Who drives the restructuring bus?

Nigel Ward is a banking partner at Ashurst in London, advising on leveraged finance and restructuring, with a particular focus on cross-border deals and transactions involving complex intercreditor relationships.

The world is a dangerously leveraged place.

The Institute of International Finance estimates global debt hit a record $300tn in June of last year, totalling 349-per-cent of the world’s gross domestic product. As of 2022, government debt had climbed to 102-per-cent of GDP, while non-financial corporate debt reached 98-per-cent of GDP.

While borrowing has surged, the suite of protections afforded to leveraged loan and bond investors has weakened dramatically over the past two decades. Lenders have shed burdensome maintenance covenants and embraced the incurrence-based provisions popular with their high-yield-bondholder cousins. And in the decade-plus when global interest rates hovered around zero, issuers were relentless wielding their power to dictate terms to yield-starved lenders and bondholders.

Faced with a huge wave of funding coming their way, sophisticated borrowers and issuers weakened lenders’ contractual protections to the point they became almost illusory. In short: Lenders and bondholders have been boxed into a corner.

The Covid-19 credit crunch hasn’t made the situation much better. In a recent internal study, we analysed a 2022-vintage term loan B — all 440 glorious pages. We considered 83 different features. Benchmarked against historic norms, we judged 13 features to be very disadvantageous to lenders, 29 to be moderately disadvantageous and a further 29 to be slightly disadvantageous. The remaining 12 features we judged to be neutral. No lender advantage to be found.

Does this matter? We believe it does, because leverage can’t grow forever. There must eventually be a reset. To quote Carl Jung, “no tree . . . can grow to heaven unless its roots reach down to hell.”

Covenants in loan and bond documents are there to protect investors from the most hellish consequences of corporate deleveraging, whether through restructuring or liquidation.

To use a different metaphor, covenants provide guide-rails and speed limits for borrowers. Guide-rails prevent them from straying dangerously off-road. Speed limits reduce the probability of a horrible wreck in poor conditions. Yet the dramatic weakening of lender protections over the last 15 years has given ample opportunity to borrowers/issuers (and ultimately the borrowers’ shareholders) to drive the bus how they want — to the extent that a crash could be inevitable.

This isn’t to say that lenders or bondholders make the best drivers in times of trouble. Historically they could (and often would) take control too soon. Squabbling lenders simultaneously seeking to grab the wheel seldom produces good outcomes. No surprise then that the Chapter 11 process in the US has many admirers — it leaves the borrower/issuer at the wheel, but with a judge looking over their shoulder.

That said, there is little doubt the pendulum has swung too far in borrowers’ favour. To wit: Many of the controls imposed by loan and bond covenants are ebitda-based. But lest we forget, ebitda can often be contorted and recalibrated into whatever figure the borrower/issuer wants it to be.

Other significant detours from the expected rules of the road include J. Crew-style asset dropdowns (2016) and Serta-Simmons-style favoured lender up-tiers (2020). The details and cleverness of these manoeuvres may be best saved for another day, but broadly, too often debt contracts are a case of ‘look no hands, no brakes’.

The problem is that central banks are raising interest rates fast, and financial stress is building.

So how will this contractual demolition derby affect European companies facing financial difficulties? It means the liquidity available to implement a restructuring may be limited — perhaps very limited. Travelling without brakes is dangerous for everyone, and the brick wall may be all too close by the time a restructuring becomes the only option.

Fortunately European borrowers and lenders have new tools in the box. Of particular note in Europe is the UK restructuring plan, introduced in the Corporate Insolvency and Governance Act 2020. This is a terrific development.

At last the UK has a self-standing tool for compromise between creditor classes — including the cramdown of out-of-the-money creditors. (Indeed some suggest a plan can be used to cram up or any other which-way if needed). As of late February, 13 statutory restructuring plans had been deployed since the option became available in June 2020. They include plans for well-known names, like PizzaExpress and Virgin Atlantic. A couple more are winding their way through the courts.

When the next round of restructurings hits, we may see some repetition, given borrowers’ aforementioned lack of guardrails and/or speed limits against cash burn and asset-base erosion. That would require a European take on serial US Chapter 11 filings (or Chapter 22’s as they are colloquially known).

An initial relatively simple restructuring plan (Plan A) may operate, for example, to inject super-senior cash to keep the lights on. It may also impose a standstill period on the main financial creditors and/or defer maturity dates to create breathing space for full-on restructuring negotiations to take place. In due course, Plan B will follow — a more comprehensive plan to restructure balance sheets and put the business back on a firmer footing.

We saw something like this scenario in the case of Smile Telecom’s sequential restructuring plans in 2021 and 2022. The 2021 plan bought time to conduct a sale process. The 2022 plan fundamentally restructured the balance sheet when the sale process bore no fruit. The two-step process is potentially expensive — but it is capable of delivering results. And still substantially cheaper than the US’s “Chapter 22”s.

But will these UK restructuring plans be recognised across Europe? One big fear after Brexit was that English restructuring proceedings might not be honoured elsewhere — following the UK’s post-Brexit loss of the Recast Brussels Regulation and the EU Insolvency Regulation reciprocity rights.

Yet early indications suggest those fears may not bear out. Take German real-estate firm Adler Group. Just a few weeks ago, Adler announced an English restructuring plan rather than using the German StaRUG process (the new 2021 German restructuring tool). This came after a new English subsidiary assumed primary and guarantee liability for six series of Adler bonds.

Perhaps the UK’s restructuring-plan mechanics, combined with the pragmatism and expertise of the English judiciary, will see London maintain and enhance its role as the restructuring capital of Europe.

But if we learned one thing from the aftermath of the global financial crisis it is this: Never underestimate the ability of market participants (and their lawyers) to find inventive and unexpected loopholes and restructuring solutions.

Expect borrower-friendly financing contracts to provide fertile ground for creativity and surprises. But the lack of runway will demand quick thinking and fast reactions from all those involved.