Pivot Tabled

While energy and commodity prices have fallen significantly in recent months, as supply fears abated, recession fears have risen as the cost of living crisis bites.

The pace of rate hikes is slowing, we are a quarter or two away from terminal interest rates in the US and UK, but still have some way to go in the eurozone. Inflation may have peaked, and financial markets are betting on a central bank pivot expecting rates (interest and inflation) to come down sharply in H2, with a shallow recession being their default position. But central banks remain wary, and their managing of expectations will be another key theme for 2023.

Risk assets are coming off the back of a strong Q4, with the iTraxx Crossover (after a mini-wobble from ECB comments last week) currently around 510 bps, around 150 bps tighter than end September and well inside the wides of 680 bps mid-year. Some research houses such as Deutsche would argue that current levels are not pricing in recession risk, pointing out EHY corporate spreads typically discount recession at around 800 bps, a mere 300 bps wider from here. If recession expectations change for the worse, it could lead to yet another repricing of risk.

Bank of America sees "baby" bull market for returns, but they caution it may still feel like a bear market, with hikes, stagflation and "credit events" likely hurting European markets in the first half. 2023 is a game of two halves with a strong performance in H2, they say.

But in the meantime, LevFin bankers are seeking to taking advantage of tighter secondary spreads. Issuance picked up in December, with one banker telling 9fin’s David Orbay-Graves the monthly tally for European Leveraged loans and High Yield could reach 23. The ability of House of HR to place a deal that was pulled in October may encourage LevFin bankers to be more brave and test the waters for larger refinancings in January (the pipeline for M&A is almost empty).

Dealing with the Maturity Wall

Despite some improvement in sentiment, primary pricing has failed to tighten to a significant degree with many borrowers (which can afford the sharp rise in interest costs) still having to pay double digit spreads to get deals away.

Many borrowers got ahead of the curve before the shutters came down in 2022, so the maturity wall is relatively light in 2023. But it’s closer than you think if you include the accompanying revolvers maturing six to 12 months before bond/loan maturities. Banks are becoming less keen to provide RCFs, making an extension less than certain (clearly borrowers must pay up) but clearly they don’t want to create liquidity issues for their sponsor clients.

There are 140 European loans from 82 borrowers with maturities up to 30 June 2024, according to 9fin data. Of these 22 from 13 are trading at prices below 90, which suggests they are unlikely to be refinanced. Another 13 from 11 are at risk, being priced between 90 and 95.

This compares to 281 EHY bonds from 209 companies due in the next 18 months. Of these, 35 from 29 borrowers are trading at a spread to worst of over 10%, and may be unable to be refinanced.

The wall is much tougher for lower-rated leveraged loans than bonds, with the former universe averaging single B, compared to HY which is closer to BB. With historically elevated leverage and generating minimal FOCF, we expect a raft of A&E requests for loan names in coming months.

But should we be looking further out than June 2024?

One common theme from conversations with advisors in the past week, is that auditors are pushing companies for a longer look forward on dealing with their maturities, from the usual 12 months to 18-24 months and beyond.

According to one financial advisor, sponsors are doing a lot of planning on their core investments, looking as far out as their 2025 and 2026 maturities. Liability management is likely to be key theme for 2023, he said, with many sponsors looking to take advantage of document flexibility.

One restructuring lawyer concurred, saying there are a lot more conversations going on below the surface than the market thinks. While Plan A is to speak to large investors about a consensual deal first, sponsors are also considering more coercive deals with some form of exit consents (as seen in Keter and Diebold) as either a Plan B or Plan C, he added. (more on liability management later)

It’s worse than you think

While the majority of Q2 and Q3 earnings were better than expected, as companies saw strong growth in their revenues from price hikes, the outlook for the fourth quarter is less rosy. Speaking to 9fin, a number of advisors report a sharp deterioration in recent weeks.

From company and sponsor side conservations, the situation is very bad, is unprecedented and worsening rapidly, said the restructuring lawyer. Supply chain issues and input costs are continuing, but with a deterioration on the demand side and rate risk impacts not yet appearing in the numbers. The lawyer said that companies were finally seeing a reduction in orders, especially in manufacturing and consumer businesses. Markets are also underestimating the level of civil disruption and extent of distress at Emerging Markets Sovereign level [as other external factors], they added.

A proportion of companies got it wrong with their input cost and energy hedging, but most are fundamentally decent businesses with late 23, 24 and early 25 maturities which are unable to refinance, they concluded.

