Mon 01/09/2023 07:48 AM
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To restructure or to do a liability management exercise? This year, debt maturities will dictate.

Capital markets are volatile. Supply-chain pains have not abated. Labor is expensive, and the economy is slowing, maybe into a recession. This mix means that issuers with near-term maturities, especially smaller-sized companies, probably cannot amend and extend, and struggling companies with debt due in two years and beyond, especially large-cap ones, will try transactions to cut debt and raise capital first. The healthcare services, consumer discretionary, automotive, technology and financial services sectors are expected to be the most active, according to restructuring experts.

“Issuers with 2023 and 2024 maturities will have a decent amount of restructurings, because there isn’t a market to refinance these loans, for the most part,” Scott Greenberg, global co-chair of Gibson Dunn’s restructuring practice, said. “2025, 2026, 2027, is gonna be more liability management. There is enough room in the maturity schedule to roll the dice, to live to fight another day, and 99% of debt documents have lots of room for aggressive transactions.”

Terminal Point

“When you have a maturity coming up in the very near term, at a time when capital markets are effectively closed, the company’s flexibility to go into the laboratory to develop a creative transaction, stress test it, get a new money constituency whose support and funding is needed to buy into it, is very limited,” Evan Fleck, a partner in Milbank’s financial restructuring group, said. “It can be a terminal point, unless the sponsor wants to refi the maturing debt.”

Issuers may not be able to convince creditors to extend debt due in a year or two, Fleck said, because the requirements of creditors may not be available from sponsors, including, very rationally, large paydowns, tighter debt documents, and/or an equity infusion, especially if sponsors have already taken their money out of the business, or if the business is challenged as it goes into a recessionary environment.

The cost of capital will finally lead to more restructuring as well, after the end of an era of cheap money.

“The desire to do liability management previously is around the fear of some other capital provider giving borrowers capital, for example, at an unrestricted subsidiary,” Neil Augustine, vice chairman and co-head of Greenhill’s financing advisory and restructuring group for North America, said. “The competition is coming down in that market, because of where secondary loan prices are, because of the higher risk-adjusted rates of return investors require. Companies, especially in the middle market (with $250 million to $1 billion of debt), are going to more likely need to pursue a typical restructuring path.”

“Even if a company has access to capital to refinance its near-term maturities, chapter 11 can help address operational and/or balance sheet inefficiencies, including rightsizing a lease portfolio, renegotiating or shedding unprofitable contracts, or eliminating mass tort liabilities,” Maja Zerjal Fink, partner in Arnold & Porter’s restructuring department, said. “What’s ahead is a prolonged, multiyear, steady pace of restructurings.”

A ‘Credit Analyst’s Market’

“We are at the front end of an ascending activity cycle in the restructuring space, as market conditions worsen and the real economy enters a period of contraction,” Todd Snyder, global head of Piper Sandler’s restructuring group, TRS Advisors, said. “It’s going to be a ‘credit analyst’s market,’ instead of what we have been experiencing for the past decade or so: big thematic swings in the availability of capital, risk-on, risk-off, kind of environment.”

2023 will be defined by volatility, according to an array of hedge fund and CLO portfolio managers interviewed by Reorg, meaning that careful credit selection will be of paramount importance. The first half will likely be the most volatile period of the year, with a focus on high-frequency economic data such as PMI, inflation, unemployment and jobs data, with a possible recovery in the second half, some sources said. Others suggest that economic data may suggest a recovery in the first half, only for the recession to arrive in the second half. Under either scenario, however, sources agree that it would be imprudent to expect a pivot by the Federal Reserve to lower rates as long as inflation remains high and jobs data continues to be strong.

Credit quality will likely deteriorate over the year, resulting in an uptick in defaults toward their historic average of 3%-4%, presenting a broad array of opportunities for distressed hedge funds, sources said. The environment would be challenging for CLOs, sources said, noting that ratings agencies have been more aggressive than normal in recent months, as a result of which many CLOs are over the usual 7.5% limit in their CCC baskets.

The primary constraints on cash flow this year will be higher interest expense, particularly from floating-rate debt, and increasing labor expenses. While floating-rate debt can be hedged in the swap market, the increase in labor costs and the stickiness of it will be a much more significant problem, the sources said. In addition, many of the PE-backed deals executed in 2021-2022 will be under pressure, as the financials for these companies contained a hefty amount of Covid givebacks.

For prohibitively high costs of capital, Exhibit A is the financial services companies, which make a living on the spread between what they lend money out to consumers and the rate they have to pay for the financings.

“It’s incredibly challenging for mortgage originators because application volume dropped and now remains low, and in an environment of rising rates, the spread shrinks significantly and may even turn upside down, where the cost of capital, particularly for non-bank lenders, is higher than the interest income earned on the loan,” Tanya Meerovich, senior managing director in FTI Consulting’s corporate finance practice, said. “As the value of originators’ assets, the mortgages they issued, fall, due to rising interest rates, they may get margin calls from their own lenders to make up the shortfall, putting pressure on liquidity. In a restructuring situation, pure mortgage originators often end up in a wind-down, unfortunately, because there are no or limited, unencumbered assets to restructure around.”

Snyder of Piper Sandler said that even though excess saving and stimulus money have bolstered the economy during the pandemic notwithstanding the economic trend, liquidity in consumers’ hands is coming down, and when that burns off, real contraction in the economy will occur, and it may very well be deep.

If and when that happens, Meerovich of FTI said, mortgage servicers, which have fared better because their assets appreciate in value as rates increase, may start to see the impact because of an increase in defaults from borrowers.

Carrot and Stick

For companies and lenders that believe a Band-Aid fix with exchange offers and unsub deals will suffice for now instead of a surgery in a bankruptcy court, non-pro-rata transactions like what Serta Simmons executed will not disappear, and pro-rata deals, including with cooperation agreements, will continue to show up as well.

“Investors appear undeterred for the time being by recent judicial decisions at the motion to dismiss stage sustaining legal challenges to non-pro-rata transactions,” Adam Shpeen, a partner in Davis Polk’s restructuring department, said. “For pro-rata deals, much attention is now being paid to the new, next-generation technology that mixes carrots and sticks to minimize holdout risk and motivate creditors to extend maturities and participate in transactions out of court - What incentives are sufficient to generate high levels of participation? At the same time, what set of sticks do you need to increase the risk for creditors who might consider not participating?”

--Harvard Zhang, James Holloway
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