in both economic growth and inflation sooner than expected. Of course, this is showing up – depending on your interpretation – in how flat 2s10s is right now. If we do see cracks in inflation, even if it comes along with modest cracks in economic growth, there would be significant opportunities in the secondary market. With some debt on the secondary market trading at substantial discounts due to the aggressive run up in yields recently, we would be in for a substantial price rebound if near term rate expectations were to suddenly reverse.
However, what many with cash to deploy on the sidelines are still worried about is the potential for air pockets to develop in the high yield and distressed secondary market that could cause a sudden gaping down in pricing due to the lack of liquidity in markets at present. Just how quickly liquidity has been drained has taken many by surprise.
Anyway, these are just a few late-night thoughts – hopefully somewhat coherently strung together – that may be worth mulling over. If you enjoy thinking and reading about more general economic issues, I’ve been thinking quite a bit about a Fed working paper by Jeremy Rudd titled, “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)” that was published last year. Pair this with the 2001 Fed paper titled, “Does Stock Market Wealth Matter for Consumption?” by Dynan and Maki that tries to tease out the impact on household consumption from the rapid rise in equity prices seen in the late 90s.
]]>So, while I always try to put out a post toward the end of every month, I haven't had the time to put together an absurdly long post on something more technical like rights offerings, structural subordination, or China offshore bonds this month.
But given that we're in the midst of the summer analyst recruiting season, I figured I'd just share some general tips and tricks on navigating the superday process. Nothing groundbreaking -- just some things to keep in mind.
Below are a few things to keep in mind during your interviews to help make sure you standout from the rest.
There's no getting around the fact that something is just lost when using Zoom, et al. to conduct interviews.
What's being lost, in my view, is the inability to really speak over each other. Because during normal conversations - whether by phone or in-person - you play off the other person by occasionally chiming in with a little interjection here and there, which creates a natural flow to the conversation.
But this back-and-forth isn't really possible when using Zoom due to its audio switching. So, the end result is that everyone speaks in a more uninterrupted fashion than they normally would, which just feels awkward and scripted.
Anyway, it's hard to alleviate the awkwardness that can crop up in virtual interviews. But I've always found most of the awkwardness with Zoom, et al. tends to come from people not knowing when the other person is fully done speaking (creating a kind of awkward relay handoff scenario where you're bumping into each other).
So a little tip is trying to end your answers to questions with a pretty clear statement that implies you're done speaking. For example, if you're answering an accounting technical, your final step will obviously be working through the balance sheet. So, at the end of your answer, you can say something like, "So, we're in balance and I think that's it." This provides a pretty clear signal to your interviewer that you're done speaking.
Note: I don't want to get into a whole body language thing here -- but make sure your face isn't entirely deadpan while your interviewer is speaking as well. It's always easy to forget to show some expression when things are virtual.
Almost every interviewer will leave a little bit of time at the end of the interview for any questions you have for them. This is one of the best opportunities you'll have to really differentiate yourself from other interviewees.
Under no circumstances should you ask questions about when you'll hear back about offers, how many candidates they'll be taking, etc. Instead, you should ask thoughtful questions that implicitly show off your knowledge of restructuring.
Awhile ago I wrote a post going over some "rules" for crafting good networking questions to ask, which would likely be helpful to read. There's also the Networking Questions Guide in the members area, which has some good questions for the end of interviews as well.
Some questions that would be good to ask would be along the lines of:
One thing to always keep in mind: you've undoubtably thought a lot more about the firm than the firm has thought about you.
Most of those interviewing you will have given your resume a very cursory glance -- scanning for what school you went to, things you may have in common, etc.
So, you should always try to wedge in who you've talked to at the firm wherever you can. If you're asked why you're interested in the firm, give your answer while namedropping those you've talked to. If you're asked why restructuring, give your answer and say that talking to x, y, and z at the firm only solidified your interest.
Of course, you shouldn't embellish the depth of the conversations had. You don't want your interviewer going and asking an analyst about you, and then having that analyst say they don't remember you that well because they've done thirty networking calls over the past few months. Namedropping who you've talked to at the firm is really just about trying to build some level of social proof and more generally show your interest in the firm.
Note: Don't worry about not having talked to every analyst or associate at the firm. Just namedrop a few people you've spoken to, if the opportunity arises. Also, most firms will keep a list of who candidates networked with and how those conversations roughly went. However, don't take it for granted that your interviewer will have reviewed this closely pre-interview.
This is hopefully obvious, but make sure you have some pen and paper in front of you. The expectation will be that you'll use it to work through accounting questions and some more involved restructuring technicals.
Occasionally I get questions from folks about using a calculator. When all superdays were done in person, you definitely wouldn't bring in a calculator. If you were doing some YTM question, you'd just leave it as a fraction instead of finding the exact percentage.
However, given that you'll be doing interviews remotely, it doesn't hurt to have a calculator nearby. If you end up with a thorny fraction when doing a YTM calculation, you can just give the fraction and say you have a calculator nearby if they'd like the exact answer (they'll say not to worry about using the calculator, but having it nearby will show you're prepared, etc.).
Finally, always try to work in more restructuring-specific terminology whenever you can in your answers. In some interviews you may not be asked questions that are really amenable to working in excess terminology, which is perfectly fine. Just make a best effort when you can and, most importantly, when you feel comfortable and confident doing so.
For example, if you're asked to run through some types of out-of-court restructuring solutions, you can begin your answer by saying, "Well, depending on what the cap structure looks like, I suppose you could first just look at whether you can do a quick amend and extend in order to push out the maturity walls to give the debtor some breathing room...".
Likewise, if you're walking through a Chapter 11 deal, you can reference what classes were impaired, how they were treated, what the post-reorg cap structure roughly looks like, who got the post-reorg equity, etc.
Note: Keep in mind that the vast majority of interviewees work in very minimal terminology, so definitely don't try to cram things into your answers for the sake of it. While you want to standout from the rest, you also don't want to look like you're trying a bit too hard (especially if your use of terminology comes across slightly stilted).
I suppose one final thing I should add - that seems obvious, but is probably worth mentioning - is that while superdays can be stressful, it's absolutely essential to try to keep a positive attitude, laugh if your interviewer tells any little jokes, and always thank them for their time at the very end of interviews.
Ultimately, when bankers talk about "fit" all they really mean is that they want you to be someone they wouldn't mind working with on a stressful deal late at night. While an interview - especially a virtual one - makes it difficult to accurately gauge this, it's all your interviewer has to go off of.
So, with all that being said, try not to get too stressed out before the interview, don't start catastrophizing during the interview if you get one or two technicals wrong, and just try your best while keeping a positive attitude.
If you're currently going through the interview process, I wish you the best of luck. Also, if you end up getting an offer and found the guides helpful, be sure to send me an e-mail to let me know! It always makes my day to hear how my writing has helped people break in.
]]>Now let’s imagine this company is in the oil and gas space and it’s 2016-18. After years of intensive investments funded through debt issuance, the company has ended up in a place of distress given the suppressed price of oil. Ironically, the suppressed price of oil is largely caused by all of this company’s competitors - who all are remarkably similar - desperately trying to stay afloat (along with OPEC keeping production high so as to squeeze out all these overlevered American upstarts).
As a smart analyst, you look at this situation and say to yourself, “This company would be phenomenal if only the price of oil were higher, or if this company could delever significantly.” You say this to yourself with complete confidence even though when you were previously looking at a distressed natural gas company someone kept on mentioning strip pricing and you thought they were referring to steaks.
Anyway, let’s say the unsecured notes are trading at sixty cents on the dollar and through your brilliant analysis - or your general predisposition toward conformity - you think they’re perfectly pricing in the recovery value if the debtor were to file Chapter 11.
Given this scenario, would it ever make sense to recommend a building up a position in the unsecured notes?
The answer is potentially yes. Not only because as an impaired class in this simplistic scenario some post-reorg equity will make up at least part of your recovery – and you said you’d love to own the equity, because you think the company would do great if it could be delvered – but also because you can potentially buy even more of the post-reorg equity via a rights offering, at a steep discount, while making sure the company doesn’t emerge nearly as levered as it was beforehand.
One thing I haven’t written much about – because it’s entirely outside the bounds of what you would ever be asked in an interview – is the way in which pre-petition creditors can participate in giving the debtor new money while in Chapter 11 in exchange for some pretty enticing securities.
However, when you’re in a distressed-oriented seat – and looking at buying debt in a company you think is likely going to have to file – you won’t always be buying with the intention of then sitting on your hands and waiting to see what your recovery will be.
If you’re in the secured part of the capital structure, you may be looking to participate in the DIP facility. If you’re further down the capital structure, you may be looking to participate in a rights offering or even, depending on your fund’s appetite and ability, backstop the rights offering.
Both of these ways of committing more capital to the debtor allow a fund to potentially enhance their overall returns (although both will lead you to being even more closely wedded to the debtor – especially when it comes to participating in a rights offering).
Note: Just to be clear, rights offerings don’t happen in every Chapter 11. Generally, rights offerings will occur in the larger and thornier cases, and you’ll frequently see distressed funds in the mix like SVP, Contrarian, etc. (although sometimes you have other odd players suddenly step in – like in the case of Chesapeake where you initially had Franklin Resources come in to backstop the rights offering).
Note: As we’ll get into, not every class of debt will be able to participate in a rights offering. Normally it’ll be some lower parts of the capital structure (e.g., second-lien, senior unsecured, or sometimes common equity holders) that will be allowed to participate. However, depending on the capital structure, and who the holders are, you can see first-lien holders being allowed to participate as well.
Note: By far the most notable rights offering of the past few years was Hertz at over $1.6b with nearly $800m reserved for the backstop. Yet another reason why Hertz was such a bizarre case is that this massive rights offering was for prepetition common equity (although nearly all non-institutional equity holders couldn't participate due to security regulations surrounding needing to be accredited, so these non-accredited holders took the alternative warrant package for their recovery value). The divergent treatment of equity by Hertz is an entire saga in and of itself.
Note: The preamble above is somewhat tongue-in-cheek, because from 2016-18 many distressed funds got burnt on oil and gas rights offerings (which is largely a reflection of O&G making up the majority of the restructurings taking place during that time).
You can use the links below to go to specific sections of this page. As usual, I’ve written far too much on this (so hopefully you find this helpful!). Keep in mind that none of this will come up in restructuring interviews except maybe if you’re lateraling in.
Rights Offerings from the Debtor's Perspective
Rights Offerings from the Creditor's Perspective
Rights Offering Example Analysis
Simply put, a rights offering allows a company to raise new money from existing creditors – or occasionally pre-petition equity holders - through the issuance of post-reorganization equity or debt that is normally issued at a steep discount.
While you can certainly have either debt or equity issued as part of a rights offering, the most common form of rights offering in the Chapter 11 context involves post-reorganization equity, so we’ll focus in on that. However, for reference a debt rights offering will have similar characteristics to an equity rights offering (e.g., it’ll be offered to a limited number of classes, have a backstop party that gets some kind of backstop fee, and will involve some kind of discount that’s baked into the debt offering to incentivize participation).
Alright, it's probably easiest to just set the stage with a simplified and stylized rights offering example. Let’s say that a company is currently in Chapter 11 and their restructuring plan has come up with an equity plan value of $500m (what the equity value is based off the total valuation determined).
The company goes to one or two junior and impaired tranche of debt and basically says, “Sorry about this whole, uh, going bankrupt thing. Deeply unfortunate, isn’t it? Anyway, the reality is we took on too much debt before, but in our proposed restructuring plan, as you know, we envision coming out with a very modest amount of debt. We’re going to be the envy of all our competitors with how little debt we have! But we do need to raise cash somehow to make this debt-lite plan work, so we’re prepared to make you a deal. We’ll let you purchase a big chunk of our post-reorg equity. While our equity pre-filing wasn’t great to own since we, uh, went bankrupt, that was really a reflection of how debt-laden we were. But now, through our brilliant maneuvering of the restructuring process, we’re confident our post-reorg equity will more truly reflect how great our business is. Since we figure you may be skeptical, we’re prepared to let you purchase $100m of our post-reorg equity at a 30% discount to the plan equity value! As a junior creditor we’re giving you the ability to participate in this – meaning you can take your pro-rata share of post-reorg equity – but if you don’t want it, no worries. We have a bunch of very savvy distressed debt hedge funds like Anchorage, Monarch, and Diameter backstopping this – meaning they’ll fund not only what we’ve allocated to them, but everything that you and your fellow creditors don’t want.”
So, basically what’s happening here is that the post-reorg equity value is $500m, and we’re allowing these junior tranches of debt to purchase $100m of it at a 30% discount. So, it’s effectively like these junior creditors are buying equity as if the plan equity plan value were $350m, not $500m. Further, for the $100m put in by these junior holders they’ll end up controlling 28.6% of the total post-reorg equity.
Therefore, if the plan equity value itself is low – or even if it’s just accurate – suddenly these junior classes have the potential to make a sizeable return if they participate in this rights offering (which they have the right to, but not the obligation). Of course, from the debtor’s perspective this is all great – they raise cash based on issuing post-reorg equity not debt. And it’s not like the debtor’s current management cares much about issuing post-reorg equity – they’ll be given a non-dilutive chunk of the post-reorg equity as part of a management incentive plan (MIP) anyway. The debtor’s management almost invariably just wants the least debt in the post-reorg capital structure as possible.
Note: We’ll get a bit more into the debtor and creditor incentivizes at play for a rights offering later on.
Anyway, as discussed above, in order to ensure the debtor can do a relatively large equity rights offering and maximize participation – and thus bring in significant new money to the debtor without adding any additional leverage – post-reorg equity is usually offered at a steep discount to the equity plan value that’s been agreed upon within Chapter 11.
Generally, the discount offered is somewhere between 20-40%. However, you can have some rights offerings that offer no discount, and some that offer even higher discounts.
For example, one of the more notable rights offerings – because it was large and resulted in the only litigation around rights offerings that reached the circuit-court level – involved Peabody Energy. Peabody was looking to raise $750m through an equity rights offering at a 45% discount to plan value, and an additional $750m raised through a private placement of preferred stock at a 35% discount to plan value.
Notably, one of the characteristics of a rights offering in the Chapter 11 context is that participation in it is usually confined to one or two classes of debt. So, for example, in the case of Peabody it was just the senior unsecured and second-lien noteholders who could participate in the rights offering.
Note: Each holder within a class that is allowed to participate in a rights offering has the opportunity, but not the obligation, to purchase a pro-rata share of the new security being offered (e.g., post-reorg equity).
Note: I don’t want to muddy the waters here too much, but the reason why Peabody’s rights offering was litigated and reached the circuit-level is because a small minority of unsecureds didn’t have the same ability to participate as others in the same class (because of the structure of the rights offering, which essentially gave preferential treatment to the unsecureds who participated in the private placement and backstopped both the private placement and rights offering). Basically, the Court ruled that you can treat certain creditors within the same class more favorably if those creditors shouldered significant risks outside the context of their claim (e.g., by providing new commitments to the debtor).
Note: Generally, participation in the rights offering happens concurrently with soliciting votes on the overall restructuring plan (as obviously the new cash raised through a rights offering is integral to making the overall plan feasible).
While there’s a lot of nuance I’ll glaze over here, from the debtor’s perspective there are two main benefits to doing a rights offering.
First, obviously one of the primary goals of a Chapter 11 is right sizing the balance sheet, which invariably means reducing down the debt load of the company. So, doing an equity rights offering has the obvious benefit of bringing cash in the door – to fund restructuring plan distributions and costs associated with emergence from bankruptcy – while ensuring that the post-reorganized debtor isn’t too bogged down in newly issued debt.
However, one issue that gums up the works of many Chapter 11 processes are valuation fights. If you think back to basic waterfall interview questions, in those questions we’re assigning a value to the company and that then informs the recovery of each class of debt.
If you’re the debtor, you obviously want a low valuation as this ensures you emerge with a very lightweight capital structure. Likewise, if you’re a senior creditor in the capital structure, you want there to be a low valuation (one that gets you full a recovery, but that gives very little to all the creditors who are junior to you). However, if you’re more junior in the capital structure and are not getting a full recovery with a proposed plan, you may want to put up a fight and argue that the company is worth more so, as a consequence, your recovery should be worth more.
So, the second benefit of doing a rights offering, from the debtor’s perspective, is that it can help build consensus among the more contentious junior groups in the capital structure. Basically, the debtor can go to the junior creditors who are not getting full recovery and say, “Hey, we know you think the valuation of the company being used in the plan is too low. But what if we did a rights offering, and that way you can participate in all the upside post-reorganization? If the valuation is really too low, like you think it is, then the equity should benefit substantially upon emergence from Chapter 11! And, just to make this even more enticing for you, we’ll even give you a hefty discount to the current plan valuation. So instead of feeling jilted by the low valuation, you get to take advantage of an even lower valuation than the valuation that you already think is too low!”