Weil’s European Distressed Index for December, which looks more broadly across 3,750 listed European Corporates, says that distressed levels have intensified over the past quarter with seven of the 10 industry groups covered showing levels of distress worsening in the past 12 months.

This is due to “the backdrop of slowing global growth, spiralling inflation, tightening fiscal and monetary policy, China’s on-going Covid restrictions and the Russia Ukraine conflict weighing heavily on corporate distress.”

It adds “in the latest quarter, distress was pushed higher by deteriorating investment metrics, growing pressure on liquidity and weaker valuations.”

UK Corporates are the most distressed in Europe, with distress at the highest level since July 2020.

Is this increased corporate distress reflected in European bond and loan prices?

Using 9fin’s screeners for LevFin issuers, we have 93 bonds from 63 issuers with a spread-to-worst of over 12%, our definition of distress. This is up from 79 from 57 at end-August, and is almost triple the number at end-March (32).

In the past Month, among the biggest movers in our distressed category were Lycra (still no update on progress of RCF and bond refi); Food Delivery Brands (Telepizza) — 75% haircut on the table? Atalian (CD&R sale disappointment); Vivion (short seller report); Tullow Oil (merger failure); Ideal Standard (liquidity worries) and Schoeller Allibert (sponsor plans for rental biz).

The big movers in November, included Hurtigruten, AMC, Veritas, Petrofac, Solocal, LR Global, Naviera Armas and Selecta.

In leveraged loans, we have 107 loans from 66 borrowers trading below 85, our measure of distress. This is up from 68 loans from end June.

Biggest loan movers in the past month include Technicolor Creative Studios (shock profit warning); Idverde; Covis Pharma (lender advisors appointed); AMC; Labeyrie; Cision; Accolade Wines; Flakt Woods and The Hut Group.

Triggers and Drivers

Delving deeper, how will the wave break, and what are triggers and drivers for 2023 Restructurings?

In an early December webinar, Shearman & Sterling lawyers identified four key drivers:

1. Inflation and monetary policy
2. Liquidity issues
3. Leverage and its effects
4. Market volatility

With soaring inflation, which hasn’t been seen for 25 years, a number of businesses are unable to pass through cost increases. Interest rates haven’t risen much nominally, but proportionally, they have leading to a significant impact on debt servicing ability, said Alex Wood, one of the Restructuring Partners.

Liquidity is another factor. Companies are suffering from squeezes on their cost of debt and cost of goods sold. With most deals now covenant-lite, problems are arising at a point where often it is too late for lenders, the lawyers cautioned. Even in mid-market deals where maintenance covenants are in place as protection, there are built-in time lags, which diminish the ability of direct lenders to act.

A significant number of deals are overtly levered, with generic leverage levels at a 20-year high. The true level could be even higher, given significant in-built flex in the way that leverage is calculated plus a raft of EBITDA adjustments. Shearman & Sterling’s team said they are seeing banks getting nervous and start to reduce uncommitted funding lines.

Finally, there is the issue of market volatility. This makes it harder to price risk. Restructuring talks are complicated given so many different inputs and output assumptions and reduced certainty, and investors have a greater opportunity to challenge assumptions relied upon to develop and implement restructuring deals.

59% of respondents to an online poll during the webinar identified liquidity as the key driver for restructuring in 2023.

The first restructuring lawyer agreed, noting they had two calls earlier that day which were cash-related. Sponsors are looking at using the flexibility in their borrowing docs for liquidity generation, and are talking to third-party funds keen to provide funding. Investors’ base assumption should be that sponsors are actively looking at solutions and could team up with other lenders to get a deal done, they added.

“Liquidity issues are definitely out there, but it is much harder to see than in 2020,” said a second financial advisor. “Interest rates are clearly making refinancing more difficult, and there isn’t enough cash in these businesses to pay the rates. Arguably, the situation is more similar to 2007/2008 [than 2020].”

While agreeing with the audience that liquidity is the key driver, in reality it is likely to be a combination of factors, said Wood. “But liquidity is the hard trigger for a restructuring.”

The role of credit insurers is one area to closely watch. Their willingness to provide cover can dramatically affect liquidity for retailers, especially those with sharp swings in seasonal working capital. Giant German electronics retailer Ceconomy is one name frequently mentioned by advisors as being particularly exposed to this risk, as is Takko the discount retailer, Douglas the beauty products group and HSE24, the TV e-commerce company.

