The prospect of a rise in the number of distressed assets and default rates has been a topic of conversation among loan market stakeholders for the past three years. However, we have yet to see a significant surge.
While concerns still run high, there is also a more optimistic scenario. Amidst current challenging conditions, lenders are showing an increased willingness to work through alternative approaches to the more traditional bankruptcy court process. Private lenders especially have more flexibility. As a result, distress and defaults may be unlikely to reach true “high-tide” levels.
The macro picture for distress
Many loan market analysts have taken a dim view of the distressed space in the next two years. Fitch, for example, sees a band of 2023 institutional leveraged loan default rates between 2.5%–3.0%. They project $47 billion of defaults in 2023 at the midpoint of their forecast.1
Deutsche Bank is more pessimistic, expecting a 5.6% default rate in the United States and a 3.7% rate in the euro market in 2023. Per their estimates, default rates on U.S. leveraged loans will hit a near-record high of 11.3% in 2024, while defaults on euro-leveraged loans will hit 7.1%.2
Undoubtedly, the economic climate is harsh for borrowers. A complex economic cycle continues to spin. Wilmington Trust’s 2023 Capital Markets Forecast highlights an inflationary vortex driven by labor, China, and energy, which creates structural stress.3 This vortex and the resulting monetary policy are exerting its pull across companies’ capital structures.
Signals from first quarter 2023
The start of 2023 has already seen an uptick in distressed and defaulted situations. The impact has been showing up in several deals where Wilmington Trust serves as the administrative or facility agent, including a rise in defaults and a handful of deals falling into legal enforcement actions. Signs of trouble are appearing in loan portfolios for asset managers in both Europe and North America.
However, we do not anticipate a surge of free-fall bankruptcies. Given the cost for borrowers and lenders, both parties will be keen to stop short of traditional bankruptcy filings. Instead, defaults are more likely to lead to arrangements such as prepackaged/prearranged filings with terms agreed upon in advance or Restructuring Support Agreements (RSAs), where borrowers and lenders negotiate the terms of a debt restructuring plan. These scenarios will likely play a much more significant role the rest of this year and into 2024.
Private credit and broadly syndicated trends
Unlike the last debt restructuring cycle during the Global Financial Crisis of 2008, private credit has built up a significant market share, especially in middle-market deals. Private creditors such as private equity firms or institutional investors typically have more leeway in renegotiating terms or agreeing to a forbearance period. However, banks in broadly syndicated loans must contend with more guardrails and regulations, which limit their options.
For example, institutional investors may have a much greater comfort level with swapping debt for equity when they believe in the long-term value of the borrower. They may be more willing to amend terms and extend agreements within a broader range of borrower-friendly options.
By contrast, banks treat loans as items on their balance sheet and cannot easily accept trade-offs or hold equity. Their risk appetite is lower. They are more restricted to extending short grace periods or offering leniency on certain loan covenants provided they believe the borrower remains financially viable in the short-to-medium term.
The agreement typically includes provisions for modifying the terms of existing debt, such as reducing interest rates or extending maturities.
Impacts on new lending
The potential for distress has also changed the climate for new lending. Lenders across the lending base have significantly more sway in the negotiation process. As a result, loan sponsors and borrowers must make more concessions in terms and conditions. The market has significantly less room for the kinds of covenant-lite transactions that have characterized the market in recent years.
In turn, additional bargaining power among lenders has led to more extended and complex negotiation periods in setting up a new deal on both the bank and private debt sides. Negotiations can include amendments such as adding loan tranches or changing the currency of existing tranches to boost the secondary market and encourage additional investors to buy out those with lower appetites for distressed debt. Precise and equitable terms can also help stave off inter-creditor fights if these new deals become distressed.
The dynamics for loan agents
As intermediaries between lenders and borrowers, independent loan agents play a critical part in distressed credit situations. Agents strike the right balance between holding firm to existing loan documentation within the context of borrowers’ and lenders’ needs and interests. In addition, sometimes certain waivers or amendments may be necessary to achieve the most efficient and sensible outcome for the deal parties. Doing so helps create compromise solutions rather than lender-on-lender conflict that triggers litigation.
In scenarios where a majority of lenders direct the agent to take actions that other lenders may dispute, agent experience is essential. Finding ways to navigate such scenarios requires significant savvy and flexibility backed by a rigorous understanding of the credit agreement. It also requires clarity around what is and is not in the agent’s purview and when to pull in other resources needed before, during, and after the transaction. Without such experience, agents' risk taking actions that are not in accordance with the finance documents. Doing so can be far more complicated and complex to navigate if the agent is also a lender in the facility.
In parallel, agents need to be able to maintain business as usual, such as tracking interest, closing trades, and issuing notices. And finally, when a restructuring is complete, flexibility comes into play again as the agent operationalizes changes to terms.
The current economic cycle differs from past credit crises as unpredictable factors are causing inflationary pressures, resulting in a prolonged period of uncertainty for loan stakeholders. Rather than a sudden wave of defaults, we anticipate choppy waters that require the willingness of all parties to adjust terms and respond to distress.
However, it is important to note that restructuring efforts must consider the interests of multiple parties with varying risk sensitivity. Successful renegotiation and deal management require experienced agents with nuanced decision-making abilities and a talent for generating innovative solutions. As intermediaries between borrowers and lenders, agents play a vital role in working through distressed credit situations with out-of-the-box solutions.