The Skinny on Workouts — Dynamics in Bank Syndicates
To conclude her three-part series intended to de-mystify the workout banker’s motivations, Kristina Anderson of Carl Marks Advisory Group examines some of the dynamics inside senior lender syndicates and how those dynamics affect the syndicate’s ability to respond in workout and default situations. As Anderson notes, distress doesn’t necessarily have to lead to war.
By Kristina L. Anderson, Managing Director, Carl Marks Advisory Group LLC
For many companies, a syndicated senior credit facility is a key feature of their capital structure, and for many lenders, leading or participating in syndicated loans is their primary business. While there are significant benefits and efficiencies for both borrower and lenders by funding larger credit facilities through the syndicated loan market, a company’s ability to manage through tough times can be fraught with unexpected challenges when dealing with multiple creditors under the same umbrella.
While things certainly can progress smoothly, in large part because the lenders are governed by a common credit agreement, it can also seem at times to borrowers and their professionals like the biggest problem they have is not the challenges in their business but the difficulty in getting any kind of reasonable consensus out of their lender syndicate. Even lenders participating in syndicated facilities can find themselves incredibly frustrated when the lender group is asked for accommodations or faced with addressing covenant defaults or other difficult situations. In this article, we’ll examine some of the dynamics inside senior lender syndicates and how they affect the syndicate’s ability to respond in workout and default situations.
Voting Rights Drive Decisions
So long as a company complies with all the terms and conditions in its credit agreement, there is generally no need to approach the lender syndicate. However, when borrowers trip financial covenants or seek other accommodations from their lenders, they will usually need to modify their credit agreement. It is important then to understand how syndicated credit agreements can be modified.
Bank syndicates are, simplistically speaking, tiny little democracies. The proverbial majority rules, except with respect to certain key issues commonly referred to as “sacred rights,” discussed below. What constitutes the majority, often referred to as “required lenders,” is defined specifically in each credit agreement, but it is generally measured in terms of dollars rather than number of lenders and is always at least 50.1% of the total debt under the agreement.
The distribution of total credit amongst the lender group thus becomes a critical element when a borrower needs participation of its lender group to implement a turnaround plan. If a credit agreement defines required lenders as 51% and one lender has invested 55% of the total dollars in the deal, then that one lender will single-handedly control the vote on most issues no matter how many lenders participate in the credit. Conversely, if “required lenders” is defined as 66-2/3%, and no single lender holds more than 5% of the total dollars, at least 14 lenders will have to agree to pass any modification.
Sacred Rights and the 100% Vote
There are certain issues in credit agreements where majority doesn’t rule; these issues cannot be altered without each institution’s specific consent. These are often referred to as “sacred rights,” and generally include at a minimum modifications affecting maturity, interest rates and principal amortization.
This means if a company wants to extend the maturity of its loan or defer even one principal payment, for example, it will require consent of 100% of the affected lenders in its syndicate. Recall the earlier analogy about tiny little democracies and consider for a moment if U.S. presidential elections required consensus of 100% of the voting electorate. While lender syndicates are of course smaller in number than the U.S. voting population, the parallel is valid; it is extremely difficult to get 100% of a group of any composition to agree unilaterally on anything. As a result, sometimes the ability to implement an out of court turnaround plan hinges on the success in getting, or sometimes in avoiding, 100% votes.
Whether a required lender or 100% vote, achieving the necessary consensus to implement modifications needed to support a borrower’s turnaround plan can be challenging, to say the least. What is going on inside the syndicate that can make it so difficult for the participants to find common ground?
Senior Syndicated Lending: Not Just for Banks Anymore
While syndicated lending has historically been dominated by traditional commercial banks, the past decade has seen a marked rise in non-traditional participants, such as hedge funds and CLOs. A group of lenders with different business models, regulatory regimes (or lack thereof in some cases), risk tolerances, and return requirements often times hold significantly divergent views on the preferred way to address defaults or respond to requests for accommodations.
While a traditional commercial bank that is investing the government-insured deposits of taxpayers may focus on preservation of principal and avoidance of loss in a problem situation, the loan in question for a CLO is just one of many sold into in a pool that has been funded by investors. The CLO, therefore, has challenges being singularly focused on the health of any individual borrower as it has to avoid decisions that could negatively impact the health of the pool into which that borrower’s loan has been sold or interrupt the cash income stream promised to the investors in that pool.
A hedge fund, in contrast to the banks and CLOs, typically has higher risk tolerance and higher return requirements, and is often funded by sophisticated investors. A hedge fund, therefore, may be motivated by the opportunity for enhanced returns in a problem situation, and its legal structure provides it more flexibility to implement structures and/or convert to positions elsewhere in the capital structure through which to achieve those returns.
No one is right and no one is wrong; generally speaking, each lender’s approach is likely to be economically sensible in the context of each institution’s business model, return requirements, regulatory regime and risk tolerance. However, getting these groups to agree on a singular approach to a borrower’s financial challenges can be difficult because their business models and goals are often so divergent.
Secondary Market Trading
There is an established secondary loan market for trading bank loans. Once a borrower defaults, under most credit agreements it will lose the right to approve loan assignments that would otherwise allow it to control trading activity in the syndicate. Trading activity will often increase for deals in distress, and both borrowers and lender participants must be prepared to deal with changing players in the syndicate. Why don’t the lenders that did the deal stay in the deal?
