Liability management is becoming increasingly prevalent in private credit, but it happens behind closed doors and can be quite complex.

To help you decode it, we put together a primer based on our recent Cloud 9fin podcast episode with Freshfields.

What is liability management in private credit?

Generally, when a company borrows money and can't pay it back, the debt gets restructured. This typically involves the owner of the company losing their equity — but sponsors increasingly have ways to maximize value in these situations.

In the 2010s, lending standards deteriorated as credit investors searched for higher returns amid low interest rates. This deterioration has enabled sponsors to extend the runway of underperforming companies, often at lenders’ expense:

These so-called “liability management exercises” are sometimes called lender-on-lender violence. It’s not a term everyone likes, but it does communicate how bruising these deals can be for some investors:

The new Chapter 11

Liability management is an umbrella term for how companies restructure their debts once they becomes unsustainable. This can happen when a company:

• Is over-levered because there's been a deterioration in the business
• Has upcoming debt maturities that it may not be able to refinance easily or economically
• Has a liquidity or cash flow issue and therefore needs new funding

These situations are sometimes fixed by filing for Chapter 11 bankruptcy, but that can be an expensive process. Not only that, but there are more ways to avoid bankruptcy these days, because of looser debt documentation.

Ultimately, company directors have a fiduciary duty to their shareholders. So if there’s a chance that their debt agreements might allow an out-of-court restructuring as an alternative to a bankruptcy, they are somewhat obliged to pursue that.

But not everyone agrees on how today’s looser credit agreements should be interpreted. As sponsors and their lawyers cook up new ways to use these looser docs to maximize runway and value, lenders are working hard to anticipate their next move and protect themselves.

So what now?

As liability management exercises have played out over the past decade, they’ve spurred on a shift in the way that credit documents are constructed.

There have been several high profile legal battles that have set precedents as lenders have constructed new mechanisms to protect themselves. Our audience will likely be familiar with J. Crew and the “J. Crew Blocker”, as well as the Serta blocker, which we covered in this explainer of cooperation agreements.

But these are all examples of LME protections in syndicated credit deals, as opposed to private credit transactions. And as we covered in our recent article on Pluralsight, private credit LME are highly complex and not always what they seem.

For more detail on how liability management made its way to private credit and how lenders are trying to protect themselves against these deals, check out our Cloud 9fin podcast with Freshfields.