Liability Management Exercises: An Ambiguous Acronym

There are many bad habits that lawyers have – but one of them that has knock-on ramifications on all of us is a pension for coining acronyms that serve no purpose and then bludgeoning everyone into using them. (Literally trying to make fetch happen – perhaps this is one of the inevitable and disastrous consequences of millennials now getting older and getting into more senior positions?)

LME, short for liability management exercise, is one of these acronyms. It’s hard to believe there’s a turn of phrase, and an acronym derived from it, that is both so boring and so devoid of explanatory power. At least when Congress creates absurd acronyms out of their legislation they have a bit of fun with it. The Sequestration Tied to Member Pay (STOMP) Act. The Servicemember Assistance for Lawful Understanding, Treatment, and Education (SALUTE) Act. The Working to Encourage Community Action and Responsibility in Education (WE CARE) Act.

I’ve tried my best to avoid invoking this acronym for a few years, hoping against hope that it would retreat back into the ether a bit because it is more or less useless. But it’s now become lodged in the lexicon and its usage has multiplied like a cancer so, for the sake of completeness, let’s talk about LMEs as best we can.

First of all, there’s no definitive definition of LME, nor is there a uniform usage of LME. It’s kind of one of those things that’s thrown around in some circles, without fear or favor to the context, and that everyone nods along with because they have some vague notion as to what it’s referring to.

Most use LME as a convenient catchall term for the more creative (read: aggressive) types of out-of-court transactions that have arisen as of late: drop-downs (e.g., J. Crew, US Renal Care, Instant Brands, etc.), non-pro rata uptiers (e.g., Serta, TriMark, Incora, Mitel, Robertshaw, Apex Tool, etc.), double-dips (e.g., At Home, Sabre, Wheel Pros, etc.), or some combination of these together (e.g., Envision Healthcare, Trinseo, Shutterfly, Lumen, Alvaria, etc.).

For example, if you were to use LME in a sentence it’d be something like, “There were LMEs done by At Home, Trinseo, and Frontier in 2023 that’ll hopefully work out better than the LMEs done by Envision and Incora in 2022 since both of them ended up filing in 2023.”

When used this way to refer to a pretty narrow set of transaction types it’s not an entirely useless term – and even though I’m having a bit of fun above I use it every now and then. Because it is more efficient than saying drop-downs, non-pro rata uptiers, etc. over and over again when talking in broad terms about these types of transactions. For example, it’s a lot easier to say, “LMEs require a careful analysis of the debt docs, although interpretations may vary and in most LMEs litigation from those ‘harmed’ should be expected no matter what – it’s par for the course and just the cost of doing one of these transactions.”

However, some, and this really grinds my gears, have started to use LME as a catchall for any type of transaction that allows a stressed or distressed company to obtain liquidity, capture discount, and/or extend maturities. So, this would even make a vanilla amend-and-extend an LME. Which, I mean, an amend-and-extend or a transaction like Carvana’s exchange are obviously exercises in which liabilities are managed – but c’mon. We have the term out-of-court transaction that’s been used for decades as a catchall to refer to all the types of transactions that can, like, happen out-of-court. (I mentioned in my last post that a similar sentiment was echoed by Tuck Hardie of HL where he called LMEs a “new buzzword for out-of-court transactions” which is a fantastic summation.)

In the end, it doesn’t matter. LME is just a catchall that is most often used almost as a euphemism for the types of transactions that are going to be contentious and litigated. However, I’m not a lone voice in the wilderness vis-à-vis my soft-hatred of the acronym. Because now you’ll hear people say stuff like, “We think an LME is possible here and is worth exploring” which is a borderline waste of breath to utter as it’s so non-specific. Or you’ll read something that’s like, “[x] is exploring an LME. In the proposed transaction, similar to J. Crew’s 2016 transaction, material IP would be moved to an unrestricted sub…”. Why bother saying LME? Just say drop-down.

Anyway, in an interview if anyone uses the acronym then they’ll almost certainly have the narrower definition in mind (e.g., a catchall for drop-downs, uptiers, and double-dips) and if you’re asked what it means in an interview context (doubtful) then use the narrower definition.

Rest assured that if you’ve read through my post on Serta (or the Serta Postmortem Guide) and my post on double-dips (or the Double-Dip Guide) then you already know what the proper types of LMEs are (even if you were unfamiliar with the acronym until now) and that’s what matters. LME is just a catchall – but, as it happens, people can’t quite figure out what it’s meant to be catching (presumably a prerequisite of a catchall is that people should mostly agree on what it’s catching, or at least agree on how to use it in a sentence, but I digress…).

