Investment Fund Activity in US Debt Restructurings

In summary

This chapter examines the role hedge funds and private equity funds have come to play in US bankruptcy cases and the variety of investment strategies they deploy in distressed situations, including in connection with pre-negotiated and pre-packaged Chapter 11 cases and various litigation scenarios.

Discussion points

• Conditions leading to increased investment fund participation in US bankruptcy cases
• Overview of notable investment fund strategies
• Recent trends in investment fund tactics and the impact of such funds’ roles in large Chapter 11 cases and debt restructurings

Referenced in this article

• James J Mazza and Zahed A Hanseeb, Rights Offerings in Chapter 11 Bankruptcies, Review of Banking & Financial Services (July 2020)
• In re Windstream Holdings, Inc
• In re Peabody Energy Corp
• In re Breitburn Energy Partners LP
• Kenneth Epstein & Eric Fischer, ‘Litigation Funding in Bankruptcy Court: An Essential Tool for Maximizing the Value of the Debtor’s Estate’, 259 New York Law Journal, 50 (2018)
• Laurie DeMarco, Emily Liu & Tim Schmidt-Eisenlohr, ‘Who Owns U.S. CLO Securities? An Update by Tranche, Board of Governors of the Federal Reserve System’, 25 June 2020
• In re Deluxe Entertainment Services Group Inc
• In re Pioneer Energy Services Corp

Introduction

Hedge fund and private equity fund participation in US debt restructurings has proliferated since the 2008 financial crisis. Funds specialising in distressed investments now appear in almost every large US debt restructuring and often play a significant role in shaping the course and outcome of the restructuring. Investment funds continue to be a strong force in Chapter 11, as sophisticated investors are adept at finding creative ways to maximise their returns. This chapter examines some of the investment strategies that funds have deployed in response to current market conditions and the impact of such funds’ roles in large Chapter 11 cases and debt restructurings.

Background

The global financial crisis that began in September 2008 precipitated a huge increase in Chapter 11 filings: nearly 20 times more debt was restructured through Chapter 11 in 2008 and 2009 than in the two preceding years. Not only did the total number of bankruptcy filings increase, but the size and complexity of companies seeking bankruptcy protection also grew considerably. Yet this unprecedented upswing occurred at a time when banks and other traditional lenders were themselves struggling with the impacts of the financial crisis (and, later, with the regulatory repercussions that significantly scaled back their ability to invest in distressed situations). Non-traditional lenders, such as investment funds – both private equity and hedge funds – stepped into the resulting funding gap. Unlike traditional banks, investment funds are subject to significantly less regulatory oversight and reporting obligations. This gives them greater flexibility in their investment strategies, which, in the economic downturn, meant that they had a greater appetite for and ability to invest in distressed situations.

Today, investment funds play diverse and varied roles in Chapter 11 cases. They:

• invest in every level of a debtor’s capital structure;
• provide financing to distressed companies out of court to help them avoid bankruptcy;
• provide financing to debtors to fund Chapter 11 cases and post-emergence operations;
• purchase assets from companies in bankruptcy through section 363 sale and Chapter 11 plan processes;
• engage in constructive negotiations with debtors to implement fully consensual restructurings in record time; and
• may stake out positions that require them to employ a full range of litigation tactics.

Of these myriad approaches, two overarching themes stand out. First, investment funds are often the primary financing source for distressed companies, providing everything from rescue loans and financing for out-of-court restructurings, to debtor-in-possession (DIP) financing to fund Chapter 11 cases and exit financing to fund operations post-bankruptcy. Investing new capital in a distressed company in this manner can yield substantial returns for a fund over a relatively short period of time, since the interest, fees and premiums that are earned on such investments tend to be significant. Moreover, by providing such financing, funds gain substantial leverage and control over the company’s direction.