Note: In the restructuring guides (the “bonus questions” report) I talk a lot about how to think about the equity of a distressed company in terms of asymmetric value. This is a somewhat similar kind of framework for thinking about post-reorg equity.
Thinking through rights offerings from the creditor’s perspective can be taken in innumerable directions, and this post is already much longer than I wanted it to be, so I’m going to just quickly touch on the basics.
From the perspective of the creditors who are participating in the rights offerings, they get the benefit of buying the post-reorg equity of a company that has a slimmed down capital structure at a deep discount.
Further, if a creditor participates in the backstop – which basically means they’ll buy up whatever post-reorg equity other creditors decide not to – they also get a backstop commitment fee (usually around 8-10% of the total rights amount). This fee usually is paid in the form of post-reorg equity as well.
From the perspectives of the creditors who are not participating in the rights offering – so, for example, those in other classes who are not allowed to participate – they also benefit from the fact that the company is bringing in cash while not needing to take on new debt. In other words, they benefit from the capital structure being kept slim too.
While I’ve tried to gradually build up concepts without complicating things too much, it’s probably easier to just run through a more detailed example.
So, let’s imagine we have a company that’s currently in the Chapter 11 process. The restructuring plan devised calls for the post-reorganized equity to be divvied up, pre-dilution, as follows: 80% to prepetition unsecured noteholders, 15% to prepetition preferred equity holders, and 5% to prepetition common equity holders.
Note: It’s quite rare for prepetition preferred and common equity holders to get any post-reorg equity, but I’m just trying to flesh out our example a bit here. Also, given the strangeness of the 2020-21 restructuring landscape, we actually saw quite a few deals where prepetition equity did get some post-reorg equity.
Now let’s say that restructuring plan has come up with an equity value of $800m. As part of the plan, a rights offering will take place in which $300m will be raised at a 32.5% discount to plan value.
According to this plan, we’ll say that unsecured holders can participate in up to 50% of the rights amount and prepetition common equity holders can participate in up to 5%. Finally, the backstop party – which will be made up of existing creditors – will be allocated 45% of the rights amount.
Note: Keep in mind that virtually every rights offering has a backstop party, and the purpose of the backstop party in this example is to buy up both their allocation and whatever the prepetition unsecured and common equity holders don’t.
The final piece of the puzzle we need here is the backstop premium, which is the commitment fee paid to the backstop party for being willing to backstop the entire rights offering. We’ll say this is 9% of the total rights amount and that it will be paid in post-reorg equity. Further, we’ll say that this backstop premium does not dilute the newly issued post-reorg equity.
Note: While the backstop premium can vary, recently it’s been common to see between 8-10%.
Alright, so now let’s take a look at the equity splits. These equity splits show what groups own what percent of the post-reorg company when it’s all said and done.
What we’re showing in the “Pre-Dilution” column is what the pre-dilution post-reorg equity split looks like based off of the aforementioned restructuring plan. Then in the “Rights Offering” column we’re showing how those pre-dilution values get watered down as a result of the $300m rights offering. Finally, in the “Backstop Premium” column we’re showing how the backstop premium impacts the equity splits (keep in mind we said the backstop premium doesn’t dilute the new equity issued).
Note: There are other ways in which a plan can introduce even more dilution. For example, via having a management incentive plan or warrants that ultimately get exercised. Further, you can have some nuance over who of the pre-dilution post-reorg holders get diluted and by how much.
Note: We’re assuming here that everyone takes their pro-rata share of the rights offering.
So, basically what’s going on here is that we’re telling the unsecured and common equity holders that they can buy $300m worth of post-reorg equity at a 32.5% discount to the $800m plan value. Therefore, they’re effectively buying at a $540m valuation. In the end, when we include the backstop premium, this leads to 60.6% of the post-reorg equity going to those who participated in the rights offering.
All of this may seem like a lot of dilution! But while this example is on the higher side, you can definitely have situations where dilution is at or above these levels when you have a rights offerings and a management incentive plan (MIP).
For example, in a recent deal Carlson Travel had their senior secured notes getting 100% of the post-reorg equity in their restructuring plan. But after accounting for the rights offering, MIP, and a few other things that gets down to just over 11% of post-reorg equity. However, those senior secured notes can participate in the rights offering if they want thus getting themselves back to a higher percent of the total post-reorg equity (just like in our example above).
Another thing you may be thinking is that it seems quite lucrative to be a backstop party. Not only does that involve you getting a steep discount on buying post-reorg equity, but you also get a pretty large fee for providing the backstop.
This is a source of occasional controversy and consternation in-court, because if you assume that the post-reorg company does well the returns can be incredibly impressive. However, providing the discount and large backstop fee is a result of the i) temporary illiquidity of the post-reorg equity and ii) uncertainty of if the company will really perform well after getting out of Chapter 11.
To bring this all home, many distressed investors – including potentially our hypothetical analyst in the preamble – have been burned by participating in the rights offerings of oil and gas companies. It’s true that - especially when you provide the backstop - on paper things initially look great. However, when oil continues to go lower, the debtor goes out raising more debt for more exploration, etc. equity value can quickly collapse below where it was when you bought in.
More recently, we’ve seen many retailers who went through Chapter 11 in 2020 provide large discounts and high backstop fees in their rights offerings. At time zero, things looked great for the funds who participated. However, today many are underwater.
But, of course, not everyone participating in rights offerings gets burned (that’s why they’re popular!). The rights offering done last year by Chesapeake Energy – with a heavy discount to plan value and a 10% backstop premium – has provided some absolutely eye watering returns (the judge should’ve allowed for a new rights offering based on a higher equity plan value, but that’s what you get when dealing with courts in Texas not Delaware).
Well, there you have it. Because every rights offering needs to be viewed in the context of the debtor and their overall restructuring plan, every rights offering is somewhat of a unique situation to analyze. In fact, there are a lot of caveats I should have included in this post, but I’ve really tried to simplify things down for you while also not glazing over too much of the nuance.
Ultimately, rights offerings are an incredibly valuable tool in the toolbox of debtors. Not only because they allow the debtor to raise cash without taking on additional debt, but also because they can be used by the debtor to not so subtly coerce creditors into coming to an agreement (or, perhaps better said, coerce enough creditors such that a plan can get approved).
Just to reiterate – as I know many reading this post will be gearing up for restructuring interviews – none of this is something that would ever come up in an interview context. So definitely focus your time on classic restructuring interview questions and knowing what restructuring investment banking generally is. However, as you look up various deals that have happened over the past few years, you’ll probably notice that many will talk about a rights offering taking place – so now you have an idea of what that means and how they roughly work!
]]>One important thing to keep in mind is the distinction between when mandates are announced - and reported on in the press, etc. - and when deals actually get done.
For example, LATAM Airlines was the second biggest Chapter 11 filing in 2020. It was a classic pandemic-related case; an over-levered airline that was already in a relatively precarious situation beforehand. However, given LATAM's organizational complexity, sprawling capital structure, lack of concentration among key creditors, etc. it dragged on and the Plan of Reorganization (PoR) didn't end up getting announced until November 26th of 2021 (which is actually relatively speedy for such a complex free fall Chapter 11).
So, even when new mandates are harder to come by, it doesn't mean that there's not still plenty to do on some pre-existing mandates. Rest assured that there were some poor analysts and associates at PJT - the debtor-side advisor on LATAM - who were kept frustratingly pre-occupied throughout 2021 on LATAM.
Note: For interview purposes, it's entirely acceptable to talk about a deal so long as the consummation of the deal (closing of the out-of-court transaction or exit from Chapter 11) occurred in the past six to twelve months or so. So, you could certainly talk about LATAM in interviews at PJT (because they were debtor-side) or at Evercore (because they advised a critical ad hoc block of creditors). However, I always recommend trying to steer clear of complex free falls that drag on for over a year given the amount of twists and turns that occur during the process.
With all that being said, in this post I'm going to briefly go over a few deals that you could dig into a little more and talk about during restructuring interviews. What I've tried to do is pick some deals that are notable, timely, not overly complex, and that had banks on the debtor- and creditor-side (so you can use one deal through multiple interview processes and save yourself some time).
Below are some notable restructuring deals for some of the larger restructuring shops that have occurred recently. Of course, each bank mentioned has advised on many more deals in 2020 and 2021 than what I'll briefly go through below -- these are just some deals that are notable, interesting, and would be good to learn more about for interview purposes.
Houlihan Lokey Restructuring Deals
As you'd expect, PJT picked up a number of the largest and thorniest debtor-side mandates during 2020. The two most prominent would be LATAM Airlines, which filed their PoR in November of 2021, and Intelsat which had their PoR confirmed in December of 2021.
While LATAM is a bit too thorny to talk about in an interview, Intelsat is a bit more straightforward (plus it's a very notable deal).
It's certainly important to know that PJT had some of the largest mandates of 2020, but it'll be a bit easier to talk about some of their creditor-side mandates from 2021.
For example, PJT advised an ad hoc group of creditors on the Washington Prime Group deal (they filed in June of 2021 and confirmed their PoR in October of 2021). As you'll see throughout this post, WPG isn't a bad deal to talk about in interviews because quite a few other banks were in the mix as well.
PJT also advised a crossover lender group in Belk, who did a pre-pack Chapter 11 in early 2021 and notably got in and out of Chapter 11 in a day. Belk is a great deal to talk about because it's a pre-pack, so you just need to read the Restructuring Support Agreement to see what's going on. This allows you to avoid having to worry about what battles occurred through the Chapter 11 process. Instead you can just walk through what everyone agreed to pre-filing (what classes of debt existed, who was impaired, what their recovery values are, etc).
Further, Belk demonstrates one of the core themes of restructuring over the past few years: pre-packs occurring more frequently and the amount of time pre-packs are taking to finalize in-court lessening. Like with WPG, Belk also has the benefit of having quite a few other banks involved as well.
As is almost invariably the case, when notable restructuring deals occur you'll tend to find the same mix of banks advising different groups.
So, in LATAM Airlines, Evercore was creditor-side and advised the Parent Ad Hoc Group - led by Sixth Street, Strategic Value Partners Global, and Sculptor Capital - which would have been a very time intensive mandate (much more than most creditor-side mandates).
Note: Just as a note, apropos of nothing, whenever you see Apollo in the mix as a creditor you'll often see them hiring PJT (if they hire bankers at all). Likewise, when you see SVP Global in the mix as a creditor you'll often see them hiring Evercore.
In 2021, Evercore was also creditor-side (along with PJT) in the Washington Prime Group case. Evercore solely advised SVP Global (who did incredibly well off of the WPG deal and put up great returns in 2021). Likewise, in Belk Evercore advised an ad hoc 1L group.
Just as a point of reference, Evercore also advised on two of the largest and most complicated Chapter 11s of 2020: Diamond Offshore Drilling and Frontier Communications. Neither of which I'd probably advise talking about in an interview, but it's worth being aware of their involvement (I wouldn't recommend talking about these in interviews because Diamond is quite complex from an organizational and capital structure perspective, and Frontier has an absurd amount of regulatory nuance to it).
Houlihan has been debtor-side on some of the most notable deals of 2021 in terms of overall press coverage.
They advised Seadrill - one of the largest Chapter 11s of 2021 in terms of size - which filed in February and had its PoR confirmed in October.
Further, Houlihan got engaged by Evergrande, which is probably the restructuring transaction that has received the most media attention in 2021 (Moelis is advising a creditor group). In a prior post I covered the dynamics surrounding restructuring offshore bonds, which is at the heart of Evergrande's restructuring (and the restructurings of all the other troubled China property developers).
As per usual, HL has also had a large number of creditor-side engagement. But keep in mind that not all creditor-side engagements are the same. For example, HL had a creditor-side mandate on LATAM, but this just involved advising Knighthead on a DIP proposal (which ultimately resulted in an in-court tussle and created a bit of a mess).
More recently, in November of 2021, Houlihan was debtor-side on CWT's pre-pack Chapter 11 (Evercore and Rothschild advised different groups of creditors on it).
Lazard was the debtor-side advisor on Belk's pre-pack. So, if you wanted to talk about Belk you could do so for Lazard, PJT, and Evercore. This is also a deal folks at Lazard would love talking about given that Belk was able to get in and out of court in a day (with a lot of wrangling beforehand to get an agreement with creditors put in place, of course).
Lazard also worked on a classic out-of-court solution for Peabody around a year ago (Lazard has worked closely with Peabody for years on their various restructurings).
Like every restructuring shop, Lazard also got some notable mandates in 2020 that dragged on into 2021. For example, they advised Valaris which was one of the largest Chapter 11 filings of 2020 (HL advised a creditor group). They also were creditor-side on Garrett Motion (advising the Unsecured Creditors Committee).
It's certainly true that 2021 was a quieter year in the world of restructuring. However, that's largely a reflection of how many deals were pulled forward into 2020 when the pandemic began, and how many deals were pushed back due to the incredibly hot credit markets that existed in late-2020 and throughout 2021 (the hot credit markets allowed many relatively unhealthy companies to extend out maturities and kick the can down the road for at least another year).
What we've gone over in this post are just a smattering of interesting deals at a few restructuring shops. Of course, I've left out a large number of deals and many shops in the process. For example, TRS Advisors (recently acquired by Piper Sandler) advising GTT on their pre-pack, Guggenheim advising on the debtor-side of WPG and advising creditors on Intelsat, Moelis advising CBL & Associates (which was a 2020 filing that just exited Chapter 11 in early-November), etc.
Remember that being asked to walk through a deal is just one of the questions you'll face in a restructuring interview. It's definitely an important question to have a good answer for, but don't get too in the weeds reading up on deals to the detriment of practicing classic restructuring interview questions. Also, if you haven't yet read the very long restructuring investment banking post - where I briefly go through the restructuring of Neiman Marcus and talk about various forms of restructuring solutions - it will likely help you when reading up on deals.
This year - if I can find the time - I'll try to put out more in-depth case studies on a few recent deals that have interesting features (like I did for the case of Serta and the rise of non-pro-rata uptiers, which is contained in the members area).
]]>Chances are you've already heard of the mounting distress among notable Chinese property developers. While Evergrande has been the primary focus of the media because of its incredibly large outstanding liabilities, they are just one example of a distressed property developer among many (some others are further along in their attempted restructuring processes, such as China Fortune Land Development).
Note: To give you a sense of scale, in just 2022 there will be over $92b in offshore dollar-denominated bonds coming due that have been issued by mainland China property developers.
Given the dearth of distressed assets out there, many notable distressed funds such as Redwood and Silver Point have recently got in on the action by buying up non-trivial amounts of distressed offshore bonds. This buying activity ramped up beginning in early 2021 as the three red lines policy began to have negative ramifications across the mainland China property development sector.
In years past, the idealized trade of any distressed fund would be to go buy up the notes or loans of a debtor that the fund had some underlying conviction of the market being too pessimistic on. A distressed analyst would have to pour over the credit docs, try to model out recoveries, and think strategically about how you could achieve a higher level of return than what the market was pricing into these securities (potentially by trying to push the debtor toward their favored restructuring solution pre- or post-filing Chapter 11).
While this is admittedly somewhat of an idyllic portrait of how distressed investments are made, one thing that most in the industry would not have believed even a few years ago is that funds would be jumping headlong into offshore bonds because there was so little else to do.
This is because offshore bonds exist in a murky ecosystem. In a case like Serta's non-pro rata uptier - which I wrote a little case study on - a strict reading of the credit docs allowed for a quasi-novel restructuring transaction to occur. Apollo, et al. sued over this, and the Court ultimately rejected their arguments based on a strict interpretation of the credit docs. In other words, the credit docs of Serta meant something and had the force of law behind them.
The offshore bonds that distressed debt funds are currently buying most certainly have extensive credit docs. Many even have verbiage surrounding how a holder will have some level of recourse in a restructuring or default scenario.
However, these bonds reside in an entirely foreign legal construct. One in which precedence is hard to come by, and where past precedence is in no way indicative of future actions.
In keeping with these theme of all my posts, I'm going to try to break down what these offshore bonds are, why anyone would buy them to begin with, and briefly touch on the restructuring and default process (insofar as you can really say much definitively here).
What are China offshore bonds?
How much onshore vs. offshore debt do mainland China property developers have?
Why would anyone buy offshore bonds to begin with?
How can offshore bonds be restructured?
Offshore bond restructuring example
How could a distressed Chinese property developer try to raise cash now?
Offshore restructurings and defaults to follow
Simply put, China offshore bonds are dollar-denominated bonds that are issued by a HoldCo that is usually established in the Cayman Islands or the British Virgin Islands. These HoldCos own nothing beyond shares (common equity) in operating companies that will be domiciled in mainland China. It's these OpCos that actually hold the assets of the company and engage in business activity.
Therefore, the holders of the HoldCo bonds are structurally subordinate to any debt issued at the OpCo level. And, as you'd expect, OpCos do issue debt themselves. The debt they issue comes in the form of onshore bonds, secured loans, and all the others forms of unsecured claims any business will rack up as a consequence of their normal business operations (all of this onshore debt is obviously RMB-denominated, not dollar-denominated).