Note: Some use Liability Management Transaction (LMT) instead of Liability Management Exercise (LME) but the definition, insofar as one exists, is the same. It seems like a year or two ago it was more evenly split between LME / LMT whereas now it seems like most have coalesced around using LME. To be honest, LMT has always struck me as better than LME but I regrettably don’t dictate our social mores.

Liability Management Exercise #1: Double-Dips

It seems like every time I do a post I preface it by saying I can’t keep writing thousands of words every month or two – then I turn around and create ten thousand word posts on something like non-consensual third-party releases.

But this time I (mostly) mean it, and since I’ve already written tens of thousands of words on double-dips, non-pro rata uptiers, and drop-downs I’ll provide a quick and dirty overview here and maybe sprinkle in a few extra thoughts. (These extra thoughts will be brief and somewhat slapdash since I’m writing this when I have a bit of free time over Memorial Day weekend).

In the double-dip post I broke down the process of manufacturing a double-dip into four steps. First, a non-guarantor restricted subsidiary or (preferably) an unrestricted subsidiary is spun up. Second, debt is issued out of this new SubCo that’s been created. Third, the new debt at this SubCo is guaranteed on a secured basis by entities where some value resides (e.g., the same entities that guarantee the company’s pre-existing secured debt) thereby creating one “dip”. Fourth, the funds raised at the SubCo are upstreamed, via a secured intercompany loan, to the existing credit group (where the company’s pre-existing secured debt has been issued) with SubCo then receiving an intercompany loan receivable that’s then pledged to SubCo’s creditors as security for their debt – thus creating another “dip”.

Given this, if filing occurs down the road there’ll be two independent allowed claims that will redound to the benefit of SubCo debt holders: the direct claim arising from the secured guarantee of the SubCo debt and the indirect claim arising from SubCo separately being able to enforce the intercompany loan against the debtor with any recovery then flowing to the SubCo debt holders.

So, in this formulation, SubCo debt holders will receive two bites at the same apple (the same set of entities where value resides) because the SubCo debt and the intercompany loan will be pari to the pre-existing secured debt of the company, and thus will dilute down the recoveries of everyone else since there’s now more claims competing for recovery alongside the pre-existing secured debt.

This is the “classic” double-dip structure, and what At Home started us off with last year…

Now, some have begun to insist that when we talk about double-dips there should be a bifurcation between the “classic” style above and what’s been called pari-plus. Which, I mean, is fine and understandable. I suppose I’m guilty of this too as in the Guide I referenced “clean” double-dips vs. the “messier” Trinseo and Sabre structures. But if we’re going to start calling each double-dip transaction that has a somewhat unique element by a different name then we’re going to get into some rather long naming conventions (if Sabre is pari-plus then presumably Trinseo should be a pari-plus-with-an-added-twist to differentiate it from Sabre, and Alvaria and City Brewing should have their own special little names too).

Anyway, in the Double-Dip Guide I went through Sabre and Trinseo which are both pari-plus. If you read that Guide then you already know why this is: instead of both claims, directly or indirectly, hitting the same value (within the same set of entities), in these transactions you had guarantees being provided to the SubCo debt by non-guarantor restricted subs at capped dollar amounts.

So, put another way, we still have an intercompany loan – which is guaranteed by the same entities as the pre-existing secured debt and thus the intercompany loan is pari to that debt – but the guarantees of the SubCo debt itself are coming from a different set of entities (e.g., non-guarantor subs) outside the pre-existing credit group. Thus, the SubCo debt has a structurally senior claim on the assets at these entities vs. the pre-existing secured debt and the new intercompany loan.

Therefore, we don’t have the SubCo debt and the intercompany loan both taking a bite out of the same apple as in the “classic” double-dip formulation – to stretch the metaphor we have the intercompany loan taking a bite out of a big apple with a bunch of others in unison, the SubCo debt taking the first bite out of a smaller apple, and both of these bites being to the nutritional (recovery) benefit of SubCo debt holders (apologies for a gross food-based analogy).

With all that said, the reason these are both double-dips is that, upon filing, there will still be two independent allowed claims the total of which will be in excess of the total amount lent (which is the raison d'être of double-dips). The distinction is just where some of the credit support is coming from.

In the end, some companies have simple enough corporate structures and loose enough docs that a classic double-dip can occur – or, in the case of Wheel Pros, enough pre-existing creditors will participate in the transaction such that the docs can be amended to enable a classic double-dip to occur (although Wheel Pros has its own nuances as we discussed). Other times, to manufacture claims well in excess of the amount lent requires some creative maneuvers due to debt doc constraints – this is what we saw in both Sabre and Trinseo and why they needed to be pari-plus.

