Thu 11/30/2023 09:40 AM
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Credit Research: Mark Fischer
Relevant Items:
Link to Reorg’s BDC Database
Link to Reorg’s First Day Database

Business development companies’ recoveries on private debt as a result of a chapter 11 restructuring tend to be lower than fair values assigned to these investments prior to petition dates, according to an analysis of loans held by BDCs. However, because a large number of single-lender private credit deals resulted in a par recovery for lenders, the recovery shortfall to prepetition marks is greater for private credit club deals, or loans held by more than one lender where the loan is not broadly syndicated, and for publicly traded or broadly syndicated loans, than the average recovery shortfall. Additionally, in cases where recoveries are below the fair-value marks reported in the quarter prior to petition date, the recovery shortfall is less severe for single-lender private loans than for publicly traded loans.

Reorg analyzed 36 companies that had loans held by a BDC, and filed for chapter 11 in 2022 or 2023. The report pulls data from Reorg’s BDC database. Because many BDC investments are in private loans, and BDC managers are required to provide fair-value marks for all investments, the BDC database can be used as a good proxy to track valuations and trends in lending.

As shown below, median recoveries for single-lender private credit loans in companies that filed for chapter 11 in 2022 and 2023 were 85.6% of par, as compared with fair-value marks of 96.7% of par in the quarter preceding the bankruptcy, representing a drop of approximately 11%. This compares with a drop of 22% from fair-value marks for private credit club loans (more than one lender but still not broadly syndicated) and a 45% drop for publicly traded loans. In this analysis, recoveries are based on the recovery amount disclosed in the bankrupt companies’ disclosure statements as a proxy for market recovery.
(Click HERE to enlarge.)

As shown above, 58% of single-lender private credit loans analyzed resulted in par recoveries.

As noted above, when disclosure statement recoveries are below fair value marks immediately prior to the petition date, the shortfall is less severe for single lender private loans than for either publicly traded or broadly syndicated loans. In the loans analyzed, Reorg calculates a 10% median drop in the estimated recovery, as provided in the debtors’ disclosure statement, when recoveries are lower than prepetition fair-value marks as compared with a median 45% drop in private club loans and a 58% drop in publicly traded loans that recovered below their prepetition marks.

Lenders to publicly traded loans, however, should be able to easily sell these loans in the market. and the lenders analyzed often do. Almost 50% of the publicly traded loans of companies that filed bankruptcy held by the BDCs that were analyzed were sold by the BDC prepetition.

Reorg’s BDC Database and Private Lending

In this report, Reorg uses the BDC database to better understand private credit valuations and changes in valuation prior to and during the chapter 11 process. Reorg has identified 36 companies that filed for chapter 11 in 2022 and 2023 and had securities owned by BDCs in the quarter prior to the petition date and throughout the chapter 11 process. Of the 36 chapter 11s analyzed, 19 involved private, direct loans, either by a single lender or via a club deal in which, while there was more than lender, the loans were not broadly syndicated.

Reorg’s BDC database, based on second-quarter reports, included approximately $276 billion of invested capital with a fair value of $272 billion across 8,900 investments at 125 different BDCs. The database pulls holdings from publicly filed quarterly reports. BDCs receive special closed-end investment status under the Investment Company Act of 1940 in order to facilitate capital formation by smaller companies. They are intended, according to the SEC, to invest in “small, developing, and financially troubled companies that do not have ready access to the public capital markets or other forms of conventional financing,” and they are required to have at least 70% of their assets invested in these types of companies. BDCs file their holdings quarterly with the SEC, including the name of the company, the cost of the investment, a security description and the investment’s fair value. Reorg’s BDC database also contains the individual investments and tracks any changes made to it over time.

As shown above, Reorg compared BDC-reported fair values with recoveries as a result of the bankruptcy process. The report also examines how certain bankruptcies involving private creditors unfolded.

However, as shown below, a simple examination of BDC-held companies reveals distinct differences in case outcomes between private credit deals and publicly held or broadly syndicated loans. Private credit deals at BDCs, in which there is just a single lender, tend to result in more asset sales during the bankruptcy. Private club deals have resulted in more credit bids by the lender group. Alternatively, the publicly held loan cases act more like other public cases, resulting in more reorganizations.

