An ad hoc discussion of ad hoc lender groups

[MUSIC PLAYING] Hi, and welcome to DeadWired. I'm Andy Serby, Deputy Courts Editor. If you're a legal lens listener and feeling a little bit confused right now, here's an update. We're going to be joining the DeadWired umbrella moving forward, but continue with the same great content at the same frequency discussing legal issues impacting the restructuring industry. I'm excited to introduce our content to a new audience and to join my colleagues under a more comprehensive banner, giving our listeners a true one-stop shop. Now let's get on with today's episode. Today, I'm glad to be joined by Stephen Silverman, a partner at Gibson Dunn's New York office, and a member of the firm's restructuring and organization practice group, as well as the liability management and special situations practice group. Welcome to the show, Stephen. Thanks, Andy. So as we always do, let's go into a little bit of professional background first. Can you tell us really quickly just how you got into restructuring? The firm that I started out after law school had a rotational program. And it was as simple as we just enjoying the people in the work of the restructuring group more than any other practice and was off to the races from there. Today, we're going to be talking about ad hoc groups, which are such a massive part of the way that chapter 11 cases move forward these days. Based on your expertise came, we do a little bit of history first, which is broadly or historically why and in what sort of situations do you tend to see ad hoc writer groups forming? I think the answer to this question is shifted in morphed over time since I started my career. Historically, I'd say going back 10 years or so or even shorter, ad hoc roots were forming around loan-to-own strategies, especially in the Fulcrum security. The traditional paradigm was a company is bona fide distressed, a chapter 11 or bankruptcy is on the horizon. And you have a mix of investors that are strategically buying into the debt to either advertise that debt or facilitate a strategic recovery. And ad hoc groups would form around that share goal. Typically, it was one big ad hoc group. Obviously, the larger lenders were the louder voices, but they were speaking for everybody. You may have a steerco or you may have had a steerco dynamic solely for efficiency purposes to reduce the number of cooks in the kitchen and institutions that are actually leading in driving the negotiations. Since LME has taken off and proliferated so significantly, I think the reasons behind and the manner in which ad hoc groups formed has changed, material. These days, mostly ad hoc groups are forming from a protective standpoint. And the institutions that are part of that group in driving the organization efforts are largely part investors, trying to protect their capital as opposed to folks that bought in at a lower price, trying to execute on a specific strategy, whether that's equalization or otherwise. We've alluded to a little bit of the future of this conversation, but are there other common markers that you used to see that you're no longer seeing or that you have seen consistently throughout things like their formation being more common in a certain size of debtor or attached to a particular filing strategy? We touched on the LME thing, and that can often include long-running pre-petition litigation or even prepags pre-arranged plans, which are aiming to legitimize an exercise that was done before the case. Going back in time, you really didn't see ad hoc groups form unless there was a truly acute issue. Usually, a chapter 11 filing on the horizon where coordination was really necessary or certain real, litigable issues or pending litigation where folks needed to be coordinated from a collective action sample. These days, it's really all about defense in the first instance. Most of the calls we're getting again from par investors are around how can I get screwed for lack of a better word, less about what can I do proactively. And for that reason, there's a combination of factors. And they all flow into the risk profile of the credit, which is what people really focus on when they call us. I think the most salient of those factors are probably who owns the company, who's the sponsor, what's their track record like of being aggressive? What does their portfolio look like? And strategically, is there a necessity for them to do something proactive to facilitate the leveraging? And then credit specific, it's a combination of maturity, liquidity, and leverage. What does the maturity profile look like? Do people think there's real, bona fide, refire risk? Depending on where the debt's trading, what does the company's leverage profile look like, which either flows into the quantum or significance of the refire risk or standing alone, whether or not the sponsor may be inclined to opportunistically try to capture discount. And then liquidity, of course, does the company need money? Aside from those factors, which are all interrelated and flow into the necessity to organize, you also have a venture of impactors, of course. What does the macro back job look like? Is there litigation or the risk of litigation? Was there a significant contract loss? Should people think there may be a significant contract loss on the horizon? So esoteric, specific macro industry and business factors as well that sort of flow into the analysis? This is a moving target that we're going through when we're saying the table here. But you mentioned full-crowned security earlier, but we often see these groups forming around multiple instruments and one institution might hold multiple pieces, but it's focused on one. A group one