A wave of bankruptcies and restructurings is always on the horizon, depending on who you ask. Whether it materializes is another thing entirely. 2024 is showing some signs that the wave might crest.
At the start of 2023, it looked like a wave might materialize. Many firms staffed up their restructuring teams, expecting a busy season. But, sources say, bankers were willing to extend and amend financing if it looked like a given business had a path forward. According to data from a recent analysis by FTI Consulting, “the distribution of filings by debtor size in 2023 is consistent with annual averages since 2017, except for 2020, which was an outlier. Approximately 55% of large filers have liabilities at filing between $50 million and $250 million (middle-market cases); about 25% have liabilities at filing between $250 million and $1 billion (large middle-market cases), while nearly 20% of filings are above $1 billion—and 2023 was unexceptional in this respect.”
Those findings are consistent with what Brian Davies, a managing partner in the financial advisory services practice at investment bank Capstone Partners, saw play out. He says he did not ramp up headcount on his team, in part because the ascent of private credit changed the math for borrowers. They have more ways to secure financing, and private lenders may be willing to find solutions during times of trouble, instead of forcing businesses to seek legal protection.
“Many lenders hold their assets, because capital is much more difficult to redeploy at the moment,” Davies says. “Another issue is that we’ve been in a very competitive lending environment, so it’s difficult for some lenders to force a restructuring if a borrower breaches the agreement, because so many deals were drafted covenant light. These two factors can limit a lender’s options.”
Moving into 2024, these trends may be starting to shift. The year started with a number of high–profile filings, including Signa Group and Diamond Sports.
Vincent Indelicato, global co-head of Proskauer Rose LLP’s business solutions, governance, restructuring and bankruptcy group, says, “restructuring professionals have seen a conspicuous uptick in restructuring activity.” He adds that in some cases, private equity managers are taking a look at the balance sheets of their portfolio companies and realizing they have run out of options. “For the first time in a long time, we are seeing private equity sponsors approach their lenders and say, ‘Do you want the keys?’” he says.
Indelicato adds that there is still a desire from lenders and borrowers to find a workout without going to court, even in a change–of–control arrangement at the borrowing company, unless the business has troubled assets that would benefit specifically from tools available in bankruptcy proceedings. Businesses with unexpired leases or labor agreements that cannot be managed in a workout are two examples.
Challenges Ahead
Despite the desire to stay out of federal bankruptcy court, being able to do so is likely to become harder. Businesses that extended and amended their way through the past three years may be out of runway, and what’s more, depending on their overall balance sheet, they may not have the equity available to get refinancing, even from flexible lenders.
“I think creditors are beginning to realize that even if the Fed cuts rates this year and next, a lot of balance sheets are still broken or unserviceable,” says Tuck Hardie, managing director in the financial restructuring group at investment bank Houlihan Lokey. “Creditors are beginning to say, ‘OK, someone has got to de-risk me either through an equity contribution, an accretive asset sale, or deleverage by having a junior stakeholder convert to equity, because senior creditors are not being compensated for the risk they are taking.’ I think that attitude will continue to harden.”
Hardie notes that there are loans maturing this year and next that were written when interest rates were significantly lower, and companies may find they cannot afford to refinance at a higher rate. That pressure is likely to be most acute in the middle market, where significant private credit activity is focused and where businesses have fewer financing options overall.
Capstone’s Davies agrees. “Historically speaking, when we started a restructuring process, there often was some unencumbered assets that would provide incremental capital, thus giving additional runway to work with,” he says. “What we’re seeing now, and what I think we’re going to see going forward, is that there are very few unencumbered assets left. The competition to place these credits has been so high that they’ve stretched the collateral to provide more credit for the business. So getting restructuring financing in place is going to be more of a challenge.”
Even if it is challenging, parties may try getting as creative as possible to avoid court. Bankruptcy proceedings are more expensive than an out–of–court restructuring and can take much longer. Hardie adds that middle market companies could lose 10% or more of their enterprise value in a bankruptcy proceeding, even if the company eventually exits and resumes regular operations. With the cost of capital already high, bankruptcy will be even harder to come back from. Sources say creditors and investors also have a preference for so-called “packaged bankruptcies,” meant to be entered and exited quickly. If that’s not possible for a given company, it could be challenging to secure debtor-in-possession financing to go through the process if the exit strategy is not straightforward.
