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Creditors Not So Keen on Distressed Credit Swaps

What’s the alternative to a bankrupt portfolio company? A distressed credit exchange. Private equity pros are fully aware of this option, because it keeps their companies afloat without requiring new capital infusions or equity dilutions.

Today Bloomberg reported there have been at least seven such transactions this year. Compare that with last year, which saw a total of 12, according to S&P.

Lenders and bondholders are none too happy about the rising number of distressed credit exchanges. And why should they be? Lenders are offered a chance to exchange debt at a discount for cash or new securities. The transaction essentially benefits the PE backer because it keeps the company afloat while the bondholders take a loss.

It’s different on a deal-by-deal basis, but PE firms generally give up nothing, while lenders at the bottom of the capital structure can put in more money in exchange for moving up the capital structure. Some lenders can’t or don’t want to re-invest, so they are “up-tiered,” or stepped over in the pecking order by someone below them. One lender told me, “Private equity remains in place, and bondholders take a loss. That doesn’t sit well with us.”

PE pros can hang the threat of a bankruptcy over the heads of bondholders, saying the loss taken in a liquidation would be better than a smaller up-front loss. S&P said the move was “essentially coercion,” and both S&P and Moody’s classify a distressed exchange as a default, since the obligations on the original debt aren’t met. But it seems that lenders “are starting to push back for better terms,” the bondholder said.

If bondholders start pushing to the brink of Chapter 11, it could have some dire consequences. With debtor-in-possession (DIP) lending sparse, such a filing could be disastrous for a company’s survival.

The largest PE-backed Chapter 11 this year has been TPG’s Aleris, which was a $3.3 billion deal — not huge in the grand scheme of boom-era buyouts. I don’t want to see the effects of a mega-buyout Chapter 11 as large as, say, Blackstone Group’s Freescale Semiconductor or Apollo Management’s Harrah’s Entertainment.  Freescale and Harrah’s have each undergone debt exchanges this year, and there’s talk of Harrah’s going back for a “double dip.” The company’s first debt exchange “didn’t take care of the problem,” a lender said.

Even the Aleris situation required creativity on the DIP lending side. The company asked existing bondholder to pony up cash for the DIP loan while TPG itself expressed interest in investing. Similarly, Lyondell Chemical’s $8 billion DIP loan “rolled up” old loans with the new loans and gave priority to the combined rather than the old loans as an incentive to lend more.

As a lender told me, “At this point, private equity firms are just throwing proposals out there to see what sticks.”

There’s more on this topic in a story by Ari Nathanson called Distressed Exchanges Could Spike In Popularity, published the Feb 12 in Buyouts.