Lenders are no different than their borrowers; all are economic animals that ultimately have a responsibility to their stakeholders to identify and pursue strategies that contribute economic value. For some lenders, the secondary loan market provides a quick, easy and clean exit to loans that they can no longer economically support. For others, the secondary loan market provides an alternative trading arena through which they can enter and exit loan situations, quickly and sometimes often, in an attempt to generate trading profits.
Lenders generally do not trade loans with the intention of altering the dynamics of a lender syndicate; they do so because they believe it is economically advantageous for their institution to do so. However understandable or economically justifiable trading decisions may be, though, the end result is that any change in the lender participants affects the voting dynamics in the syndicate, and that can impact the ability of the syndicate to garner consensus, particularly during periods of financial distress.
Failed and Defaulting Institutions
In this cycle, bank syndicates have been faced with an issue not prevalent for some time — failing and failed institutions in the syndicate. Failed or failing institutions are often simply unable to vote or their representatives literally disappear, which can paralyze a bank syndicate from taking action and leave a borrower with few options to address its challenges. How, for example, can a 100% vote be achieved when one of the participating lenders is experiencing severe financial distress and, as a result, has been restricted by its regulator from making commitments of any kind? A 100% vote becomes wholly unattainable and borrowers and their professionals are faced with the difficult task of trying to develop solutions that can be legally implemented around failed or failing institutions.
Conflicting Economic Interests
Though this article focuses on the senior loan component of the capital structure, it is worth noting that many companies have multiple layers of debt. These capital structures can present individual lenders with potentially conflicting loyalties in a distressed situation.
For example, it is not unusual to see lenders in a senior loan syndicate also investing in a subordinated tranche of the borrower’s debt. Alternatively, a single syndicated credit facility may include multiple pro-rata facilities, for example, a revolving credit facility and a term loan. A lender may participate in the revolver but not the term loan, or a lender may have a disproportionate share of one facility vis-à-vis the shares of the other participants.
Each lender has responsibility to his or her institution and, thus, must view proposals not only in the context of the overall expected outcome but also in the context of the impact on that lender’s individual investment. If a lender has competing interests in multiple facilities, the lenders’ assessment of what constitutes a fair accommodation may not be congruent with other lenders whose dollars are invested in different credit facilities, and their vote will typically reflect that perception of inequity.
Developing a plan that is perceived as wholly equitable across a company’s entire capital structure is often difficult. It is important for borrowers, lenders and each group’s respective professionals to examine the composition of all credit facilities on the borrower’s balance sheet and identify where competing financial interests could impact negotiations and voting situations both favorably and unfavorably.
The Hijack Factor
Some lenders in syndicates may attempt to use their vote to “hijack” a more favorable deal for their institution, believing that if they simply refuse to agree to anything, someone will pay them to get out of the way so the company and its other lenders can proceed with the turnaround plan. Admittedly, this sometimes works, and for that reason, lenders will probably keep trying.
Be cognizant of the small participant or the lender whose investment has little if any value; while many borrowers expect that with little at risk such participants would simply acquiesce to the wishes of the majority, reality is that small size or lack of value actually gives them much greater leverage than the value of their share of the loan might imply. With little if anything to lose if their hijack strategy fails, some can afford to play a hijack strategy out to its most draconian conclusion.
In any group, challenges will exist in gaining consensus, and lender syndicates are no different. For borrowers and their professionals, it is important to be aware of the dynamics driving each lender in their syndicated credit facility and how those dynamics will influence negotiations and decisions, particularly in times of financial stress.
For lenders, pay attention to who’s in the syndicate and remember to re-assess the landscape if the players change. Be aware of the fact that what may seem an obvious solution to you may make absolutely no economic sense to another syndicate participant that represents a different type of financial institution.
Distress doesn’t have to mean war. Though lenders in syndicates often disagree with each other, not to mention the borrower, everyone is generally trying to do what’s right for their investors and shareholders. For any deal to work, each participant has to perceive a benefit versus the realistic alternatives at that juncture. Any proposal that satisfies the interests of one group of participants at the expense of another is unlikely to succeed. By understanding the goals of each participant in their syndicate, a borrower and its professionals can work with, rather than be at odds with, its lender syndicate to develop proposals that can achieve a consensus and help put the company on the necessary path to advance its turnaround plans.
Kristina L. Anderson, managing director at Carl Marks Advisory Group LLC (CMAG), has nearly 20 years of financial transaction experience working with both healthy and distressed companies, including ten years negotiating, structuring, implementing and managing the restructuring and rehabilitation of distressed debt for the commercial banking industry. She has been involved in the resolution of numerous distressed debt investments for both public and private companies across a broad range of industries and outcomes. Anderson has worked extensively in distressed syndicated transactions with complex capital structures and diverse stakeholder constituencies in roles such as sole lender, participant, steering committee member, and agent. In her position with CMAG, Anderson focuses on financial restructuring transactions.
Prior to CMAG, Anderson spent 19 years with SunTrust Bank, where she most recently held the position of SVP and manager of the Corporate and Investment Banking Special Assets Group. Anderson also served as director of SunTrust’s Corporate and Investment Banking Special Assets Group, and held previous positions with SunTrust as VP of Debt Capital Markets, VP and relationship manager of Corporate and Investment Banking and AVP of Commercial Credit. She began her career in banking with the Bank of Boston Connecticut. Anderson graduated with honors with a B.S. in Finance from the University of Illinois at Urbana-Champaign.