Second, the strategies employed by investment funds may affect a distressed company’s prospects for a speedy and successful restructuring. In many cases, the presence of well-heeled, sophisticated investment funds facilitates a quick and cost-efficient restructuring, avoiding a prolonged Chapter 11 case and the resulting administrative expenses – most notably professional fees – and delays that can materially impair the company’s ability to successfully reorganise and the fund’s ultimate returns. As a consequence, ‘pre-arranged’ and ‘pre-packaged’ Chapter 11 cases are increasingly common.^[1] In these instances, the terms of a Chapter 11 plan are fully negotiated before the case begins with an agreement among the company and its key creditor constituencies – typically, one or more ad hoc groups of investors holding majorities of the company’s funded indebtedness – including the group believed to hold the fulcrum security. The company then enters Chapter 11 to implement the negotiated deal in the shortest possible time frame.^[2] Pre-packaged Chapter 11 cases can often be completed in 30 to 45 days, sometimes even less. Indeed, debtors in recent pre-packaged Chapter 11 cases were able to obtain confirmation of their plans of reorganisation in a single day.^[3]

On the opposite end of the spectrum, investment funds may invest in more junior levels of a company’s capital structure or seek to exploit what they perceive to be a flaw in the company’s loan agreements or indentures. These more speculative investments are popular in slower restructuring markets where distressed investment opportunities are diminished and returns are harder to come by. Generally speaking, realising a return on these types of more speculative investments often requires funds to employ litigation tactics. These tactics can be aimed at proving an entitlement vis-à-vis other creditors in the capital structure or as leverage to obtain outsized recoveries as part of an overall settlement divorced from economic entitlement. While difficult to prove empirically, anecdotally, this practice increases the frequency of restructuring litigation and drives up the overall cost of a restructuring.^[4]

The prevalence of collateralised loan obligation funds (CLOs) has also had a direct impact on several recent large restructurings. While CLOs generally acquire senior secured positions in capital structures of distressed companies, they have recently begun to play a larger and more active role in restructurings and are subject to unique constraints and incentives that may shape outcomes for all participants in unexpected ways. As a result, market participants have begun to develop creative strategies to accommodate CLOs’ specific needs and obtain their support for restructuring transactions.

What follows is a look at some of the more recent tactics employed by, and the unique characteristics of, investment funds in large US debt restructurings.

Recent developments and trends

Backstopped rights offerings

A fertile ground for generating returns is to offer to backstop new money investments, whether in the form of debt (eg, DIP and exit financing) or equity. The latter often takes the form of a rights offering, where investors are provided an opportunity to invest in the equity of a company about to emerge from Chapter 11, often at a discount (sometimes a substantial one) to the company’s Chapter 11 plan value.

Rights offerings are attractive to companies in Chapter 11 that are otherwise capital-constrained because they offer companies access to equity capital without substantial cost. This is due, in part, to the fact that many such offerings are exempt from registration with the US Securities and Exchange Commission if certain requirements are met. Moreover, rights offerings are highly flexible financing structures that permit parties to customise both the terms and conditions of the equity issuance as well as the terms of the offering (including the allocation of the right to participate) to best serve the needs of the company or the specific circumstances of the company’s Chapter 11 case. As a result, rights can be a valuable form of currency when negotiating creditor recoveries under a proposed plan. For these reasons, rights offerings are exceedingly popular. In 2020 alone, distressed companies raised nearly US$14 billion through rights offerings in large Chapter 11 cases.^[5]

In addition to providing a company with much-needed equity capital, rights offerings are attractive to creditors. A key reason is that rights are usually offered at a significant discount to the assumed value of the reorganised company to encourage participation; while the exact percentage can vary widely from case to case, recent offerings have frequently provided a discount to plan value in excess of 20 per cent, with discounts in the range of 30 to 37.5 per cent becoming more common.^[6] That means investors can often acquire a more significant stake in the reorganised company at an implied ‘in the money’ valuation. These rights offerings further favour funds with capital to invest, given the dilution that typically occurs in a rights offering.^[7] Thus, participation is critical to protecting plan recoveries, with those that participate benefitting at the expense of those that do not.