“[Credit insurers] are strictly monitoring the entire [German Retail] industry.” said a third financial advisor. We have seen some reductions of insurance limits due to the weak operational performance (significant decrease in demand) and respective working capital issues – mainly inventory. In addition, worsening balance sheet KPIs (e.g., equity ratio) raise concerns. “Our recent experience in the fashion/beauty retail industry has witnessed tightening of payment terms with suppliers…In addition, recent ratings downgrades have led to lower insurance limits.”

While Retail and Real Estate top many advisors’ watchlists, the second financial advisor said that restructuring activity is unlikely to be linked to specific sectors, but more broadly-based.

Vive la difference

A common theme from the advisor conversations is that the restructuring negotiating dynamics will be very different this time around.

Loose docs, creditor-on-creditor violence (a term disliked by many advisors, who prefer the more genteel ‘liability management’), different actors and new funding tools are all cited as reasons.

Most agreed that restructuring deals will become more bespoke.

“There is a lot of room for innovation. For example, I expect to see forward start deals to re-emerge,” said the second advisor who added that loose docs for leveraged credits could see restructuring following the pattern seen for previous workouts of fallen angel deals, which have investment grade-style docs with few or no covenants.

Commercial dynamics will differ company to company and sponsor to sponsor, so deals will be done on a case-by-case basis, they continued. “We don’t expect to see boiler-plate restructurings like we had in 2007/08. Loans are likely to be more active than bonds, they have more leverage, lower-rated and with bulk of CLO holders, there is often less room to manoeuvre.”

Sponsors are looking at all the tools available under the docs, said the restructuring lawyer. Tools on the table include everything from liquidity generation to A&E and debt/equity swaps, with some degree of coercive elements such as covenant stripping and exit consents. PE sponsors are also actively looking at distressed M&A opportunities such as Atalian (note this conversation happened before CD&R’s latest about-turn).

According to the Shearman lawyers, the creditor dynamic is important. Distressed players, as ever, will be keen to drive a more fundamental restructuring, but sponsors now have more flexibility under the docs to keep them at bay, with CLOs stuck in the middle. But new money provision (using ample baskets and priming existing lenders) with tighter protections for the new debt makes a second phase restructuring much harder, they added.

Distressed investors will have to develop more positive relationships with sponsors. Looser docs give more optionality for PE funds, so it is less likely that aggressive loan-to-own strategies will work, said the second FA. Sponsors will be wary about locking themselves into excessively onerous terms for too long, so will favour shorter extensions and/or deals which preserve optionality.

The emergence of Private Credit adds another dynamic to negotiations and is another source of liquidity, but often comes with different demands (returns, structure, and docs protection) than traditional distressed funds. Conversely, few private credit-owned situations have entered restructuring, with most successfully avoiding trouble, said the first restructuring lawyer.

Then there is the question of dealing with CLO investors, who make up the majority of lenders in leveraged loans. Many CLO managers have learned lessons from the last financial crisis and have more flexibility this time around, such as being able to take equity positions from debt/equity swaps.

But not all CLOs are the same, as Owen Sanderson points out in his excellent year-end piece. Most CLOs issued since 2020 have flexible language allowing them to participate in “Loss mitigation obligations” (new money facilities for distressed borrowers). In 2022, CLOs added a further tweak allowing them to participate in “Uptier Priming Debt”, beginning with Bain Capital Euro CLO 2022-2 to avoid them being victims of creditor-on-creditor violence, becoming increasingly commonplace stateside.

Owen adds that an increasing amount of CLOs are post-reinvestment, with a significant number of 2018-vintage deals set to exit reinvestment in 2023. He remarks that a meaningful amount of the leveraged loan universe will now be passive, “able to sell or accept maturities but not to purchase new issues or roll into refinancings.”

As reported, this issue came up in the recent A&E request for Keter. A number of CLO holders which were post-reinvestment were unable to affirmatively vote in favour of the exchange. This led to a complaints they were being penalised (left in the rump, with covenants and security stripped) despite in principle being unopposed to the request. A ‘snooze-you-lose’ would have been preferable, suggested a second restructuring lawyer. The other alternative is to use an English Scheme (or similar foreign process) to bind in the minority, he added.

Better In, or out?

So, is it better to use Schemes/UK plans/other legal processes as your plan A for an amendment?

This question arose in the Shearman & Sterling webinar, with Keter no doubt in front of mind.

Typically, the route has traditionally been to try and secure a deal via a consent solicitation first and then go down the alternative implementation route, often a via an English Scheme.

The positives of using a legal process as a plan A are that it lowers the consent thresholds (from unanimity or supermajority) with greater certainty as it gives you legal finality, said the Shearman lawyers.