Note: If you're a bit iffy on the HoldCo / OpCo distinction, reading this post on structural subordination should help clear things up.
To give you an idea of where onshore vs. offshore debt resides, I've drawn up a little diagram:
Note: The cash needed to repay the coupons due to HoldCo holders comes via dividends that OpCos issue that then flow through to the HoldCo. Alternatively, sometimes the relationship between the HoldCo and OpCo - by which the HoldCo passes on the proceeds from bond issuance and the OpCo passes back up proceeds for the coupon payments - comes via an intracompany loan as opposed to an equity investment by HoldCo into OpCo.
Remember that all else being equal, as a creditor you want to reside closer to where the assets are. But with offshore debt you're about as separate from the actual assets of the OpCo as you can get because you're at a HoldCo domiciled in a different country with an inability to have true upstream guarantees as they're conventionally understood and practically applied.
If you've read through the Restructuring Guides, you may be wondering to yourself what exactly precludes the offshore bonds from being primed (having lots of onshore debt being issued, which will have a higher priority than the HoldCo debt).
It's a good question! To which there's a bit of a hand-wavy answer of, "The credit docs say there will be some form of limitation on the amount of onshore debt that will be raised".
While I'm trying to be relatively concise and high level in this post, if you're dealing with a restructuring in the United States you'll think a lot about "basket capacity". All this means basically is how much more money can be placed at a certain level of priority per the existing credit docs.
This is a bright-line rule. If there's only the ability for the debtor to raise $100m more of secured debt, then a series of amendments to existing credit docs (that creditors will likely not be keen to consent to) would be needed to raise more secured funding.
The point I'm trying to illustrate with offshore bonds is that while they have somewhat analogous verbiage to traditional credit docs, their practical ability to be enforceable is rather dubious. Both because it can be hard to know exactly how much debt OpCos actually have to begin with (e.g., private construction loans or small unsecured debt issuances) and because there's no obvious time-tested venue at which offshore holders can try to stop OpCos from raising onshore funding.
While there are potential legal ways to prevent being primed or otherwise having no influence in a restructuring - in particular if the company has assets in the United States, the U.K., Canada, etc. - the main way is through a kind of quasi-political influence. Basically by trying to convince the debtor that if they treat offshore holders unfairly, then the offshore funding market will be entirely cut off to the debtor forever.
This may seem like a poor hand to play in a restructuring negotiation, but it's not terrible because of how reliant most prominent Chinese property developers are on the offshore bond market as we will get into below.
What may surprise you is that the capital structure of most prominent mainland China property developers will be comprised of mostly offshore bonds. Usually offshore bonds will make up between 50-80% of the total capital structure.
For example, below is Greenland Holdings, which had been actively trying to raise debt to avoid a serious restructuring:
The cap table above is analogous to the cap table of every major Chinese property developer, and there a few things you should note.
First, all the secured debt that the debtor has issued is onshore debt. Second, while there are both onshore and offshore bonds, the onshore bonds have a substantially lower coupon.
The second point should be entirely logical and expected. As was discussed in the structural subordination post, all else being equal you want to reside closest to where the assets are (even if classic upstream guarantees are in place, which are not in play here). Whenever you reside further from where the assets reside you should be demanding a higher coupon to compensate for that risk.
An obvious question you may be asking yourself after reading all of this is why would anyone even touch these offshore bonds? They operate in a weird legal limbo, have minimal practical protections relative to traditional HoldCo bonds, etc.
The answer is yield. Credit markets - with the brief aberration brought on by pandemic - have been incredibly tight in the United States and Europe for the past decade.
For years mainland China property developers looked relatively sound, and so even though buyers of offshore bonds understood the downside risk was severe they were enticed by the eye-watering coupons that were 500+ basis points over what you could get in the United States.
Further, there's a form of self fulfilling logic at play here. Even though these offshore bonds operate in a weird legal limbo, offshore bonds are not an afterthought for prominent mainland China property developers. Rather, the offshore bonds are an absolutely essential form of funding.
So, the logic is that offshore bond holders can't just be left with nothing in a restructuring, as that would close off the offshore funding market for years, which would impair the ability for even healthy mainland China companies to raise offshore debt. Thus, creating a credit crunch cycle that, if nothing else, the Chinese government would not like to see occur.
So, in other words, the mindset of many offshore bond holders has historically been that they can't be entirely cast aside in a restructuring - even if they technically can be - as it would have devastating consequences for how one of China's most important sectors funds itself.
It's relatively easy to look at the offshore bond market and say that it doesn't make much sense. However, there is an underlying rationality to how it began and there's still an underlying rationality to why it will persist in the decades to come (even with the major restructurings that will need to take place over the next year or two).
For offshore bond holders, the tools in the toolbox that exist after a debtor actually defaults are severely limited relative to if an analogous situation took place in the United States under Chapter 11.
This is not only due to these holders being structurally subordinate (although that doesn't help!), but is rather also a reflection of how arbitrary the mainland legal process can be and the lack of clear precedence that exists when it comes to the handling of offshore creditors.
So, what we've seen a lot of in 2021 are classic out-of-court style restructurings with the exception that there aren't (obviously) debt-for-equity swaps occurring whereby offshore creditors are taking chunks of mainland China OpCo equity.
What we've seen primarily are various forms of debt swaps. The structure of these debt swaps will usually involve some level of cash pay down to entice existing holders to take new bonds that have a longer dated maturity. Alternatively, they could involve debt being exchanged at a haircut, but with new debt having a much higher coupon rate.
Further, if the debtor believes they need to spice up the offer even more to get above a certain consent threshold (usually 85%) then they can mix in new guarantees (some of which have dubious value).
These guarantees can take a few different forms.
First, they can be cross guarantees with other offshore bonds (which are very common, and essentially mean that a default of one offshore bond will also make another be considered in default even if a coupon payment hasn't yet been missed).
Second, you can have personal guarantees from the founders of the debtor. This is increasingly common and something the government has not so quietly been supportive of debtors doing because so many of the founders of mainland China property developers are billionaires.
Note: Should a debtor default within mainland China the insolvency process undertaken is somewhat similar (theoretically) to a Chapter 11 proceeding. The rule of absolute priority will be followed and there will be a restructuring plan. In this plan impaired creditors will be listed along with their recovery values. The form of recovery that creditors will receive can come via cash, reinstated debt, or equity in the reorganized debtor. However, the devil is always in the details and there's much greater opacity, a lack of precedence, and a level of arbitrariness as to how the practicalities are all worked out relative to the Chapter 11 process (especially around what exactly the recovery values will be, and how one can argue for higher recovery values).
While there are many potential restructurings to talk about, let's briefly cover what occured with Yango (a modestly sized property developer).
In mid-November of 2021, Yango came to an exchange agreement with the vast majority of the creditors that held Yango's January 2022, March 2022, and February 2023 offshore notes. These notes represent just shy of $750m in face value. Creditors holding $669.9m worth of notes agreed to tender their notes, which represents a consent level of just over 89%.
In exchange for tendering (swapping) these creditors will receive new notes that pay a 10.25% coupon, along with an immediate cash payout of $25 for every $1,000 tendered.
Further, to sweeten the deal and get above the 85% consent threshold that Yango sought, the founder personally guaranteed these newly issued bonds. You can read the full revised offer to creditors here.
This is a classic example of a distressed exchange; buying the debtor sometime to hopefully turn things around by avoiding an otherwise imminent default (which is why Fitch downgraded Yango after the exchange). Currently Yango's offshore notes due 2024 are being quoted in the high 20s so the market is quite pesimistic on them turning things around.
So, let's say you're a distressed Chinese property developer. You don't have imminent maturities, but you also don't have much liquidity.
Of course, you could try to raise money onshore. Either through issuing secured debt backed by existing assets, or through doing an onshore bond offering. Both of these options will have lower yields than anything raised offshore - as we've already discussed - but the issue for property developers is that raising too much onshore may make them run afoul of the three red lines policy.
What many developers in the situation have done is try to offer quite short dated bonds that have embedded put options.
For example, Greenland (one of the largest mainland China property developers) attempted earlier this year to do a $200m+ offshore bond issuance. The bond they pitched would have had a two maturity with a put option at the end of the first year.
What the put option gives a note holder is the right, but not the obligation, after the first year to demand the debtor repurchase their note for cash at face value.
What embedding a put option in a bond does for the issuer is lower the coupon rate that the market will demand. Because the put option - like all other options - has value unto itself. So, market participants will take a lower coupon for the optionality that the put option represents (e.g., a buyer can think to themselves, "Instead of being locked in for two years by buying this bond, I can get a good yield for a year and reassess the situation at the end of one year and get cash back if the company is beginning to look a bit riskier").
So, one of the most popular ways for Chinese property developers to raise cash over the past year has been to do these slightly funky offerings with embedded put options. Yuzhou has done several of these types of transactions in 2021 to raise cash to repay older offshore bonds coming due.
Obviously the biggest name to follow in the space is Evergrande, which had a technical default on December 9th. Houlihan Lokey is advising Evergrande, while a sizeable group of creditors hired Moelis.
Another big name is Kaisa, which also technically defaulted on December 9th as well. A sizeable group of creditors hired Lazard.
Other names worth following include: Greenland, China Fortune Land Development (which was among the first large developers to default), Yuzhou, and Yango.
Given the dearth of restructuring activity lately, almost every major RX shop has some kind of creditor-side mandate dealing with offshore bonds. So, for interview purposes, it's worth having a rough idea of what we mean when we're talking about offshore vs. onshore bonds.
What we've gone over here will be more than sufficient to thoroughly impress your interviewer. If I can find the time over the next few months, I may put together a slightly longer guide on all this like I did for Serta for those that are interested.
However, one big takeaway from everything we've covered here should be that while companies domiciled in the United States (or the U.K., Canada, etc.) follow very formal processes, when it comes to these property developers everything will get quite a bit messier and lots of odd things will no doubt occur.
But, in the end, despite all the opacity that will occur in the post-default processes, the rule of absolute priority will (more or less) be followed, there will be a restructuring plan brought forward, and there will be arguments about how much various creditors should receive and in what form they should receive it (cash, new debt in the reorganized debtor, or equity in the reorganized debtor).
We've covered a lot here, but hopefully it's somewhat helpful. I've also put together a longer list of typical restructuring interview questions and an overview of restructuring investment banking if you're gearing up for interviews and haven't read those posts yet.
]]>One of the more famous examples used during the early aughts to illustrate the perceived brokenness of the Chapter 11 system involved PG&E, who took three years to emerge from bankruptcy protection after filing Chapter 11 in 2001.
The problem with sustained Chapter 11 proceedings is the immense business disruption and value destruction that occurs. When a company enters into a prolonged Chapter 11 process, it’s not only highly disruptive to the ordinary operations of the debtor – due to suppliers becoming reticent to extend credit and key employees leaving the company – but also value destructive due to the general financial and reputational harm of being in the bankruptcy process (along with the exorbitant fees that need to be paid to lawyers, consultants, and bankers).
Given this, over the past few decades efforts have been made to try to incentive both debtors and large creditors to come to an agreement pre-filing, or just after filing, regarding how the debtor will be reorganized upon emergence from the bankruptcy process (thereby limiting the amount of time the debtor has to spend in the actual Chapter 11 process negotiating with creditors).
The primary way in which these agreements are codified is through the creation of a Restructuring Support Agreement (RSA) or Plan Support Agreement (PSA), both of which are terms that can be used interchangeably.
An RSA can be thought of as a preliminary Plan of Reorganization (PoR) formed between the debtor and key institutional creditors – who often have commanding positions in the capital structure – that details how the company will ideally be reorganized. As a consequence of agreeing to this RSA, the debtor and these key institutional creditors agree to support a future PoR, which will be voted on by all relevant creditors, so long as it significantly adheres to what was laid out in the RSA.
Therefore, if an RSA has been signed off by a sufficient number of creditors to actually approve a PoR in-court, then the ultimate PoR that will be consummated in-court will be the same as the RSA (with potentially some slight modifications).
However, if the RSA has been signed off by a significant number of institutional creditors, but not enough to approve a PoR without the support of other creditors not involved in the RSA creation process, then the RSA will really act as a kind of initial offer to the rest of the creditors to try to get them on board with the Plan. So, in the end, the RSA may end up being more or less the same as the PoR or there may need to be further significant negotiations and changes to get a PoR ultimately approved by a sufficient number of creditors.
From a debtor’s perspective, there are significant benefits to getting an RSA in place (either pre-petition or shortly after filing) and limited downsides.
First, getting an RSA in place early will enhance the confidence of everyone directly or indirectly involved with the debtor. It’ll demonstrate to suppliers, employees, and potential new customers that while it’s never ideal to be going through the Chapter 11 process, there’s a clear plan in place for what’s being done and by following it the debtor will quickly emerge as a leaner, healthier company.
Second, part of every RSA is a requirement that existing creditors who support the RSA must vote for any PoR that is consistent with the RSA and must not undertake any activity that could delay confirmation of a PoR. In other words, once a creditor signs off on an RSA, they can’t change their mind and try to extract better terms if the debtor suddenly ends up looking a bit healthier than they did a few weeks or months beforehand.
Third, part of every RSA is a requirement that existing creditors who support the RSA must not assign (meaning sell) their claims to third parties unless those third parties agree to be bound by the RSA as well. So, in other words, you don’t need to worry about some distressed debt fund coming in and accumulating claims that previously supported the RSA, reneging on that support, and thus throwing a wrench into the Chapter 11 proceedings.
Fourth, contained within every RSA will be some verbiage surrounding a so-called “fiduciary out” for the debtor. All this means, practically, is that if at some point the debtor believes that the RSA is no longer in the best interests of the estate, then it can terminate the RSA.
So, the debtor can strike the best deal possible with some creditors, but if it believes later that a better deal could be had, it can terminate it and try to renegotiate anew.
Note: This is very rare to see as it creates a great deal of consternation among the key creditors that the RSA was initially entered into with (as you can imagine!). In reality, given the value destruction that can occur through a Chapter 11 process, terminating an existing RSA must always be counterbalanced with the potential for value destruction in the advent that a new RSA cannot be readily entered into with better terms for the debtor.
For the creditor’s who participate in the crafting of the RSA with the debtor – which, to be clear, will usually be a small number of large holders – there are a number of benefits to participating in the process.
First, credit investing – whether you’re buying new issuance or you’re a distressed debt fund buying at a discount – always revolves around downside protection. It suits neither the debtor nor the vast majority of creditors to see a prolonged Chapter 11 process that deteriorates the underlying value of the debtor. So, the first benefit of having a prepetition or post-petition RSA in place is simply creating some level of certainty (assuming the Plan ultimately looks more or less like the RSA) as to how the debtor will be reorganized.
Second, when a debtor reorganizes that will almost invariably come along with some level of new money issuance that existing creditors can participate in (such as a post-petition DIP, which often has great economics). For large institutional creditors, most will be open to participating or rolling up their preexisting secured debt into the new DIP facility. By having a seat at the table to negotiate the RSA, a creditor can try to push for favorable terms for new money issuance that they would like to participate in.
Note: I'm trying to keep this all reasonably high level, so I'm glazing over quite a bit of nuance on the mechanics of how creditors participate in new money issuance and how sophisticated credit investors will think about participation in DIP facilities or the eventual exit facility (and the linkage between these two, and what you had prepetition, in terms of rolling your consideration). Maybe I'll try to tackle this a bit in a post later on, but rest assured this is all lightyears outside of what is talked about in restructuring interviews.
Third, another benefit conferred from having a seat at the table is that debtor’s will often throw little incentives at creditors to try to get them to partcipate in the process given that there are some downsides to participating. These incentives can include having their advisory or legal fees paid for if they agree to support the RSA, along with also providing liability releases.
To be clear, there are downsides for the creditor associated with participating in putting together the RSA. Most notable among these are that by agreeing to support the RSA the creditor will be restricted in their trading (if they do sell their claims, the buyer will need to agree to support the RSA fully) and will need to support a PoR so long as it’s substantially similar to the RSA.
Thus far I’ve tried to skirt around some of the more technical nuances to RSAs in an attempt to give you the bigger picture.
However, there are a few things you should be aware of:
For RSAs that are created pre-filing, a debtor would file a motion with the court seeking for this contract to be assumed under Section 365 of the Bankruptcy Code (which is the provision that allows for a debtor to seek to assign, assume, or reject leases and contracts within Chapter 11).
This is incredibly routine, and the court will show a great amount of deference to the debtor that is seeking to assume an RSA that was created pre-filing. Generally, a business judgement standard will be utilized by the court which more or less means the court will ask itself, “Is it reasonable to assume that the debtor wishes to assume this contract in order to maximize the value of the estate?”.
For RSAs that are created post-filing, things get a bit trickier. The debtor will seek for the court to review the RSA under Section 363. However, section 1125(b) of the Bankruptcy Code prohibits soliciting votes on a plan prior to the court approving the disclosure statement.
