The LME Wave

A surge in liability management exercises (LMEs) has manifested from a potent combination of weak credit documentation, elevated debt costs, impending maturities, and resourceful sponsors in need of a way to create equity value. While most of the sub-investment grade credit universe remains healthy, the sheer amount of outstanding debt means even a relatively low distress rate can inspire significant LME volume. LMEs remain ill-defined but generally encompass actions taken by a troubled borrower to restructure its debt obligations outside of court rather than through a formal bankruptcy process, or to raise money through unconventional means in order to address a liquidity need.

Executing an LME can generate the runway required for a borrower to avoid or postpone a “full” default. However, this creative debt management technique may lead to divergent outcomes for investors that hold the same instrument, presenting both attractive new-money opportunities and the potential for a re-ordering of the priority of pre-existing claims on the borrower’s collateral. It’s therefore essential that investors deftly navigate the risks and opportunities present in the LME wave, instrumental to which is drawing upon robust legal acumen and maximizing the benefits of scale and industry relationships.

The Origin

If the onset and acceleration of the LME wave were to be explained in just two charts, the two below would be highly effective.

Figure 1: Most Senior Loans Now Lack Meaningful Covenants

Figure 2: Base Rates Have Significantly Increased

Source: Pitchbook, Bloomberg

Firstly, over 90% of senior loans are now issued with no meaningful covenants.¹ Documentation standards deteriorated rapidly during the era of ultra-low interest rates following the Global Financial Crisis, as investors compromised on lender protections amid the chase for yield. Weak documentation gives borrowers increased flexibility to avoid defaults, and pursue creative ways to raise additional capital, including through issuing new debt that is senior to existing debt in the capital structure. Crucially, it also allows borrowers to pit creditors against each other, creating a prisoner’s dilemma that allows the company to obtain concessions. Fundamentally, this permits the potential for asymmetrical outcomes for lenders invested in the same instrument, a factor that partly explains the oft-used term ‘‘creditor-on-creditor violence.’’

If loose documentation standards formed the groundwork for the LME wave, the most significant catalyst that pushed borrowers to exploit them was the historic increase in interest rates in 2022. For floating-rate borrowers, elevated base rates are almost immediately reflected in coupon payments: since the start of 2023, the average coupon in the senior loan market has been 8.9%, up from less than 5% in 2020.² While most sub-investment grade credit issuers have demonstrated remarkable resilience to this increased interest burden, a meaningful cohort of challenged borrowers may need additional liquidity to run their businesses, and/or struggle to meet upcoming maturities.

For this stressed subset of borrowers, conducting an LME presents the opportunity to secure new liquidity and/or cut their existing debt burden. This may help to avoid – or at least delay – a formal bankruptcy process which, in addition to being very expensive, typically results in a change-of-control transaction pursuant to which creditors exchange their debt for all or substantially all of the equity of the bankrupt company, leaving the sponsor with little to no value. Given the cost, time, and loss of equity associated with an in-court restructuring, an LME is increasingly the preferred option. (See Figure 3.) For private equity sponsors, even if LMEs may only delay the eventual day of reckoning, they can provide additional runway to drive improvement in their portfolio companies without the need to contribute more equity, and without the need to crystallize a loss.

Figure 3: LMEs Represent Over Half of All Defaults

Source: Moody’s, Barclays Research, as of August 2024

Exercise Methods

The breadth of the term ‘‘liability management exercise’’ (i.e., indicating any action to manage liabilities) is such that basic amend-and-extend transactions (generally benign transactions that involve pushing out maturities) and even debt buybacks could be considered LMEs. For the purpose of this piece, we’ll focus on the more contentious LMEs in which (a) new money is provided on a priming basis, and/or (b) creditors holding the same instrument experience disparate outcomes.

Prominent Forms of LMEs:

• Uptier: With support from a majority of existing lenders, a borrower amends its credit documentation to permit the issuance of new debt that is senior to the existing debt. Typically, the new senior debt is provided by the majority lenders, who, in addition to providing the new money, get to elevate the priority of their claims on existing collateral, subordinating the claims of other minority creditors that hold the same instrument. (See Figure 4.)

