With Liability Management Transactions on the Rise, Borrowers Need a Risk Mitigation Strategy
Rob Shapiro
LMTs are an increasingly popular way for borrowers to address balance sheet liabilities ahead of impending debt maturity, but they require careful planning and strong operational support
During the pandemic, when interest rates were low and competition among creditors stiff, corporate borrowers had the upper hand. Many played their cards effectively, securing “loose” credit documents that provided them with significant leverage and flexibility.
Now, with interest rates stubbornly high, the tables have turned, and borrowers are struggling with liquidity as pandemic-era loans come due. As a result, they’re increasingly turning to what was once considered a last-ditch effort to stave off bankruptcy: liability management transactions (LMTs). In short, by leveraging the flexibility built into these looser credit documents, borrowers can execute a range of transactions that allow them to restructure their balance sheet liabilities to meet their short-term financial needs and longer-term business goals.
Yet LMTs are not without risks: approximately 40 percent of borrowers who attempted one between 2019 and 2021 have since defaulted or filed for bankruptcy. What’s more, most pandemic borrowers only get one good shot at these deals, since creditors will attempt to tighten up ensuing credit documents to prevent future LMTs. That’s why borrowers considering an LMT should do so with a careful strategy in mind.
In fact, while a “one-shot” mentality is vital for borrowers, successful liquidity and covenant management throughout an LMT should be top of mind, since tripping a covenant could shift leverage back to the lenders. With limited room for error, BRG professionals work closely with borrowers to develop and implement strategies and operational improvements that minimize near-term LMT execution risks while promoting the company’s long-term viability. Here’s what to know.
The Three Major Types of Liability Management Transactions
Liability management transactions can take many forms, depending on the loan’s financing terms and corporate borrower’s needs. The three most common types include:
Amend and extend. Borrowers and supportive creditors amend the current debt facility to extend the debt maturity, offering more time for financial performance and macroeconomic conditions to improve. This is a popular option for those facing the upcoming debt maturity wall but may not be aggressive enough for borrowers facing imminent bankruptcy; it also requires a majority of the creditors to agree to an amendment, which may be difficult if the borrower’s prospects appear weak.
Uptier transaction. Supportive creditors not only work with the borrower to amend existing financing documents, but also issue new senior-secured financing to the borrower, allowing them to move up in the capital structure and functionally subordinate debt from any nonparticipating creditors (meaning participating creditors are more likely to see a recovery in bankruptcy). For borrowers needing a near-term cash infusion, however, this type of LMT still requires a degree of consensus and cooperation with creditors.
In a well-known case, a mattress company opted for this strategy, allowing participating lenders to benefit from a super-priority loan facility and a discounted debt-for-debt exchange that reduced the company’s existing debt by more than $400 million and increased its cash on balance sheet by more than $300 million. Though it eventually led to litigation, the court validated the legitimacy of the company’s transaction.
Drop-down transaction. A more aggressive approach, drop-down transactions utilize existing “basket capacity”—exceptions to covenant restrictions in the existing credit documents—to move collateral to unrestricted subsidiaries, which can then be sold to bring in capital or used as collateral for new secured debt.
Existing creditors generally dislike this type of LMT as it shrinks their collateral base and recovery potential. Moving valuable assets can also pose significant operational disruptions to the business—though it can help borrowers take advantage of discounts in the debt market while avoiding dire financial straits.A pet retailer famously took this strategy, selling off equity in its e-commerce subsidiary to make it an unrestricted subsidiary—thereby moving it outside the reach of existing lenders. Though the transaction went through and gave the company much-needed breathing room, the move wasn’t without controversy.
Borrowers may pursue these types of LMTs in tandem or even leverage their ability to take more aggressive action to entice creditors into making a better deal. Faced with the prospect of seeing their investment sidelined in a drop-down transaction, for example, creditors may be more willing to make a deal to extend the current terms of the loan or even inject new capital through an uptier transaction.
Strategies for Success with Liability Management Transactions
While LMT strategies are unique to each situation, borrowers should keep these best practices in mind as they explore and execute an LMT.
Don’t wait until it is too late.
A company should not wait to consider a liability management transaction only when its financial situation is desperate—at that point, it will be more difficult since the business will need to employ more aggressive transactions and may struggle to find creditors willing to back its long-term prospects.
Instead, the ideal time to consider an LMT is when the borrower is still confident in the business’s health and debt maturity is still a few years away. This leaves open more options, makes it easier to strike deals with creditors, and takes advantage of market conditions while improving the likelihood of avoiding defaults and bankruptcy.
Conduct liquidity and capital structure analyses.
Ultimately, a borrower pursuing an LMT will need to weigh what the business needs with what its existing financials and risk appetite will allow. The more complex and aggressive the LMT, the more investment is needed to execute the transaction. LMTs that lack widespread support from creditors could also end up in litigation, adding more risk to the calculation.
Borrowers should therefore conduct long- and short-term liquidity assessments and in-depth scenario analyses to determine debt capacity.
Those looking to execute a drop-down transaction, for example, should examine not only the flexibility of their baskets within their credit documents but also how their legal structure could accommodate moving assets to unrestricted subsidiaries. This can be industry dependent: borrowers in healthcare, for instance, may be more capable of executing drop-down transactions thanks to their complex legal structures and a tendency toward rollups and consolidations. Additionally, healthcare still has a viable business model and an essential offering. Retail companies with just a few brands may be more limited in moving assets—and may be less attractive to creditors should they fail to adapt to changing consumer behaviors.
Work with experienced advisors.
In addition to bankers, borrowers should work with experienced advisors throughout the LMT process. Skilled advisors can offer informed guidance and support at key steps in the process, from choosing the right strategy to operationalizing structural changes to minimize disruption and risk.
Knowledgeable outside advisors are especially valuable when identifying strategic assets that are best suited to complex transactions like drop-downs. Supplementing bankers’ financial analyses, they can offer business-focused insights on assets that can operate on their own, have consistent cash flow, and can move within the legal entity structure without unwanted tax impacts.
With one good chance to get it right, borrowers should ensure that they have the information and advice they need to make the strategic choice for their business needs—and the operational support to see their decision through.
Rob Shapiro is a managing director in BRG’s Boston office leading BRG’s healthcare restructuring vertical and is responsible for driving cross-functional delivery for the firm’s Corporate Finance clients in the space. He routinely represents boards, management teams, and lenders in stressed and distressed situations.
Email: rshapiro@thinkbrg.com
Phone: 646.327.5868