As we’ve discussed, the RSA is not a plan per se, but is a precursor to a plan reached by key creditors along with the debtor so this raises the question of whether or not an RSA is really a solicitation of votes in all but name. For this reason, at the very top of every post-petition RSA you’ll have the following bold disclaimer making it clear that the RSA is not soliciting votes:
Below are a few examples of RSAs, one done pre-petition (as part of a prepack) and one done post-petition.
Guitar Center is one of my favorite debtors to talk about. For years they did relatively small out-of-court restructurings to try to buy themselves enough time to turn things around as they progressively became more and more distressed.
By late November of 2020 the writing was on the wall so they did a prepack in order to gain the benefits of the Chapter 11 process, while having all the details of what they wanted to do already ironed out beforehand with their primary creditors so they could get in and out of court quickly.
Here's a breakdown of the support Guitar Center had for their plan pre-filing:
Guitar Center, after putting together an RSA and supporting prepack documents (the RSA is Exhibit B, page 66 of the PDF), entered Chapter 11 on November 17th, had its final plan confirmed on December 17th, and then officially emerged from Chapter 11 with ~$800m less debt and an equity injection of $165m before the start of the new year.
Today Guitar Center is preparing to do an IPO. Thus illustrating how a well managed restructuring process can lead to distressed companies turning things around and being set on a sound financial foundation for the future.
Note: Houlihan Lokey advised the debtor on the transaction. Part of the reason why the process was so clean-cut was due to Guitar Center being owned by Ares (who is obviously a very sophisticated player and who was actively looking to inject new equity into the company as part of a comprehensive restructuring). Further, Guitar Center had a supermajority of their noteholders (most of whom were sophisticated credit funds) on board with the RSA.
Restructurings are always trickiest when you have lots of small, relatively unsophisticated credit investors. With Guitar Center a critical mass of creditors (enough to push the Plan through) were sophisticated credit investors and the owner of Guitar Center was obviously a large PE fund, so everything ran as smoothly as you could have hoped.
Of course, one of the more notable and widely discussed Chapter 11 filings of 2020 was Hertz. Hertz gained notoriety primarily because after it had filed, it became a bit of a meme stock and had its equity bid up.
As you likely already know, while almost everyone in the restructuring and distressed debt world thought meme stock investors were literally throwing away their money, they turned out to be right for all the wrong reasons as equity holders ended up getting non-trivial compensation in the end due to a turnaround in Hertz while they were in Chapter 11.
Note: It’s relatively rare – but not abnormal – for equity investors to receive some form of compensation in a Chapter 11. Normally this is in the form of warrants and normally what equity investors are getting is worth nowhere near what the equity was trading at just before the company filed. But I’ve lost the desire to try to explain the machinations of equity markets in 2020/2021, so I won’t elaborate further here.
Anyway, Hertz filed a post-petition Plan Support Agreement that was agreed to by the debtor (obviously) and a series of key creditors, along with the “PE Sponsors”, who include Centerbridge (who incidentally has done incredibly well over the past year in their credit funds and who love doing hairier buyout deals out of their PE funds), Warburg Pincus, and Dundon.
Note: The Plan Support Agreement above is not the ultimate Plan approved. I'm just linking this as an example of a post-petition RSA. As you may know, part of the reason why equity holders received non-trivial compensation is due to the bidding war that broke out over Hertz. While Hertz was initially going with the Centerbridge, Warburg, Dundon offer (which the PSA above notes), in the end a group lead by Knighthead, Certares, and Apollo ultimately won. If you're curious, here's a reasonably good Bloomberg piece quickly going over the bidding war.
As with nearly everything in the world of restructuring, there’s quite a bit of nuance I’m glazing over in order to try to cram this all down into a few thousand words.
But to be crystal clear, all an RSA really represents is an agreement between the debtor and some, but not all, creditors as to what the final Plan (that all eligible creditors will vote on) should look like. Although if the RSA doesn’t have a critical mass of creditors across the capital structure agreeing to it, then there will likely be fights in court that will lead to the final Plan potentially looking quite a bit different than the initial RSA.
Since most of the people who come across this site are preparing for restructuring investment banking interviews, I should probably note that details surrounding RSAs will never come up in any meaningful way in an interview.
What will come up in an interview are the classic restructuring interview questions or perhaps tricker ones on structural subordination, so you focus on those and not be spending hours poring through the minutiae of Guitar Center’s prepetition RSA.
With that being said, RSAs are a great way to get a feel for how debtors plan on restructuring themselves in-court, what consideration (read: compensation) various classes of creditors will receive, and what their exit capital structure will look. So, if you're curious, feel free to check out the RSAs discussed above.
]]>Nowhere is this more true than in the world of restructuring. Over just the past ten years you've had firms near the top of the RX league table fall heavily down after a few key departures to either other banks, or to start their own shop altogether. The latter of these scenarios most famously happened when top producers from PWP RX left to form Ducera, which immediately caused a deterioration in deal flow to PWP's RX practice.
Guggenheim Partner's restructuring business began in 2012 after enticing Ronen Bojmel from Miller Buckfire to come start it. However, in mid-2018 Guggenheim made a significant commitment to restructuring by acquiring Millstein.
Millstein has always been a small, but relatively heavy hitting RX shop with a particular emphasis on sovereign restructuring (which is not something most RX shops have much experience in given the limited number of mandates that come up in that area).
Just to illustrate the musical chairs aspect of restructuring a bit further, Jim Millstein - the founder of Millstein - was before that the co-head of restructuring at Lazard.
Normally I don't get into the history of how various restructuring groups came to be. But Guggenheim has been by far the most aggressive in building out a restructuring business since PJT spun out from Blackstone (which was before my time in RX).
So it's been interesting to see what Guggenheim has been doing and it will be equally interesting to see what mandates they start getting now that they have two heavy hitters to bring into pitch meetings when necessary (Bojmel and Millstein).
Below are some interview questions you should know for Guggenheim. Feel free to skip around using the links below.
How would you screen for potential companies that may need to restructure?
Part of the reason for going over the history of Guggenheim's RX business in the preamble is that you should be cognizant of it when crafting your "Why Guggenheim?" answer.
In nearly every interview process you'll be asked at least once why you want to work at a given firm in particular. Normally you can get away with quite generic answers referencing league tables, who you've talked to at the firm, etc.
However, a great way to differentiate yourself at Guggenheim is to reference how quickly they're building out their RX business. You can then say that this is appealing because it means juniors will likely get more responsibility and there will likely be a flatter and more entrepreneurial culture.
Note: It's a truism that all banking groups like to think of themselves as having "entrepreneurial cultures". Why this is the case is beyond me, but it's true nevertheless.
With all that being said, there is one thing that you should not stress in your answer to this question: sovereign restructuring. Many candidates do a bit of research on Guggenheim, learn about the Millstein acquisition, and then decide that their angle to differentiate themselves in an interview will be to profess their interest in sovereign restructuring.
This is wrong to do for a few reasons.
First, sovereign mandates are rare. Even at a shop that's well positioned to get sovereign mandates, juniors will likely spend just a few months during their banking stint on them (if they even spend that much time). So talking about how you really want to work on sovereign mandates can betray the reality that you don't understand how relatively rare they are, and can perhaps leave the impression with your interviewer that you aren't overly interested in traditional corporate restructuring.
Second, Guggenheim isn't looking to be branded as a sovereign restructuring shop. They want to frame themselves as being a top restructuring shop that happens to have experience through Millstein in sovereign RX. Talking about sovereign RX too much during your interview could potentially irk your interviewer as they (rightly) don't want Guggenheim to be thought of a sovereign restructuring shop that also happens to do corporate restructurings.
So I would recommend talking about sovereign restructuring incidentally. As something you'd be really interested in working on if the opportunity ever came up, but that you realize how rare sovereign mandates are.
This is a classic question. If we think about a simplified enterprise value formula, there appears to be a bit of a discontinuity here.
We've been told the enterprise value, the debt, and the cash. But in order to have a balance between both sides of the equation it appears that we'll need to have a negative equity value, which is obviously not possible (remember we aren't talking about shareholders equity here).
The remedy, of course, is to think about where debt trades as opposed to just the face value of it.
First, you should clarify with your interviewer that this debt is all of the same seniority. If the debt is broken into tranches (e.g., a revolver and some senior notes) then you'd need to work through the waterfall (which I've covered in many other posts).
Assuming that the debt is all of the same seniority - and thus, in the advent of a Chapter 11 filing, would all receive the same recovery - we can just divide our enterprise value by the face value of debt to get a rough idea of where it'll trade. In this case, it'd be $250/$300, which would give a trading value of 83.33 cents on the dollar.
Now we also need to contend with the residual equity value here. Naively, since the debt above it is quite impaired, we could say that the equity value is zero. However, in reality it'll trade at some modest, non-zero value due to optionality (as I've also covered in other posts a few times).
So, practically, maybe debt trades at something like 81 cents on the dollar and the equity value is the differential - $0.0233*face value of debt - which keeps us in balance with the enterprise value of $250.
This is a great question to ask because it gets to what the signs of distress are, but with a slightly more practical twist.
In the course I go into much more detail on this and what deliverables for screens actually look like. But let's run through it quickly here.
You'll start by firing up CapIQ or FactSet. You'll then start with an industry (e.g., industrials) and begin the process of pairing down companies to a reasonable list of 10-20 potential restructuring candidates.
In order to pair down, you'll start by thinking about size. If a company doesn't have a lot of debt to restructure - but rather just has become very unpopular or whatever - then there's not many options for it from a restructuring banking perspective (plus there aren't many fees when you're restructuring a small face value of debt!).
So you'll begin by, for example, looking at companies with at least $500m of debt outstanding across their capital structure. You'll then often look at credit ratings. But remember that credit ratings lag a company's health so we don't want to be too stringent. So, choose something in the low investment grade range and below.
Then you can add things like overall leverage to the mix (e.g., 6x Debt / LTM EBITDA) and interest coverage (although you won't do this in some industries as it can exclude some companies that still may need to restructure).
Finally, you can generate a list from these criteria. If it includes 100+ names, then you can just rejigger some of the criteria used above (usually by raising the leverage qualification to a higher multiple) in order to get to a list of 30-50 names.
After that, you can look at each company's tranche of debt with the lowest trading value and sort the list that way. This will give you a good - but not perfect - sense of whether or not the market thinks a restructuring is likely to take place.
In the end, no screen will give you a perfect list of candidates. You'll always end up including some that, upon closer inspection, won't need to restructure or only may need to years down the road.
So the real challenge in doing good screens is manually pairing down the list from the 30-50 names you generate into a more manageable number of 10-20 names that seem like they'll need to restructure sometime in the next year or two.
This is one of my favorite questions and crops up in both M&A and restructuring interviews (remember that you'll still face many traditional accounting questions in RX interviews).
First, we need to record the gain on the income statement, which is $200. For a tax rate, we'll use 20% giving us $160 in net income.
Note: Some banks still use 40% as the tax rate in interview questions. Others use 20%. Of course, it doesn't really matter, but just something to be aware of.
Moving over to the cash flow statement, at the top in CFO we start with $160 from net income, but then net out the entire gain ($200) as we'll be reclassifying the full sale under CFI. So CFO is down by $40 and CFI will be up by $300 (the sale amount) after the reclassification. This leaves the cash flow statement up overall by $260.
Finally, on the balance sheet we have cash up by $260 and an asset off the books of $100, leaving us on the asset side up $160. On the liabilities and shareholders equity side, we'll have $160 flowing into retained earnings from the net income on the income statement. Therefore, everything balances out.
When preparing for either M&A or RX interviews, I find often the most eager candidates often overlook the most simple accounting questions in order to focus on more difficult (but rare) interview questions.
But simple accounting questions do crop up in every interview, so it's important to always be refreshing the more basic accounting questions like this one.
So here we have revenue of $200, COGS of $100, and thus pre-tax income of $100. Let's assume a 20% tax rate, so we'll have net income of $80.
Moving to the cash flow statement we have $80, but we add $100 due to the fact that inventory decreased (assets down, cash up). So we are up $180 on the cash flow statement.
Finally, on the balance sheet we start with cash up by $180. We then take off the inventory value of $100, which leaves us up $80 on the asset side. On the liabilities and shareholders equity side, we'll be up $80 as well from the flow of net income into retained earnings. Therefore, everything balances out.
Over the past few years Guggenheim has been expanding out their restructuring practice significantly. I've had a few people who went through the Restructuring Interviews course end up with offers from Guggenheim, and all reported back that they really liked the people they met through the process.
Whenever you join a group that's expanding quickly, there's always concern over how much exposure you'll get, what your exit opportunities will be, etc. I've been asked about this by a number of people over the past year and I really wouldn't worry about it too much. You may not get quite as diverse an array of exits as you would at EVR or PJT, but you will get plenty of opportunities from private credit to distressed funds to PE.
As always, if you're looking for more questions, you can check out the larger list of restructuring interview questions or my overview of restructuring investment banking.
Best of luck in your interviews!
]]>Sure, Evercore is known for having a less intense culture than Moelis. But the reality is that the differences are usually slight and contingent on many different factors, like what MDs you end up primarily working with. So some analysts and associates will have a better experience at Moelis than Evercore and vice versa.
Among the investment banks, Centerview Partners is probably the singular one that really is quite differentiated. At the end of the day, banking is banking, but Centerview does tend to go by the beat of their own drum.
The reality is that joining Centerview - especially at the analyst level - isn't necessarily for everyone (as we'll get into in the first question). But if you're interested in restructuring, don't shy away from Centerview.
Centerview doesn't do a large number of RX deals - relative to HL, for example - but they have a knack for getting onto some of the largest and thorniest. If you end up joining Centerview, and want to get RX exposure, you'll get more than enough. And if you ultimately want to exit to a top distressed or special situations shop, you'll absolutely get interviews.
Note: While Centerview used to offer a generalist program across M&A and RX, they've recently changed this. Now Centerview brings on a few "Restructuring Majors" each summer to work within the dedicated RX group. They'll spend the majority of their time on RX deals, but will still get some M&A exposure (depending on how heavy the RX deal flow is). So, these few people are the only ones who are true generalists across RX and M&A anymore -- the rest of the 28 or 29 in the class will just be focused on M&A (although even if you aren't a "Restructuring Major" you can probably still get staffed on an RX deal occasionally if you really want to).
Below are some of the top Centerview Partners questions you should prepare for. The interview format isn't different than any other banking interview, but you will occasionally get more abstract problems (like question six).
Question 6: Some think that stock buybacks should be banned? What do you think?
Question 7: Walk me through a recent deal we've done?
When I've written up the most common interview questions for other elite boutiques, I usually haven't gone over the "Why this bank?" question. This is because normally the answer is just the generic rationales that they have great deal flow, seem to have a great culture, etc.
However, with Centerview you should spend quite a bit of time thinking about why you want to join them and have a good answer prepared.
This is because, as you likely already know, Centerview has a three year analyst program and the expectation is that you'll stick around for the entire thing. Further, while you can get great exits after the analyst program, the majority stick around and become associates (which is very rare among top EBs). It doesn't hurt when they offer you $200,000 to stick around, I suppose.
While it's never a good idea to say that you have no intention of being a career banker in an interview, no one at Moelis or PJT is under the illusion that you're likely to stick around after your analyst stint. But that's just not the case at Centerview. They want people who are leaning towards being career bankers and want to grow up within the bank.
So the first part of your answer should involve making it clear that you recognize the analyst program is slightly different than at other banks and that's a positive for you (because you believe that you'd like to stay on as an associate and beyond).
Note: No one is going to hold you to the answer you give in an interview (especially if its a summer analyst interview!). But if you're looking to exit to the buy-side in 12-16 months, then you really should look elsewhere.
After this, you can give any additional generic reasons you have (e.g., great culture, lean deal teams, large mandates, etc.). Those additional reasons are all valid, but you should bring up the prior two points as those are the meaningful differentiating points.
This is really more of a reclassification exercise. On the income statement you need to demonstrate that you own only 80% of the company somehow, so you add a line item "Net Income Attributable to Noncontrolling Interests" prior to "Net Income" and subtract $40 (20% of the $200 in net income of the company that you have an 80% stake in).
On the CFS, you add back $40 to the $160 in net income the flowed to the top, because you own the majority of the company and have consolidated financials.
Moving to the BS, we have $200 that flows to the top and will just do a little reclassifying within SE. Obviously we have $160 in net income that flowed to retained earnings. Within SE we'll create a line item "Noncontrolling Interests" and place $40 there (thus creating balance).
Here's another accounting question (which are always popular). Remember that accrued expenses have been accrued, but not yet paid.
So assuming a 20% tax rate, we'll have our pre-tax income of $100 go down to being $80 of net income. Moving over to CFO, it'll start down by $80, but then we'll add back the $100 since it's a non-cash expense. Therefore, we'll have CFO being up by $20 and there are no other changes on the cash flow statement.
