Liquidity pressure stemming from the Federal Reserve’s monetary tightening policy that increased base interest rates by approximately 5% between March 2022 and August 2023 has driven a growing number of indebted companies to seek breathing room via the use of out-of-court liability management transactions. Amid the preponderance of these restructurings, discounted recoveries among companies that emerged from a default event in 2023, and in 2022, are far higher than long-term averages. This trend has also lifted the average recovery rate among an increasing sample size of covenant-lite loans that largely defaulted outside of bankruptcy court.
Out of court
In this evolving landscape, loose documentation terms, the appeal of shorter restructuring times, tightening credit conditions and an increasing need to manage the burden of higher interest rates/funding costs have all contributed to the rise in distressed liability management transactions (LMTs).
Looking at defaults that occurred in 2023, the S&P Global LossStats database tracks 20 defaults covering 72 leveraged loan and high-yield debt instruments. Of the 20 issuer defaults, 17 stemmed from distressed out-of-court restructurings. Three were via bankruptcy filings.
This 85% share of out-of-court distressed transactions is the highest on record, and is up from 73% in 2022. It compares to just 30% in the 2020 cohort.
The long-term average for out-of-court distressed transactions through the end of 2022, as a share of defaults, was just 28%.
Prior to the 2016 oil & gas-driven uptick in defaults, the long-term average for this share was only 17%.
By volume, the share of LMTs of overall defaults fell to 69% in 2023, from 90% in 2022. This compares to a long-term average of a 32% annual share through the end of 2022. The 2022 distressed share received a boost from two mega-sized distressed restructurings: Envision Healthcare and Diamond Sports.
Rate of recovery
To the recovery rates on defaulted debt: All told, the analysis of S&P Global’s LossStats database covers $1.3 trillion over 36 years. In terms of methodology, the nominal recovery value in the database can be calculated in one of three ways:
- The trading price of pre-petition debt at emergence;
- The settlement pricing (earliest public market values of the new instruments a debt holder receives in exchange for the pre-petition instruments);
- The liquidity pricing event (or the final cash value of the new instruments that were acquired in exchange for the pre-petition instrument).
Using discounted recoveries values the nominal recovery back to the last date at which a cash payment was made on the pre-petition debt to eliminate the noise of time, thereby maintaining comparability between varying lengths of time spent in restructurings.
Of the 70 instruments that emerged from default in 2023 and were added to the database for this recovery study last year, 43 are bank loans, of which 24, or a 56% share, are covenant-lite facilities. This compares to a 22% share of the 2022 cohort. Cov-lite loans do not include maintenance covenants, which require a borrower to meet regular financial tests, potentially allowing for earlier warning signs for balance sheet fixes.
Bonds emerging from a default event in 2023 include 10 senior secured tranches and 17 senior unsecured or subordinated bonds.
The average nominal recovery for the newly added instruments across bonds and loans is 82.6%, while the average discounted recovery is 81.5%. Both of these metrics virtually match last year’s sample, which were the highest recovery levels since 2016, a year also dominated by distressed exchanges, in the aftermath of the oil price plunge of 2014-2016.
Time is not a healer
As far as restructurings go, recovery rates are proven to be higher for distressed transactions outside of bankruptcy court, where the time in restructuring is significantly shorter, and asset preservation higher. Shorter bankruptcy stays, also, yield better recovery rates, where quick trips through bankruptcy court are largely pre-negotiated.
The longer it takes the more likely the restructuring will be complicated, and the negotiations contentious.
In 2020, when defaults via bankruptcy made up 70% of the cohort, the average nominal and discounted recoveries were just 68.8% and 68.0%, respectively. Furthermore, 28% of the 136 facilities in the 2020 sample spent between one and three years in bankruptcy, versus none in the 2023 sample.
Across all instruments and the entirety of the dataset between 1987-2023, the average discounted recovery for distressed exchanges is 79%, 19 points higher than the average of 60% for bankruptcies lasting less than six months, and 23 points higher than the average of 56% for those lasting less than one year. For bankruptcies lasting 1-3 years, the average discounted recovery drops to 48%.
The pattern is the same for term loans — recoveries are considerably higher following a distressed exchange (89%) than following a prolonged bankruptcy process. In the event of a bankruptcy process taking a year or more, the average discounted recovery drops below 70% of face value.
Newly tracked loans
Discounted recoveries for the 43 newly tracked bank loans across 14 default events emerging in 2023 improved to 80.6%. This compares to 79.1% from 50 loans from 19 default events in the 2022 study, but is down from 83.6% for the 2021 cohort (49 loans across 21 events).
Last year’s average is above the 20-year historical-average discounted rate of 77.9% for bank loans.
As mentioned earlier, the average discounted recovery for all newly added instruments across bonds and loans of is 81.5%.
By default year, for all newly added instruments, the data shows a decrease in recoveries for last year’s cohort, to 81.5%, from 84.3% in 2022. This is up from pandemic-era defaults — the average discounted recovery was 79% for 2021 defaults and 66.5% for the 2020 cohort.
The average stood at 73% in the two years before the pandemic.
Returning to bank loans, the data by default year, across of course a thinner sample, shows 2023 defaults that have emerged from bankruptcies and distressed transactions had an average discounted recovery of 80.6%, versus 83.4% in 2022.
Mirroring the trend seen across all instruments, among the cohort that defaulted in 2020, bank loans recovered, on average, 76.1%. This was when the US leveraged loan default rate reached a cycle peak of 4.17% in September 2020, as tracked by the Morningstar LSTA US Leveraged Loan Index.
