Against a backdrop of mounting economic challenges, syndicated lending and private equity financing are becoming high stakes bluffing games. Hugh Larratt-Smith of Trimingham Inc. explores this phenomenon and how lenders can make the right calls to protect their positions.

In the first year of the U.S. Civil War, the Confederacy faced a severe cash flow problem, as its leaders failed to realize that a massive economic schism had grown between the North and South, and that the South’s industrial base was one-fifth the size of the North’s.

To address the problem, the Confederacy first thought it could pressure England and France to provide financial support by withholding the South’s cotton from mills in Europe. However, buoyed by a bumper cotton crop from Egypt in 1861, England and France called the Confederacy’s bluff, causing the secessionists to use their cotton as collateral for a European bond issue (the “cotton bonds”). But like any too-good-to-be-true investment, there was a catch: the collateral backing the cotton bonds was located in warehouses in the South, and the Union navy was blockading many key Confederate ports.

The Leadup to 2023

Let’s fast forward 140 years to the turn of the 20th century. The two decades leading to the new century featured an explosion of innovative financing structures, including first in-last out loans, derivatives, junk bonds and mortgage-backed securities. (Remember Liar’s Poker?)

Back then, syndicated loans typically required 75% or more votes on major changes to terms such as pricing, payment dates, covenants and control/ disposition of collateral. Lenders who dissented to major changes would be quietly replaced. Private equity groups paid close attention to their reputations with their financing sources. Covenants were routinely accepted as important guardrails to manage the direction of travel. Loan agreements were fairly straightforward and intercreditor agreements were not commonplace until second lien and FILO deals crept into the marketplace in the 1990s. Dividend recaps were uncommon and the keys to a business were not thrown on the table without careful consideration.

Rescue equity capital players such as Heller Financial’s turnaround fund in Chicago, Sun Capital in Florida and Recovery Equity Partners in California were the only game in town. Deals that had hair all over them were Prime plus 5% for three years with hefty prepayment penalties provided by the likes of Congress Financial, Finova Capital and Fremont Financial. Getting primed was a technique for preparing steaks for the grill, not a restructuring financing technique. Blacklists were for members’ bad behavior at the golf club, not to prevent unwelcome loan purchasers. Houses on the beaches in the Hamptons and Nantucket were three-bedroom cottages. Bluffing was something you did while sitting at the poker table.

Let’s fast forward again, this time to 2023.

The U.S.’ $1.4 trillion leveraged finance market has been hit by the biggest slew of downgrades since the depths of the COVID-19 crisis in 2020 as rising borrowing costs strain businesses piled high with floating-rate debt. U.S. junk loan downgrades totaled 120 for the first six months of 2023, according to J.P. Morgan, amounting to $136 billion, the highest total in three years.

In the next six months, if too many borrowers slide down the ratings scale to CCC, a protective switch within typical CLO structures could trip, resulting in loans getting dumped into the market. However, many CLOs have built-in defense mechanisms to manage risk in their portfolios including maximum portfolio holdings of 7.5% in CCC paper.

“In many sectors, it’s a target rich environment,” CJ Burger, president and CEO of Summit Investment Management, says. “Restaurant chains and healthcare companies with revenues under $100 million are struggling with higher borrowing and labor costs. We are seeing at least one office deal each day. It may be a soft landing for the economy or a more bruising landing. The Federal Reserve has signaled that more hikes could be in the offing in the third and fourth quarter. Some investors have been foaming the runway, betting on rate cuts in the second half of the year, but there is a saying that ‘you don’t fight the Fed.’”

Bluffing Games

With the reset of the economy from higher interest rates, some syndicated loans and private equity financings have become bluffing games. In some instances, syndicated loan agents are calling the bluff of syndicate members, trying to force new terms on the syndicate. In other instances, private equity groups are calling the bluff of their lenders, trying to get better terms, even threatening to either “prime” the lenders’ security interests in exchange for additional funding or throw the keys on the table.

“We have had a very long period of economic prosperity since the conclusion of the Great Recession, and that has produced ever increasing competition among an ever increasing population of lenders,” Walter Schuppe, senior vice president of the special assets group at Pacific Western Bank, says. “This leads to weaker loan structures and weaker covenants. This shifts the negotiating leverage to the borrowers, or their owners, who play the ‘relationship’ card and tell lenders they are looking for flexible ‘partners.’ This creates a natural internal tension between the business development group who needs to be competitive in the market and the portfolio management group that has to manage ever increasing levels of risk.

“We have seen this movie before, and the ending never changes, and it can be a very sad ending for the lenders. When a borrower develops operating or financial problems and it negatively impacts cash flow, the owners are going to lean on their ‘relationship’ with the lenders to slow or prevent aggressive action. This can quickly turn into a ‘loss sharing relationship’ between the lender and the private equity group. This is great deal for the private equity group, whereas the lender is working off slim net interest spreads. The lender has to question if absorbing a devastating loss is worth the relationship.”

When a lender is an investor in the private equity group, this can lead to problems, even when the lender participates as a limited partner in one fund and the investment in the borrower is domiciled in another fund. When a lender has a slice of equity in the borrower, things can turn bad quickly. In the past, lenders would only take equity when forced to, but today, some lenders take a slice of equity to juice their return.

How can this lead to problems? When a private equity group injects new money into a deal by way of a second lien loan, the senior lenders’ hands may get tied through cross defaults and rights granted to junior capital in the intercreditor agreement. Sometimes the immediate paydown from the second lien money is not worth “the deal with the devil.” In other cases, the private equity group can selectively buy back debt at a discount to get rid of troublesome lenders.

