06 Jun Eat Or Be Eaten (Q1-23)

The current macroeconomic environment has undergone a significant transformation, shifting from a prolonged period of historically low interest rates and robust growth to a new phase characterized by rapid interest rate hikes, sustained inflation, geopolitical tensions, supply chain disruptions, and volatile energy prices. These complex factors are exerting immense pressure on the cash flows of many middle market companies, prompting them to implement strict cost controls, hiring freezes, and even workforce reductions.

In some cases, these measures may prove insufficient to address the cash flow challenges faced by some companies. As a result, owners and lenders are actively seeking strategies to inject much-needed liquidity into distressed situations with the aim of supporting the implementation of turnaround plans. The need to address exigent liquidity issues can develop suddenly, so lenders must structure to accommodate such extenuating circumstances. The challenge lies in the fact that the eventual state of the business on the other side of the turnaround remains unknown. This uncertainty instills fear and avoidance on the part of most lenders when it should be recognized and embraced as the origin of a lucrative possibility.

Most strategic liquidity transactions that occur in the private credit market do not make media headlines and rarely make their way into courtrooms. Nonetheless, we have over the past few months participated in or witnessed several notable situations that shed light on the opportunities (or perils, depending on which side you’re on) afforded by weak credit documentation and inexperienced lenders. Many of these instances involve either the interpretation of provisions in syndicated credit agreements made among multiple lenders or uninitiated private credit managers inadequately prepared to handle the challenges associated with loan defaults and distress.

During periods of financial distress, borrowers will resort to radical measures to raise critical new liquidity even if it means negatively impacting certain existing lenders in the capital stack. When this occurs between a group of lenders in the same syndicate, it becomes what some affected lenders have termed a “cannibalistic assault!”¹ By leveraging the authority granted to majority lenders within the framework of their credit agreements, minority lenders can be effectively strong-armed into relinquishing their first-lien rights without their consent or even the requirement of seeking it. Investors of ours know that we emphatically emphasize the importance of private credit managers controlling the terms, amendments, waivers and exercise of remedies in their credit agreements. In an uncertain macroeconomic climate, borrowers will be increasingly tempted to use gaps and ambiguities in their lenders’ rights to unlock additional liquidity and uncover leverage against such lenders. Strong, experienced lenders will feast; weaker ones will be devoured.

Take the recent example of our rescue financing for a Canadian online grocery and wholesale distributor of fresh, local, organic produce and groceries. Existing lenders, including a government credit agency, a now defunct U.S. bank, and several small Canadian private credit funds, lacked the skill and will to provide the liquidity that was prudent and necessary to ensure the company’s survival and protect their investments. Our new superpriority loans secured against all existing loan collateral became a triumph for us but a disastrous woe for the existing lenders – all of them were completely wiped out. This outcome could have been prevented with creativity, additional investment, and more rigorous enforcement.

Perhaps, owing to the regulations governing risk weighting and asset treatment, or the desire to raise more capital, the lenders that backed the company were inherently inclined to delay acknowledging the distress and avert harm to their balance sheets. The lenders found themselves in a state of uncertainty, unsure of the appropriate course of action, and consequently lacked the motivation to actively enhance asset value or invest in initiatives that would improve future monetization prospects for their existing loans. We, on the other hand, are driven by our relentless pursuit of maximizing returns and capitalizing on mispriced risk. Banks are bound by a structural and regulatory framework that restricts their flexibility in deviating from narrow pricing parameters. Newer private credit managers that have not engaged in extensive loan workouts and corporate restructurings are ill-equipped to navigate through turbulent, volatile, and adversarial lender negotiations. In stark contrast, we thrive on the inherent possibility of transforming a secured debt instrument into an ownership instrument, thereby opening the door to unlimited upside potential.

Debt restructurings are going to increase in frequency and complexity. We believe this will lead distressed borrowers to engage in aggressive tactics to access new capital by finding loopholes in or amending their existing credit agreements, to permit new, and sometimes “superpriority”, secured debt. Such tactics are not new and increase in prominence during periods of economic crisis. In 2016, for instance, when deflation fears and a slowing Chinese economy caused oil prices and stock markets to plunge, many companies struggled to raise new capital. J. Crew, an apparel company, was facing the impending maturity of over US$500 Million in unsecured notes but had no new assets to pledge as collateral. The company exploited a loophole in its secured credit agreement to remove intellectual-property collateral from its lenders’ reach to help refinance the other maturing but unsecured debt. With the help of sophisticated distressed lenders, J. Crew found a “trap door” provision that facilitated the transfer of collateral and new secured loans. A closer look at this provision reveals that it was intended to permit J. Crew to invest in overseas subsidiaries and minimize taxes, not to permit the transfer of the lenders’ collateral.² After the fact, it is obvious that J. Crew’s existing lenders could have stopped this specific maneuver with a simple change to the contract.

One way we protect collateral leakage is by restricting transfers of assets and ensuring that the most precious “crown jewel” assets are held in entities that are firewalled from business risks and over which we have effective control through sole liens, share pledges, and lockbox arrangements. Borrowers’ tactics to exploit contractual weaknesses will become the norm and lenders must exercise caution to avoid falling victim to the pitfalls in their credit agreements lest they become “J. Crewed.”