has a little bit of everything, but 40% of the term loan and then entity two has a little bit of everything, but they've got 50% of the revolver. How common is a certain degree of diversity when you see that these membership groups form? Is it we want control across the capital structure if we can get it or is it more around like, the term loan is the central security, the full-crowned, let's just get all of that? It depends on a couple of things. The first is are we in LME land or chapter 11 land and then has the paper turned over. So from an LME standpoint, we generally advise clients that debtors' counsel and debtors' financial advisors love when there's disperity organized constituencies. Generally speaking, they want to capture as much discount as possible. They want the cheapest cost to capital on an amended extended or an extension. They want the cheapest cost to capital from a liquidity standpoint. The best way to facilitate that, if you're looking at this through the lens of a company, or a company advisor, is to create a race to the bottom. Have everybody compete to be the anchor tenant, anchoring the LME, obviously depending on how the docs work, and create a competitive dynamic, where you have multiple parties bidding against one another. In that scenario, it's often beneficial to have a cross-order group, where you have one group speaking for a majority or control position in a number of different instruments, because it heads off the rest that you're going to have that race to the bottom dynamic, or that the debtors are going to be able to manufacture it. The flip side of that coin obviously is that intro-creditor discussions and negotiations get really complicated and often heated. I'd say nine times out of 10, having a cross-order group, where to use a term coined by a financial advisor we work with a lot, everything is all in the family, ends up producing the best outcome. It could take longer to get there, but you're going to end up with the best economic outcome for lenders and creditors. If you are having that negotiation amongst each other without the company in the room, as opposed to the company driving a race to the bottom dynamic. One related anecdotal point is chokes and NDAs. Companies want them for a reason, and they become market for a reason, and it's to create that race to the bottom. They don't want the creditors groups talking with each other. They don't want them negotiating with one another bilaterally, which could not be in the best interest of the company, and the company is able in that respect to control the puppet strings and control the chessboard. And that could be really effective when you're advising a company and something we try to avoid on the front end. I think that calculus gets a lot more complicated when you're going into chapter 11, because you're obviously thinking about, what do I need to do to confirm a plan? There's a number of litigable issues you have injured in the bankruptcy code, you have potential fraudulent conveyance claims. The strategy becomes a lot more complex. And in that respect, often it's still beneficial to have crossholding other instruments. Think, control in the bankruptcy majority in one creditor class that is most likely to be the folkroom while controlling the bankruptcy block in another creditor class to mitigate the risk that the company has another constituency to engage with, and potentially threaten to cram down or cram up plan. These are the year of a majority position. But that can cut both ways. If you are confident that the class in which you have a majority position is definitively the folkroom, let's say you have a relatively simplistic capital structure, you may be able to realize the best possible economic outcome by running all the economics through that class. And if you are confident that you can execute on a cram down plan, if you need to, you may only need to give the added amount of your other creditor class tip. And if you hold a significant position in that class, it's obviously going to result in a lower blended all in return. So it ends up being super complicated. You have to evaluate the merits of your litigation strategy in chapter 11. You have to think really hard and carefully about valuation. Those considerations aren't present when you are talking about a liability management transaction, or at least they're less significant. So the math equation is less complicated. Statutory committees generally have more leverage from a litigation perspective. Is there a state fiduciary? There are certain things they can do enough standing to do that ad hoc credit groups don't. But the flip side of that coin is almost all the time you're going to have an ad hoc group that's the plan sponsor or the party that's credit bidding. So ad hoc groups tend to be the most well-capitalized institutions, large asset managers, large investors that can write a check, that can get you through chapter 11 from a liquidity perspective that hold the most exposure from a fund to debt perspective, have the most to lose. And almost always, there are going to be the ones that are going to get you out through confirmation of a plan by controlling the requisite majority in a fund to debt class. So I'd say, and I don't know if you disagree, on balance ad hoc groups tend to have more leverage, especially in chapter 11, only in chapter 11. That's when you're saying that, quick committees at UCCs. But less litigation firepower, but more situational leverage. Is I guess how I boil it down? I definitely wouldn't disagree. There's kind of a roundabout to it, because when they're both present, they both have a hand on the wheel. And we see a certain amount of out-of-difference is the right