Distressed debt developments: The rise of LMEs
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Article Type
Insights
Topic
Credit
Published
August 27, 2024
Read time
5 mins
Author
Rishi Goel
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The leveraged finance markets continue to be bifurcated, with better-rated issuers experiencing tight credit spreads on their debt. On the other hand, according to data from S and P, issuers rated CCC+ and below are seeing option-adjusted spreads in the 800 basis-point range, as they contend with high interest rates and a muted economic backdrop.1 In all, during the first quarter of 2024, 47% of CCC-rated issuers had under 1x interest coverage, excluding EBITDA add-backs,2 according to Pitchbook LCD.3

 

As in any credit cycle, we would expect weaker issuers to try to reduce debt, extend maturities, lower interest or amortization payments and enhance balance sheet liquidity. While we still see plenty of typical "playbook" restructurings by issuers (asset sales, chapter 11 filings, distressed debt exchanges, equity raises, payment in kind (PIK) securities, amend and extend transactions, etc.), how the vast majority of restructurings that are getting done today has been shifting.

 

With guidance and often encouragement from legal and financial advisors, investors are banding together and working as a group with troubled companies to engage in liability management exercises (LMEs). In recent months, there has been an increased number of cooperation agreements, where investors sign a pact to formally work together for an extended period of time to strike a deal with or block a deal with the distressed debt issuer. There has also been an increased number of non-pro rata deals (where certain lenders are treated better or worse than others), causing investor frustration and paranoia.

 

'LMEs add a new wrinkle to the restructuring process and some lenders are working together with companies to forge new capital structures', said Rishi Goel, Aegon Asset Management Global Head of Special Situations and Distressed Credit. LME transactions are a huge opportunity for proactive investors, but also a massive risk if some investors are excluded from negotiations as the number of non-pro rata deals continues to increase.

 

Many of the companies engaging in LME transactions today, still face a long road ahead to grow into their capital structures, absent a material improvement in fundamentals and a lower interest rate/cost of capital environment. This may take several years to come to fruition and a prolonged default cycle should create substantial opportunities for years ahead. However, this restructuring environment currently presents potential once-in-a-cycle opportunities for active managers to capitalize on dislocations within stressed and distressed credit.

 

Dual-track US loan default rate: issuer count

Sources: PitchBook | LCD; Morningstar LSTA US Leveraged Loan Index Data through July 31, 2024

The growing number of LMEs has helped bump the Morningstar LSTA US Leveraged Loan Indexs trailing 12-month default rate that includes distressed exchanges up to 4.02% as of July 31. Thats well above its 0.78% reading in July 2022.

 

In contrast, the default rate excluding distressed exchanges rose to 1.45% as of July 31, 2024, from 0.43% in July 2022.

 

Overall, we believe there are attractive investment opportunities today within lower-quality credit and even more appealing entry points in performing credit should continue to materialize as the economic cycle evolves. The addition of LMEs to the restructuring toolbox adds a new option for both lenders and borrowers and while risks remain for several of these issuers long term, many of these situations are opportunities if investors can structure and participate in the LME transaction.

 

1Global Distressed Credit Weekly Wrap, Pitchbook|LCD, August 9, 2024.

2EBITA add-backs are adjustments to a companys earnings or expenses to account for one-time events. By excluding those items, the goal is to provide a clearer picture of a companys true income and expenses.

3Global Distressed Credit Weekly Wrap, (n1).

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Author

Rishi Goel
Global Head of Special Situations and Distressed Credit

Rishi Goel is global head of special situations and distressed credit and a senior portfolio manager.

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Distressed debt developments: The rise of LMEs
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