The negatives are increased expense (company side), and it can open-up questions of fairness and challenges on class composition. The courts of late have been resisting widening the envelope [on interpretation], they noted.

Out-of-court processes are cheaper (and quicker), but there are risks of challenge after the event. However, to challenge you will often need to be determined and have deep pockets as a court litigation is costly, especially if the other side asks for an adverse costs order.

Directors’ duties are often overlooked. These will increasingly come into focus and must be taken into account if you are doing aggressive up-tiering and/or exit consent deals, noted the second restructuring lawyer.

You could argue to a court that these actions are necessary to avoid an insolvency, but this needs to be backed up with evidence, such as that other alternative transactions were considered/pursued. Duties and legal protections will vary from jurisdiction to jurisdiction.

Last year, in a number of high profile cases, most notably Virgin Active, the actions of directors came under the spotlight, with company executives being grilled by QCs under cross-examination on the events leading up to the court filing and the considerations made.

For future Schemes and Plans, companies will need more robust valuation evidence, especially as the market volatility and increased uncertainty over outcomes will lead to a greater number of challenges, suggested Alex Wood from Shearman & Sterling. The ED&F Mann case earlier this year provides a useful guidance, whereas creditors challenging must actively participate in the process (Smile Telecom) and will have to line-up their own expert evidence, he added.

We have yet to see a case of cramming-up — where junior creditors work with companies to impose a Plan on dissenting senior creditors — although this is theoretically possible under the UK Restructuring Plan. But seniors still have enforcement rights — as there is currently (it could change) no moratorium under the UK Plan, meaning they retain first mover advantage. An alternative plan submitted by junior creditors might also impose fresh rights on the seniors (as opposed to being repaid for example), an issue which came up in APCOA’s Scheme. It could also be hard to satisfy the ‘relevant alternative’ test, and it will be interesting to see how SSRCFs will be treated.

Liability management

The hottest topic of the moment is creditor-on-creditor violence. Loose docs, lack of financing options and willingness of distressed investors to work with sponsors on bespoke solutions outside of the existing creditor groups could all drive creative solutions in 2023, pitting pari passu creditors against one another.

Most advisors admit that there is a lot of activity already going in the background in Europe, advising sponsors on the art of the possible. Distressed funds, private credit and special sits funds have been proactively approaching sponsors with ideas.

Typically, the initial plan is to talk to your largest lenders, but if this is unsuccessful, adding coercive elements to an amendment requests and/or considering drop down or uptiering transactions are a Plan B or Plan C, said a fourth restructuring lawyer.

I won’t go into great detail about up-tiering transactions, drop-downs, and intermediate HoldCos, as our legal team have produced an excellent piece already: Priority of Debt — Getting Primed which better explains over the main points. For those don’t have time to read, in brief:

Drop Downs: A way of enabling priming debt by transferring assets out of the Restricted Group (for example, to an Unrestricted Subsidiary) and using these assets as credit support for new debt financing. This debt is effectively senior as it is secured on assets which do not secure the facilities, and it also structurally senior because it is incurred by subsidiaries that do not guarantee the facilities.

Up-Tiering: involve distressed borrowers accessing new capital by amending their existing secured debt documents via the requisite majority of lenders to permit new “super-priority” secured debt. These lenders subscribe to this new debt, and the remaining debt (which is often unaware until it is too late) is primed and subordinated. In some US cases, incumbent lenders have gone from first to third-lien.

The level of violence has increased markedly in the US over the past 18 months, and advisors are expecting it to come over here too, though in slightly different forms.

It is worth keeping an eye on legal developments stateside, as a number of motivated holders are determined to have their day in court (read the following lawyer write-ups for Boardriders and Serta Simmons). The initial hearings, where companies have submitted motions to dismiss, have had mixed results (often in front of the same judge), but lawyers say that a substantive hearing on at least one of the two is expected in the first half of 2023.

But there are substantial differences in the legal interpretation, lawyers caution.

In the US, the challenges are claiming breach of the implied covenant of good faith and fair dealing by having their sacred rights stripped away. The courts will be looking at the literal or overall intention of the docs.

Over here, the question is whether the parties are acting in bad faith, and whether the interests of minorities are protected. This could mean that proposed financings might need to be offered on similar terms to all, with the ad hoc lender group gaining better economics from fees.

But there is very little English case law with Assenagon in 2012 the only challenge to coercive exchanges, and arguably in that case the offer for the junior creditors was very extreme. In the UK it will come down to balancing the interests of creditors as a whole, said the third lawyer. “You might need to give others just enough to stay on the right side [of the judge]”

Some lawyers are welcoming the expected legal challenges.