Note: As I’ve stressed before, remember that the “double” in double-dip refers to the multiple (direct and indirect) claims, not that the total amount of claims will be exactly double the amount lent. This is something I talked about at length regarding Trinseo and the hodgepodge of stuff that backed the SubCo debt.

Note: As I’ve also stressed before, the reason that a company will go through this whole rigmarole to manufacture a double-dip is because it provides downside protection to the new-money lenders. It all comes back to a lender’s IRR, and if there’s a non-trivial probability of filing in the future then manufacturing a lower downside for lenders can offset the need for lenders to obtain higher rate or a lower entry point to reach the same IRR (e.g., simplistically, if you think there’s a 50% chance they file down the road and your recovery will be sixty then you’re going to demand higher rate or a lower entry point than if you think there’s a 50% chance they file down the road but your recovery will be ninety). Or to put it even more simply: a company doesn’t need to offer the same upside pre-filing when they manufacture a lower downside for lenders post-filing.

Liability Management Exercise #2: Drop-Downs

While J. Crew’s drop-down of ole caused much indignation and hand-wringing at the time, drop-downs are treated as almost benign these days. Now, in order for a drop-down to raise eyebrows it needs to be mixed-and-matched with other kinds of LMEs as part of a broader transaction ala Trinseo, Alvaria, or Envision – or catch creditors by surprise ala Altice.

To an even greater extent than with non-pro rata uptiers, there has been an acceptance by the market that drop-downs are here to stay, and this has led to the inclusion of so-called J. Crew blockers in docs becoming yet another thing to bargain over (which, as I’ve argued in the past, is exactly the way it should be).

In my last post, where I talked about J. Crew blockers a bit and their current prevalence, I included a nice little graphic that summarizes the mechanics of drop-downs…

While that’s a nice little overview and covers the primary function of drop-downs, there are a few things worth noting here…

First, most drop-downs will involve assets being transferred to an unrestricted subsidiary – outside the restricted group, and thus no longer bound by the negative covenants underpinning the pre-existing debt docs. This then allows for as much new (structurally senior) debt to be raised at the UnSub level as the market will bear (of course, there’s a natural limit to how much debt it makes sense for a lender to provide at the UnSub-level, and we talked about this at length as being a reason why Serta opted against a drop-down back in 2020).

However, instead of new debt being raised at – and/or pre-existing debt being exchanged into – the UnSub where the assets have been transferred, the assets could just be sold with the net proceeds then not having to be used to repay pre-existing debt within the restricted group (since the UnSub is outside it). This is one way for a company to increase leverage and set the stage for a more comprehensive future transaction (read: to make their creditors start to have heart palpitations and realize it’s time to negotiate as value drains from within their reach). (Alternatively, a company could, capacity permitting, just drop-down assets to an UnSub and take no immediate action as an initial step to create a bargaining chip for future transaction negotiations.)

We’ve seen this with Altice which is a hilarious (ongoing) situation that involves the controlling shareholder, Patrick Drahi, pursuing a strategy of strategic destabilization to keep everyone on their toes and hoping something good comes from the chaos sowed (emphasis on hoping, emphasis on chaos).

To this end, Altice announced in March that the entity that housed UltraEdge, a data center company, was designated as an unrestricted subsidiary. This definitely caused some heart palpations (some Altice France debt dropped by over 20 points in a day) since it was previously announced, back in 2023, that a 70% stake in UltraEdge was being sold to Morgan Stanley Infrastructure Partners and Altice creditors assumed those proceeds would be used to repay debt and delever Altice – not that those proceeds would languish in an UnSub, out of the reach of creditors, and would be used as a bargaining chip to facilitate a more comprehensive transaction that would involve creditors needing to take a haircut to help really delever Altice.

(Altice has one of the most complex capital structures in Europe with around €24bn of debt, and the above is just a sliver of the story to-date – however, Altice is a classic case of creditors tallying up basket capacity wrong and, as a consequence, not realizing that Altice could designate UnSubs / transfer assets to UnSubs almost at will due to how much capacity had been built up. Where some assumed there was a touch less than €2bn in capacity, there was actually a touch less than €19bn. And so Altice has been gradually moving assets – UltraEdge, Altice Media, XpFiber – out of reach of pre-existing creditors to ratchet up pressure. Thus, if you want credit support from those assets, you’re going to need to participate in some broader transaction and take a little haircut. Whoops.)

