In Observing with Attention, Something Inherently Changes them: Restructuring Deals

Observing recent developments in financial restructurings reveals notable dynamics shaping the leveraged finance landscape. I will refrain from commenting on specific names slated for restructuring in 2025; however, it is evident that some cases stem from protracted underperformance, while others involve companies that have only recently emerged as distressed credits—often misjudged by inattentive investors. Signs of deteriorating balance sheets, exacerbated by the excesses of prolonged low interest rate environments and insufficient earnings to sustain positive cash flows, have long been apparent to discerning viewers.

For some sectors the outlook deteriorated faster than the Europe’s credit cycle, for others the business model did not work anymore. All problems had too much debt.

The phenomenon of "lender-on-lender violence" is becoming increasingly prevalent across both the U.S. and European leveraged finance markets. Investors face challenges stemming from priming and uptiering transactions, releases of guarantees, dropdown mechanisms, double dips, and other contentious borrower actions, all of which are reshaping the creditor landscape. The root causes of this new environment are traceable to the permissive documentation standards and weak legal frameworks established during the period of positive credit markets. These conditions were fueled by elevated risk appetite, abundant liquidity in zero interest rate environment, and, in some cases, a lack of sophistication among certain investors in leveraged finance (the way "today" differs from the “past” can be viewed through various lenses…). Fueled by euphoria, people chose to invest in dreams over realities.

Contentious intercreditor disputes are underpinned by structural deficiencies in financing documentation and the inexperience of some market participants. Opportunistic investors have capitalized on these vulnerabilities through cooperation agreements, rallying consensus around specific liability management exercises (LMEs) to safeguard or enhance their positions—often at the expense of other creditors. This doesn’t apply in all circumstances, but some cases certainly raise perplexities. Each restructuring case is unique, with secured versus unsecured debt and first-lien versus subordinated debt frequently clashing over contractual loopholes and contested enterprise valuations. Outcomes often hinge on which stakeholder-investor wields greater leverage in negotiations (big and multi-credit platforms have an advantage above small and nimble investors).

What have we observed in Europe so far?

A) Recent high-profile LMEs, such as those involving Intrum, Lowell, and TalkTalk, underscore shared complexities. Injecting fresh equity into deeply distressed balance sheets, where prior equity has been entirely eroded, remains a formidable challenge. Exceptions exist—notably TalkTalk, Pfleiderer, and Demire just for mentioning three examples— and indeed those transactions required substantial new equity funding as a prerequisite for the successful execution of restructuring plans and amendment and extend (A&E) exercises. In such cases, reputational considerations and valuation dynamics also played a role, although a detailed discussion of these factors is beyond the scope of this analysis. Conversely, other scenarios have seen existing shareholders reluctant to contribute additional equity due to uncertain prospects or limited visibility into future operating performance. Weak capital structures in these instances necessitated new debt to bridge equity shortfalls, as seen in the Thames Water emergency financing. However, the introduction of new debt often ignited controversy among existing creditors regarding its structure and seniority, leading to intercreditor conflicts—Hunkem?ller provided a prime example of this dynamic. Thames Water is another example that can appear in any credit book seeking to illustrate the challenges faced by both borrowers and lenders in a situation of financial collapse (and where the existing creditors influence? future equity investors' strategies and returns; something extraordinary, seldom witnessed).

B) Valuation disputes among investors frequently result in excessive leverage persisting within capital structures, with creditors hoping for an extended runway. Distressed exchanges may provide temporary relief, but recovery for existing debt holders, particularly subordinated creditors or future Holdco investors, remains highly contingent on the terms of new money injections. Reinstated debt instruments, often issued with burdensome coupons, place an unsustainable financial obligation on borrowers already grappling with insufficient cash flow generation. This underscores a shift from traditional "hardcore restructurings" to "smooth LMEs" processes, characterized by protracted timelines and incremental adjustments.

C) The macroeconomic environment and sector-specific challenges in Europe offer little optimism for meaningful recovery in some distressed credits. Revenue and EBITDA improvement targets remain elusive, with many projections appearing overly ambitious. Consequently, deleveraging strategies are unlikely to achieve, in my opinion, their stated objectives.

D) The role of credit default swaps (CDS) and derivative positions is increasingly shaping outcomes during LME processes. While these practices warrant attention, they are not entirely new; seasoned market participants may recall the engineered CDS transactions from cases like Codere in Spain back in 2013. However, the influence of CDS players diminished after the Europcar event in 2021, where CDS contracts proved to be practically worthless. The re-emergence of stressed situations—after they disappeared during the bullish market era when refinancing packages were readily available—highlights the evolving dynamics of the CDS market. These shifts have introduced new actors and behaviors, particularly in relation to unconventional and complex LMEs which include multiple tranches of debt being at odds to each other. CDS contracts have once again become standalone investment strategies, reflecting their renewed significance in today’s market environment and for return-seeking credit players.

E) Financially strained entities continue to be prime targets for short-focused hedge funds, which are capitalizing on opportunities in both long-standing distressed names and new credit cases arising from poorly structured liability management exercises- transactions that offer a silver lining for high-returns funds. While investors are right to focus on restrictions around priming debt and buyback mechanisms, they must also remain vigilant about the inherent risks involved in efforts to stabilize fragile capital structures. Compromise solutions do not always deliver optimal results.

In conclusion, the evolving dynamics in LMEs, where borrower and investors play hardball, necessitate heightened vigilance and expertise among market participants. The interplay of legal frameworks, investors’ sophistication regarding debt and derivatives, capital structures crafted by debt advisors, and turnaround plans will continue to define outcomes (both in the short and medium terms) in an increasingly complex credit environment. Low default rates in the US and Europe may fail to provide the full picture, as greater attention is often given to those credit investors with significant financial influence, big financial muscle, and the ability to play in game theory, rather than focusing on the accurate modelling of balance sheet items and projections (FT article of 2nd of August 2024). This is a problem because ultimately companies are the engines of GDP growth.