September 30, 2020 - On September 29th, the LSTA hosted a webinar, Recent Distressed Liability Management Transactions: Lessons for the Loan Market, presented by Meyer Dworkin, Jason Kyrwood, Brian Resnick, and Ken Steinberg of Davis Polk. Liability management transactions are relatively new to the loan market.  In recent years and especially during the past six months, two forms of such transactions have dominated the market: the drop-down financing structure and the uptiering transaction structure.  In the typical “drop-down” financing structure, borrowers create structurally senior debt by moving assets outside an existing collateral package, often using unrestricted subsidiaries. The well-known loan market example of this is the 2016 J.Crew transaction. Other 2020 notable examples of this type of transaction include Travelport, Cirque du Soleil, 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.  The 2017 NYDJ transaction is an example of this, as is Serta Simmons, which has been in the headlines this year.

Uptiering and drop down transactions have been commonplace in the bond market for years; however, although there has been a convergence of certain bond and loan terms, the use of such bond market strategies in credit agreements has frustrated many lenders, taking them by surprise and challenging their traditional assumptions of what it means to be a lender in the senior secured asset class.

Looking at the specifics of the structures, in the typical drop down structure, the company forms or designates an unrestricted subsidiary which is completely excluded from the restrictive covenants in the existing debt documents (or there is sufficient capacity in the existing loan documents for the subsidiary to incur structurally senior debt). Then the company sells assets (often intellectual property as in J Crew) to that subsidiary, which is permitted under the existing loan documents and results in an automatic release of liens on such assets in favor of existing lenders. The subsidiary then incurs new debt financing that is secured by those contributed assets, and as consideration for providing such new debt financing, participating lenders may also be entitled to exchange or “roll up” all or a portion of their existing loans into a pari passu or junior claim against the subsidiary. The end result is that the new debt is structurally senior to the existing debt closer to the assets. This can come as an unwelcome surprise to first lien lenders who, at the time they extended the loans, thought they had a first priority claim to the assets.

The other type of liability management transaction – the uptiering transaction, falls into the category of a payment or lien subordination.  In the uptiering transaction structure, the company incurs new money “super-priority” loans provided by a group of existing lenders.  In exchange, existing debt of participating lenders is exchanged for or rolled up into pari passu super-priority or second priority loans.  The existing loans of non-participating lenders are then, effectively, subordinated to two tranches of debt.

Priorities may be effected by incurring the new and rolled up loans under a separate credit facility (a side car) and secured by separate classes of liens with priority as between the new/senior and existing/junior facilities governed by an intercreditor agreement. It may also be done by incurring the new and rolled up loans as new classes within the existing credit facility with priority dictated by the credit agreement waterfall (this is the structure followed in NYDJ). As the market sees new money coming back into the market, loan market participants should carefully review new credit agreements in the light of these types of transactions. For example, when looking at the covenant package, lenders must examine the investments baskets as a whole, and they should know exactly what to look for when seeing if the document “shuts down” J.Crew. They should also review the tests for designating unrestricted subsidiaries.  Lenders should focus on whether the subordination of claims (or liens) are a “sacred right” and should  ensure pro rata sharing provisions – all of them – are sacred rights and should also consider capturing transactions that have the effect of impacting pro rata sharing. In summary, lenders should read the fine print carefully.  Click here for the slides and replay.

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