On the balance sheet, cash is up by $20, liabilities are up by $100 (since accrued expenses are, obviously, liabilities), and retained earnings are down by $80 (flowing from the net income on the income statement). Therefore, we have balance.
When these expenses are ultimately paid in cash, nothing happens on the income statement (as these expenses didn't occur in the period cash is paid out, but in the prior period when they were recognized). So cash is down on the CFS by $100, which flows to the asset-side of the balance sheet being down by $100. On the liabilities-side of the balance sheet, liabilities (the accrued expenses themselves) are down by $100.
This is a relatively straight forward EV question, but with a bit of a trick thrown in.
First, we can find the equity value by taking $50m / 0.1, which gives us $500m. Then we can add back the debt and subtract the cash to get $700m. After this, we just need to deal with our capital leases and operating leases.
In the past operating leases were considered off-balance sheet items, but capital leases were considered in the EV calculation due to their debt-like characteristics (chances are you read about this distinction in the traditional IB guides). Therefore, we would just say that our final EV is $750m after including the capital leases.
However, with the introduction of IFRS 16 almost all operating leases are now considered debt-like for accounting purposes. This would mean the EV in our example here would be $775m after rolling in the operating leases (instead of just ignoring them for EV calculation purposes as you would before).
Practically, in most situations folks like to calculate EV as it was done previously (without operating leases). However, if you're just drawing an enterprise value figure out of somewhere like CapIQ they'll bundle operating leases into the EV calculation now (so you need to back out operating leases, which is annoying).
As mentioned, in practice you'll likely strip your EV of operating leases. However, if you do include operating leases in your EV calculation then your EBITDA is no longer apples-to-apples and you'll have an artificially inflated multiple (as the numerator will now be larger than the denominator).
Instead, you'll need to adjust EBITDA for lease expense (creating EBITDAR) if you're going to keep operating leases in your numerator.
Note: If for some reason you can't find the operating leases contained on the balance sheet anywhere, you can multiply the annual lease expense by Moody's industry multiple grid. However, if operating leases aren't to be found on the balance sheet it's probably because they're incredibly small.
This is all a bit in the weeds for interview purposes. But EV calculations crop up in every interview in some form or another and it's great to have this in your back pocket.
It's not uncommon for Centerview to ask some questions that are a bit more abstract than what you would get in a traditional IB interview. For example, sometimes you'll be told about a CEO making a certain decision and whether or not you agree with it. When you get these kinds of questions, don't worry about the interviewer looking for a singular answer as they understand you may not have much background knowledge on the subject.
The interviewer really just wants to see if you can answer in an intelligent and thoughtful manner, without being flustered by being asked an open-ended question you've never seen before.
Stock buybacks have become (bizarrely, in my view) a hot topic among some lawmakers and economists. This has been spurred by William Lazonick's 2014 article Profits Without Prosperity and brought to the public via articles like this from the New Yorker.
During 2020, buybacks once again enter into the fold after airlines received government assistance after spending billions on buybacks over the prior decade. The underlying theory of critics is that the airlines should have created a rainy day fund instead of buying back stock. Of course, the rainy day funds necessary to withstand the pandemic would have had to have been orders of magnitude larger than the buybacks done by the airlines, but whatever.
There are a number of ways you could frame answering this question either way (although I would side on stock buybacks not being banned). My shortened answer would be that buybacks - like dividends - reward existing shareholders and promote the efficient usage of the company's capital.
Investors have generally no issue with companies that invest heavily in themselves at the expense of profits (e.g., Amazon) if they are convinced that management is doing things that will result in enhanced long-term cash flows. However, if management can not convince shareholders that capex or acquisitions represent an efficient use of capital, then they should put pressure on the company to either disburse some excess cash back to investors via dividends or buy back stock.
If either of these were banned - since they're similar in effect - this would result in profitable companies hoarding cash that they would likely disburse in undisciplined ways (e.g., doing acquisitions for the sake of acquisitions, raising cash management compensation, etc.).
Ultimately, I view buybacks (like dividends) as being one way in which shareholders can put pressure on management to be disciplined; forcing management to either make a compelling case for investment that will boost returns or buying back stock to do so.
Of course, from an M&A perspective maybe it'd be best if stock buybacks (and dividends) were banned. Then M&A activity would explode as companies flush with cash ran around trying to buy whatever looks remotely accretive.
Fortunately, Centerview lists all of their completed transactions online here. In the world of restructuring, Centerview had an extremely busy 2020 (although a quieter 2021 thus far, as is to be expected given the environment).
Notably, Centerview advised an ad hoc group of 1L and 2L lenders in the Serta Simmons restructuring. I actually wrote a whole guide on this transaction, because it was the most notable (and controversial!) of 2020. You can find that in the members area of the course if you're interested.
Another notable restructuring deal that would be relatively easy to talk about in an interview would be the Ultra Petroleum pre-pack Chapter 11.
On the M&A side, deal flow has been incredibly strong at Centerview thus far in 2021. You can see the list of all their M&A deals for 2021, but certainly Canadian National Railway merging with Kansas City Southern is intriguing (although it's not yet closed as of this writing).
I've written quite a bit before on how to talk about deals (including exactly what I'd say about the Serta deal in an interview) so I won't belabor the point here. As always, talk about deals you feel comfortable with even if they aren't overly large or complex. Far better to be able to confidently answer any follow ups then to regurgitate something you aren't entirely sure on.
As I said at the outset, Centerview is quite unique. They bring in more revenue per partner than any other bank most years and generally provide higher all-in compensation than other elite boutiques. But, at the same time, they put an emphasis on retaining people within the bank, which is quite rare for top shops.
Needless to say, cultural fit is important at Centerview. This is partly why Centerview doesn't generally adhere to the recruiting schedule all the other banks follow (they're much later!). They want people to select for Centerview, not the other way around.
If you think being a career banker could be right for you, then there are few if any better places to be than Centerview.
If you're looking to join Centerview as a "Restructuring Major", then I've put together a long list of restructuring interview questions here. Of course, if you're looking for even more there's also the Restructuring Interviews course, which includes real-world examples, case studies, and hundreds of additional interview questions. Keep in mind that if you're interviewing for one of the generalist M&A summer analyst positions, you aren't likely to get any direct RX questions.
As always, best of luck!
]]>I wasn't sure how many people were ever really going to find this site, because I had no intention of really promoting it, but it turns out to have become quite popular. More importantly, it's turned out to become very helpful.
Hearing from people who aced their interviews and got jobs as a result of what I've put together has been incredibly rewarding. This summer alone there are six restructuring summer associates that I did little mock interviews with that are at top shops (which is probably ~30% of all the restructuring summer associate class on the street).
Anyway, a few weeks ago I meant to do up a post going over some little things to keep in mind during a summer analyst or associate stint to be as productive as possible and take the most that you can out of your time at the firm.
When you begin at a firm you'll be given access to shared drives. These are just folders that everyone on the team has access to where all the past deals and pitches are stored.
You should go through this drive to check out what deals have been done in the past, what was successfully or unsuccessfully pitched, and generally just poke around to familiarize yourself with what's been going on at the firm.
Each folder in the drive - that will be dedicated to some pitch or deal - will have separate folders for the decks (PowerPoint slides) and models / cap tables (Excel sheets).
So, if you've been assigned to do some cap tables in the retail space, for example, it's a good idea to go look at past pitches for retail companies that the firm has done so you can see how they like things formatted and what they footnoted for retail companies (so you can keep that in the back of your mind).
Note: If you're doing a cap table from scratch, you can also look at the industry screens that have been done in the past (which will just be a series of cap tables and illustrate the formatting / what types of things are often footnoted).
Note: Whatever you do, when you open up the latest version of an old file do not change anything and save it again!
Note: You should also take notice of the formatting of the slides. Pay attention to what size font is used where, what color is used for sub-headings, etc. You'll probably be given a one-pager when you begin laying out the color scheme the bank uses, but it's good to see what all the formatting is like in action. Nothing irritates senior members quite like inconsistent formatting, so try not to do that!
There are many oddities about banking. One of them is how much young analysts and associates are judged implicitly by their e-mail response time.
Personally, I always hated having to respond to e-mails as they came in because it precluded being able to not look at your e-mail while trying to get serious work done.
But the realities are what they are. Especially for summer analysts or associates. When any little request comes in, respond as soon as possible by saying "Will do" or whatever the verbiage of choice appears to be within the firm.
The only exception would be if the request is some small change you can do in under five minutes. Then you can just e-mail back when it's done. Otherwise, always make it clear to the individual that wrote the e-mail that you've read it and will do it.
Note: When given a request, you should also give an approximate time frame for doing it if you feel comfortable doing that. Always overestimate a bit.
Chances are you'll be placed on a pitch or deal that is already ongoing during your summer stint.
The chances are definitely not that you'll be placed on a pitch with an analyst that abruptly leaves and then you'll become the go-to person for said pitch with only a VP and MD on it (although this happened to me and it was not fun).
So, the first thing you should do whenever you're placed on something that is already ongoing is to just go spend some time poking around past iterations of the thing in the shared drive. In the folders for the deal or pitch every past iteration will be "saved down" so when you look in the folder you'll see pitch v4, v5,..., v66.
Read through some of the latest iterations and then spin back to one of the first iterations to see what the initial pitch / deal deck looked like.
If, when you have some spare time with a more senior member of the firm, you ask a question like, "I was poking around past iterations of this pitch and I see a bond refi was proposed that involved new 2L money being raised. I was just curious why that was ultimately taken out of the pitch as a potential solution?"
This is a phenomenal question that maybe has an interesting answer, but will most definitely earn you points for being a "smart" question to ask and showing that you've been proactive in looking at past iterations of the pitch. The key to this question is that it can't make you look dumb, because they had it in the pitch initially for a reason!
Every deck - for deals, but in particular for pitches - will have a set of common slides. These will be biography pages, past deals done, disclaimers, short case studies of past deals, etc.
Often there will be some folder in the shared drive - for reasons unknown to me, often hidden away somewhere that's impossible to find when you need to - that will contain these "template" slides.
One of the tasks of summer analysts and associates - because it's hard to totally mess up - is just grabbing these slides and putting them into the deck. So you'll be told to go grab the precedent transactions slide for past oil and gas restructurings, for example.
It's a good idea to know where this template folder is and poke around to just get a feel for what's included in there. This way when you inevitably get asked to insert something, you can do it quickly and it won't be your first time seeing them.
Let's say you've been given a task, and you've been told it'll take you around three hours to do. If after a few hours in you think for sure it'll end up taking a bit more time, then it's always best to give an update that it'll take you twenty minutes more.
This is never ideal to do, of course. You'd love for work to be delivered on the timeline given to you. However, no one can predict how long slightly more complex things can take. So, it's always best practice to over communicate rather than under communicate.
With that being said, don't e-mail about a three hour task likely taking you four hours after only working on it for thirty minutes! You don't have that good of a concept of how long things will take once you get going and people will think maybe you got distracted by something else so are lowering the priority of their request.
If you are asked to do something in Excel, open up the latest iteration (so, for example, v56) and then immediately save a new copy (labeled v57 in the case).
This way if you majorly mess something up you haven't destroyed the latest iteration of the model! Because, if you did, this would require going back to v55 and then trying to remember what you did to get to v56 (but, of course, you don't have a working copy of v56). Nearly every analyst or associate will make this mistake at some point and it's always something that someone will get iritated about.
For whatever reason reading something on paper illuminates the errors you glaze over when reading something you've done on the computer.
As a general best practice, print out everything you do and read it over again. If you've been given a mark up, try to print it out and put it side-by-side with your corrections and make sure the two now align.
Finally, and perhaps most importantly, try never to take anything personally. One of the hardest things to realize in the moment in banking is that senior members of the firm think about what they say far less than you realize.
If someone makes a comment in an e-mail that seems a bit negative, don't take that as a reflection on you personally. It's not a calculated comment, it's one that was written in 15 seconds when they were probably already busy thinking of something else.
Further, if you unequivocally mess something up, don't be hard on yourself. The person who recognized the error will have forgotten about it by the next day. It's only if you get upset because of the error, or how you were spoken to about it, that the individual will remember it (because they remember your emotional reaction, not the action that led to it).
As you no doubt already know, banking has a penchant for attracting people who are miserable to deal with, or who enjoy making other people miserable. This isn't universally true, of course! But chances are you've seen some of the unhinged e-mails that VPs have sent to juniors floating around online. Nearly every firm has an example of one of these e-mails and disgruntled, miserable Senior Associates / VPs / MDs are at every firm no matter what a firm says about their rock solid culture.
With all that being said, if you're going to over analyze every comment made to you and take it all personally, it's going to be a very long and unenjoyable slog in banking. Instead, whenever you deal with someone who's difficult, miserable, etc. just try to not think about any of their comments too deeply (which I know is hard when inexperienced). Just recognize that they almost certainly hate their lives for whatever reason and being unpleasant to young analysts and associates is a form of cathartic release for them.
On the flip side, when someone takes the time to help you, make sure to tell them you really appreciate it. You want to be someone that people want to help succeed, not someone who is treated just as a workhorse.
I think this is it for my little summer analyst and associate tips. Honestly if you just have a relatively strong understanding of RX, are good at moving around Excel/Powerpoint, have attention to detail, and follow the tips above you'll be head and shoulders above everyone else during your summer analyst or associate stint.
As always, best of luck!
]]>Probably the trickiest kind of restructuring questions surround structural subordination and the dynamics of HoldCo / OpCo structures. These were a bit more popular to ask in restructuring interviews a few years ago – like when I did my summer analyst interviews – but seem to be much less popular now.
Before we begin, I should mention that issues of structural subordination, upstream guarantees, and HoldCo / OpCo dynamics are quite complicated in practice.
Like anything else in restructuring, terms can mean whatever you define them to mean so you will often come across rather thorny or ambiguous scenarios. This is compounded by the fact that as organizational structures grow over time, they aren't always overly well thought out. This can lead to having wildly sprawling organizational structures with upstream, downstream, and cross guarantees many of which may be slightly differently defined.
I think the best way to try to build up your understanding of structural subordination is through a series of questions and answers. We’ll start with some basic definitions, then get into a few example scenarios where structural subordination is playing a role.
Below are some questions on structural subordination. You can click the links below to be taken to any of the questions. I'd recommend reading these from start to finish first though as these questions do build on each other.
A HoldCo / OpCo structure is simply one where we have a series of operating companies – often either diverse in the countries they operate in or with each OpCo being dedicated to one major corporate project – and a HoldCo that owns (holds) the equity of these operating companies.
The HoldCo – as the name implies – is like a legal umbrella under which all the operating companies coexist so the HoldCo has ultimate ownership.
Normally the OpCos are where the assets themselves reside and HoldCo holds nothing other than the equity of the OpCos. One thing to note is that – again, normally – at least secured debt is housed where the assets are located. As a lender you always want to be closest to where the assets actually reside (as you’ll see as we go through examples).
There are two primary reasons why these kinds of structures exist – one generally applicable and one more specific to high yield issuers.
First, if I have a company and I sell products in the U.S., Canada, and France then for regulatory, tax, and / or accounting purposes it is much more efficient to have specific operating companies.
Second, by having a HoldCo we have another area to raise debt off of (ultimately, all HoldCo / OpCo questions surround HoldCo having debt). As you can probably imagine, the kind of debt issued at HoldCo tends to be the highest yielding debt as it is removed from where the assets reside.
Note: Like I mentioned before, in practice things get complicated! Think about a company like Hertz that has a diverse line of businesses and is spread across geographies. Here’s their org structure from their Chapter 11 filing.
Or take a look at Transocean as a complex - but not quite as thorny - current example:
Note: For interview purposes, everything will be kept within the realm of just having a HoldCo and OpCo (or a few OpCos maybe). So, I won’t bother delving into subsidiary guarantors or anything although the reason why Hertz is such a mess stems from numerous OpCos operating like HoldCos over subsidiaries.
Structural subordination involves debt being junior due to where it’s located in the organizational structure. In other words, debt being subordinate or lower in priority solely by dint of where it's located. For example, let’s imagine we have an OpCo with assets of $150 and debt (Unsecured Notes) of $100. Then we have a HoldCo that owns the equity of OpCo, but no assets, and has debt (Unsecured Notes) of $100.
In the event of filing, OpCo’s debt is made whole, and it has $50 in value left over (equity). HoldCo has a claim on this residual value but has $100 in debt so these HoldCo Unsecured Note holders would only receive a fifty cent on the dollar recovery.
In this scenario, we’d say that HoldCo’s Unsecured Notes are structurally subordinate to OpCo’s Unsecured Notes.
So, if we’re a distressed investor, pre-filing we may quickly look and see the market pricing two different unsecured notes with one being around par and one being around fifty cents on the dollar.
This looks like a great arbitrage! Somehow two things called the same thing are trading at wildly different levels!
Of course, in reality debt instruments can be called whatever one wishes to call them. Just because two things are called the same thing doesn’t mean they have the same underlying claim or potential return. In this scenario, because the HoldCo Unsecured Notes are more remote from the assets – and have no guarantees, which we’ll touch on shortly – the market is pricing in what it should based on the expected recovery values.
