Beating up junior

When Nordic Capital’s restructuring of Swedish car roof-rack and sports equipment maker Thule saw an entire SKr2bn (US$244m) mezzanine tranche wiped out, it concentrated the minds of junior lenders on the increased vulnerability of their portfolios of investments.

Far from an outlier, that December restructuring increasingly looks like the harbinger of an exceptionally tough period for junior debt holders as a significant number of LBO deals look set to follow the same pattern.

“There are very few data points so it is early to identify a trend, but it does look like recoveries for junior debt will be dramatically down because in so many situations value is breaking in the senior debt,” said an adviser acting on a number of current restructuring situations.

Of the relatively small number of deals where restructurings have completed or where concrete proposals are being considered the situation for junior debt is grim.

A debt-for-equity proposal being considered for UK housebuilder McCarthy & Stone, for example, would see senior creditors take 100% of the company’s equity in a pre-pack deal that leaves second lien and mezzanine with nothing.

Similarly, a deal on the table for Finnish bathroom maker Sanitec proposes to write off 100% of a second-lien tranche in exchange for a conditional 5% of equity, offered in the form of warrants that will only be triggered if sponsor EQT achieves a 25% IRR on its new equity injection.

UK speciality chemicals maker Vita provides another example. In its case, which is currently going through a scheme of arrangement, the senior lenders have in effect taken all of the equity and are selling it back through a pre-pack to the incumbent sponsor TPG and mezzanine investors, who each only stay in the deal by reinvesting.

Poor recoveries have always been a risk for junior debt, but the extent to which debt at that level is set to suffer across a raft of credits is new.

“There is evidence that credits are performing so badly, and declining so rapidly, that value is being wiped out to a greater extent than in the past,” one mezzanine investor said. “In such cases equity owners and junior creditors can only stay in deals if they can invest new funds,” he said.

But there is more to the trend than simple value erosion.

According to a restructuring specialist: “The position of junior debt is technically no worse than it was in the past but this time around the ratio of junior to senior debt has shifted dramatically. Deals that feature ‘stretched senior’ facilities with relatively thin junior tranches are more likely to see value break in the senior, even if the overall leverage has not changed hugely.”

That means that senior lenders are more likely to suffer write-downs than in the past, forcing them to equitise all or part of their investment, leaving junior lenders empty-handed.

Compounding the issue is the continued absence of available refinancing from sources outside existing syndicates. In previous downturns, junior lenders could drive events by accessing financing from alternative senior lenders.

In situations where mezzanine was out of the money it was at least possible to equitise their investment into a controlling stake and refinance the facilities above them to keep senior lenders whole and away from the equity.

In many cases that option is no longer realistic, cutting the wiggle room available to out-of-the-money junior lenders.

Jurisdictions matter

While the situation is stark, it is not uniform. Europe’s plethora of jurisdictions means that junior debt can expect different outcomes in different places.

“The UK and Nordics are tough regimes right now because they are generally supportive of in-the-money lenders,” said an investor. “In less creditor-friendly places, senior lenders will throw some bones to the junior in order to get deals done consensually,” the investor added.

Out-of-the-money but dissenting creditors have a nuisance value in Italy, for instance, because paying them off can keep situations out of the morass of insolvency.

Saeco and Ferretti are two examples where that tension is currently in play. In both cases creditors are considering proposals whereby junior lenders will suffer 100% write-downs but are being offered thin slices of equity or warrants for supporting consensual deals rather than insisting on formal insolvency.

“In a restructuring the golden rule is that you don’t want to be a lender in a Latin jurisdiction, but that can be used to the advantage of junior lenders who are otherwise out of the money because it is harder to force them out and senior lenders don’t want to end up in value destructive formal procedures,” a banker said.

Relying on nuisance value is a tough proposition, but with prospects otherwise stark, investors will use every tool at their disposal to realise any value.

For example, the specific subordination of junior facilities has major implications for the nuisance value of the securities. The closer a tranche of debt is to a company’s operating assets, the more likely its holder can influence events.

Advisers expect that this will be especially true in the current round of restructurings because of the potential to exploit the loose documents often associated with recent vintage LBO deals.

Second-lien debt, though much derided as cheap mezzanine, tends to be contractually subordinated rather than structurally subordinated, increasing its nuisance value and allowing holders to punch above their economic weight. Similarly, where mezzanine is secured and benefits from operating company guarantees, the likelihood of being able to extract concessions from senior lenders is increased.

There are other informal levers mezzanine lenders in particular can pull.

“Traditional mezzanine lenders have excellent relationships with sponsors, and in smaller deals – or deals where the mezzanine is fairly concentrated – the relationships do come into play and you might see a different outcome than in a deal where the mezzanine is widely held or held by other investors,” said a banker.

Being ostensibly out of the money also means junior debt holders’ interests are increasingly aligned with sponsors rather than other lenders. That is because the prospects for coming out of deals whole depend on trying to keep credits going as long as possible in the hope that companies survive the downturn, rather than enforcing securities.

Ironically for credit-focused investors, that makes covenant-lite situations less stressful and should also make junior lenders more supportive of covenant waiver requests and other easing of credit constraints on borrowers, even if that is only because it means they can pick up a fee while the inevitable is delayed.