Investment Fund Activity in US Debt Restructurings

In summary

This article examines the role private equity and hedge funds have come to play in US debt restructurings and the variety of investment strategies they deploy in distressed situations, including in connection with pre-negotiated and pre-packaged Chapter 11 cases and out-of-court restructurings.

Discussion points

• Conditions leading to increased investment fund participation in US debt restructurings
• 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

• In re Carlson Travel, Inc.
• James J Mazza and Zahed A Hanseeb, Rights Offerings in Chapter 11 Bankruptcies, Review of Banking & Financial Services (July 2020)
• In re LATAM Airlines Grp, SA
• Audax Credit Opportunities Offshore Ltd v TMK Hawk Parent, Corp
• LCM XXII LTD. v Serta Simmons Bedding, LLC
• Bayside Cap. Inc v TPC Group Inc (In re TPC Group Inc)
• Laurie DeMarco, Emily Liu & Tim Schmidt-Eisenlohr, ‘Who Owns US 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

Private equity and hedge 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 its course and outcome. This trend shows no signs of stopping, particularly in light of the growth of direct lending and private credit. 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 article 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 has led to an explosion in private credit and direct lending since the financial crisis.^[1] And during periods of increased restructuring activity, such as the months following the outbreak of the covid-19 pandemic, investment funds have had a greater appetite for and ability to invest in distressed situations.

Today, investment funds play diverse and varied roles in debt restructurings. 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 key stakeholders and primary financing sources 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. Distressed investment funds often acquire concentrated positions in debt of distressed companies at a discount to par. And as direct lending proliferates, future restructurings may increasingly see ownership of issuers’ debt already concentrated in the hands of relatively few investment funds before the issuers become distressed. Such investment funds often stand ready to defend their existing positions and gain leverage and control over the company’s direction by providing additional financing to distressed companies, whether in the form of rescue loans to stave off a bankruptcy filing, or DIP or exit financing to support a debt restructuring. Investing new capital in a distressed company can also 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.

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, out-of-court ‘liability management’ transactions, as well as in-court ‘pre-arranged’ and ‘pre-packaged’ Chapter 11 cases, are increasingly common.^[2] Through liability management transactions, investment funds work with distressed issuers to structure creative financing solutions that may provide additional liquidity, extend maturities, or even develerage an issuer’s balance sheet without the need for Chapter 11 proceedings. In the case of pre-arranged or pre-packaged Chapter 11 cases, 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.^[3] 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 within one to two days of filing.^[4]

The prevalence of collateralised loan obligation funds (CLOs) has also had a direct impact on several recent large restructurings. CLOs are structured investment vehicles that issue multiple tranches of securities with different risk profiles against a diversified portfolio of senior secured loans. The documents governing CLOs often contain restrictions to protect CLO investors from loss, including limits on the amount of junior and unsecured debt and equity that can be held in the portfolio. While CLOs may hold senior secured positions in capital structures of companies that become distressed, they have recently played a larger and more active role in debt restructurings as they increasingly retain ownership of troubled loans rather than selling to investment funds specialising in distressed strategies. Because CLOs are subject to unique constraints and incentives that may shape outcomes for all participants in unexpected ways, 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 its 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 and increasingly large. In 2021, distressed companies raised over US$30 billion through rights offerings in large Chapter 11 cases, including a single rights offering as large as US$10.5 billion in LATAM Airlines’ bankruptcy.^[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 35 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 any equity that remains unsubscribed following the rights offering. 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 10 per cent 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.

For example, in LATAM Airlines’ recent bankruptcy, the court approved backstop agreements that obligated the debtors to reserve (or hold back) 50 per cent of the US$6.816 billion in new convertible notes to be issued under the Chapter 11 plan for certain commitment parties (who were a subset of the unsecured creditors that would receive a distribution under the proposed plan of reorganisation). The unsecured creditors’ committee, an unsecured notes trustee and other unsecured noteholders argued that the proposed restructuring plan violated the equal treatment requirements under the bankruptcy code because other unsecured creditors would not be given the same right to purchase the convertible notes as the backstop parties, which they argued would result in materially lower recoveries than the backstop parties would receive. They also argued that the aggregate consideration (including the hold back and a 20 per cent backstop fee) to be paid to the backstop parties was unreasonable.

