Distressed Companies’ Debt Deals Often Lead to Bankruptcy, Study Finds

A growing number of financially troubled US companies are attempting to avoid formal bankruptcy proceedings through complex deals with creditors, but new research indicates these arrangements often fail, and can even worsen outcomes. These deals, known as liability management exercises (LMEs), are increasingly common, yet a significant majority result in default within three years, frequently leading to the very bankruptcy they were designed to prevent.

The Rise of Alternative Restructuring

LMEs, sometimes referred to as “non-pro rata” refinancings or “creditor-on-creditor violence,” involve a company reaching an agreement with a majority of its creditors. In exchange for new funding, these creditors receive a prioritized position for repayment. However, this often comes at the expense of minority creditors, whose claims are diminished or rendered worthless.

A High Rate of Failure

A study by Mark Roe of Harvard Law School and Vasile Rotaru of the University of Oxford examined 89 LME transactions in recent years. The research revealed that over 80 percent of these deals resulted in default within 36 months, with many ultimately requiring a formal bankruptcy filing. The academics suggest that pursuing bankruptcy initially might have been a more effective course of action, allowing for proactive fixes to underlying business problems.

Did You Know? Saks Global completed an LME in June, raising $600 million, but was forced into bankruptcy seven months later due to a lack of cash.

According to Roe and Rotaru, “half of the purportedly successful LMEs end up in bankruptcy anyway, and those bankruptcies tend to be longer and more contentious than for non-LME filers.”

Factors Driving the Trend

The increase in LMEs is linked to the prevalence of “covenant-lite” debt – loans with limited investor protections – sold since the financial crisis. Additionally, the growing number of companies owned by private equity firms is contributing to the trend. These firms are often motivated to employ aggressive financial engineering to avoid bankruptcy, where a company’s valuation could be reset to the detriment of junior debtholders and equity holders.

The Role of Private Equity

Private equity ownership can embolden companies to pursue these complex financial maneuvers. Bankruptcy court proceedings can lower a company’s valuation, potentially wiping out the investments of equity holders. LMEs offer a way to potentially circumvent this outcome, though, as the research indicates, not always successfully.

Expert Insight: The pursuit of LMEs highlights a tension between protecting creditor interests and addressing fundamental business challenges. While these deals can offer a temporary reprieve, they often fail to resolve underlying issues, ultimately increasing costs and risks for all parties involved.

Success Stories and Caveats

While the majority of LMEs end in default, there have been exceptions. In 2018, PetSmart, backed by BC Partners, successfully separated its online unit, Chewy, shielding it from creditors. Chewy’s subsequent public offering and $40 billion market capitalization allowed PetSmart to repay its debt. Similarly, Carvana and EchoStar have recently executed LMEs and experienced operational turnarounds, increasing their market value and improving their debt ratings.

However, these cases are the exception, not the rule. Most LMEs provide only temporary liquidity and extended maturities, often accompanied by increased debt and interest expenses that prove unsustainable.

Concerns and Scrutiny

Some legal and banking professionals are expressing discomfort with LMEs that merely delay inevitable bankruptcy. While acknowledging the lucrative fees associated with these transactions, one restructuring lawyer stated, “I’m not saying most LME’s aren’t worth a shot, but the fact that they don’t solve long-term issues in many cases is just fundamentally bad.”

The firms structuring these deals are facing increased scrutiny, with accusations of prioritizing fees over long-term stability. Altice USA, for example, has sued private capital firms, alleging that advisors intentionally created tensions in distressed debt markets to maximize their earnings.

Data from Moody’s indicates a decline in recovery rates for senior loans. Between 2008 and 2022, these loans recovered an average of 75 cents on the dollar. However, the combination of covenant-lite debt and complex restructurings has reduced that average to just 57 cents after 2022.

Frequently Asked Questions

What is a Liability Management Exercise (LME)?

An LME is a deal where a company, facing financial distress, negotiates with its creditors to restructure its debt outside of formal bankruptcy proceedings. It typically involves a majority of creditors agreeing to provide new funding in exchange for a more favorable position for repayment.

What are the potential downsides of an LME?

Research shows that LMEs have a high failure rate, with over 80 percent resulting in default within three years. They can also disadvantage minority creditors, whose claims may be diminished or eliminated, and often delay necessary business restructuring.

Are LMEs always a bad idea?

While the majority fail, some LMEs have been successful, allowing companies to turn around their operations. However, these cases are relatively rare, and the research suggests that pursuing bankruptcy initially may be a more effective strategy in many situations.

Given the increasing complexity and questionable long-term efficacy of these financial maneuvers, what role should regulators play in overseeing liability management exercises and protecting the interests of all stakeholders?