Per LCD’s analysis, the average discounted recovery in the 2023 sample had the narrowest standard deviation to the mean, compared to other post-pandemic years.
Absorbing losses
Looking at other metrics tracked for this analysis, an ongoing topic of discussion is the depletion of loss-absorbing debt layers below that of senior bank loans, and the ultimate impact this depletion will have on recovery rates for instruments at the top of a thinning pecking order, in the event of default.
Indeed, as financing costs skyrocketed and buyout activity plummeted, fewer of the sponsor-owned companies that did come to market to raise debt in 2023 supported their first-lien funding with a second-lien term loan or an unsecured bond issue. The result was a near-negligible debt cushion. For more coverage on this, see “Loss-absorbing LBO debt cushion layer thins, putting recoveries at risk”.
As mentioned in prior studies, debt cushion and seniority have a direct impact on recoveries: the more sub-debt there is to the defaulted instrument, the stronger the recovery for the instrument in question.
Indeed, the broad recovery levels are unchanged by the latest additions to the data set.
For all debt types, instruments with more than 75% of the capital structure subordinated to its position had an average discounted recovery of 91%. This dropped to 82% for those with a 51-75% cushion, to 69% for a 26-50% cushion, and to 51% for those with a cushion of 25% or less.
Bank loans, which benefit from the senior secured position in the priority waterfall, performed much better across all debt cushion buckets.
Having a first-lien claim on security further boosts recoveries. Loans with more than a 75% cushion have a 94% average discounted recovery, with a coefficient of variation of just 0.17. The average discounted recovery is 87% for bank loans with a 51-75% cushion, 73% for those with a 26-50% cushion, and 70% for a cushion of 25% or less. Clearly, while more subordinated debt is better for bank loan recoveries, the reality is that any debt cushion boosts recoveries.
Similarly, given the higher-priority structure in the event of default, senior secured loans outperform all subordinated debt, as bank loans have an average discounted recovery of 79%, versus 49% for bonds (the recovery rate for bonds edges slightly higher with the addition of the 2023 sample to the overall history of the dataset). In 2022, the recovery history for the database for all bond instruments was 48%.
Likewise, revolvers outperform term loans (because of their relationship to DIP funding), while first-lien debt outperforms second-lien.
Back to the topic of covenant-lite. The 24 new cov-lite facilities in last year’s cohort brings the total count of these instruments tracked by LossStats to 133.
Although the data set for cov-lite defaults/recoveries remains thin (relative to other types of debt tracked for this analysis), the growing sample size offers a meaningful glimpse into the impact of stripping financial maintenance tests from these facilities.
Recoveries on these newly added cov-lite loans jumped to 78.7%, from 68.5% across 11 facilities the previous year.
This brings the long-term average across the history of the database to 67%, up from 65% the previous year, and compares to the bank loan average for covenant-heavy and covenant-lite term loans of 73%.
Note, however, of this year’s sample, 96% stem from distressed exchanges, compared to 73% in 2022 and 36% in 2021 and 2020.
Note that in prior LossStats studies, the average discounted recovery for cov-lite generally skewed higher because the cov-lite debt primarily came from the pre-credit crunch boom. Back then, cov-lite deals were available only to higher-quality issuers. Indeed, in 2007, just 29% of new-issue volume lacked maintenance covenants, versus the 75% average in 2013–2019. All of the cov-lite facilities that were added to the recovery study last year were from 2013 or later.
Now that cov-lite lending has become the norm in the leveraged loan market — 90% of the $1.4 trillion in outstanding US leveraged loans in the Morningstar LSTA Leveraged Loan Index lack maintenance covenants (an all-time high in April) — what does that mean for recoveries?
Looking at term loans issued after the Global Financial Crisis in 2009, and excluding second-lien facilities, shows that cov-lite term loans have underperformed, recovering 70% on average, versus 78% for all first-lien loans issued over the same time period.
BSL vs middle market
With increasing focus on lending to smaller companies and away from a broader syndication, this study breaks down how company size influences recoveries.
LCD tracked pro forma financials for default events in LossStats, and focused on cash flow in the pre-petition transactions. The results were consistent with previous studies. When looking at pro forma EBITDA, negative or zero EBITDA structures had the lowest ultimate recoveries, but large corporate credits (transactions with more than $50 million in EBITDA) recovered slightly less, on average, than did middle market credits (transactions with $50 million or less in positive EBITDA).
For a single default event, this study averaged the ultimate recovery levels for all pre-petition debt. Companies with zero or negative EBITDA had the lowest ultimate recovery, with an average of just 43%, versus the average of 63% for middle market companies and 58% for large corporate borrowers.
Warning bells
Given that interest rates are at 23-year highs (and are expected to remain close to the Fed’s current target range through the end of the year), the impact of higher-for-longer interest rates has yet to fully play out in recovery data.
Furthermore, amid loosening documentation terms, warning bells are being sounded concerning the increasing use of aggressive out-of-court restructurings that could impair recoveries by transferring collateral via asset dropdowns, or by subordinating existing investors via priming uptiering exchanges.
LCD’s default data also demonstrates increasing instances of repeat defaulters, following unsuccessful attempts to kick the can of debt away from court, potentially impacting asset preservation along the way. LCD’s data shows that, of the issuers conducting these liability management exercises during the pandemic default wave of 2020, nearly a quarter returned with a conventional default of missed interest payments or a bankruptcy filing within the next three years. In 2022, despite the shorter timeline, the share of companies returning with a payment default or bankruptcy jumped to 33%.
Featured image: Sasin Tipchai/Getty Images
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