Let’s say a company, like the one we drew above, wants to go raise some HoldCo debt. Potential lenders may very well look at the organization structure of the company and come away asking the company why they would lend at the HoldCo level given that they have, well, no assets (other than holding the equity of OpCo).
To pacify lenders, an upstream guarantee could be put in place. Look at the little structure we drew above. All an upstream guarantee means is that OpCo guarantees HoldCo debt.
Now, guarantees can be structured (hypothetically) in whatever way folks will agree to. However, in general guarantees – especially for interview purposes – are going to give HoldCo lenders an unsecured claim at the OpCo level. In other words, this gives HoldCo lenders assurance that even though their debt resides in a HoldCo, they are effectively a part of the OpCo capital structure where the assets actually reside.
Note: Like I said, however, you should be aware of the fact you can have senior / secured guarantees as well.
A downstream guarantee is (obviously!) just the inverse. HoldCo guarantees OpCo debt. In our simplified HoldCo / OpCo structure above, obviously OpCo wouldn’t care about having a downstream guarantee from HoldCo as that doesn’t help (or harm) them in any way.
Alright, we’re starting off with the simplest scenario here. Note that there are no upstream guarantees here. So OpCo’s unsecured debt is made whole as it’s fully covered by the assets at OpCo.
There’s $100 left over at OpCo, which flows through to HoldCo (since they own the equity of OpCo) so HoldCo gets $100 for a recovery value of fifty cents on the dollar.
We can then conclude that that HoldCo's debt is structurally subordinate to OpCo's debt.
Now we have an upstream guarantee. This upstream guarantee will result in HoldCo debt being pari with OpCo’s debt (as both are general unsecured claims at OpCo).
Therefore, we have $400 in debt with assets of $300, giving a recovery to both tranches of debt of $300/$400 or seventy-five cents on the dollar.
Obviously, what this upstream guarantee has done is effectively get rid of the structural subordination that would otherwise exist without the guarantee.
Here we have an upstream guarantee but remember that generally upstream guarantees will result in HoldCo debt being unsecured at the OpCo level.
As I mentioned, guarantees can be defined and structured however folks want, but unless you’re told that this is some form of senior secured guarantee, this will not result in HoldCo and OpCo debt being pari.
Instead, the OpCo debt will be made whole and the HoldCo debt – even though they have an upstream guarantee – would get a fifty cent on the dollar recovery ($100 / $200).
So while the upstream guarantee does get rid of the structural subordination, it doesn't change the outcome that OpCo debt is dealt with first due to its specific claim.
In the members area of the Restructuring Interviews course I've uploaded a nine page PDF dedicated just to structural subordination questions. These questions get into slightly more complicated scenarios in which you have multiple OpCos, HoldCos with assets, etc. which you may find interesting (it's probably entirely overkill for interview purposes, but better safe than sorry).
Whenever you're thinking about structural subordination, try to draw it out and place arrows where they need to go. In the real-world, things are usually not as complicated as Hertz, but you are normally going to have more than two layers to the structure. For example, you'll commonly see a HoldCo, an OpCo, and then a series of operating subsidiaries below the OpCo.
Another thing to always keep in mind with structural subordination is the need to carefully read what guarantees do or do not exist and what benefits they confer.
As I've harped on many times before, terms mean whatever they are defined to mean in credit docs. Guarantees can sometimes have unique sounding names, so you need to carefully review what benefit is actually being conferred by the guarantee (meaning where the guarantee effectively places the HoldCo debt in the OpCo capital structure).
Finally, also keep in mind that in the real-world it's not invariably the case that HoldCo will have no assets of their own! Capital structures creep up and evolve over time; their messiness is due to the fact that they are usually not elegantly structured from the beginning. So be sure to track where assets reside and where they flow (or not).
As always, best of luck!
]]>Historically, perhaps the best known special situations group is Goldman's SSG (which has since been rebranded and moved over to the merchant banking division). However, even Goldman's SSG had four distinct groups that all had quite differentiated and defined mandates.
I think the best way to define a classic special situations group is one that focuses primarily on unique (usually at least stressed) credit situations, but can express their view on that situation outside the realm of credit if so desired.
So while the impetus for involvement is usually the same across situations (some level of stress in the capital structure), capitalizing on that situation could be achieved by buying or shorting equity, buying credit-linked derivatives, buying a controlling stake of a likely impaired class, or providing some kind of financing somewhere in the capital structure (usually with non-traditional characteristics).
All of this is to say that a classic special situations group (should!) have the ability to use more tools in the toolbox than perhaps a traditional distressed debt group would. Again, all of these lines have blurred over time and I think the industry has got to a point where these are all mostly distinctions without much of a difference.
Note: Of course, one can make an argument that merger arbitrage and work done in the CLO space are also forms of special situations investing, both of which don't necessarily involve any stressed credit situation.
In a prior post I spoke at great length about a few distressed debt interview questions. Here I'll go over some special situations interview questions. All the distressed questions would also be relevant for a special situations interview. However, some of the interview questions in this post may not be relevant to a distressed debt fund depending on how narrow their mandate is.
Anyway, let's get into it.
Below are some questions that cover a wide range of potential topics that are relevant to special situations investing. Obviously while the exact type of questions asked will be contingent on the group's mandate, hopefully this gives you a sense of the general theme behind the questions.
Question 1: What's a total return swap?
Question 3: What would be an example of a structurally subordinated security?
Question 6: What special situations or restructuring deals recently have you found interesting
In recent weeks we've seen the collapse of Archegos a large tech-focused hedge fund that was levered long, uh, like 5-20x? Who knows.
Whatever the case may be, the collapse led to much hysteria - including from reasonably sophisticated circles - about the use of shadowy and dangerous derivative products like total return swaps.
The general commentary around Archegos was pretty disappointing to see. The reality is that Archegos didn't reveal some kind of outsized risk - powered by complex derivative structures - that could have systemic ramifications. Like in so many aspects of finance post-GFC, everything is much more boring and simple than it was pre-2008.
So what are these supposedly dangerous derivatives used by Archegos to gain leverage?
Total returns swaps are a way for you to get economic exposure to an underlying, without actually having to own it. Instead, a prime broker (Goldman, Morgan Stanley, etc.) buys what you'd like economic exposure to and passes on the gains or losses to you, which you dutifully pay. For the service rendered, you pay a swap fee so your gains are slightly less than they would be if you just bought the underlying yourself and your losses are slightly more than if you bought the underlying yourself.
Like in a traditional interest rate swap, you aren't exchanging the full notional value of the trade at time zero and again at the end of the swap. Instead, as a hedge fund, you're paying a swap fee (LIBOR + 115bps, for example), posting an initial slug of collateral, and then getting paid or paying out (variation margin) as the underlying changes in value.
A TRS allows for leverage, of course, if so desired and is an economically efficient way for a hedge fund to get leverage. Instead of having to get margin through a prime broker and go out and buy in full, you simply post a certain amount of initial collateral to the prime broker and then (if the underlying declines) post variation margin that reflects the price decline of the underlying grossed up by the leverage utilized.
For equities, a TRS can be a useful way to mask your involvement as a hedge fund in a certain equity (by you not needing to disclose your ownership stake being above 5% on a 13D) or having your involvement come up in a Bloomberg holder screen.
So, a total return swap is just a simple instrument that can applied to any given underlying or basket of underlying. If you have a basket of things you want economic exposure to then you can be sure you can go to Goldman and have them write up a TRS on that (and charge you a nice swap fee for their troubles).
For instruments like levered loans in particular, a TRS can be a very efficient way to gain exposure due to some of the complexity that can be involved in transferring ownership and voting rights. This is why if you do a holders screen on Bloomberg for some secured parts of the capital structure you'll see banks holding large swaths of the debt. While there could be a number of different reasons for this, one of them is likely that a hedge fund has a TRS on it.
A simple, back-of-the-envelope way to answer this is to look for how much yield per turn of leverage you're getting. At the Senior Notes level, you're getting 5% / 2x, or 250bps per turn of leverage. At the Subordinated Notes level, you're getting 8% / 5x or 160bps per turn of leverage.
Assuming all else being equal, you're getting more out of the Senior Notes and should be looking at them.
Of course, maybe you don't find the yield overly enticing on the Senior Notes to begin with. If the Sub Notes are trading at par, and are only levered 5x through to them, then maybe that's a better yield and is obviously relatively safe. However, it's important to remember what the first question touched on: leverage.
Note: With bonds you're normally just going to get leverage through margin, not through a TRS.
While you could use a real world example, it's just as easy to create a stylized little example, so that's what we'll do here.
Let's imagine a company has a simple HoldCo / OpCo setup. At the OpCo there are $150 in assets and $100 in Unsecured Notes. At the HoldCo level there are $100 in Unsecured Notes as well along with the equity of OpCo.
Here all the tranches of debt involved are called Unsecured Notes and all have a general unsecured claim. However, in terms of recovery values we would see the OpCo Unsecured Notes being made whole and the HoldCo Unsecured Notes getting a recovery value of fifty cents on the dollar.
In other words, the HoldCo Unsecured Notes are structurally subordinated as a result of being removed from where the assets are held. This would be remedied by there being an upstream guarantee in place whereby you'd have both Unsecured Notes being pari and each getting a recovery of seventy-five cents on the dollar.
I probably should have come up with a better way to word this question, as it probably comes across as quite a leading question. However, what this question is really getting at is how volatility affects the value of long put and long call options.
During the chaos and general degeneracy of the GameStop spectacle, you actually saw deep OTM puts go up in value as the price of GameStop soared.
So how does this make sense? Let's imagine that a stock is trading down over time in a reasonably lock-step and not overly volatile fashion. Then a bunch of nonsense occurs and it gets pumped up to $40 and kind of oscillates around $30-50 for a month.
Perhaps you're in a special situations group and are involved in the credit of this company. You look at the equity and think to yourself that this makes no sense! There's some irrational stuff happening and perhaps you think putting on some equity puts will enhance your returns or whatever. Because you're in a special situations group with a broad mandate, you buy some puts with an expiration date set three months out.
Then all of a sudden even more nonsense occurs and the stock spikes to $200 one day, then $350 the next, then $175 the next, then $325 the next, etc. You're still months away from expiration, but you're convinced the value of your poor puts must be near zero.
Could it be the case that the option value of your put actually increased in value?
Sure! I mean, maybe. Generally speaking, of course, a stock increasing in value when you're long a put is bad, but if the stock moves upwards violently enough in a short enough period of time it can be not so bad (or even good, as in profitable!).
The reason why is that for long call and long put positions volatility drives value as the greater the level of volatility the greater the chance sometime before the expiration date you'll be in the money. So, as a theoretical matter, because of the massive spike in vol in this stylized example your put position (which was struck quite out of the money) is potentially more likely to end up in the money than if the stock stayed more range bound around $40 like when we initiated it.
As mentioned, this all was actually seen for some very OTM puts on some equities, like GameStop, in February 2021.
This question picks up on the general theme of the prior question.
So first of all, let's qualify what's going on in the capital structure of both of these companies. If we imagine they have a simple capital structure, with perhaps a term loan and senior notes, then given that the debt is greater than the EV we would expect at least the senior notes to be trading below par.
Therefore, as we've talked about in prior posts, you would expect equity to trade a bit more like a call option (depending on just how distressed the debt in the capital structure is trading).
So, if we know nothing other than that these two companies are identical and that one has a larger market cap than the other, what can we infer? We can infer that the one with the larger market cap must have more volatility as more volatility in an underlying leads to more option value (and given that we're saying these equities trade like call options, that must mean the value is tied to volatility).
In the last question we discussed how enhanced volatility leads to enhanced long call and long put option values due to the increased chance of the option ending up ITM.
In the context of buying straight equity in a distressed company, what does this really mean though? The way that you can think about it is as enhanced volatility being translated into an enhanced chance of the company being able to turn things around - perhaps via an out-of-court transaction or general business turnaround - without obviously having to file, which would lead to outsized gains for the equity.
For example, if you had a company with steadily declining fundamentals (negative FCF, declining same-store-sales if they're in retail, etc.) then you'd expect the equity to exhibit relatively modest volatility. It'd just grind down lower and lower as the inevitable Chapter 11 date approached.
On the other hand, if you had a company that had volatile earnings, then announced they had engaged PJT or Evercore or whoever to advise them on alternative restructuring solutions, then what would you expect from equity? Probably a lot of volatility! This scenario doesn't preclude the possibility that the company ultimately decides to go Chapter 11 and that the equity gets (almost certainly) wiped out, of course. But if some market participants are betting on an out-of-court that solves the catalyst for filing then you'd see lots of swings in the equity over any piece of news regarding the company as folks re-evaluate what the likely outcome.
Of course, you should do as much due diligence as possible on the group you're interviewing with (which is often easier said than done!) to figure out what kind of deals or transactions would be best to talk about.
For example, a case like Serta (which I wrote a rather long case study on in Restructuring Interviews) is neat to talk about and everyone will be familiar with it. However, it's not that actionable or applicable for most special situations groups. Although you could try to frame discussing Serta from the vantage point of being defensive (understanding the need to pay attention to how open-market purchasing language is defined, who holds what amount of secured debt, how aggressive the debtor will be in seeking restructuring alternatives, etc.).
Keeping in the more distressed, but not quite conventional mold, you could talk about Tupperware's Senior Notes. They were trading below fifty cents on the dollar and then Tupperware, advised by Moelis, drew down their entire revolver and did a few tender offers.
This didn't solve the impetus for filing (there will still quite a few Senior Notes outstanding), but created a scenario in which the Senior Notes traded up a bit. Then the dilemma becomes, from a special situations seat, do you believe filing is inevitable - in which case your recovery value will probably be less than you bought in at - or do you believe that Tupperware could get outside financing to go and take out the rest of the Senior Notes (that were holding out) at par. Ultimately, the latter happened and many did well off of this trade (including those who held equity).
You could also discuss the new financing Tupperware got - which were two term loans, with most of the proceeds specifically earmarked for taking out the Senior Notes - coming from Angelo Gordon and JPMorgan's new Special Situations Initiative Group.
Getting more into pure special situations territory, you could talk about the CDS trades made out of GSO and Tac Opps (Blackstone) a few years ago. While they aren't as relevant these days - due to changes in what constitutes triggering default - it'd show a continued interest in creative transactions and in understanding CDS.
There you have it. Given the diversity of special situations investing it's hard to come up with an entirely representative sample of questions without going over many more. But hopefully these make you think about a few different lines of questioning that could crop up in an interview.
If I get time over the coming months I might write up a few more pure special situation case studies to illustrate some of the things that have been done in the past, why they make sense, and what the ultimate result was.
If you're thinking about joining a special situations group - but aren't coming out of restructuring investment banking - the course I put together on restructuring may be helpful. It has hundreds of interview questions created from Moyer, Whitman, etc. to help with terminology along with more standard RX analyst and associate questions and answers.
If these kinds of posts are helpful, let me know and I'll be sure to put together more resources as I find the time. I find it fun to do and given the lack of writing on buy-side credit interviews online, hopefully it helps out in some way.
Best of luck!
]]>Before beginning, I'll just say what you probably already know: credit recruiting in general is quite ad hoc relative to other areas of the buy-side (like private equity if you're coming out of M&A).
Speaking in the most general terms, whether your recruiting for a position in direct lending, private credit, or distressed debt you should expect a series of pretty ad hoc interviews - that will be both fit and technical - followed by a modeling test or case study of some kind (it'll vary as to what the test or case entails, unlike in PE where it's pretty predictable and standardized).
While I hesitate to make any sweeping generalizations, I would say when you think about the structure of credit buy-side recruiting you should anticipate having somewhere between five and eight roughly 30-minute rounds of interviews that will be primarily one-on-one.
If we assume there are six rounds, then the first four are likely to be one-on-one sit-down interviews. These will look more or less like what you went through in banking. However, the primary difference is that while in banking you're getting quite a few short questions that have relatively objective answers, for distressed debt or special situation interviews these will feel much more like intelligent conversations that will flow relatively naturally.
In these one-on-one interviews - I mean, maybe some will be two-on-one, but whatever - you'll certainly get some fit questions, but most of how you will be evaluated on fit will come through how you articulate your answers to relatively broad questions surrounding your background, deals, why distressed debt, etc.
For example, when discussing a deal you worked on are you articulate and succinct? Are you skewing your answer toward what a distressed debt investor is most interested in, as opposed to what a banker would be most interested in? Did you consider how a distressed debt hedge fund was thinking about their 2L position, even though you were advising the debtor so didn't necessarily need to that much? And, just as importantly, do you seem at all interested in discussing the deal and have some general level of enthusiasm?
You will likely be asked some more pure "technical" interview questions as well. Depending on your background - especially if you're coming out of a non-restructuring job - you may get some that have quite objective answers. For example, what's contained in a plan of reorganization (POR)? What out-of-court solutions exist for a troubled debtor? What kind of consideration could you receive as part of a Chapter 11?