“The days when lenders could anticipate the rights afforded them in a credit agreement are behind us,” Rick Hyman, a partner with Crowell & Moring, says, reminding lenders to carefully read their loan documents. “There are surprises on every page, and lenders are slowly trying to close gaps that opened with the dominance of private equity groups coming out of the financial crisis. With the cooperation of participating lenders, loopholes have famously been taken advantage of in the Revlon, J. Crew, Boardriders and Serta Simmons bankruptcy cases, among many others, to obtain financing during difficult times.”

In Serta’s bankruptcy case, for example, 51% of the syndicate was able vote to subordinate their position (through a complicated series of steps) to new money funded by those same lenders. Some syndicated loan agents and private equity groups use such loopholes to leapfrog over existing lenders in the waterfall. In the Serta case, non-participants have been left to litigate, with disappointing results so far.

Creative techniques in some of today’s loan agreements have caused a drift away from 75% to 100% lender consent for major changes to 51% without anyone really noticing. For example, some private equity groups throw lenders a bone by way of springing guarantees or capital calls to get concessions. The language around these “backstops” can be as complicated as the wiring on a nuclear power plant and exceedingly difficult to enforce. Some private equity groups use these as strategies to bridge to the next set of negotiations. Meanwhile, other private equity groups want to kick the can down the road past a quarterly or annual mark, so they withhold negative information from lenders or “put lipstick on the pig” with talk about exciting new business for the borrower. Not all private equity groups will act on these strategies, especially those with private credit arms, since bad behavior may have unforeseen consequences and reputational risks.

The good news for lenders is that tighter bank regulation may change the power dynamic between private equity groups and lenders. The bad news is that credits that have been downgraded are more expensive to hold. Regional banks may need to dump high leverage loans to avoid pressure from the Office of the Comptroller of the Currency. In addition, many banks are contending with loans to struggling office buildings and shopping malls that are defaulting or throwing the keys at their lenders. In fact, more than $14 billion of shopping mall loans are due in the next 12 months, according to Moody’s, as some older low-end malls have experienced declines in valuations of more than 70%. This is putting enormous stress on regional banks with heavy commercial real estate exposure.

“Banks seem to be taking a cue from their regulators and really focusing on distressed CRE loans,” Steve Emerson, a partner at Dry Creek Capital Partners, says. “The FDIC, Federal Reserve and other regulators recently released a 90-page guidance on extending distressed CRE loans. One unusual section from this guidance highlighted by many noted that ‘in certain situations, banks can modify loans without taking a loss even if the properties backing them are worth less than the debt.’ Given this backdrop, it is not surprising that banks aren’t spending as much time on, or trying to dispose of, commercial and industrial deals as they are on their CRE portfolio.”

A Murky Economy

On a final note, if an asset-based loan is properly structured and monitored as the senior piece and is “collateral good,” everyone in the capital stack below the asset-based lender should take the pain, not the senior lender. When significant concessions are requested, the asset-based lender should strongly consider calling the bluff of the term lender or the equity owner.

“There’s a dangerous middle ground of ‘no man’s land’ where financings are neither a strong ABL deal nor a strong cash flow deal,” George Psomas, senior managing director at BHC Capital Partners, says. “It’s where lenders who are too clever by half go to lose money. Calling the bluff of the equity in the capital stack can be tricky.”

As for private equity groups bluffing (or actually throwing the keys at lenders), there are numerous instances where companies have been too battered by the COVID-19 pandemic. While some private equity groups are taking a wait-and-see approach to a potential recession, others have hit their initial rate of return targets with dividend recaps and are “uninterested” in putting new money at the bottom of the capital stack. Thus, the bluffing game begins.

This is all against the backdrop of an economic outlook that remains murky. To wit, in August, Fitch Ratings cut the U.S. debt rating from AAA to AA plus, citing worsening fiscal conditions. The rating agency said its downgrade reflected “expected fiscal deterioration over the next three years” and “a high and growing general government debt burden.”

The biggest increase in outlays so far this year has been net interest on soaring federal debt, which has risen $146 billion to $572 billion. In August, Moody’s cut the credit ratings of 10 U.S. regional banks and said it was reviewing the ratings of six other institutions, pointing to lower profits and higher funding costs. The ratings firm also pointed to the prospect of a recession in early 2024, eroding demand for loans and leading to loan defaults.

As if that wasn’t enough, here is the canary in the coal mine: an inverted yield curve. The benchmark 10-year U.S. Treasury note has been lower than that of the two-year U.S. Treasury note for more than a year, the longest streak since a span ending in 1980. Notwithstanding this, the stock market is continuing its robust 2023 rally. All this points to interesting times in 2024. To wit, there were 634 commercial Chapter 11 filings registered in August, an increase of 54% from the 411 filings registered in August 2022, according to Epiq Bankruptcy.

An Unsuccessful Bluff

Shortly after the Civil War, Jefferson Davis, president of the Confederacy, admitted that the Confederacy had misplayed “King Cotton.” It had bluffed, hoping to create a “cotton famine” and thus pressure the British and French for financial support. But Davis could have adopted a March 1861 proposal by the Confederacy’s then attorney general to purchase as much cotton from farmers as possible and immediately send it to England, where the stockpile might be gradually sold as needed to raise funds. If the cotton had been shipped to England in early 1861, Davis concluded, it could have been converted to enough hard currency to have “more than sufficed all the needs of the Confederacy during the war.” Fortunately, the Confederacy’s bluff was unsuccessful.

ABOUT THE AUTHOR: Hugh Larratt-Smith is a managing director of Trimingham Inc. and a regular contributing author to ABF Journal.