Investors can further enhance the investment opportunity afforded by a rights offering by agreeing to ‘backstop’ the offering, which means committing to purchase their pro rata shares along with any unsubscribed shares. This guarantee of the offering’s success is of enormous value to the company. As a result, acting as a backstop party can prove very lucrative. Backstop parties typically earn fees of between 3 and 9 per cent (averaging approximately 7.2 per cent in 2020) of the total offering in exchange for their commitments, which can be paid in cash or additional shares.^[8] Backstop parties may also obtain a preferred, or over-allotment, of rights to ensure a minimum participation above their pro rata allocation. In practice, these mechanisms provide backstop parties with enhanced economics that increase the return on their pre-existing investment in the company. These mechanisms also afford the backstop parties the opportunity to increase their ownership stake and resulting voice in the governance of the reorganised company.

Given the substantial value at stake in a backstopped rights offering and the potential for overreach, these arrangements are often subject to challenge. Challenges are often levelled at the reasonableness of the backstop fees, though this can be difficult to establish since the market for these fees varies widely.^[9] Other challenges take issue with the need and size of the preferred, or over-allotment of, shares reserved for the backstop parties. Still, other challenges have been made to the seemingly disparate treatment offered to the backstop parties as compared to similarly situated creditors in the same class.^[10] The terms of such backstopped rights offerings increasingly generate litigation.

In the Peabody Energy case, for example, the bankruptcy court confirmed a plan that contemplated a US$750 million backstopped rights offering of preferred equity to all eligible holders and a US$750 million private placement of such equity that was offered only to the backstop parties, over the objection of certain non-participating creditors who argued that the plan discriminated unfairly^[11] against creditors that were not backstop parties. The court found that the fees and premiums provided to the backstop parties – including the separate private placement as well as the allocation mechanisms therein – were permissible because they were not on account of the backstop parties’ prepetition debt holdings, but were in exchange for their post-petition backstop commitments. Therefore, section 1123 of the Bankruptcy Code was satisfied because all similarly-situated creditors were treated equally as they were given the opportunity to participate in the rights offering.^[12] Unsecured convertible noteholders raised similar arguments in the SunEdison bankruptcy case – namely, that the backstop commitments provided by certain holders of the debtors’ second lien claims for a US$300 million rights offering constituted vote buying and bad faith on the part of the debtors.^[13] The court rejected these arguments, recognising that the objections were ‘a thinly disguised effort to force the debtors and the other backstop purchasers to allow [the objecting parties] to participate’ in the backstop commitment.^[14]

Furthermore, a decision in the Breitburn Energy bankruptcy case confirms that for the purposes of section 1123, the opportunity to participate itself provides cognisable value, regardless of whether a particular creditor ultimately chooses to participate.^[15] In that case, the debtors’ plan provided that the sole source of recovery for a particular class of creditors was the opportunity to participate in a US$775 million rights offering. Parties that elected not to participate would receive nothing. At confirmation, the court overruled the objection of a creditor who had chosen not to participate in the rights offering and argued that it was not receiving a similar recovery as other similarly situated creditors who had chosen to participate. As part of a lengthy confirmation ruling, the bankruptcy court concluded that this plan treatment was permissible, because ‘section 1123(a)(4) requires equality of treatment, not equality of result. It is satisfied if claimants in the same class have the same opportunity for recovery’.^[16]

The creative structuring of backstop commitments and rights offering allocations that heavily favour the company’s largest stakeholders – who are the parties most likely to provide a backstop commitment – is a trend that is likely to continue.

Litigation trusts

The use of bankruptcy litigation trusts that are formed under a Chapter 11 plan to pursue litigation post-bankruptcy has provided investment funds with an additional source of recovery and an opportunity to deploy capital.

Post-confirmation litigation trusts are commonly used when debtors have significant litigation claims against third parties, the resolution of which is not required for the company to emerge from Chapter 11. In these cases, the debtor will bequeath the right to pursue these claims to a newly formed litigation trust and will typically seed the trust with some amount of initial funding. Interests in the trust will then be distributed pro rata to particular creditor groups (typically, junior classes) as part or as all of their recovery on account of their prepetition claims. Those interests, which often are freely transferable, entitle the holders to receive their pro rata share of any value that is ultimately obtained through prosecution of these claims.

