Liability Management’s Limited Runway: Corporate Restructuring Today

Coercive, non-pro-rata debt restructurings, driven often by private equity sponsors, have become a major force for fixing distressed companies. The coercive recapitalization is promoted—by stressed companies, their owners, their advisors, and favored creditors—as avoiding bankruptcy and reducing the firm’s financial stress by extending the runway for its operations to recover and take off. If generally true, this would be reason to expect the upward trend in their frequency to persist.

But the positive characteristics promoted cannot be pervasively found in the data and post-deal results of these new-style restructurings.

First, a majority of the coercively restructured firms end up filing for bankruptcy anyway. For a coercive effort whose justification is largely to avoid bankruptcy, this bankruptcy-anyway trend is not a good sign. Second, the participants typically do not exchange their debt for stabilizing equity but instead take higher-priority debt that further destabilizes the firm’s overly-indebted capital structure. As a consequence, low credit ratings persist and a thinned-out equity layer remains in control, with distorted incentives. And those that go bankrupt anyway face a longer, more complicated than typical bankruptcy. Third, efficiency justifications commonly offered—like avoiding the expense of bankruptcy—are questionable and perhaps untrue. After all, coercive debt restructurings are themselves expensive. And saving bankruptcy expense does not work for most coercive LMEs, because most end up bankrupt anyway. Fourth, underrecognized qualities of the coercive restructurings are as consistent with value grabs as with efficient restructuring.

If most of these four features are present and important—we present evidence that all are—then the coercive recapitalization induces, in the finance vocabulary, overinvestment, locking capital in less-than-worthwhile investments for longer than is efficient. From a lawyer’s perspective, that could raise troubling fiduciary duty questions. From a market-wide perspective, regular overinvestment and inefficient recapitalizations will tend to favor terms and transactions that diminish the extent of inefficient recapitalizations going forward. It remains to be seen whether frictions in updating contracts and whether resistance from those who benefit from not updating them will slow or stop that evolution. But more of a contest seems to be brewing than conventional wisdom suggests.