Distressed Exchanges Could Spike In Popularity

Lenders may have the upper hand with regard to new loan seekers in today’s marketplace, but they still need to cooperate with their existing borrowers. Especially if they want to get paid back.

With little hope for an economic turnaround in the near-term, more and more companies are expected to default on their debt through missed interest payments or tripped covenants as cash flows continue to evaporate. A tide of defaults could cripple lenders, many of whom are already hurting from the sub-prime meltdown and writedowns on the secondary market. To mitigate further losses, debt providers are increasingly forgiving loans they think have a good chance of failing and replacing them with others they feel have a better chance of being serviced by borrowers.

Last year there were 12 such distressed exchanges in the United States, with sponsor-backed issuers accounting for nearly half of them, according to information compiled by Standard & Poor’s and Buyouts. Meantime, there is reason to believe those numbers will increase in 2009. One disturbing sign is that three quarters of the distressed exchanges that took place for the whole of 2008 occurred in the month of December alone. And with S&P forecasting that the speculative grade default rate for corporate debt will reach 13.9 percent by the end of 2009, it’s likely that more borrowers will seek distressed exchanges and more lenders will capitulate to the requests. Thrown in pressure from approaching maturities on existing debt and the weakness of the economy, and the stage seems pretty well set for a spike in such swaps.

In a typical distressed exchange, the borrower works out a deal to swap a debt security that’s at risk of default for another debt obligation furnished with either a smaller principal amount, a lower coupon or par amount or a combination of these relaxed terms. The benefits for the borrowers are manifold as they are able to bolster liquidity, extend maturities and reduce leverage. At times, the new debt product is higher in the capital structure than the original obligation.

Residential Capital LLC, the troubled home finance subsidiary of GMAC LLC (owned by Cerberus Capital Management) was the beneficiary of two distressed exchanges last year; one in June and another in December. GMAC LLC itself also held a distressed exchange at the close of the year. Other buyout-backed companies that have gone this route include casino owner Harrah’s Entertainment (Apollo Management and TPG) and construction equipment renter Neff Corp. (Lightyear Capital and Norwest Equity Partners).

Though the move gives a company relief and may even enable it to wiggle its way out of, or at least prolong, a default, the credit ratings agencies have a less than favorable view of distressed exchanges since the transactions almost always lead to a monetary loss for the creditor.

“In most cases, investors are essentially coerced into accepting the offer, as the alternative could be bankruptcy, which could lead to a lower value for debt claims,” Standard & Poor’s said in a research note it issued last month on the topic. Both S&P and Moody’s Investors Service classify distressed exchanges as tantamount to default since the obligations on the original piece of debt weren’t met.

Meanwhile, for lenders, “the basic assumption is that a distressed exchange would provide more value to creditors than a bankruptcy or creditors would refuse to participate,” the S&P note offers. Also, there is the reassurance for providers of subordinated debt that they know what they are being offered in a distressed exchange, versus the potential uncertainty of how things will work out in a bankruptcy situation, S&P said.