Within syndicated credit facilities, a natural inequality or imbalance exists between lenders holding the majority of the debt and the other lenders. As a general rule, waivers, amendments and other modifications to the terms of a credit agreement must be approved by the “required lenders”, which is typically defined as those lenders holding a simple majority (i.e., over 50%) of the aggregate principal amount of the relevant credit exposures (including undrawn revolving commitments and outstanding term and revolving loans). Exceptions to this general rule are generally provided for amendments to so-called “sacred rights”, which represent lenders’ critical rights or core economic terms and which will require the consent of all lenders or every affected lender to be amended. These “sacred rights” typically include: (i) increases to lender’s commitments; (ii) reductions of principal amount; (iii) extensions to the payments dates; (iv) reductions of interest margins or fees payable; (v) amendments to the pro rata provisions; (vi) releases of all or substantially all of the collateral and (vii) other fundamental aspects of the credit agreement terms, such as voting rights.

However, cash-strapped borrowers in desperate times will resort to desperate measures. Rather than removing collateral from the reach of existing creditors, a borrower could obtain consent from required lenders to create new superpriority debt capacity under its existing credit agreement. In order to avoid running afoul of lenders’ sacred rights, the borrower crafts its amendment so as not to alter the credit agreement’s pro rata sharing provisions. Courts have rejected the argument that the sacred right protecting against releases of collateral is implicated by amendments causing (even deep) lien subordination.³ Pro rata sharing provisions, a key aspect of lenders’ sacred rights, ensure that lenders receive their proportional share of collateral proceeds based on the face value of their loan ownership. Typically, amending these provisions or other sacred rights requires the unanimous consent of all lenders or all affected lenders. Sacred rights serve to safeguard minority lenders from changes that could alter the fundamental aspects of their investment. Conversely, apart from sacred rights, most other provisions in the credit agreement can usually be amended with the consent of the required lenders alone. Increasingly, however, even the sacred rights are no longer truly sacred.

The Serta Simmons Bedding (“Serta”) restructuring in 2020 is an example of a crafty maneuver by which the borrower collaborated with the required lenders to amend the credit agreement to permit the borrower to incur incremental superpriority debt. The lenders in the majority group funded a new tranche of first-out superpriority debt and then exchanged their existing senior loans for a new tranche of second-out superpriority debt. The remaining minority lenders (who were not afforded the opportunity to participate in the new money financing or the exchange) found themselves effectively subordinated to these two new superpriority tranches. Serta circumvented the pro rata sharing provisions of the credit agreement by using undefined “open market purchase” language in their credit agreements. An open market purchase is a transaction in which a borrower purchases its own debt from lenders under a credit agreement’s terms. The open market purchases between Serta and the required lenders drew the ire of the minority lenders because the purchases were not offered to all lenders and were conducted via debt exchanges, not as purchases for cash.

The minority lenders appealed the transactions but in April 2023 the U.S. Bankruptcy Court ruled against them. The success of such so-called “uptier transactions” has revealed that minority lenders may not be able to rely on any contractual protection not expressly covered by a sacred-rights provision, particularly in distressed situations. Future majority lenders will be empowered to make aggressive amendments upending the rights and payment priorities of nonconsenting lenders. A lot of unsuspecting private credit managers are minority participants in syndicated loans governed by credit agreements that could suddenly render them unprotected or worse, unsecured. As a general rule, TEC does not participate in credit agreements where it does have majority control and administrative and collateral agent status.

The optimal solution to a borrower’s short-term liquidity crisis that threatens lender recovery may be the infusion of cash pursuant to debt restructuring transactions that involve a superpriority tranche of debt from existing lenders or otherwise. These transactions have the potential to serve as a lifeline to distressed businesses by allowing them to acquire much-needed new capital. They also benefit participating lenders, who receive enhanced priority and premiums on new or exchanged loans, while strengthening their position in any future financing or restructuring decisions. In our rescue financing for a Canadian e-grocer, for example, the existing lenders would have vastly enhanced their prospects of recovery had they joined TEC in its superpriority financing. The unfortunate reality is that many debt restructuring transactions present a zero-sum game.

Given these circumstances, it becomes paramount for investors exposed to direct lending strategies to carefully assess the track record and expertise of their managers in this dynamic economic environment. In Canada, a scarce number of private credit managers possess the requisite skills and experience to deliver innovative solutions that bridge the liquidity gap and adeptly steer companies through challenging periods of transformation. So many lenders unfamiliar with dealing with distressed borrowers will be disappointed by the willing bargain they made under their credit agreements. Recent debt restructuring transactions in the market illustrate the lengths to which borrowers and certain lenders will go to stay afloat (and recoup their investment) when under duress. Restructurings have become lender-vs-lender contests with competitors angling to push the losses of default onto others.

With the rise in defaults today being inevitable, private credit managers need to be prepared to consider extreme options when loans in their portfolio show signs of stress or distress, including foreclosing on assets or “taking the keys” of the business of their borrowers. Failing to do so will result in these managers being eaten alive by their own peers.

[1] From complaints in litigation of Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., No. 565123/2020, 2021 WL 3671541.
[2] King & Spalding Private Credit and Special Situations Investing Group. “J. Crew and the Original Trap Door”
[3] Moore and Van Allen Special Situations Client Bulletin. “The Tyranny of the Majority”