Figure 4: Sample Uptier Transaction

Source: Oaktree observations

• Drop-Down: The borrower moves collateral from loan parties (against which existing lenders have a claim) into an unrestricted subsidiary or non-loan party (against which existing lenders have no claim). The unrestricted subsidiary or non-loan party entities can then issue new debt that is structurally senior to, or secured against, this transferred collateral. This new debt may be issued to third parties that do not hold debt in the capital structure, or to certain existing lenders. Pro forma for such a transaction, non-participating existing lenders are left with less collateral securing their claims.

• Double-Dip: A financing in which a lender seeks to maximize its recovery by establishing multiple independent claims against a borrower’s corporate enterprise. As this credit enhancement provides downside protection in the event of a restructuring, the stressed company can attract new lenders with more favorable terms. A pure double-dip may be perceived to be more lender-friendly than a drop-down or uptier; while the new debt may dilute the claims of existing lenders, it doesn’t prime existing lenders or transfer away collateral.

Participation Awards

For the borrower to achieve the aim of raising new liquidity or cutting existing debt, not all lenders can receive a favorable option. As mentioned, the flexibility of documentation enables the borrower to offer different terms to different lenders.

Participation in an LME is generally encouraged via offering certain existing lenders better terms for supporting the new transaction (e.g., receiving second-out loans rather than being left with third-out). Recently we’ve observed a trend toward more “benign” LMEs, in which the differential in recoveries between participating and non-participating lenders has been reduced, so that sponsors can maximize participation in the transaction.

In recognition of the fact that non-participating lenders typically receive the worst outcomes in an LME, CLO managers – the largest holders of broadly syndicated loans – have updated their own documentation to facilitate greater participation in LMEs.

LMEs often lead to the formation of creditor groups. While each situation is different, in the context of an LME, a common breakdown is as follows:

• Steering committee of the ad-hoc group: Typically comprised of the largest lenders, the steering committee negotiates directly with the borrower to structure and implement the LME. The steering committee members generally receive the best economics, including through fees paid for backstopping new money, and the ability to roll up their pre-existing debt on the most beneficial terms.

• Ad-hoc lenders: This group typically doesn’t drive the LME but achieves some protection by participating in the transaction, albeit on terms that are often less advantageous than those offered to the steering committee.

• Non-participating lenders: Don’t participate in the LME, and are thus left with their existing debt, which is generally subordinated in lien priority to the debt holdings of the participants.

Unequal Outcomes

Since LMEs only impact a borrower’s balance sheet and don’t affect its business operations, there is a significant risk that despite the transaction the company will eventually need to file for bankruptcy. If a bankruptcy filing does occur post-LME, the negative impact to lender recoveries can be substantial. (See Figure 5.)

Figure 5: Aggregate Recovery Rates Are Lower for Post-LME Issuers

Source: Fitch Ratings, Bank of America Global Research, as of December 31, 2023

However, the true impact can be harder to discern, since recoveries can vary greatly across lenders. Although historically, with certain exceptions, lenders holding the same debt instrument were generally treated on a pro rata basis, LMEs can disrupt this outcome, creating a significant disparity in recoveries across otherwise similarly situated lenders.

Indeed, the biggest determiner of recoveries in a bankruptcy for individual lenders may be their participation (or lack thereof) in an LME. For example, non-participating lenders who didn’t exchange their prepetition debt for new senior debt may be left with a recovery far worse than if the LME hadn’t occurred. Meanwhile, participating lenders, who access the new debt (either as an existing lender who exchanges their old debt or as a new-money external lender) can receive enhanced recoveries, generally based on their greater priority of payment. Ensuring participation in an LME, and in the steering committee, is often a function of size of holdings, proven restructuring experience and relationships, and having the scale and capital to commit to new-money opportunities.

Defense Mechanisms

Protecting against LMEs is important for both opportunistic and performing credit investors, despite the reality that these two groups generally have different entry points. Once invested in a credit, opportunistic lenders – who likely purchased the loan or bond at a discount – and performing investors – who generally invest at or near par – have similar incentives to protect the value of their investments.