The second thing worth noting is that while most drop-downs will involve assets being transferred to an unrestricted sub, they can be transferred to a non-guarantor restricted sub instead. This isn’t as ideal, since we’ll still be within the restricted group and thus bound by the negative covenants underpinning the pre-existing debt, but it does mean that any debt incurred at this sub will still be structurally senior on the assets that reside there relative to the pre-existing debt.

Liability Management Exercise #3: Non-Pro Rata Uptiers

Since I’ve talked about Serta and Incora so much, and they’ve become the posterchildren for non-pro rata uptiers, there’s no point relitigating the simple mechanics but here’s a brief overview…

 

The last time we talked, I discussed both Incora’s adversary trial over its non-pro rata uptier – which I had my issues with aspects of as I alluded to while holding my tongue a bit – and also the hilarious boondoggle that was Robertshaw’s non-pro rata uptier.

With non-pro rata uptiers already being in the crosshairs, Robertshaw doesn’t help the optics for us here (Judge Lopez made it known today in Robertshaw's adversary trial that he wasn't too happy about how this all looks – apparently he doesn't share the childlike amazement at seeing "financial titans" engaged in "winner-take-all battles" that Judge Jones did).

But, as I’ve argued, what does (or should) help the optics of non-pro rata uptiers is that the market has responded to their rise with the introduction of blockers that, like J. Crew blockers, are now just another thing that can be bargained for in debt doc negotiations.

Further, leaving aside Robertshaw which is a bit of a unique situation, there has also been a response in terms of the aggressiveness of non-pro rata uptiers. Whereas in transactions like Serta and Incora there was an immediate and almost absolute harm done to non-participants we’ve now seen more transactions that should strike anyone as being more fair (a word that I’ve invoked a number of times in the past given that, despite all the smoke and mirrors, views on fairness, however nebulous a concept it may be in this context, will be the driver of the constraints, or lack thereof, that non-pro rata uptiers are bound by when the dust settles – which is why I’ve always been sympathetic to Judge Jones who was at least more honest about this).

I think one way to roughly frame the evolution of non-pro rata uptiers over the last four years is that we’ve gone through three phases (although this is more of a rough heuristic, so don’t take it too literally…).

First, we had the Serta-era transactions in 2020-22 with non-pro rata uptiers that were more textbook: there were those that could participate, those left out in the cold, and at time zero there was a significant value shift between the two that was immediately reflected in trading prices. (Although Boardrider’s uptier was a success insofar as the business did turn around, so all’s well that ends well. TriMark was settled in 2021 with the second- and third-out tranches being combined together and the new-money component of the transaction still being top of the stack – but after some continued struggles TriMark this year changed hands out-of-court with Ares, Oaktree, et al. that participated in the uptier equitizing a chunk of their debt and injecting new cash to take the keys over from the original sponsors, Centerbridge and Blackstone.)

Second, in response to the litany of litigation that arose, and the fraught foundation that the concept of non-pro rata uptiers rested on, we began to have transactions like Envision where instead of leaving non-participants out to dry and seeing how litigation would go, a series of distinct follow-on transactions occurred that initial non-participants could participate in. These transactions, of course, were crafted to not be near as favorable as the initial transaction, but were better than what the holders were left with after the initial transaction.

But, as we’ve talked about before, in order for holders to participate in follow-on transactions they’d have to do the small favor of not litigating the original transaction. So, the lesson learned from the first phase was that you wanted to pre-empt litigation as much as possible – of course, some would come regardless, but it’d be better if it came from a smaller and less-resourced cohort. Therefore, put together some somewhat coercive follow-on transactions to try to mollify (or at least sideline) as many of those left behind as possible.

Envision was a masterclass in this respect and was an overall clever structure (perhaps too clever by half in retrospect) but there was still a tremendous amount of value shifted to initial participants (which was both reflected in trading prices at the time and then even more so in recoveries after Envision filed later – since Envision deteriorated more quickly than anyone expected not even the original ad hoc group did as well as they would’ve thought at the time of the transaction with recoveries in the 80s). (Envision’s broader transaction involved both a drop-down and non-pro rata uptier, but the point here is that it exemplifies the movement toward attempting to bring initial non-participants into the fold, and thus minimize future litigation as much as possible, through coercive follow-on transactions.)

Third, now we’ve begun to see transactions where everyone has the opportunity to participate in the same (or more or less the same) transaction, but on somewhat different terms – with the net result being that the amount of “value” shifted is more muted at time zero.

Now, there are some who view any transfer of value that occurs when not everyone can participate on the same terms as an affront – all should be given an opportunity to participate on the same terms at time zero, then if someone doesn’t want to (e.g., doesn’t want to participate in the new-money component and get a more favorable exchange rate on their pre-existing debt as a result) then the value shift that occurs is on them.