SEC guidelines require that, in the absence of market quotations, fair value be determined by the board of directors “in good faith.” The board can designate a valuation designee, which according to a report by Wilkie Farr is generally the investment advisor to the fund, which determines appropriate valuations for Level 3 assets using a variety of sources and methodologies. As an example of valuation disclosures, AB Private Credit Investors notes that “investments are valued at fair value as determined in good faith by our Adviser, as valuation designee, based on input of management, the audit committee and independent valuation firms that have been engaged to assist in the valuation of each portfolio investment without a readily available market quotation under a valuation policy.”

Given the discretion that boards can take in valuing their holdings, the same private loan could have multiple values across different BDCs. For instance, both Cion Investments and Main Street Capital reported holding Independent Pet Partners’ priming facility and delayed-draw term loan prior to its chapter 11 filing on Feb. 6. Each loan was a private club deal with three lenders: CIon, Main Street and Newstone Capital. Independent Pet Partners’ capital structure at petition is below:

As of Dec. 31, 2022, Cion valued its investment in the delayed-draw term loan, which was junior in right of payment to the priming facility, at 93% of par. Main Street valued the delayed-draw term loan at 43% of par. Reorg calculates a 28% recovery on the delayed-draw term loan as the lender group credit bid to buy the business out of bankruptcy. The total credit bid was for $60 million and included $23.5 million of the delayed-draw term loan claims as part of the credit bid. As shown below and included in the debtors’ disclosure statement, the remaining $51.4 million of delayed-draw term loan claims was classified as a deficiency claim, and the lender group waived its right to receive distribution under the deficiency claim.

New-Money Investment in Bankruptcy

When a company whose debt is held by a BDC enters bankruptcy, the BDC can frequently choose whether or not to invest new money into the company as a function of its chapter 11 process. New money can include either a debtor-in-possession loan at the onset of the chapter 11 cases or money invested as part of a rights offering or exit financing which facilitates the debtors emergence from chapter 11.

In general, BDCs serving as the sole lender to a private credit have avoided putting in new money as part of the bankruptcy, while members of a private club deal or lenders to publicly traded, broadly syndicated securities have contributed their pro rata share of new-money opportunities.

A breakdown of cases are below.

In a number of the large, public-company bankruptcy cases, the BDCs that Reorg analyzed have sold their position either prior to or immediately after the petition date. It appears, on the basis of the data, that when BDCs can monetize their position in a newly bankrupt company, they will do so. Almost half of the bankruptcies analyzed in which a BDC owned a publicly traded security, the BDC sold its position prepetition. Many of these cases in which the BDC sold ahead of the petition date included new-money contributions by existing lenders as part of the eventual bankruptcy plan, further showing the BDC’s predilection against investing new money into publicly traded bankrupt companies.

The decision on whether or not to contribute new money often has significant consequences for recoveries.

Carestream Health filed for chapter 11 on Aug. 23, 2022. Portman Ridge Finance Corp reported that as of June 30, 2022, it held a $1.837 million stake in the company’s L+7.25% second lien loan. Portman made the original purchase on May 8. 2020. The position was valued on June 30, 2022, at $1.763 million, or 90.2% of par, consistent with quotes displayed on Solve Advisors.

As part of the prepackaged plan, holders of the $448.2 million second lien loan received 10% of reorganized equity and the right to purchase their share of 80% of reorganized equity via a rights offering. The plan had broad support among second lien holders, with 99% of principal supporting the RSA.

In the quarter after the petition date, Portman Ridge updated its holdings in Carestream to reflect only a $53,000 position in its common stock, consistent with its receipt of its share of 10% of reorganized equity. However, neither the Sept. 30, 2022, or Dec. 31, 2022, filings reported additional equity, indicating that Portman Ridge BDC did not participate in the rights. Carestream exited chapter 11 on Oct. 3, 2022, suggesting the rights would have closed prior to the Dec. 31, 2022, reporting date.

Reorg calculated that the rights were offered at a 50% discount to plan equity value, indicating significant upside from participating in the rights. According to the disclosure statement, recoveries, including the equity and the rights, would total 23% of prepetition claims. However, recoveries solely using the plan equity value for creditors not participating in the rights would be 4.8%, consistent with Portman Ridge’s reporting of $53,000 in common stock relative to its $1.8 million original loan cost.

In filings with the court, both Great Lakes Portman Ridge Funding and Portman Ridge Finance Corp. were listed as holders of the company’s second lien notes. Therefore, it is possible that other funds within Portman participated in the rights, while its BDC did not.