With that being said, most technical interview questions will be slightly more open-ended and difficult (which is what we'll be going over in this post).
Like with everything in the realm of restructuring and distressed debt, reasonable people can disagree about almost everything. What your interviewer is looking to see is that you have thought about how someone on the buy-side would think about the question, can articulate your answer in a definitive and reasonably persuasive manner, and that you aren't caught completely blind by the very nature of the question.
Moving on, the final few rounds of the interview process will involve some kind of modeling test or case study. Normally there's a bit of modeling and then a few slides you have to create pitching buying (or not) a certain part of the capital structure.
While every firm will view these differently - and give different tests / cases - I think it's fair to view these as more of a competency test. I think (generally) you can view it as a bar to hurdle as everyone knows these aren't overly representative of the work done in practice. It's more about showing that you have the capacity to model and then put some thoughts to paper in a limited time frame than showing that you are some kind of modeling savant.
Most often, you'll have one "round" where an interviewer just pokes around your model and slides, asks some questions, etc. Then another round will follow where an interviewer - or group of interviewers - will hear you walk through what you've done, etc. They'll probably be quite aggressive and contrarian, because that's what you should expect in investment committee meetings anyway.
My personal view - which, again, may not extend to everyone else! - is that probably the most important thing to do when you're doing these tests or cases is to make sure you have a slide or two going over "Additional Considerations".
Because you definitely won't have the time to go through - or perhaps even be given - all the credit docs, etc. you should make reference to what else you'd want to look at before making a definitive decision. You should frame the investment you're choosing (or not) as a kind of initial indicative decision, subject to change based off of these "Additional Considerations" you've laid out.
Because any test or case study is necessarily stripped down and simplified, you want to show that you understand what additional things you'd need to consider. If nothing else, this will help buffer any deficiencies in what you actually did (e.g. "Well they missed a few things, but they had some good points for what else to consider, so chances are if they had more time they would've picked up some of the things they missed as well").
Note: Some firms are more apt to do the test or case upfront -- especially if they view it as just being a hurdle to weed out candidates.
Obviously in banking there are some questions that everyone gets asked and this is more or less the way you compare and contrast candidates.
On the buy-side - at least in the distressed world, in my view - questions are asked much more with an eye toward your process of answering, what you prioritize including in answers to open-ended questions, etc. as opposed to just being expected to give a definitive one-sentence answer.
The following interview questions aren't necessarily ones that you will invariably get if you interview across enough distressed debt funds. Rather, I've put these together to kind of be a representation of what style of questions you can expect and so you can see what they're testing.
I'd treat these as being indicative, not illustrative, and as a way to help prod your thinking on areas where perhaps you haven't given much thought.
When asked questions like these, I wouldn't restrict yourself to a one or two minute answer like you may in banking. Chances are these questions will spark follow-up questions and a conversation will more naturally develop.
This is a typical question in that there's no objective answer necessarily (who knows what is truly ever baked into debt pricing and what the ultimate downside will be in the future?), but we can ramble on for quite a bit of time about this and circle around a potential answer.
Note: Let's pretend the we're looking at all of this at such a time in which the '21s are a year away from maturing and so we'll have a few coupons between now and maturity.
So first of all, let's set the stage a bit. There are a few things that should immediately jump out here.
I think the best way to frame the answer to broad questions like this is to begin by stating a simple answer - a kind of best first guess - and then provide complicating factors that need to be considered that could lead to a closer, more real-world answer.
So the simple answer is that the '23 Notes are probably pricing in the recovery value with a touch of optionality (reflecting a potential turnaround in the company's fortunes that would lead to the ability to roll these over in a few years).
What the '21 Notes are pricing is the enhanced probability that given that current state of the company - whatever it is - there's a higher likelihood these will be able to be dealt with.
In other words, the spread between the '21 Notes and '23 Notes is likely reflecting a scenario where the '21 Notes have a good shot at being refinanced, but that the '23 Notes will probably not when they come due (thus they're trading at more or less what their recovery value would be should filing occur).
Simplistically, if we assume just two outcomes - refinancing of the '21 Notes or filing before maturity - then we can say the market is pricing in a 50% probability of either happening as 50%*0.70+50%*1.0=0.85 (this assumes the actual recovery value is just the market price of the '23 Notes).
Therefore, carrying this simplistic example forward, we can think of the potential upside as involving buying at 85 and getting back par. Similarly the potential downside would be buying at 85 and getting back 70 in recovery. Therefore, the max downside would be 15 cents on the dollar.
However, this is all a bit too simple! There are obviously a few nuances that should be considered.
First of all, is our downside really 15 cents on the dollar if we buy at 85? Even assuming we're certain (for whatever reason) as to the recovery value being 70, what about the coupons we'd be clipping between now and when filing occurs? They need to be blended in because chances are you wouldn't have the company file immediately after buying the Notes at 85 (or before the first coupon is clipped). So, the actual downside would be some amount lower than 15 cents.
The other nuance to consider is our belief that the '23 Notes are pricing in the recovery value. Chances are the recovery value is actually lower than what is priced into the '23 Notes as the '23 Notes will have some level of optionality reflected in the price (as previously mentioned). This optionality is not just reflective of the potential capacity for the company to turn things around, but also reflective of perhaps the belief that the '21 Notes will be dealt with before filing occurs so that the impaired class would just be the '23 Notes (not the '21 and '23 Notes in the same class, diluting down the recovery values for all holders).
So, when thinking about the max downside risk to the '21 Notes we know it will be whatever their recovery would be in the event of filing. We can say this is certainly some non-zero value as the term loan is trading at par and the Senior Notes are the only things behind the Term Loan.
For the purposes of the '21 Notes max downside, we would need to assume filing occurred when both were outstanding so you have both pari tranches getting recovery. We can't per se look to the '23 trading levels as reflecting filing happening when both are outstanding, as one could imagine them pricing in a) optionality of a full company turnaround that allows both tranches to refi and b) the recovery level that would be obtained if the '21 Notes are dealt with before filing.
So, a more fulsome picture of what the true max downside is would need to be obtained by modeling out the company and making your best guess as to the recovery value if filing were to occur prior to maturity of the '21 Notes. Chances are, we'd come up with a downside between 13 and 20 cents. The fact that 13 cents (which is just an illustrative number, since we haven't actually assigned any coupons here) is less of a downside than the 15 cents priced between the '21 and '23 would reflect being able to clip some coupons before filing occurs and then getting a 70 cent recovery, which would be the best case scenario. In other words, the 70 price of the '23 Notes is probably the ceiling on any recovery value.
Note: You may look at this little cap structure and say obviously the company will try some out-of-court solution. That's probably true! But remember, we're just looking to our max downside risk and an out-of-court solution involving the '21 Notes would probably be providing us a level of compensation well in excess of ~70 cents on the dollar (probably closer to where the '21s are trading now give or take). So our max downside must involve the company filing.
Taking a step back, if we're interested in buying the '21 Notes then the rationale behind it is obvious: we think these Notes will be able to be refinanced.
So our belief is that we'll be able to clip some coupons and pick up 15 points when the Notes mature, which provides a great YTM (I mean, we haven't specified a coupon rate for anything in this little capital structure, but even if it was absurdly low it'd still provide a great YTM in the current credit environment given where the '21 Notes are trading now).
Now what risk are we really trying to hedge here? Obviously, we're trying to hedge the risk of the '21 Notes not being refinanced, but instead the company filing prior to that event. As we discussed in the last question, the '21 Notes would then fall pari with the other Senior Notes due in '23 and provide a recovery significantly below where the '21s are trading now (and probably below where the '23 Notes are trading too).
Now if we're looking to hedge our exposure - operating within this capital structure - then we first need to find the most ideal part of the capital structure that would move the most in the event of a default.
Hypothetically, we don't care if our hedge position moves down or up a lot as we can express our hedge via a functionally long or short position. We just want to find a hedge that:
If we think about this little capital structure, what would we expect to move the most in the event of a default? Chances are it will be the tranche of debt that has the highest level of "optionality" priced into it.
If we think about the TL, there's really no optionality priced in. If the company magically becomes the picture of ideal health, the TL will probably trade around par like it is now.
However, when we begin moving down the capital structure more and more of the price we see in the market will reflect the optionality of the company potentially turning things around (as these areas of the capital structure will provide for larger gains should a turnaround occur).
This is most evident, obviously, when we look at equity for a distressed company where you have a very clear asymmetric profit profile. If you buy equity - when the debt above you is significantly distressed - you know when the company files you'll almost certainly have no recovery, but if the company does turn things around you could expect equity to trade up many multiples. A real-world example of this is Tupperware, which went from $1.15 in March 2020 to ~$32 at year end after skirting needing to file after it appeared likely they would (the most junior part of the capital structure trading below fifty cents on the dollar at one point).
The same holds true for debt, but of course debt has a more obvious upper-bound on how high it could ever trade up.
So if the lower down the capital structure we go, we find more optionality priced in then we'd expect in the event of default for the lowest parts of the capital structure to trade down the most all things being equal.
Perhaps another way to say this is that you can consider debt trading levels the further you go down the capital structure as becoming more and more detached from what the recovery value will actually be. Or, said yet another way, as you move down the capital structure there will be more optionality premium layered over the market consensus for what the recovery value of the tranche will be. This premium, of course, is extinguished when filing becomes evident.
So one would imagine (probably!) that the piece of the capital structure (excluding equity) that will move down the most in the event of filing will be the Subordinate Notes. This is because it is probably trading at a premium due to outsized gains that could occur if the company turns things around or is able to forestall filing by dealing with the '21 Notes.
Therefore, the trade we could do within the current capital structure is going long the '21 Notes (expressing our bullish view on refinancing these) and hedge this by going short the Subordinated Notes (since they will likely fall the most in the event of filing, given that the optionality premium will evaporate).
Note: Of course, we could also go short the equity if it's publicly traded as well since it will have the sharpest reaction to a filing. But I'm assuming we're dealing with the capital structure in the strictest sense of the word for this question.
The obvious thing to be mindful of here is that we're dealing with a negative carry scenario.
Although I haven't specified what the coupon rates are for anything in this capital structure, it's safe to say the Sub Notes are going to have a much higher coupon than the Senior Notes.
So let's say the Sub Notes have a coupon of 8% and the Senior Notes have a coupon of 4%. We're clipping coupons on the 4%, but having to pay out the 8% coupons.
As long as we have this trade on we are dealing with a negative carry of 4%. Assuming that over a year no prices on either of these tranches of debt are moving, then we're just bleeding money.
Now given how I've set up the question, this isn't a huge deal as the catalyst for the trade (refi or not) will take place in a year so we won't be bleeding this negative carry over a prolonged period of time.
But with that said, you should be mindful of how this hedge is dampening returns. If our thesis proves true, then the Sub Notes will probably increase in value (as the '21 Notes being refi'ed will almost certainly be good news for the Sub Notes prospects) and we will be paying negative carry.
If our thesis does not prove to be true, then we'll have a sharp decline in the '21 Notes we're long, a gain in the Sub Notes that trade down, and we will still be paying negative carry.
So the fact we're paying negative carry dampens down the upside potential of the trade and adds insult to injury should the trade not go our way (although, of course, negative carry is the price you pay to have the hedge, which dampens the max negative returns you'd get in this scenario).
Of course, how much this effects our returns is contingent on how large of a hedge we're dealing with here.
If we're dealing with a YTM of ~21% on the '21 Notes - assuming a year to maturity and a 4% coupon - then we may be reluctant to engage in any hedge that limits our upside to anything below a 14% IRR.
If we think we the company won't file until after a few coupons have been clipped, then that income dampens down the max downside risk.
So, if we think the recovery is - just to throw out an example - 70 cents on the dollar, but we'll be able to clip two coupons, then our IRR would be ~(15%) if the company files. So we already have a bit of asymmetry between the downside (-15%) and upside (+21%) due to the coupon income embedded in this trade.
If placing a small hedge within the capital structure - that has negative carry - causes our range of outcomes to go from +21% / -15% to +14% / -10% then maybe we have enough conviction in the trade (assign a high enough probability to the refi occurring) that we roll the dice without a hedge since we don't want to crimp our upside too heavily.
This question is emblematic of the kind of open-ended, more conversational style that many interviews can devolve into.
I could ramble on this subject in a number of different directions for far too long, but I'll try to keep it short given how long this post already is and try to provide a more interesting take.
Many have commented that the case of Serta - where we saw a non-pro rata uptier done - is indicative of the increased "creditor on creditor violence" we've seen over the past few years.
I mean, sure, that's true. But traditionally when we think of creditors battling it out we're talking about more activist distressed funds getting involved as a company heads into distress; jockeying for position, arguing over valuation, fighting over language or priority nuances, etc.
One side of the Serta case had traditional players (Apollo, Angelo Gordon, et al.), but the other side had, uh, mutual funds? Rather robust mutual funds, etc. etc. but still not exactly the kind of classic activist distressed players we're used to seeing.
This strikes me as being a natural out growth of the size these kinds of funds control within the secured tranches of large debtors in general and their realization that they don't need to be entirely passive players through the process.
From a distressed seat, this is troubling as you're faced with needing to be more careful not to get into a position and then get squashed by a large holder - or consortium of similar large holders - who decide they want to more actively dictate a restructuring.
It also poses a challenge in that if you're going to get involved in one of these larger debtors, proposing something controversial, you may need to up the size of your position (which is logistically difficult and likely will lower your return or require more leverage).
As for non-pro rata uptiers themselves, I think it's quite clear that there's no getting around an anti-subordination provision if they exist in the underlying credit docs. So if they exist in credit docs, then worry about something else. If they do exist, pay attention to current holders and think about how you could be blind sided by this kind of transaction.
I think the open-market purchases language argument around non-pro rata uptiers is of more interest in general. I would be curious to see it tested in the courts when it is not so explictly defined in the underlying docs as it was for Serta.
Hopefully this has all been somewhat helpful or at least enjoyable to read. Given that distressed debt and special situations interviews tend to be a bit more conversational and open-ended, I've tried to reflect that in how the questions above were answered.
Of course, for some of these questions you could go on at much more length and perhaps take them in different directions.
For example, while the hedging question limited the type of hedge to being within the current capital structure itself, you could be asked about how you would think about using CDS and how that would work.
I've often been asked to put out a guide - like I did for restructuring - focusing on distressed debt and credit more broadly. While it'd be impossible to create a comprehensive overview guide - given how diverse the buy-side is in credit - I do have fun writing up these questions and talking through my perspective on them.
If you think more of these kinds of questions would be good, be sure to let me know and I'll work away (as time permits) on putting forty or fifty of these questions together in a little guide.
As always, best of luck!]]>Recruiting for Lazard is a bit distinct compared to other leading elite boutiques (EBs). Lazard's summer analyst interviews will be for a generalist position and at the end of the summer you'll be able to select your preferred group (restructuring is generally the most sought after and competitive to get placed into full-time). On the other hand, you'll be able to recruit directly for Lazard's restructuring group if you're applying as a summer associate.
This stands in contrast to PJT, Houlihan Lokey, and Evercore where both summer analysts and associates recruit directly with their restructuring groups. It also stands in contrast to Moelis and Centerview that have a generalist program throughout the summer program and one's first few years at the firm.
This creates a bit of a tricky situation for undergraduate candidates dead-set on doing restructuring. While Lazard has a very strong practice, you do run the risk of not landing in RX full-time even if that was your preference (given how competitive getting into the RX group is).
In terms of general advice when interviewing with Lazard, I'd say two things.
First, if you're an undergraduate your interviews will be primarily M&A-focused. You may get some restructuring interview questions, but they will be in the minority of your interview questions. When asked about what groups you're inclined towards I wouldn't be too definitive in saying restructuring. This is because (quite obviously) your interviewer knows how competitive RX is and they don't want you to recruit elsewhere full-time if you can't get into the RX group. Feel free to say you have a particular interest in restructuring, but you should leave the definitive impression that you're open to traditional M&A as well.
Second, if you're a summer analyst at Lazard who wants to be placed in restructuring full-time then you should have a reasonably strong understanding of restructuring prior to requesting the placement. This may be hard to come by during your brief summer analyst stint, so you should read up on deals Lazard has done recently and be prepared for slightly more intensive restructuring interview questions to come your way at the end of the summer. They'll want to know that you know what you're getting yourself into before joining.
Since this site is obviously dedicated to restructuring, let's go over some of the questions that have been asked to associates recruiting for restructuring (including at Lazard). These may pop up in a summer analyst interview, but you should expect primarily traditional M&A interview questions.
Question 2: What are the signs of corporate distress?
Question 3: Can you walk me through a restructuring deal?
Question 4: What are some common out-of-court restructuring solutions?
This is a bit of a tricky question that is just the inverse of the traditional bond math questions we’ve gone over before (where you need to figure out the YTM).
If we’re trying to figure out how a bond is priced, we need three details: YTM (which we’ve been given), coupon rate, and years to maturity.
