Liability management exercises: Trends, risks and opportunities

Recent years have seen a rise in borrowers employing liability management exercises to restructure or refinance their liabilities, often as an alternative to more traditional court-led restructuring and insolvency processes.

Similarly, investors and creditors are increasingly being dragged into liability management exercises, either as a proactive participant eyeing a bespoke investment opportunity or as a defensive participant seeking to protect their priority in the borrower's capital structure and, ultimately, their investment in the borrower.

This article looks at the key features of common types of liability management exercises and considers ways in which creditors can mitigate against the risk of being on the wrong side of a liability management exercise.

What are liability management exercises?

A liability management exercise is any out-of-court process, implemented within the terms and confines of a borrower's existing financing documents, pursuant to which the borrower seeks to incur new debt or reorganise its existing indebtedness.

Typically, this will involve the borrower working with select creditors (sometimes, but not always, at the expense of other creditors) to incur new debt, extend maturities or even refinance at a discount.

The hallmark of a liability management exercise is that it is implemented within the consent thresholds of the finance documents. Generally, a liability management exercise is structured in a way that it avoids triggering the obligation to obtain unanimous creditor consent under the relevant finance documents. The consensual nature of the transaction also negates the need to 'cram down' dissenting creditors through a formal restructuring process (such as a scheme of arrangement).

Liability management exercises are often associated with the 'creditor-on-creditor violence' headline. This association comes from the fact that, in certain (but not all) types of liability management exercises, the borrower will seek to work with a select group of creditors to implement the transaction. In return, that select group of creditors will generally obtain an improved position in the capital structure of the borrower as a quid pro quo for participating in the new money or otherwise consenting to the implementation of the transaction.

Why are liability management exercises becoming more common?

While there is nothing new about the issues facing companies in distress (such as near-term maturities, lack of liquidity, unsustainable leverage etc.), the rise of liability management exercises reflects certain trends in both the financing and restructuring markets in recent years. In particular:

• the dilution of (previously) market-standard protections for creditors in financing documents has given rise to additional flexibilities in finance documents, which can be exploited by borrowers seeking to implement liability management exercises; and
• the perceived cost and execution risk of formal restructuring processes (see the recent English restructuring plans which were overturned on appeal such as Adler and Petrofac) may have led some borrowers to take the view that it is more effective to implement restructurings through an out-of-court process.

On the other side, creditors have been increasingly seeking to participate in liability management exercises on the basis that financing such transactions can offer more bespoke and robust financing structures compared to more typical debt financings and may provide the investor with a ‘first look’ or a ‘seat at the table’ with respect to any broader refinancings or restructurings of the borrower.

Types of liability management exercises

‘Drop-down’ or ‘asset transfer’ transactions

‘Drop-down’ or ‘asset transfer’ transactions generally involve the transfer of assets (usually material or 'crown-jewel' assets, such as the borrower’s intellectual property) to an entity which is not subject to the covenants contained in the relevant finance documents (i.e. outside the restricted group). Once outside the restricted group, the transferred assets can be used as security for the incurrence of new debt for the borrower group.

The purpose of transferring assets to an entity outside of the restricted group is to ensure that the transferee entity is not bound by the restrictive covenants contained in the existing finance documents (such as financial indebtedness or negative pledge covenants). This allows the new debt to be incurred on terms which would not be possible if incurred by an entity which is subject to the restrictive covenants contained in the existing finance documents.

Whether an asset can (or the extent to which it can) be transferred outside of the restricted group will depend on the availability of basket capacity in the existing finance documents (e.g. the investment in unrestricted subsidiaries basket). Generally, the existing finance documents will permit security to be released over an asset if the disposal or transfer of such asset is permitted under the terms of the existing finance documents (e.g. where it is permitted under the asset disposal basket).

Consideration should also be given regarding the extent to which the borrower and a threshold of creditors can agree to amend basket capacity in the existing finance documents. Amending the capacity of a basket (e.g. by upsizing the value of the asset disposal basket) can be utilised a first step towards implementing a ‘drop-down’ or ‘asset transfer’ transaction.