Shrinking Multiples
The challenges businesses face are not limited to just their balance sheets. Investors could see contraction of the multiples within certain private equity vintages that have exposure to these companies. If private equity managers engage in the debt-for-equity swap needed for a change-of-control transaction, it can give companies more time to clean up troubled balance sheets, but it cannot fix everything. As a result, it may be harder to gauge the overall risk profile of private equity and private credit portfolios if managers are not disciplined about what they are willing to underwrite.
“When I think back to the last restructuring market we had, the amount of private equity capital that was out there then, compared to what it is now—the increase is just breathtaking,” Davies says. “So you have to think about how these funds are going to react to a restructuring if their focus has largely been on profit improvement.”
So-called liability management practices, such as accelerated change of control, could be one way sponsors avoid court. Proskauer’s Indelicato says he expects to see these practices continue. “I think in the first quarter, in particular, we’ll continue to see use of this playbook as [PE] sponsors with flexibility use these tools to extend runway and avoid a bankruptcy filing,” he says. “Many of the candidates for those trades will likely prove to be companies that have been the walking wounded since the pandemic and desperately need a capital solution because of liquidity challenges. To some extent, I think we may see ‘The Return of the Living Dead.’”
Nate McOmber, managing director in the restructuring practice at G2 Capital Advisors, says he is already seeing an uptick in demand for financial and restructuring fiduciary services, as sponsors and companies look for people to lead them through insolvency. He also points to a talent gap in the industry, saying, “There’s a pronounced shortage of junior and mid-senior people with the kind of wide-ranging toolkit required to be an effective fiduciary in special situations. Despite the soft landing the Fed is working toward, borrowing costs will remain high for the foreseeable future, which a lot of companies won’t be able to stomach, which will continue to drive a lot of need for restructuring services.”
New data from S&P Global show that private equity managers are also terminating a fairly significant number of deals. Global terminated M&A deals totaled $15.96 billion across 29 transactions in the fourth quarter of 2023, a low figure on a historical basis. However, 17.2% of those deals were backed by private equity and venture capital firms, either as buyer or seller, the highest quarterly proportion since 2020.
If more companies are running into financing hurdles and the broader M&A market remains challenging and slow, investors could encounter difficulty getting money back from private equity managers, which could make it difficult to redeploy capital, especially in institutional portfolios already struggling with denominator effect issues. As Bloomberg recently reported, some large investors have already said they will not re-up into new private equity funds until they get at least some cash back.
If investors look to the default rate as a relative benchmark to assess portfolio risk, they may find it less accurate than in the past. According to FTI Consulting’s analysis, “The ascent of private credit likely is having some indirect impact on the default rate, as more non-bank lenders opt for credit estimates (or less) and forgo a full credit evaluation process by the rating agencies for some of their loan exposures, thereby excluding these companies from the pool of issuers tracked by the rating agencies should they later default. Consequently, we believe that, in time, the speculative-grade debt default rate could become a less representative proxy of large corporate failure, if it isn’t happening already.”
Lenders, for their part, still have some tools to ensure they get something in a recovery process. Practices like priming—when the seniority position of a lender on a secured loan is superseded by another lender— can keep groups of senior creditors at the top of the repayment list. However, it requires those creditors to be relatively sophisticated in their practices. Capstone’s Davies notes when banks were doing the majority of the lending, they had workout groups within the team already. Non-bank lenders may not have that and could lose out to teams that do.
Investors may also want to look closely at the discipline of the private credit managers with which they invest. Private credit is fresh off another banner fundraising year and is looking to put money to work in a relatively slow M&A environment. Houlihan’s Hardie notes that the temptation to finance companies under pressure could add risk to managers’ portfolios.
“There are firms that will continue to finance these businesses, sometimes even at an over-levered level, because they buy into the story that the company will eventually grow into its balance sheet over time,” Hardie says. “We’re seeing debt deals get done at leverage levels that make you scratch your head and go, ‘What were they thinking here?’ They’re financing somebody else’s problem and creating a problem for themselves.”
Tags: bankruptcies, Brian Davies, FTI Consulting, G2 Capital Advisors, Houlihan Lokey, Nate McOmber, Private Credit, private lending, Proskauer Rose LLP, restructurings, Tuck Hardie, Vincent Indelicato