The preservation of causes of action through litigation trusts is increasingly popular. In large part, this is because the creation of a litigation trust enables a debtor to emerge promptly from Chapter 11, notwithstanding one or more large unresolved litigation claims. Litigation trusts can also be advantageous for creditors that perceive value in the litigation claims and are willing to incur the risks and delays associated with litigation. Traditionally, junior creditors have been more likely to accept those risks in order to obtain a potentially larger overall recovery. Increasingly, however, investment funds have shown both a willingness to receive a stake in a litigation trust as part of their overall recovery under the plan and to finance the underlying litigation.

The Paragon Offshore bankruptcy cases provide an example.^[17] There, the debtors possessed litigation claims against its former parent company, Noble Corporation, which represented a major potential source of recovery for creditors. Initially, the debtors proposed a Chapter 11 plan premised on settling these claims. This plan eventually gave way to one that preserved those claims for creditors and placed them into a litigation trust. Notably, the interests in that litigation trust were granted not just to junior creditors of the company, but also to secured creditors. The trust interest proved to be a valuable medium through which to resolve disputes between the secured and unsecured creditors.^[18]

The use of litigation trusts in bankruptcies has afforded investment funds with other investment opportunities as well – specifically, in the area of financing. Typically, the debtors’ plan will seed a litigation trust with an initial cash amount when it is formed, after which the trust is responsible for its funding needs. Increasingly, however, parties have started to experiment with alternative funding structures, including funding from third parties.^[19]

One notable case concerns a litigation trust that was established in the 2009 mega-bankruptcy filing of General Motors to prosecute certain avoidance actions relating to the company’s prepetition term loan. The initial funding for that trust proved insufficient given the size and scope of the litigation, which led the trust administrator to conduct a competitive marketing process to obtain additional funding. Through this process, the trust received two funding proposals:

(i) an investment fund proposed to loan US$15 million to the trust in exchange for up to 4.75 per cent of the eventual proceeds of the litigation; and

(ii) the company’s DIP lenders proposed to loan US$15 million to the trust in exchange for 30 per cent of the eventual proceeds of the litigation as part of a larger settlement.

The trust chose (ii), notwithstanding the apparently higher cost of the loan, because of the benefits to unsecured creditors resulting from the overall settlement.^[20] This decision was approved by the bankruptcy court and affirmed on appeal over the objection of the proposed third-party investor.^[21]

Debt default activism

Investment funds may seek to generate returns by investing in a company’s capital structure with the intention of exploiting perceived flaws in, or arguable breaches of, the company’s credit documentation. Particularly when paired with the use of credit derivatives, this strategy has received a lot of attention in recent years and has led some market participants to develop innovative provisions to protect themselves.

The case of Windstream Holdings, Inc is instructive. In October 2017, Aurelius Capital Master, Ltd directed the trustee under Windstream’s senior unsecured notes to file suit against Windstream alleging that a transaction undertaken in 2015 violated certain covenants in the bond indenture – in other words, that Windstream had, unbeknownst to Aurelius and its other investors, been in default under the indenture for more than two years. In February 2019, after a bench trial, the court ruled in favour of Aurelius and awarded a judgment of more than US$300 million,^[22] prompting Windstream to file for bankruptcy shortly thereafter. Aurelius was reported to have profited from a position in credit-default swaps (CDS) that entitled Aurelius to payment if Windstream defaulted on its debt.^[23]

The potential for CDS to create incentives for investment funds to assert debatable defaults, and to obstruct or refuse to participate in restructuring negotiations that might avoid a default, has prompted some companies to negotiate for novel protections in their credit documents. For example, in May 2019 and January 2020, Charter Communications and ADT Inc, respectively, issued bonds under indentures that included a contractual ‘statute of limitations’ limiting the period during which bondholders can declare a default to a specified time period after the underlying action is reported publicly or to bondholders.^[24] In June 2019, Sirius Computer Solutions issued bonds that prohibited holders who are ‘net short’ from voting on holder actions.^[25] While these innovations, if widely adopted, may limit the type of debt default activism pursued in Windstream, opportunities to generate returns through creative and aggressive litigation tactics will undoubtedly persist.