Alternatively, Oaktree which was the sole first lien lender to SiO2 Medical Products’ $225 million prepetition first lien loan, provided significant capital to the company in the form of a DIP loan. Of the $225 million in Oaktree’s prepetition holdings, its BDC, Oaktree Specialty Lending Corp., held $47.1 million of principal. As part of the bankruptcy process, Oaktree committed to providing a $120 million DIP, comprising $60 million of new money and a $60 million rollup of prepetition claims. In consideration for its DIP investment and first lien prepetition claims, Oaktree will receive a 12% exit loan due 2028 and 100% of the equity.

On the basis of disclosures in Oaktree Specialty Lending Corp.’s quarterly filings, it appears that the BDC participated up to its pro rata share in the new-money portion of the DIP. Oaktree’s reported holdings, including positions, cost and fair value, are shown below. The dates shown below are calendar quarters. SiO2 filed for chapter 11 on March 29. Therefore the last report prior to the chapter 11 filing would be for the fourth quarter of 2022.

The DIP was approved on an interim basis on March 30 and is recorded in Oaktree Specialty Lending’s second calendar quarter report. The increase in the reported total cost reflects Oaktree’s investment in the DIP. The third calendar quarter report includes securities received as a result of the restructuring. Oaktree recognized a realized $13.9 million loss on the SiO2 investment.

Assuming Oaktree’s new-money investment into the DIP was recorded with a fair value of par, Reorg calculates a 72% recovery on Oaktree’s prepetition investment in SiO2’s first lien term loan. According to SiO2’s disclosure statement, at plan value, the first lien loans recovered between 72% and 100% of claim value, implying Oaktree recognized fair value to be the low end of the debtors’ valuation range.

Reducing Exposure Prior to Chapter 11

As noted above, in almost half of the cases in which a BDC owns a part of a broadly syndicated loan of a company that files for chapter 11, the BDC sells its position prior to the petition date.

While the BDCs do not report to whom they sell their positions, it’s possible that sales could be to other funds managed by the parent company. For instance, as of March 31, FS KKR Capital, KKR’s BDC, reported an $86.1 million position in the senior loans of Monitronics. However, subsequent to Monitronics filing for chapter 11, the KKR BDC no longer reported a position in Monitronics, but FS KKR reported holding $110.9 million.

Blackstone’s BDC, Blackstone Private Credit Fund, reduced its position in Phoenix Services to zero in the quarter following the petition date. Phoenix’s bankruptcy included a $50 million new-money DIP and a $45 million rights offering.

Although Blackstone’s BDC appears to have sold its position in Phoenix, Blackstone Alternative Credit Advisors reported holding $50.5 million of first lien debt and was the second-largest member of a first lien ad hoc group, and according to Reorg’s CLO database, Blackstone continues to hold a significant amount of Phoenix securities following emergence.

Reorg has identified a few situations, although less common, in which private lenders were able to sell their position prior to an in-court restructuring. However, the sale prices were not reported, so it’s unclear how close the sale price was to the reported fair value.

An example of a sale prior to petition date:
  • CBC Restaurant Corp.
    • Private club deal loan with an original principal amount of $155 million issued in 2017 and $33.8 million outstanding as of the petition date.
    • Lenders including Monroe Capital ($1.06 million principal held by BDC), Goldman Sachs, Kayne Senior Credit Funding, and First Horizon Bank sold all of their holdings to SSCP Restaurant Investors prior to bankruptcy filing for an undisclosed price.
    • CBC sold its assets to SSCP via a credit bid of $15 million plus an approximate $2 million cash payment.

Additionally, likely because of the ranking within a company’s capital structure and the nature of the collateral, private lenders in certain cases have been made whole prior to the petition date in some cases.

Trinity Funding’s loan to Zosano Pharma Corp. was characterized as a “build-to-suit arrangement” in which Trinity provided construction financing for Zosano’s commercial coating and primary packaging system. Trinity provided Zosano with $14 million for the equipment and soft costs. In exchange, Trinity had a first-priority lien and security interest on substantially all of Zosano’s assets. The loan imposed a number of restrictions on Zosano’s business, including maintaining a minimum cash balance equal to 3x the remaining rent due on the loan and gave Trinity, in the case of a default, the right to request payment in full of the build-to-suit obligation. Prior to the company’s chapter 11 filing, the loan was repaid in full.
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