'Priming’ or ‘uptiering’ transactions

A ‘priming’ or ‘uptiering’ transaction involves the borrower working with the requisite majority of creditors to amend the existing finance documents to permit the incurrence of new 'super-senior' debt that has priority over existing debt.

Accordingly, unlike a drop-down transaction, a priming or uptiering transaction seeks to offer new money creditors enhanced priority with respect to the assets within the restricted group.

This type of transaction will typically be offered to existing creditors (as their consent is generally necessary to implement such a transaction) who will provide some or all of the new financing, including by exchanging or ‘rolling up’ some or all of their existing debt into the new priming debt.

A ‘priming’ or ‘uptiering’ transaction allows a borrower access to liquidity and may even allow a borrower to de-leverage if the exchange of existing debt to new debt is done at a discount.

From the creditor perspective, the majority participating creditors, in addition to receiving enhanced priority, will often receive increased economics and greater control over the borrower group through a tightening of the covenant package. This additional control can allow the majority participating creditors to have a seat at the table with respect to any future refinancings or restructurings that the borrower may undertake.

In contrast, creditors that have been primed (i.e. the minority non-participating creditors) will generally be left with a debt claim against the borrower which is subordinated to the new debt incurred (and any existing debt rolled up) as part of the transaction. Such subordinated debt is at risk of being wiped out in any subsequent restructuring or liquidation of the borrower.

Strategies for creditors to mitigate risks

The form of the liability management exercise will often determine the way in which a creditor or creditor group can react.

In relation to ‘drop-down’ or ‘asset transfer’ transactions, the consent of the creditors is (in theory) not required to move the relevant assets out of the restricted group or to create new secured debt. This is because the borrower is utilising pre-agreed basket capacity under the existing finance documents to implement the steps required. Accordingly, the ability of a creditor or creditors to challenge the proposed transaction may be limited.

In this situation, the best defence for creditors is to closely understand the existing finance documents (in particular the available basket capacity, lender consent thresholds and security/guarantor release provisions) to ensure that any action undertaken by the borrower is strictly within the limits of the existing finance documents. If such action undertaken by the borrower is not within the limits of the existing finance documents (or operates in a dubious grey area) then the creditors should be ready and willing to assert their rights against the borrower with a view to potentially challenging the borrower's proposed actions.

The situation is different in relation to a ‘priming’ or ‘uptiering’ transaction. In these types of transactions, the borrower is reliant upon obtaining a certain threshold of creditor support under the existing finance documents to implement the transaction. Accordingly, in these circumstances, the best defence for creditors may be to group together to ensure the requisite consent thresholds are not reached. This ‘grouping’ or ‘cooperation’ can be documented (sometimes referred to as a ‘cooperation agreement’) to contractually bind signatory creditors into not supporting potential liability management exercises (unless the requisite threshold of creditors under the cooperation agreement consent) as well as to provide a platform or process for creditors to work together with respect to dealing with the borrower.

Finally, to state the obvious, the point at which a creditor has the best chance of mitigating a potential liability management exercise is prior to the execution of the finance documents (or prior to a creditor acquiring an interest in existing finance documents) when the creditor can still negotiate protections into the finance documents (or decide not to acquire an interest in existing finance documents). Due diligence on the risk of liability management exercises can save significant cost later down the line, at which point mitigating the cost of a liability management exercise may not be possible.

Conclusion

Distressed borrowers are increasingly seeking to implement financial restructurings through liability management exercises rather than through more traditional in-court restructurings.

However, whether or not (or the extent to which) a borrower is able to carry out a liability management exercise is almost entirely dependent on the flexibilities contained within its finance documents.

Accordingly, when assessing the risk (or opportunity) of a liability management exercise in a given scenario, it is critical for borrowers and creditors to have a firm understanding of the capacities and flexibilities contained in the relevant finance documents.

In particular, assessing basket capacity, lender consent thresholds and security/guarantor release provisions will allow borrowers and creditors to understand how a liability management exercise might be implemented in a given scenario.

Ashurst’s restructuring and special situations team has extensive financing and restructuring experience and is ready to assist creditors and borrowers with any liability management exercise questions they may have.