word, but every judge wants to listen to the UCC because they represent generally lower on the waterfall creditors. So there is that to contend with from the ad hoc group. But like you pointed out, there's also the matter of who's bidding, who's paying, and that's also not without power or leverage in the context of a process as expensive and as complex as a chapter 11. Completely agree with that. And obviously valuation is a factor as well. If there's a cognizable position that value flows down to general on secure creditors, the UCC is going to have a lot more leverage. And the more simplistic the capital structure is, the more leverage the UCC may have too. Because especially if dogs are classified separately, that vote is going to be more important in terms of getting out of chapter 11 and confirming the plan, at least taking an isolation. So taking a look at the current landscape, we talked about we've seated this through when we're talking about the LME landscape, which is such a big part of the restructuring market right now, and has been for a couple of years now. From the perspective of your practice, do you see ad hoc groups forming more frequently than they have before? And do you feel like it's a direct response to the heating up of the market in pre-petition transactions, which then to inform the biggest issues of an eventual chapter 11, assuming the liability management exercise doesn't save the company. Pre-filing negotiations, RSAs, that kind of thing. Ad hoc groups are forming more often and earlier than they ever have. And I think a big reason is creditors want to avoid LME. So it's like a dual-pronged strategy. They want to avoid LME if they can engage on it only if they have to. And that if LME does come to fruition or the company's proposing it, they want to be in the driver's seat. And the best way to do that is to be coordinated, talking with connected counsel as early as possible. So there's a lot of sort of simplistic logic there. I'd go so far as to say a lot of our clients, especially parholders, are looking at credits that may or may not end up stressed or distressed. I think trading in the low '90s and thinking themselves, there is at least theoretical risk that if I sit and do nothing, call it a 25% chance, give him what I'm seeing in the capital structure and the balance sheet, the company could end up teaming up liability management. And if I sit, I'm not protected. So from their standpoint, there's some logic to why not just co-op up the structure. We can do something prorata with maybe a small carve out, just in case we have to fund new money and need to bad stop something. And I could put the credit on the shelf, so to speak. I don't have to worry about it. I know I'm contractually protected. I know I'm going to be entitled but prorata treatment if there's an enemy, because I'm part of a co-op. It's going to be needed to anchor that deal. And I don't have to worry about this thing. And when creditors are pushing for a co-op like that, most of them want the term to run all the way through maturity. So they really don't have to worry about the co-op expiring the co-op, terminating hedge funds or distress funds coming in and buying up the paper. There's obviously a downside to that from a liquidity perspective, or there can be, given these co-ops have requirements that any counterparty to a sale has to sign a jointer. But if they're structured the right way, oftentimes what we see is market pricing on the paper actually ticks up. Because the entire market knows there's a co-op. They know it's open to everybody. They know it's relatively prorata. The pricing that may otherwise reflect the risk of LME ends up popping because that LME risk is off the table. A roundabout way to answer your question, but we are seeing organization earlier. And it's usually from a protective and defensive standpoint and co-op's a part of the equation. And this all goes to this overarching theme, which is the rule of proactivity and to use a word. You've used a couple of times, defensive action. But as we all know, sometimes the walls are overcome. And we end up with litigation, chapter 11, and things get difficult. Do you feel like from your practice perspective, the existence of these groups has a direct correlation with higher success rates or more consensus overall, or at minimum, a more organized process? Or is it more of a base-by-case thing? I think almost all the time you get both. Both a more successful outcome and a more organized process. From a success standpoint, if the company's headed towards chapter 11 and they're going to restructure, there's going to be a change of control, you want to be sponsoring that. Almost all the time, the institution that is the plan sponsor, the impaired accepting class, the one writing a check, backstopping and equity rights offering, backstopping or funding a dip, is going to be the constituency that's taking the most economics on the back end. And as you guys know, those negotiations tend to happen on a pre-petition basis. No company wants to free fall and have to deal with all this in chapter 11. So it's super important to get in front of the company, negotiate with them, articulate the rationalist while you're the appropriate plan sponsor if they're not coming to you on the front end, and get your teeth in, so to speak, so that all the negotiations are driving through you. In fact, I'm not sure I've ever seen a situation, except for certain aboriginal circumstances where value shifting materially in chapter 11, where the plan sponsor is not the one driving the outcome and getting the best recovery on the back end. And, relatedly from an organized process standpoint, just to expand upon a point