Potential defense mechanisms include:

• Blockers:

  • – Lender protections incorporated into credit documents that attempt to close loopholes that a borrower might otherwise exploit. These are often added after an LME has been consummated in an effort to avoid the risk of a future LME.

  • – However, blockers can be imperfect and are inconsistently applied. Many outstanding loans still contain the loopholes exploited in previous LME situations. (See Figure 6.)

Figure 6: Documentation Loopholes Remain in Many Outstanding Loans

Source: Covenant Review, Barclays Research, as of August 2024

• Cooperation agreements:

  • – Co-op agreements contractually unite creditors in an effort to create negotiating leverage against a borrower which might otherwise seek to pit such creditors against each other. Used defensively, a cooperation agreement can prevent non-pro-rata outcomes among signatories by preventing such parties from entering into side-agreements with the borrower.

  • – The strength of a co-op primarily derives from its scale, which can help prevent transactions that require majority consent. This can be highly effective against uptiers (which generally have a 50.1% consent threshold) but is much less effective against drop-downs, where the borrower has more flexibility to act without the support of the existing lenders.

Blockers and co-ops can represent valuable (though also fallible) tools in a lender’s arsenal, but often the best safeguards for value are scale, proactivity, and industry relationships. And for performing credit investors who may wish to avoid borrowers that later conduct an LME, sometimes diligent credit underwriting may be the best protection.

Coming to Private Credit?

To date, LMEs have been mostly limited to public credit, which is marked by diffuse groups of many lenders, multiple classes of debt, and loose documentation. Direct lending, which is typically characterized by small lender groups and tighter documentation, has largely resisted the LME wave. However, there are indications that LMEs may spread further into the private debt universe.

Private credit covenants have become less robust as money has flooded the market and managers have competed for deal flow. Maintenance covenants – those tested on a regular basis – are noticeably absent from larger private loans, where the competition with the syndicated market is most intense. In fact, less than 10% of loans above $500 million have maintenance covenants.³ (See Figure 7.) This reduces early warning signs for lenders and impedes their ability to negotiate with the borrower. With this segment of the market set to compete with the public loan market for returning M&A deal flow in 2025, we could see further erosion of documentation standards.

Figure 7: Maintenance Covenants Are Lacking in Large Private Loans

Source: Moody’s Investor Service

Meanwhile, an increasing portion of private loans are switching from cash-pay to payment-in-kind (PIK), with PIK more than doubling as a percentage of business development company (BDC) income since 2018.⁴ Temporarily suspending cash interest payments while accruing more debt that eventually must be paid in cash might provide stressed or distressed borrowers with a brief respite. However, such a maneuver is unlikely to solve any fundamental problems associated with overleveraged capital structures.

Private credit loans that contain weak documentation or that are made to issuers that must rely on paying PIK interest may be candidates for future LMEs. Though private credit capital structures are often less complex, borrowers may still have loopholes to exploit. That said, in all likelihood, LMEs will remain less prevalent in the private credit market than in the broadly syndicated loan market.

Surfing the Wave

With interest rates likely to remain elevated for longer, loan documentation remaining weak, and private equity sponsors keen to avoid painful restructurings, we’ll likely see LMEs continue at pace. If one includes the probable progression of LMEs in Europe and the potential for LME activity in the (now very large) private credit market, we could be looking at an extended wave of liability management exercises.

Whether an existing or new-money lender, performing or opportunistic, seeking to protect value or capture upside, the same core attributes will best equip investors to navigate this dynamic. Having the scale, experience and industry reputation required to navigate LMEs and ensure success has never been more crucial.

Credit Markets: Key Trends, Risks, and Opportunities to Monitor in 1Q2025

(1) Treasury Yields Continue to Confound Expectations

Treasuries sold off during the fourth quarter as market expectations regarding the pace of interest rate cuts once again proved to be overly ambitious. With the U.S. economy remaining strong and the potential for inflationary policies from the new administration, investors are now anticipating only one or two interest rate cuts in 2025.⁵

As a result, the 10-year Treasury yield rose by nearly 80 basis points in the quarter, returning to the level seen in May 2024.⁶ (See Figure 8.) Term premium – the compensation received for holding longer-dated bonds – has returned to the Treasury market. The 10-year yield ended the fourth quarter 33 basis points above the 2-year yield, with the 30-year an additional 20 basis points higher than that.⁷ This reflects concerns about the sustainability of the U.S. national deficit and the impact of stubborn inflation.

