Coming to a cash-strapped company near you: creditor-on-creditor violence

U.S. companies that struggle to repay their below-investment-grade bonds and loans have increasingly squeezed concessions from lenders by pitting them against one another. The private-equity firms and wealthy individuals who own most of the companies call the deals “liability management exercises," or LMEs. Debt investors call them “creditor-on-creditor violence."

Companies using these tactics—or preparing to—run the gamut from telecommunications provider Altice USA to cloud-computing firm Rackspace Technology and aerospace supplier Incora. Some funds are fighting back by joining forces to pre-empt such tactics. Lenders to radio broadcaster iHeartMedia have recently organized, fund managers who have participated in the groups said. But even in such alliances, debt investors can turn on each other, they said.

“We are of the view that LME will only become more contentious from here," Barclays credit analyst Corry Short wrote in a July report. It was the bank’s first systematic analysis of the phenomenon. There are roughly $155 billion of bonds and loans trading at distressed prices that could be subject to future liability management, he said.

The clashes reflect in part the squeeze of sharply higher interest rates. Many of the companies involved have taken on loans and bonds to pay for their acquisitions by private-equity funds. Rising interest rates have simultaneously made the debt more expensive and damped returns the private-equity firms deliver to their own investors. Private equity returned about 6% last year, according to data from MSCI, compared with the S&P 500’s 24%.

Owners can prolong their control over ailing companies and postpone losses by playing the financial equivalent of Game of Thrones with creditors. The proprietors coax certain lenders to exchange debt that is coming due for a smaller amount of longer-term debt by offering them preferential treatment—at the expense of other creditors who aren’t in on the deal. Once a majority of creditors agree, owners can push harsher terms on the rest of their loan and bondholders.

Defaults have historically been overseen by bankruptcy courts, but in the current cycle, a majority are playing out in the backroom world of liability management. Private-equity firms can push the out-of-court deals through now because loan investors have been giving up legal protections for years in exchange for higher yields.

Such restructurings bolster the valuations that private-equity firms assign to the companies, protecting management fees they charge investors. They also cut the companies’ costs and give them time to potentially recover.

Still, these arrangements can help stressed firms only so much. Companies that have already defaulted are four times more likely than average to re-default and 35% of companies that conduct distressed exchanges default within two years, according to S&P Global Ratings.

The deals also worsen ultimate recoveries for debt investors, who recovered 47% in bankruptcies last year of companies that had previously engaged in LMEs, according to Fitch Ratings. Recoveries on debt of companies that hadn’t been involved in LMEs averaged 60%.

“These acts of financial war have been presented as attempts to rejuvenate a distressed company but appear to have done little more than afford private-equity sponsors additional fees and an improved position," Wake Forest University law professor Samir Parikh said in a recent paper.

The market for below investment-grade bonds and loans has almost doubled in size since 2010 to about $3 trillion, as low interest rates encouraged companies to borrow. The default rate on the loans has roughly tripled since 2022 to about 4.5% as borrowers contended with inflation and higher interest rates.

Owners of the debt are primarily institutions—pensions, insurers, hedge funds and the like—but individuals also bought in through mutual funds, exchange-traded funds and business-development companies, or BDCs.

One consequence of coercive exchanges is lower returns on senior secured loans, which typically fare better than junior loans and bonds in restructurings because they have first claim on corporate assets. Bondholders and junior lenders fared better than senior loan investors in 12 of 20 liability-management exercises that Barclays analyzed.

“It’s a small part of our market that is adding a lot of uncertainty," said Andrew Sveen, who runs $30 billion of loan investments at Morgan Stanley Investment Management. The unpredictability makes investors more likely to sell out of loans at risk of liability management unless they own large stakes that give them leverage in negotiations, he said.

Private-equity firm BC Partners was among the first to turn creditors against each other in 2019 to restructure its company PetSmart. BC launched a deal saying it would be available only to the first 51% of its loan holders who accepted it—the majority it needed for legal reasons—and that all other lenders would be left out in the cold.

Loan holders initially agreed informally to reject the deal. Then a large lender, Apollo Global Management, broke ranks and in a matter of hours the coalition fell apart.

“One by one, they dropped out," said a person involved in the informal group. “It was a disaster."

More companies adopted the tactic after the pandemic, including Envision Healthcare, backed by KKR, and restaurant supplier TriMark USA, backed by Centerbridge Partners and Blackstone. Investment banks such as Moelis and PJT Partners began building practices designing the deals, and law firms such as Gibson Dunn and Paul Weiss specialized in the lawsuits that resulted.

As the tactic grew more common, even more traditional debt investors began striking deals that disadvantaged other creditors. In the case of Advent International-owned mattress maker Serta Simmons Bedding, mutual-fund managers Eaton Vance and Invesco struck a deal with the company.

Private-equity sponsors are increasingly turning to distressed exchanges in part because they are struggling to sell companies they own since higher interest rates have chilled mergers-and-acquisitions activity. They have also been reluctant to reduce valuations of the companies they still own.

“This means that sponsors have had to get more creative with manufacturing returns," Barclays’s Short said.

Debtholders have begun pre-emptively forming co-op groups, signing binding contracts committing not to accept any exchange offers from companies unless all agreed on it. In 2023, Apollo Global Management and Pacific Investment Management joined forces effectively to preclude a coercive exchange by online car retailer Carvana. 

They negotiated a deal that gave the company time to improve operations and strengthened creditor protections. The restructuring worked, and both debt and stock prices rebounded.

Once rare, the alliances are growing commonplace, with more than a dozen forming this year, debt fund managers said. Companies affected include pharmaceutical firm Bausch Health and movie-theater chain AMC Entertainment.

Soma Biswas contributed to this article.