November 19, 2020 - On November 18th, the LSTA hosted a webinar, Recent Distressed Liability Management Transactions: Lessons for the Loan Market: Part II, presented by Meyer Dworkin, Jason Kyrwood, and Brian Resnick of Davis Polk. This webinar follows from the first webinar on the topic presented for LSTA members by the Davis Polk team on September 29th. Liability management transactions provide borrowers with financing of last resort. Two main types have dominated the loan market this year: drop-down financing transactions and uptiering transactions. In the typical “drop-down” financing structure, borrowers create structurally senior debt by moving assets outside an existing collateral package, often using unrestricted subsidiaries (eg, J.Crew and Revlon). In contrast, in “uptiering” transactions, borrowers create contractually senior debt by mixing and matching the priority of claims within the existing credit and collateral package (eg, NYDJ).
From the borrower’s perspective, these strategies are a bridge to a more normalized operating environment. They can reduce the aggregate principal amount of existing debt (and thus reduce related periodic interest payments), address upcoming maturities, obtain needed covenant relief from potential defaults, and maximize flexibility in a challenging operating or financing environment. Lenders, however, may be surprised that the relevant credit agreement even permits these transactions. One of the fundamental economic assumptions of lenders acquiring loans in the loan market is that they are acquiring first lien debt. Thus, it is problematic when these financing structures are ultimately implemented without minority lenders being given the opportunity to participate.
The provisions or language of a credit agreement which are implicated when these transactions are implemented relate to the investments covenant, unrestricted subsidiaries, pro rata sharing, and open market purchases. Lenders can protect themselves from these undesirable results by adhering to a documentation checklist when they review the applicable credit agreement before making their investment. For example, lenders who want to ensure against a J.Crew trapdoor should check the cap on investments by loan parties in non loan parties, consider all investment baskets as a whole as potentially permitting investments in unrestricted subsidiaries or non loan party restricted subsidiaries, and consider an aggregate cap or override. Lenders may also consider including anti J.Crew language to protect against investment of material IP or other assets in non-loan party subsidiaries and an example of such a provision was provided by the panelists. Lenders were, however, cautioned that in some businesses such language may not be needed because there may not be material intellectual property or divisions of the borrower’s business may not be easily separated.
Lenders should also carefully review the credit agreement language relating to pro rata sharing and open market purchases. The pro rata sharing provision is typically a sacred right subject to 100% vote to amend but documents may not capture all the categories of the pro rata treatment provision. Thus, parties should ensure that sacred rights protection on the pro rata sharing provision is air tight. In addition, lenders should revisit the open market purchase flexibility afforded to borrowers under the credit agreement. Provisions permitting open market purchases were designed to allow the borrower to delever on an open market basis and to take advantage of depressed secondary prices. Lenders may want to consider if borrowers really need to have the ability to effect these. Perhaps a Dutch auction is all that is needed or perhaps open market purchases should not be permitted in connection with a concurrent debt exchange or refinancing. Other documentation considerations include adding language that prevents “exit consents” in connection with an uptiering transactions or creating a “guarantor coverage test” in lieu of restrictions on investments by credit parties in non-credit parties in appropriate circumstances. Finally, CLO managers may consider a CLO concentration limitation as a potential solution. For example, CLOs may start by initially permitting all deals to have these provisions to allow borrowers flexibility to engage in the transactions and then include a step down such that CLOs would not be permitted to hold any or hold only a very small amount of debt that permitted liability management transactions. Although this approach would require industry wide adoption, it’s an interesting option which addresses this from the lender’s perspective. Members are encouraged to listen to the replay and review the slides which provide a helpful and detailed documentation checklist.