So, for this question you’d want to ask how many years until maturity and what the coupon rate is. For this example, you could be told it has an eight percent coupon rate and two years to maturity. That would mean a price of $80.
If we use the estimated yield to maturity formula to confirm it would be (8 + (20/2) / (180 / 2)) or 18 / 90 = 20%.
This a pretty open-ended question in which you could easily ramble on for ten or twenty minutes. It's important to remember in an interview to keep your answers to just two or three minutes and to try to always bring it back to what is relevant for the purposes of restructuring investment bankers.
For a more long-winded treatment of this answer, be sure to check out this post I made on the signs of corporate distress.
From a restructuring investment bankers perspective, the two major things that will be focused on are liquidity constraints and maturity walls.
As we've talked about in prior posts, if a company has debt coming due many years from now and they have sufficient liquidity - despite poor and declining earnings - then there's no reason for them to necessarily preemptively restructure. They have time and so can try to affect a turnaround in the business without having to deal with creditors.
For restructuring investment bankers to get involved - for either out-of-court or in-court work - there must be an impetus or catalyst. This is most commonly either the company having so little liquidity that they'll need to start missing cash interest payments soon or the company having debt coming due that they don't have the ability to just roll over.
These two elements are what I'd consider to be primary characteristics. These primary characteristics of distress inform the secondary characteristics such as debt trading down and debt being downgraded by rating agencies.
In other words, the debt will trade down and be downgraded as a result of the diminishing liquidity or maturity walls approaching that can't be rolled over.
This is one of those questions that will almost invariably pop up at some stage in the interview process.
As a general rule, it's a good idea to talk about a case that the bank your interviewing with has been involved with. However, unlike in M&A it's not strictly necessary since not every restructuring deal is well publicized.
Further, sometimes deals can be used as a way to discuss innovations in restructuring solutions. For example, I wrote a rather lengthy guide on Serta's restructuring - as part of the Restructuring Interviews course - that would be great to talk about in any interview. While Serta was advised by Evercore, the case demonstrates a relatively innovative kind of restructuring solution (a non-pro rata uptier) that restructuring bankers across the street will be pitching to some of their clients for years to come.
As another general rule, it's best to talk about out-of-court restructurings or pre-packs in interviews. Talking about traditional / freefall Chapter 11s can be a bit messier as there is always a lot of back and forth and little nuances that you can be quizzed on. Out-of-courts are generally more opaque - thus you can't be faulted for not knowing all the details - and pre-packs are more definitive since they're agreed upon prior to filing so there's no wrangling in court (everything you need to know for an interview will be laid out in the Restructuring Support Agreement).
When discussing a deal you should spend a minute or so talking about the company's background and how they got into distress. Then move toward talking about their pre-restructuring capital structure, then what their post-restructuring capital structure looks like. If possible (you may not always have access to all this information if it's a private company that restructured out-of-court, for example) talk about the total amount of debt reduction, total cash interest expense reduction, where maturities are now, and where debt is currently trading.
Whenever you're discussing a deal you always want to illustrate that you understand the entire point of the process is to put the company on a firmer footing for the future by having its capital structure right-sized or to buy the company more time to turn things around than they otherwise would have had.
Note: For reference, Lazard has been very strong in the retail space recently (which is a good space to be strong in these days!). They've had a number of large mandates including Forever 21 and J. Crew. They've also just been engaged by Belk.
Part of what makes restructuring such a fascinating field is the diversity of restructuring solutions that are possible (including how various solutions are combined to try to provide a more comprehensive solution to the debtor's struggles).
Three broad categories of out-of-court restructuring solutions can be thought of as involving debt-for-debt exchanges, debt-for-equity exchanges (equitizations), and/or amend and extends. As mentioned, more comprehensive solutions often involve a mix of these three broad categories that are contingent on what the capital structure of the debtor is and what the ultimate objective is (plus, of course, what creditors are likely to agree to!).
Over the past few years - as I wrote about in the Restructuring Trends / Serta guide - there has been two forms of innovative out-of-court restructuring solutions that have caused quite a bit of controversy among secured lenders: IP transfers and non-pro rata uptiers.
In an interview, if you can just articulate the three broad categories of solutions mentioned above, then that is entirely sufficient. No one is expecting you to know too much about more specific kinds of restructuring solutions like IP transfers or how they work.
However, if you can speak a bit about IP transfers and non-pro rata upteirs - which I may get write about in a future post if I have time - then that's even better as it shows you're keeping up with the trends in the space and must have a relatively advanced understanding of what RX banking is all about.
Guarantee questions can be tricky. They used to be asked every now and again a few years ago, but they seem to be hardly asked at all now.
I imagine this is partly because to properly ask a guarantee question you need to qualify so much (the exact nature of debt and the exact nature of the guarantee) that they can become a bit convoluted for interview purposes.
In general, when it comes to guarantee questions your interviewer most often is going to assume that the debt is all unsecured, that all the assets are held by OpCo, and that there's an upstream guarantee benefiting HoldCo.
You should begin by asking your interviewer if the debt is all unsecured. Assuming it is, then the $100 in debt at HoldCo would be pari with the $150 in debt at OpCo due to the guarantee. This $250 in debt is covered by $200 in assets leading to a recovery value of eighty cents on the dollar for both OpCo and HoldCo creditors.
If there were no guarantee, then the debt at OpCo - where the assets reside - would be made whole and $50 would be left over for HoldCo giving them a fifty cents on the dollar recovery (since HoldCo would hold the OpCo equity).
Lazard is without a doubt one of the top restructuring shops on the street. Even with significant senior exits over the past decade, they've retained their place as one of the top debtor-side restructuring investment banks.
Unfortunately, for undergrads the path to RX at Lazard is a bit more tricky. Not only do you have to get a summer analyst offer - in which your interview will be predominately focusing on M&A questions - you also have to be able to then land a seat with the RX team at the end of the summer.
Having a firm understanding of restructuring, knowing what kinds of solutions exist and recent deals, and knowing how to make little deliverables like screens and profiles will be essential to differentiating yourself and landing a seat.
As always, if you're looking for even more questions along with a nearly 100-page overview guide, actual deliverables, and case studies, be sure to check out Restructuring Interviews.
Best of luck in your prep!
]]>The primary impetus for a restructuring practice falling or rising in the league tables is, as you'd guess, managing directors coming and going.
Over the past several years Greenhill has focused significant time and effort to build out its restructuring practice. Notably, in 2018 Greenhill landed Neil Augustine and made him co-head of RX for North America (after a long stint at Rothschild).
As was quite predictable, Greenhill's deal flow has ballooned over the past few years and Greenhill has been rapidly growing its analyst and associate class to try to handle it all.
The following are some restructuring interview questions you could expect to pop up at Greenhill. From those I've talked to, they tend to be quite technical and they love asking waterfall and residual equity value questions. If you're looking for even more RX questions, be sure to check out Restructuring Interviews.
Question 2: For the aforementioned company, where would we expect equity value to trade at?
This is a pretty standard waterfall question that will often have slightly more difficult questions that spring off of it.
So we have an EV of $150. That obviously makes whole the 1L, so you would expect the 1L to trade at roughly around par. There is then $50 in "value" leftover for the 2L, which would provide for a 50% recovery.
Therefore, you'd expect the 2L to trade at roughly around fifty cents on the dollar.
That's a fine answer to give. However, if you want to get a little more nuanced we can elaborate a bit here. There is always a bit of optionality embedded in any piece of the capital structure that is impaired and one wouldn't be surprised to see the 2L trade a bit over what it's pure "recovery value" should dictate (meaning, trade over fifty cents on the dollar).
By this I mean, what if this company suddenly turns the corner - just as it was likely having to enter into Chapter 11 - and is able to raise some junior debt or new equity out of court? If this occurred, you'd expect the 1L to not change much in price - since it was probably trading around par - but you'd expect the 2L to trade up significantly in light of the lesser probability of having to file.
So if a distressed investor thinks the recovery value is definitely fifty cents on the dollar then they may actually like buying the 2L at fifty cents on the dollar even if there's just a 10% probability that the company turns things around (because then the 2L may rise to be seventy-five or eighty-five or whatever).
At the same time, it's important to note that how debt trades when it is heavily distressed (as this 2L most certainly would be!) isn't quite "efficient". There may be some institutional investors who are just trying to sell out of this 2L because they don't have the mandate, risk appetite, or expertise to carry it through a filing so they are almost forced sellers. This can create a kind of gap where the true value of the 2L isn't showing up in the price, because not everyone has the same capacity or desire to hold this kind of debt moving forward.
Naively, one would assume zero, of course, since the "value" of the company breaks at the 2L (and it's not like we're predicting the 2L will get a 95% recovery or anything close to being made whole).
However, the reality is that a distressed company of this kind does have equity value because of its inherent optionality. While equity is the lowest part of the capital structure, it has (theoretically) unlimited upside should the company turn things around before filing. It also has, by definition, a set floor or downside of zero (meaning the equity is worthless).
Obviously, what we're getting at by talking about optionality and the potential asymmetric profit profile of equity is that equity - for a highly distressed company - beings to trade like a call option.
Should the company manage to somehow turn things around and avoid having to file - by pulling a Tupperware or more recently an AMC - then one would expect debt to trade up and equity to trade up even further (the gains on Tupperware equity, for example, are over 15x from their lows at present).
If your asked how specifically one could value the equity, you can say via the Black-Scholes model as equity, in the case, is really just a call option on the company.
This is a clever question that I can't imagine most get right, but let's go over it! The key to this question is just knowing that the more volatility that exists, the higher the value of an option is.
Therefore, if a distressed company's equity trades like a call option, the company with the larger market cap - all else being equal - will per se be more volatile. In other words, high volatility increases option prices and since distressed equity trades like a call option a company with a higher market cap must - again, all else being equal - have higher volatility.
The intuition here behind how volatility increases option prices is that the more volatile an underlying is, the greater the chance is that it will be in the money at some point. This is why high vol translates to both higher put and call prices.
Often instead of being asked to simply walk through how cash interest or PIK interest flows through the three statements, you'll be asked to do both at the same time.
There's no trick or anything to do differently here. You can just walk through each process separately while making sure not to lose track. In case you aren't sure on how PIK interest is handled, I already wrote up a question on that here. The cash interest side is obviously very straightforward.
As always, best of luck in your prep! Greenhill is a fast growing firm on the RX side and a great place to join as a junior. Their RX questions they ask do tend to be some of the more difficult, so make sure you're well prepared.
You should also, as always, have a deal or two prepared to talk about. I wouldn't worry too much about it needing to be a Greenhill deal specifically -- although it's great if you cover one.
A great RX deal in general - regardless of the firm you're interviewing with - to talk about this cycle is Serta Simmons as it was well publicized and reasonably controversial (a 23-page case study is in the members area).
]]>When I'm asked by those interested in restructuring what firms to target I always include Moelis in that listing.
This is not just because Moelis has very strong restructuring deal flow (although that is certainly true). It's also because Moelis is one of the strongest banks in the restructuring space that also happens to offer a generalist program at the analyst and the associate level, which provides you exposure to both restructuring and M&A.
Note: Centerview is another firm with great deal flow on the RX and M&A side that also offers a generalist program.
The generalist nature of Moelis allows you to maintain optionality through your first few years in banking. If you end up really enjoying restructuring, then you can try to get staffed on more restructuring deals and exit into a top-tier distressed buy-side firm.
On the other hand, if you end up realizing restructuring isn't quite for you, you can try to get staffed on more M&A deals and make a pivot toward more traditional buy-side exits.
Some people have concerns that the generalist nature of Moelis may end up making you a jack of all trades, master of none. I personally put no stock into that kind of thinking. Moelis has great deal flow across restructuring and M&A along with a stellar name brand.
However, I would recommend figuring out as soon as possible which kind of exits you want to target given how early buy-side recruiting happens now. If you get a summer analyst position at Moelis, you should figure out which area you want to try to focus in on during your full-time stint by the end of your summer.
Preparing for a Moelis interview is a bit more of a pain given that you can expect to face questions on both restructuring and M&A.
However, because of the breadth of potential interview questions it also does mean that relatively speaking the bar is set a bit lower.
Because of the firm's reputation on the M&A side many candidates come in having prepared almost exclusively for M&A. Thus, if you can stand out on the restructuring side of the interview, then that can create a real competitive advantage for you over other candidates.
The following are six common interview questions from Moelis. If you're looking for more RX-specific questions, be sure to check out other posts on this site such as the much longer one done on the top 15 restructuring interview questions and the introduction to what restructuring investment banking is.
Also, if you want to more deeply understand what restructuring is, what restructuring solutions are, and get access to hundreds of interview questions be sure to check out the restructuring guide. The guide isn't meant to just help you ace your interview, it's also meant to help you understand what restructuring investment banking really is in practice so you can excel when you hit the desk.
Obviously this is a classic question that crops up in every investment banking interview. Usually you need to make up some nonsense about why the bank you're applying to is unique and special, which is rarely remotely true.
However, with Moelis there is a differentiating quality given that you will get terrific exposure to both M&A and restructuring during your analyst or associate stint.
You should make it clear in your answer that you're eager to learn more about both M&A and restructuring and that Moelis is unique in not making you choose between the two. You should also add that getting exposure to M&A and RX allows for you to better understand the full life cycle of a company; how capital structures are right-sized when over-levered and how companies can achieve growth through mergers or acquisitions.
Another unique attribute of Moelis is their analyst and associate class sizes. Because everyone is a generalist, the class sizes are much larger than what you would have if you did RX at Evercore or PJT.
This isn't something to underrate. The camaraderie and friendships you build during your grinding analyst years is very much a real thing. Personally, I wish I had a larger class size.
Showing that you value getting to work alongside many different analysts or associates shows a certain level of maturity. I would certainly include this in your answer as well.
This is a bit of a spin on a more traditional question. I would preface any answer to questions surrounding what an ideal target of a private equity firm would be by saying that obviously PE firms don't have the kinds of restrictive criteria they once had. Some PE firms are now more open to looking at companies that could have a growth story, even if that requires paying a higher multiple today, for example.
However, as a general principle some of the things contained within a CIM you would immediately look to would be:
The fixed charge coverage ratio (FCCR) is simply (EBITDA - Capex - Cash Taxes) / (Cash Interest Expense + Mandatory Debt Repayment).
If you think about this formula for a few minutes you'll see all this is really saying is: do we have enough cash flow - using the rough approximation in the numerator - to meet what our actual cash obligations are that arise from our capital structure (the denominator).
You'll often see FCCR minimums in secured debt instruments such as revolvers and term loans. For example, a minimum FCCR of 1.0x is frequently used.
FCCR can often be the trigger for springing maturities. Springing maturities are an essential thing to keep an eye out for when looking at cap tables in restructuring (as we go over in the course with some examples).
These kinds of questions are increasingly common.
The trick to these kinds of questions - insofar as there is one - is just to set everything up with a common variable.
Obviously the common variable here is EBITDA, which we will denote as "E". So we have EV = 10(E) and Net Debt = 4(E).
Therefore, our enterprise value formula is 10(E) = 4(E) + 300. Moving 4(E) over to the right hand side, we now have 6(E) = 300. Dividing by 6 we get E = 50.
Since our EV formula was rearranged to being EV = 10(E), and now knowing that E = 50, we have a EV of 500.
As a general principle you should think about one-time expenses or otherwise rare expenses that could have occurred in the relevant time period.
Some examples would be:
This is a bit of a longer question. What the interviewer is looking for is that you don't get overwhelmed and can get through each of the steps (none of which, individually, are that difficult).
First, the EV at initiation will obviously be $2,000m (or $2bn). $1,200m of the acquisition will be funded by debt, and we can assume the remaining $800m will be funded by equity.
The EV at exit will be $300m*10x or $3,000m. Since debt of $400m was paid down, with no cash being left over, that leaves us with $800m of debt remaining at exit.
At exit the equity proceeds will just be the $3,000m minus the debt remaining of $800 or $2,200m.
So $800m of equity was put into the company, $2,200 is taken out at exit five years later, which gives a 2.75x return.
You should know rough IRR calculations for various multiples like 2x, 3x, and 4x. A 2x return over five-years is 15% and a 3x return over five-years is 25%. Thus we can guess the IRR as being in the low-twenties.
Note: It's perfectly fine (and expected) for you to simply lay out the round multiples and associated IRRs and then narrow in on roughly what the actual IRR would be. No one expects you to calculate the actual IRR in your head.
Preparing for Moelis interviews will likely be somewhat challenging due to the breadth of possible questions that can be asked. In particular, most face difficulty with the restructuring questions since there is so little online about them.
As a parting note I'd recommend in your spare time going on YouTube and looking up any recent interviews given by Ken Moelis himself. It always shows initiative and / or a bit of cleverness to drop a line said by Ken himself if you're asked what you think of the M&A or restructuring landscape at present. Here's a recent interview he gave on Bloomberg.
Best of luck with your prep.
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