Participation of collateralised loan obligation funds in restructurings

The market for CLOs in the United States has grown significantly in recent years, with CLOs funding 58.4 per cent of the primary leveraged loan origination in the United States between 2015 and 2019.^[26] CLOs have correspondingly come to play a greater role in restructurings. But CLOs face certain restrictions and incentives that differ from those facing hedge funds and private equity funds and, as a result, their increasing role poses unique issues in the restructuring process.

CLOs raise capital from investors to acquire a portfolio of investments consisting primarily of senior secured loans issued by below-investment grade borrowers. To mitigate risk to investors, CLO fund documents include restrictions on the types of investments that can he held in the portfolio. For example, a CLO typically includes restrictions on acquiring CCC or Caa-rated debt in excess of a specified percentage cap of the aggregate portfolio. Other common restrictions include limitations on a CLO’s exposure to second lien or unsecured loans and prohibitions on investing in equity securities. Further, most CLOs have tax structures that effectively limit their ability to originate loans and instead require them to purchase assets in secondary market transactions.

These restrictions may make it difficult for CLOs to participate in new-money investments, such as rights offerings, in connection with restructuring transactions, putting them at risk of dilution by hedge funds and private equity funds that are able to make such investments. CLOs also have incentives to prefer restructurings where their debt is not converted to equity, which may limit the amount of deleveraging that can be achieved in the restructuring. From a distressed borrower’s perspective, the presence of CLOs in its capital structure may therefore affect the restructuring options available to it.

For example, in the case of Deluxe Entertainment, CLOs holding the company’s pre­petition debt were initially willing to participate in an out-of-court restructuring or 24-hour pre-packaged Chapter 11 plan, which would have included at least US$25 million in incremental financing. However, as the consensual plan progressed, the debtor’s term loan credit rating was downgraded to CCC- and certain CLO funds were no longer willing or able to provide the incremental financing due to restrictions on their investments in CCC-rated debt. As a result, Deluxe was unable to obtain sufficient financing to complete the restructuring out of court and was instead forced to undertake a longer and more expensive in-court restructuring process.^[27]

As another example, the Chapter 11 plan of Acosta Inc entirely eliminated the debtors’ funded debt in exchange for equity and provided prepetition creditors with the right to participate in a US$250 million equity rights offering. Because equity interests are not considered eligible collateral obligations for CLOs, many CLOs were unable to participate in Acosta’s equity rights offering and may have been forced to sell their positions rather than accept equity in exchange for their debt.^[28]

In response to the CLO-specific restrictions and limitations, companies and CLOs have worked to implement creative and flexible workout structures. For example, Pioneer Energy Services’ unsecured bondholders, some of whom were CLOs, exchanged their debt for convertible notes, rather than equity, in the company’s restructuring. The CLOs were able to invest in the notes and obtain potential equity upside, while the convertible notes were structured to be mandatorily convertible in a variety of circumstances to give Pioneer flexibility to deleverage in the future.^[29] Some CLOs may also be permitted to make, or have made, exceptions to their investment guidelines to allow direct lending as protective investments to preserve existing portfolio investments that were not expected to default when acquired.^[30] As the role of CLOs in restructurings continues to expand, market participants will continue to develop creative strategies to address the unique constraints and incentives that CLOs face.

Conclusion

Investment funds continue to play a significant role in US debt restructurings. They are sophisticated investors who are able to adapt quickly to changing market conditions to find new ways to deploy capital and maximise their investments. In the most prominent of these recent trends, investment funds have found increasingly creative ways to achieve short-term gains through new investments in distressed companies while at the same time positioning themselves to obtain longer-term payoffs. In achieving these goals, investment funds adapt existing tactics and strategies to new situations and new aspects of US restructuring practice. The new developments discussed offer excellent examples of the creativity and flexibility that can mark investment fund activity in US debt restructurings and demonstrate how borrowers and other institutional lenders are adapting their restructuring strategies in response to the participation of investment funds in restructuring transactions.

^** The authors would like to thank Paul, Weiss counsel Michael Lee for providing valuable contributions to this chapter.

Notes