How Higher Rates Will Influence the Next Restructuring Cycle
Monetary policy famously works with long and variable lags and restructuring investment bankers are finding this out the hard way. Even though the fastest rate hike cycle of the past four decades began earlier this year, in-court restructuring activity has remained historically anemic.
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.
The Ability of Issuers to Service 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.
The Ability of Issuers to Refi Their Debt
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.
The Implications of Rising Rates on Restructuring Activity
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.
Non-Macro Factors Driving 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).