In approving the backstop agreements, the court found that the objectors had not carried their burden to rebut the presumption that entry into the backstop agreements was a proper exercise of the debtors’ business judgment.^[10] In ultimately confirming the debtors’ plan, the bankruptcy court held that the plan satisfied the equal treatment requirement because all unsecured creditors ‘have the same opportunity for recovery’ and the 50 per cent hold back was distributed to the commitment parties ‘in consideration for their willingness to backstop’ the rights offering, rather than on account of their claims.^[11]

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.

Non-pro rata uptier transactions

Investment funds frequently participate in out-of-court restructurings and liability management transactions that may allow a distressed company to extend its liquidity runway or debt maturities, or even restructure its debt, without the need for a costly Chapter 11 proceeding. Such transactions often include, as a key component, a new-money investment in ‘priming’ debt structured to have priority over the company’s existing debt with respect to some or all of the company’s assets.

Several recent liability management transactions have attracted attention by combining a priming new-money debt investment with a roll-up of a portion of the company’s existing debt held by participating creditors into additional priming debt. The debt of non-participating creditors is thus subordinated not only to the new-money debt but also to existing debt that was previously of equal or even junior priority. In some cases, the non-participating creditors are not offered the same opportunity to participate, further enhancing the value of the roll-up to the participating creditors.^[12]

Several of these transactions have drawn litigation challenges from the non-participating creditors. For example, in September 2020, TriMark, a distributor of food service equipment, completed a transaction with holders of a majority of its first-lien debt, who agreed to amend their credit agreement to subordinate the first-lien debt to new ‘super-senior’ debt, US$120 million of which was ‘first out’ and issued for new money and US$307.5 million of which was ‘second out’ and issued in exchange for the existing first-lien debt of the consenting lenders. The amendment also eliminated the restrictive covenants and other lender protections in the existing first-lien credit agreement. The remaining first-lien lenders were not offered the opportunity to participate and challenged the transaction in the New York state Supreme Court. In 2021, the court denied the defendants’ motion to dismiss the lawsuit, holding that the non-participating lenders had a ‘plausible argument’ that the transaction impinged on ‘sacred rights’ under the credit agreement that cannot be modified without the consent of each lender.^[13] In January 2022, TriMark announced a settlement with the non-participating lenders, which included an exchange of all existing first-lien debt on a dollar-for-dollar basis for second-out super senior loans.^[14]

More recently, in March 2022, the court considering a non-participating lender’s challenge to a similar 2020 transaction by bedding manufacturer Serta Simmons denied the defendant’s motion to dismiss. The court held that it could not resolve as a matter of law whether Serta’s rollup of existing first-lien debt on a non-pro rata basis into priming debt was an open market purchase permitted under the credit agreement, and further held that the term ‘open market purchase’ was sufficiently ambiguous as to require discovery as to its meaning. The court additionally denied Serta’s motion to dismiss the non-participating lender’s claim that the defendants had breached the covenant of ‘good faith and fair dealing’ that is implied in every contract.^[15]

While liability management transactions will likely continue to present investment opportunities for investment funds and an attractive alternative to Chapter 11 for distressed companies, courts will scrutinise such transactions to test compliance with applicable credit agreements.^[16] At the same time, market participants may respond to this trend by negotiating provisions in debt documents that more clearly define the extent to which such unequal treatment of similarly situated creditors is permitted or prohibited.^[17]

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.^[18] 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.^[19]

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.^[20]

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.^[21]

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.^[22] For example, investment guidelines may permit CLOs to make equity-funded or restructuring-related investments with lower penalties than those that have been historically assessed, or to more flexibly use excess cash to exercise warrants or similar options included in collateral packages, each of which may lead to greater realisation of value in distressed situations. 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 article.

Notes