“We are keen to see some of these issues litigated in court, even if we lose, said the first lawyer. “It gives us good guidance going forward on what is possible.”

Consenting Adults

Using consent thresholds to make amendments, strip rights or structure exit consents is another key topic amongst restructuring professionals. The boundaries are likely to be stretched, with some arguing that some requests are breaching sacred rights.

Diebold Nixdorf’s novel A&E request (as part of a wider restructuring) has created a lot of debate. With just 50% plus one the company was able to amend the grace period for non-payment of interest of its old notes (to be extended) from 30 days to one day prior to maturity. Is this a sacred right and requires 90%? Shearman & Sterling’s assessment is that under the wording of the doc it is allowable, but the lawyers admit it is a very aggressive move.

There is also chatter among the legal community over whether amending change of control provisions can also be done via a simple majority, especially if this is being done with a near-term future event specifically in mind.

9fin’s legal team are working on a piece on this specific subject, watch this space!

Getting in front of the queue

Another interesting area of debate is likely to be temporal seniority. Is it inappropriate to put shorter maturities in the same class as longer dated?

9fin predicts that this will be a key area of debate during 2023.

There are a number of situations with complex debt stacks where pari passu creditor dynamics are not going to be simple. In many cases companies are being run for cash, and are able to repay short term maturities (often through funds from asset sales), but this will be to the detriment of future value and refinanceability for longer-dated tenors.

This is likely to play out in Adler Group in early 2023. The 2029 holders have blocked a series of amendments which they believe favour shorter-dated holders, most notably the 2024 notes whose status was elevated to help the reach agreement on the overall proposal. Adler is set to go down an alternative implementation route, most likely the English Scheme or German Starug. We assume the company will seek to lump the 2029s in with the other Adler notes to dilute their votes.

Stop Press: Earlier today, Veon managed to convene its single-class scheme despite opposition from two bondholders who claimed that two sets of 2023 notes had differing interests. While somewhat case specific, the written judgement will be closely watched by restructuring lawyers as it could provide case law in particular with regards to temporal seniority, disputes over class composition and the ‘relevant alternative’ for solvent and insolvent companies.

What 9fin is looking forward to in 2023

The author has always been sceptical of the special status afforded to Schuldschein debt.

I do not confess to be an expert (so please feel free to challenge and educate me) on the instruments but I cannot see under the new insolvency regimes that their charmed life can continue. In the past they have been hard to restructure as they don’t have collective action clauses and are individualistic and often need unanimous support.

But their status is set to be tested in the Orpea restructuring in early 2023. As reported, a group of Schuldschein lenders are opposed to the French care home operator’s plan to fully equitise the unsecured debt, of which the SSD makes up the majority. It is highly likely that the company will seek to cram them down via Sauvegarde and put them in a single class with the unsecured bonds.

The SSD holders claim that their German law debt offers them protection from a French process. But secondary cases can only be opened after the French court begins the primary proceeding and with a stay on enforcement imposed by the French process, this might limit the SSDs ability to use options such as enforcement. For legal nerds, you are welcome to go down the EU Recast Legislation rabbit hole.

2023 is likely to be the year where the tables are turned on distressed funds, with a number of their loan-to-own investments entering restructuring. Ideal Standard is top of our list. It will be interesting to see how the funds deal with being on the other side of the restructuring table.

As well as looking forward to legal challenges to A&E requests and arguments over temporal seniority in the UK courts, 2023 could be the year where we see case law develop for other European jurisdictions.

Spain could be the most interesting of the lot with CELSA creditors pushing their own plan through bankruptcy, which is opposed by the company. The Spanish government is also heavily involved due to their provision of SEPI funding.

German real estate is likely to remain a fertile ground for the 9fin editorial and analyst team, with valuations plummeting and availability of finance drying up. The interconnectedness of the market and the history of related party transactions is now becoming clearer as we join the dots.

And finally, ever the legal nerd, 2023 will be the time to see if proposed changes to the UK Restructuring Plan are implemented. Earlier this week, the UK Insolvency Service published its final evaluation piece, in which it recommends giving UK plans extra-territorial effect (similar to Chapter 11), and proposes a number of other measures to speed up the process and reduce costs. There are also hints that the moratorium process — relatively useless for large companies as it excludes finance creditors — could be amended, and the 20 business day period extended.

No doubt, not all of the above will come to pass.

But we are genuinely excited about the prospects for 2023 (for both restructurings themselves and our own content and offering at 9fin) and wish all of you happy hunting for next year.