Bankruptcy Pros Adapt Private Equity-Backed Restructuring Moves

A growing wave of financial tinkering by distressed companies to raise new money is leaving a lasting mark on corporate restructuring practices as lawyers engineer and navigate evolving forms of liability management transactions.

The controversial maneuvers, sometimes pitting creditors against one another in a battle for collateral and repayment priority, have become commonplace in the leveraged finance market since the Covid-19 pandemic. Companies hoping to stave off bankruptcy—mostly those with private equity backers—arrange lofty and often aggressive out-of-court restructuring deals to raise fresh cash by exploiting loose language in their existing loan agreements.

A proliferation of these transactions, exemplified last month by AMC Entertainment’s overhaul of more than $1.6 billion of debt, has in many ways altered the roles of bankruptcy attorneys and corporate turnaround professionals. The legal and advisory work increasingly sought out by troubled corporate borrowers and their lenders requires cross-disciplinary teams, focused on keeping companies out of Chapter 11.

Private equity sponsors have employed new tactics to competitively raise financing since the onset of the pandemic in 2020, when some firms beefed up their bankruptcy and restructuring teams amid widespread corporate distress. Since then, “it has really morphed into a substantial part of our practice,” said restructuring attorney Brian Resnick, head of Davis Polk & Wardwell LLP’s liability management and special opportunities practice.

“Many of us went from primarily being bankruptcy lawyers to being liability management lawyers with bankruptcy being a relatively smaller part of our practice,” Resnick said.

At Ropes & Gray LLP, business restructuring practice group chair Ryan Dahl helps run a liability management team that has advised on several large deals in the last four years, including a $1.1 billion transaction for materials manufacturer Trinseo Plc. The paradigm of restructuring lawyers existing to help debtors and creditors in bankruptcy has changed, he said, and “there’s been an increased emphasis on becoming facile with financial documents.”

“You no longer have everything going in front of a bankruptcy judge,” said Dahl. “You need to not only have familiarity with, but expertise in, a much broader set of things.”

Creating Runway

Clever balance sheet tricks, like stripping lender liens by shifting collateralized assets into subsidiaries that aren’t bound by a credit agreement’s financial covenants, first gained attention in the years preceding the pandemic. In 2016, retailer J. Crew executed a now infamous deal when it moved $250 million worth of intellectual property to a Cayman Islands subsidiary out of the reach of existing creditors. The transaction allowed the company to pledge those assets in exchange for new debt.

Other large companies with impending loan maturities have since pulled off similar “dropdown” deals, including Instant Brands, PetSmart, Neiman Marcus, and Party City.

Liability management became more combative at the beginning of the pandemic. In what is typically referred to as an “uptiering” transaction, distressed borrowers have negotiated deals with slim majorities of their lenders to amend existing credit agreements and create new forms of senior secured debt above that held by a minority of other lenders.

Commonly described as “lender-on-lender-violence,” this form of deal-making enables a select group of financial creditors to improve their pecking order position for repayment over others with whom they had previously been on equal footing.

In the early days, some sponsors differentiated themselves as being more aggressive than others, said Resnick. But increasingly, more have grown comfortable employing some of these tactics “when they have the opportunity to do so and avoid bankruptcy,” he said.

“Bankruptcies have become very expensive, and liability management is often a way of buying time and hoping for a turnaround,” Resnick said.

Providing counsel to the companies and investment firms locked in these restructuring talks has exploded.

“Chapter 11 is like a sledgehammer. Our LMT practice is really intended to be much more of a scalpel in terms of how we address these issues,” Dahl said.

No Sign of Stopping

Numerous lawsuits have sought to upend lien-shifting deals done without unanimous creditor support, but court rulings “have not really led to predictability on how they may come out,” said Resnick.

Some challenges brought by aggrieved lenders have settled, while others have been litigated in bankruptcy cases after last-ditch restructuring efforts didn’t save the struggling company.

The US Bankruptcy Court for the Southern District of Texas has rendered the most consequential, but seemingly contradictory, rulings on the legitimacy of certain uptiering transactions. Former Houston bankruptcy judge David R. Jones last year determined that a collateral-stripping 2020 debt transaction by bedding manufacturer Serta Simmons was not only permissible, but foreseeable, under the preexisting loan agreement.

That decision was heralded by some as a sign that similar liability management transactions and exercises, creating winning and losing lenders, could withstand legal scrutiny should the borrower end up in bankruptcy.

But this year, Houston bankruptcy judge Marvin Isgur found that a controversial 2022 rescue financing package for Platinum Equity-backed aerospace parts supplier Incora wasn’t properly authorized.

The market has become more sophisticated—ideally to avoid litigation—by inducing all lenders of the same class to come along with the transaction rather than sue, said Resnick. More often lenders of the same class aren’t being pitted against each other, or opportunities are provided to those who didn’t negotiate the original deal “to come in with slightly worse economics,” he said.

“I think it’s safe to say liability management transactions are here to stay,” he said.

Last Chance for a Fix

The growing demand both by sponsors to keep their companies out of bankruptcy and lenders to game out approaches “has been transformational for the practice,” because clients want to understand how to “utilize these strategies for their interest or how can they use defense to protect against them,” said Proskauer Rose LLP bankruptcy and restructuring attorney Vincent Indelicato.

“I think LMEs in some ways have become a gateway drug,” said Indelicato. “Their users want to find other ways to deploy them even when they sometimes lead to bankruptcy.”

The drive to keep companies out of bankruptcy through out-of-court transactions has in some instances changed the role of applying Chapter 11 expertise.

“You’ve got bankruptcy people coming into these types of situations trying to predict what the court would do and how bulletproof these transactions would be,” said bankruptcy attorney Deborah Williamson of Dykema Gossett PLLC. “It’s often more of a protective” move, she said.

While out-of-court liability management can provide a useful liquidity boost, management teams should still be carefully considering whether such a move will indeed fix underlying issues, said Jim Mesterharm, co-head of turnaround and restructuring services at AlixPartners LLP.

Mesterharm said his firm is getting hired more often to make sure there is a credible business plan and corporate structure to support these types of transactions. In those instances, he warns owners to do all they can to fix parts of the business that they can control, because hoping for changes in the economy or falling interest rates isn’t a good strategy.

If a company is going to come up with creative ways to carve up its assets in a bid to fend off bankruptcy, “people need to make sure this is really a fix,” he said. “Because this might really be the last chance for a fix.”