However, I would think about it this way: in the Double-Dip Guide I made the point – which is more obvious when thinking about double-dips – that for a company that can’t do a regular-way refi or otherwise raise new debt, then a double-dip is a way to both raise new debt and keep the rate of that new debt low since you’re manufacturing a diminished downside on the new debt for holders (through the multiple claims).

Sure, if the company files down the road then non-participating pre-existing holders are going to have their recoveries diluted down by the multiple claims – so there is “harm” done here relative to a regular-way financing – but at time zero it feels less aggressive and is less aggressive. The enhanced downside – created through the multiple claims – is a form of indirect compensation to participants, and is the reason why the new debt can be incurred to begin with and the reason why the rate on that debt can be so low (remember that in At Home, for example, the double-dip debt priced well inside the yield on the pre-existing pari debt).

The same idea applies to non-pro rata uptiers where everyone can participate eventually but on a bit different terms. However, instead of the indirect compensation for the new-money coming through multiple claims, it comes through better participation terms (e.g., a higher exchange rate on the pre-existing debt you’re exchanging into one of the new tranches, so you’re taking less of haircut relative to everyone else).

Look, this is all apologia (my biases are nothing if not well trodden, and this can all be argued the other way in certain respects) but it is important to think about these situations through both the direct and indirect economics of participants.

If a company needs to raise liquidity or needs to rework a troublesome spot in their capital structure then the mechanism through which risk is expressed is traditionally through the terms of the debt (most importantly, of course, the rate). Thus, high-yield companies issue higher rate debt than investment-grade companies, etc.

However, when a regular-way raise proves impossible – because the company can’t shoulder the cost of the debt if the rate were stuck at a level that would compensate lenders for the risk incurred – then a creative alternative like an LME will need to be explored.

And the reason that an LME could work, with new debt struck at a rate that isn’t too much for the company to handle, is because of the indirect compensation participants are getting: whether that be some kind of structural advantage, favorable exchange rate, multiple claims or some combination of these.

Anyway, I mean, there’s no getting around that in Serta, Incora, Robertshaw, et al. – in which almost all the value got sucked up to participants with non-participants left with scraps – it’s tougher to say this indirect compensation was sufficient unto the day with any less simply not being feasible.

But in recent months – with Apex Tool, Go To Group, and Rackspace – we’ve seen a more muted shift in value that does resemble a more sensible form of (indirect) compensation based on the risk involved in providing the new-money that’s expressed through more favorable exchange rates for those in the initial ad hoc group vs. everyone else who can participate on a bit worse or different terms. Here’s a nice illustration from Reorg…

So, in the end, in this third phase what we’re seeing is less winner-take-all outcomes. Instead, we’re seeing a Third Way be carved out – where those within initial ad hoc groups are shifting value toward themselves, sure, but this is being done when there is little choice but to pursue a risky transaction that needs to be compensated somehow (and since it can’t come through the rates channel, it comes through a shift in value – that’ll lead to better recoveries if filing occurs – via more favorable exchange rates).

Like I said, this is a bit of a heuristic or thought exercise for thinking through the evolution of uptiers. It’s true that the ongoing litigation – and the direction the winds are blowing after Judge Jones’ untimely departure – has no doubt contributed to the approach undertaken in more recent transactions. Likewise, each transaction happens within a unique context and with different incentives at play (see: the internecine fighting in Robertshaw which makes it such an outlier to the trend of uptier structures we’ve seen as of late).

However, one would expect that as more transactions occur that norms begin to be set, definitions of what is really aggressive begin to form, and transactions begin to fall more often within the comfortable middle which raises less ire and litigation. It takes time to work out the kinks. (Of course, we have a small sample size here and courts will, eventually, draw some firmer borders of some kind that we need to operate within.)

P.S. – Michael Gatto – head of the private side at Silver Point and someone whose name you may have heard invoked once or twice if you listened to Incora’s adversary trial – launched a new book called The Credit Investor’s Handbook back in Jan. I read it when it came out, and it’s fantastic and has remarkable coverage for its length. Make sure to pick it up. Michael and I exchanged a few emails back and forth – after he picked up the guides and had some extremely kind words to say about them – and I’ll see if maybe we can do a little interview in a future blog post or something fun like that. And, of course, for those at Columbia make sure to take his course that he teaches each year. (I think Michael is planning to do quite a few campus talks in the future, so be sure to also be on the lookout and attend one of them if you hear about it.)