Dramatic rate moves weren’t limited to the U.S. In the UK, government bonds came under heavy pressure: the 10-year gilt yield reached its highest level since the Global Financial Crisis, largely driven by worries about sticky inflation and elevated debt levels in the UK.⁸ At the end of the quarter, the 10-year gilt yield stood at 4.57%; in 2020, the yield on the same instrument briefly dropped below 0.20%!⁹

The rates sell-off was particularly painful for assets with greater interest rate sensitivity, including long-dated fixed income: U.S. investment grade bonds, which have an average duration of 6.6 years (over double that of the high yield market), returned -2.8% in 4Q2024.¹⁰

On the other hand, higher base rates may continue to be a positive tailwind for floating-rate assets, including senior loans and CLOs, helping provide a strong yield despite compressed spreads. As we discussed in a recent podcast, we believe the power of high income shouldn’t be underestimated as a driver of credit returns.

Figure 8: The 10-Year Treasury Yield Increased Dramatically in 4Q2024

Source: Federal Reserve Bank of St. Louis

(2) Record-High Issuance for CLOs

A strong fourth quarter brought CLO issuance to an annual record in both the U.S. and Europe, with $509 billion and $89 billion of volume, respectively, in 2024.¹¹ Refinancing and reset activity constituted a large portion of this volume, as managers took advantage of compressing liability spreads. (See Figure 9.)

Exceptional investor demand for CLO debt has derived from several factors:

• Elevated base rates: as a floating-rate product, higher reference rates translate directly into higher income for CLO debt investors.

• An attractive spread premium: partly due to their perceived complexity, CLOs have continued to offer additional spread compared to similarly rated corporate bonds. Despite significant tightening, BB-rated CLOs offered a spread of 580 basis points in the fourth quarter.¹²

• Greater understanding of the robustness of CLOs: more investors now appreciate CLOs’ resilience, achieved through numerous structural protections and prudent active management that has kept default rates very low.

CLO spreads have tightened after an exceptional year for total returns. The AAA tranche, the safest and largest part of the CLO structure, has seen over 40 basis points of spread compression in the last year, with compression in the lower-rated tranches even more significant.¹³ While this may limit future returns for CLO debt investors, it should benefit CLO equity holders.

Tighter liabilities are accretive to CLO equity returns, with lower funding costs supporting the arbitrage that drives cashflows to the equity tranche. In addition to issuing new CLOs with cheaper debt, CLO managers can refinance the debt on existing CLOs at a lower cost. Of course, while securing tight liabilities is key to CLO manager success, the true test will remain avoiding credit problems in the underlying loan portfolio.

Figure 9: CLO Issuance Was Exceptional in 2024

Source: Pitchbook

(3) Bubble Territory?

In a recent memo revisiting a subject he wrote about 25 years ago, co-chairman Howard Marks outlines why he believes a bubble is more a psychological state than a quantitative calculation:

In my view, a bubble not only reflects a rapid rise in stock prices, but it is a temporary mania characterized by – or, perhaps better, resulting from – the following:

• highly irrational exuberance (to borrow a term from former Federal Reserve Chair Alan Greenspan),

• outright adoration of the subject companies or assets, and a belief that they can’t miss,

• massive fear of being left behind if one fails to participate (‘‘FOMO’’), and

• resulting conviction that, for these stocks, “there’s no price too high.”

Looking at the S&P 500 today, Howard indicated that while optimism has prevailed in the market for the last two years, the atmosphere isn’t necessarily one of wild exuberance. That being said, high valuations in the S&P could make it harder to achieve strong future returns, with high p/e ratios effectively meaning investors are relying on companies generating profits for many years to come.

It shouldn’t come as a surprise that the return on an investment is significantly a function of the price paid for it. For that reason, investors clearly shouldn’t be indifferent to today’s market valuation. (On Bubble Watch, January 2025)