I just raised, he's one of a file with RSAs, they want to get pre-packs done. We've been pushing the envelope in terms of the speed of those pre-packs and how quickly we could get companies out of chapter 11 to avoid the value degradation and business degradation that comes along with that, the only way to achieve that goal is to build consensus on a pre-predeition basis. Creditors have to be proactive, but the company also has to be proactive too, and not poor creditors in a position where they only have 10 business days or something to negotiate and orderly restructuring. But pro-activity, timing and organization are all not only prudent, but I think necessary to do these things the right way and preserve value. And from the perspective, again, of your personal practice, when you're working with a group like this, how do you go about helping them manage themselves, manage potentially shifting consensus, opinions can change, people, there can be friction because at the end of the day, these are institutions, but the groups are made up of people and allegiance has changed, new ideas come up and how do you manage that when you're advising them? It's one of the trickiest and most difficult aspects of our job, I think. The most difficult dynamic tends to be when you have a group that is comprised of a mix of distressed investors or hedge funds that have a much lower basis and par investors. Those par investors usually hold their exposure through CLOs or similar vehicles. They often have less flexibility to do things like right and equity check or backstop and equity rights offering. They're also less interested in equity in terms of the credit they get under their CLO docs and more prone to be pushing for something like take back paper and hire pro-formal levers on the company on the back end. So not only are you dealing with very often the interpersonal and personality dynamics, which can be fun, honestly, and I think we're very good at it, but you're also dealing with real economic disparate interests and bridging the gap, trying to get to consensus, facilitating a cooperative dialogue where, for example, you have equal representation of hedge funds and distressed investors as well as CLOs on your searing committee that's doing the bulk of the negotiations up being super important. So people feel like they have a voice and everybody's interests are being heard. And to come back to an item or topic we were talking about earlier, you're keeping this sort of all in the family. And the company's not putting its finger on the scale one way or the other. And you're building consensus coming to agreement from an intro creditor standpoint and then taking that to the company is in the sense that you get out of chapter 11. And as I have often heard from lawyers and a couple of judges, the end game of all of this, the button on top is that consensus is king. That's ultimately what we're all in pursuit of. And to wrap up this discussion, I'm curious whether the shifts that we discussed do you expect these trends to continue or do you see a little bit of a market shift? 'Cause I'm always so curious how people think when they look into their crystal ball a little bit. I think we're going to see a shift in a couple respects, but none of them are related to proactivity organization. The first is I think we're going to see an increasing number of deals get consummated at a court. And I think a byproduct of that or maybe a driving factor behind that is increasing creativity both from investors and lawyers in terms of structuring at a court deals or making them coercive. And relatively your point too is those deals looking like hybrid enemies and recapitalizations. So deals where you're not just getting take back that. You're not just taking discount and funding new money. So they're not LMET 1.0 deals. Instead you're facilitating more de-liverging, making the LMET stickier. And in exchange for creditors being willing to do that, IE taking more discount, they're getting equity ups. So I see sponsors, public companies, family owned businesses being more willing to give up equity in exchange for discount. And I think there's a lot of logic and rationality behind that. We're all familiar with the statistics about how many LMETs end up filing anyway or ending up in chapter 11. Most of the time the reason that happens is the de-liverging is not significant enough or there wasn't enough liquidity coming in. And less often operational or underlying operational issues with the business weren't fixed. Aside from that third point, which you can really only do in chapter 11, you can solve for the other two if you're more intelligently structuring the adequate deal. And oftentimes we can use LMET tools and course of mechanics to get everybody to play ball, to build the consensus you were talking about earlier Andy, and getting to the right answer and a transaction that's stickier and actually fixes the capital structure and balance sheet. Well, Steven, thank you so much for coming on and sharing your expertise. I think that this was such an interesting discussion, especially moving through history and the current trends. So thanks again for coming on. - My pleasure, thanks for having me. - And thank you as always to our listeners for checking out this episode. For this and the next couple, we'll publish under both legal lens and debt-wired before making the full transition to the latter for our March episode. If you're not already a cross-subscriber, please follow the debt-wired page on Spotify or Apple Podcast to find us going forward. And as always, you can find plenty more insight and analysis in the form of thousands of articles on the debt-wire website. We'll see you next time.