By Samuel Antill (Harvard Business School), Neng Wang (Columbia Business School & Cheung Kong Graduate School of Business) & Zhaoli Jiang (Hong Kong Polytechnic University)
In a liability management exercise (LME), a firm raises liquidity by issuing new secured debt with a highest-priority lien on collateral that was previously pledged to existing secured lenders. Typically, a firm achieves this by convincing a majority of existing secured lenders to amend their credit agreement, allowing for new debt to obtain a higher-priority lien on the existing debt’s collateral. In return, this majority coalition gets to provide the new highest-priority loan and swap their old debt for new highest-priority debt. Thus, the firm raises liquidity, the participating majority coalition retains the highest-priority claim on collateral, and the excluded secured lenders lose priority. Many LMEs –including dropdowns (e.g., Revlon) and uptiers (e.g., Serta Simmons)—follow this structure, though the details differ in each deal.
These LMEs have become popular over the last decade. Critics argue that this trend is harmful, causing secured lenders to worry and restrict credit supply to risky borrowers. Proponents argue that these transactions are beneficial—a study by S&P Global shows that 63% of these firms avoid a Chapter 11 bankruptcy through an LME. Consistent with the proponents’ view, empirical research shows that new secured loan contracts continue to include language that allows for a future LME. Why do new loan contracts allow for LMEs?
In our article, we build a model to explain the prevalence of LMEs. In the first period of our three period model, a firm issues secured debt and decides whether to enable LMEs. Competitive bank lenders price the loan fairly, given rational expectations of future firm behavior. In the second period, some firms enter distress. A distressed firm must raise liquidity from existing lenders in a renegotiation to avoid bankruptcy. In the third period, consistent with the S&P study mentioned above, some distressed firms that raise liquidity avoid bankruptcy, while others must file anyway, incurring deadweight losses.
In the second period, if a firm enters distress, its bank lenders sell its debt to two hedge funds. Consistent with empirical evidence mentioned in our research article, these hedge funds privately observe their “required returns:” the returns they must obtain to agree to inject liquidity and help the firm potentially avoid bankruptcy. Crucially, the firm cannot observe the hedge funds’ required returns, creating a tradeoff. The firm can offer a high return for new liquidity and ensure a successful renegotiation. Alternatively, the firm can offer a low return, which risks bankruptcy but saves money for equity holders if the hedge funds turn out to have low required returns.
If the firm bans LMEs in its initial contract, a distressed firm must raise liquidity through “traditional renegotiation:” hedge funds cannot lose seniority on their existing debt if they refuse to inject liquidity. In this scenario, we show that inefficient renegotiation failure can occur in equilibrium. Intuitively, equity holders of a distressed firm have a “renegotiation debt overhang” problem. Offering a high return for new liquidity is an efficient investment, but part of the surplus goes to existing debt holders: since equity holders cannot observe required returns, they cannot extract all of the surplus. Thus, equity holders “underinvest” in the renegotiation, offering a low return and risking bankruptcy, since they do not internalize enough of the benefits from renegotiation.
Our main result shows that LMEs solve this debt overhang. In an LME, equity holders can ensure renegotiation success with a lower promised return, since hedge funds fear losing existing collateral rights if they refuse to participate. This motivates equity holders to ensure a successful renegotiation, since they internalize more of the surplus from a successful deal. As a result, some firms optimally enable LMEs to prevent inefficient renegotiation failure. Importantly, in extensions of the baseline model, we explain why some firms choose to ban LMEs, and why certain “non-pro-rata uptiers” are more likely to be banned, consistent with empirical evidence.
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