Distressed Market Dynamics: Investor Strategies and Proactive Measures for Companies in Crisis

As global market volatility escalates, businesses are faced with increased market difficulties, primarily caused by the current interest rates, debt instrument defaults, and the inability to raise capital in the credit market. The turbulence has already caused ripple effects throughout the corporate sector, with companies like Bed Bath & Beyond resorting to restructuring. The home goods retailer filed for Chapter 11 bankruptcy on April 23, 2023, winding down its operations after several failed turnaround attempts. With the current economic climate, more businesses may soon find themselves facing similar challenges.

Investor Perspective: Process and Strategies

From the investor perspective, distressed companies present opportunities if approached strategically. The process typically begins with selecting a distressed company, followed by assessing value-enhancing strategies, structuring the investment, and finally, deciding on an exit strategy. Investors can deploy passive strategies such as speculation in distressed debt, buying debt at a discount based on liquidation preference. Alternatively, they can pursue active strategies including consensual turnarounds, operational and structural innovations, legal and financial engineering, Chapter 11 plan sponsorship, Section 363 sales, control via purchasing debt on the brink of default, and loan-to-own strategies.

Restructuring can be undertaken either in or out of court, each with its benefits. Out-of-court restructuring, where management retains control over the process, is quicker and less costly. However, in-court restructuring provides options to "cram-up" or "cram-down" classes of creditors, essentially forcing agreement from different groups of creditors on the terms of restructuring, while also cherry-picking assets or liabilities to assume or reject.

Structuring an investment involves identifying the "fulcrum" security, the part of the debt that is most likely to be converted into ownership or control of the company. This involves analyzing two things: the potential ability to influence decisions within a group and the chance to swap the debt for ownership in the company. Investors can enhance their “fulcrum” position using several strategies, such as Debtor-In-Possession (DIP) financing, credit bidding, backstopping a rights offering, private investment in public equity (PIPEs), or exchange offers.

However, investors must avoid hidden pitfalls and triggers, such as structural or contractual subordination, credit rating defaults, the risk of being “crammed down,” or change-of-control issues. Carefully navigating these aspects is paramount to ensuring a successful investment in distressed companies.

Proactive Measures: Company Strategy to Prevent Restructuring

In a distressed market, companies can take proactive measures to avoid restructuring. These measures, known as “liability management” transactions, can enhance liquidity, leverage, debt maturity profile, or cost of capital. They usually focus on specific provisions in existing credit agreements like restricted versus unrestricted subsidiaries, basket capacity, open market repurchase rights, and amendment rights. Two primary transaction types are uptier transactions and drop-down transactions. Additionally, asset dispositions can also be a strategy for lowering debt or turning assets into cash.

Uptier Transactions

In an "uptier" transaction, the borrower incurs new debt that takes priority over the existing debt regarding the lien or claim. This can provide the company with a lifeline in terms of additional capital, even when it is unable to issue unsecured debt or equity.

In the Serta Simmons Bedding example, the uptier transaction was used as a strategic move to bolster the company's financial position in the face of increasing economic pressure. Serta's "uptier" strategy involved securing $200 million of new superpriority "first-out" term loans and "rolling" their existing loans into new superpriority "second-out" term loans, thereby giving priority to the new debt over the old. This maneuver effectively primed non-consenting lenders, pushing their debt to a lower priority status. The primary benefits were a significant debt reduction of approximately $440 million and an addition of $350 million of liquidity to the balance sheet, along with the flexibility to conduct future exchanges.

Drop-Down Transactions

Drop-down transactions involve the borrower transferring assets into an unrestricted subsidiary or non-loan party restricted subsidiary. Following this, debt is incurred at the subsidiary level, creating structurally senior debt.

J.Crew provides an illustrative example of a dropdown transaction. J.Crew was facing a looming debt maturity of over $540 million of unsecured PIK notes, but didn't have substantial assets to monetize. To circumvent this, J.Crew transferred 72.04% of its intellectual property, valued at $250 million, to an unrestricted subsidiary, informally called "IPCo". This entity held a significant amount of J.Crew's IP free and clear of any existing liens. The dropdown gave J.Crew an opportunity to raise $300 million of new capital, secured by that intellectual property. The result was a reduction of its debt load by approximately $340 million and an extension of its operational runway.

Asset Dispositions

Asset dispositions involve selling or transferring assets, either to third parties or related parties. This strategy can be beneficial to a company facing financial difficulty, as it provides immediate liquidity and can reduce outstanding debt.

A case in point is PetSmart’s acquisition of the online business Chewy in 2017. When PetSmart started facing financial difficulties in 2018, it eyed a disposition of Chewy to capitalize on its growth. Using several baskets available under the credit agreement, PetSmart transferred 36.5% of Chewy’s equity to two different affiliates. PetSmart's credit documents stipulated that a subsidiary that ceased to be a wholly-owned subsidiary would automatically be released from the funded debt guarantee obligations. By doing this, PetSmart effectively divested a significant portion of Chewy, thereby reducing its own liabilities while simultaneously taking advantage of Chewy's growth potential. This strategy was successful, with the dispute over the transaction settling before Chewy’s IPO in 2019.

In summary, heightened market volatility has forced companies and investors to rethink strategies. Investors are capitalizing on distressed companies, employing methods like debt speculation or active restructuring, while remaining alert to potential challenges like structural or contractual subordination, the cram-down risk, or credit rating defaults. Companies, on the other hand, can employ "liability management" transactions to avoid restructuring. Uptier transactions, drop-down transactions, and asset dispositions can optimize financial position and liquidity. However, these approaches also carry litigation risks, such as claims of fraudulent conveyance, breach of fiduciary duty, or violations of loan agreements. Thus, navigating these market dynamics demands strategic acumen, foresight, and awareness of both the opportunities and risks inherent in restructuring.

Stanislav Liaptcev serves as a Graduate Editor of the NYU Journal of Law & Business. He is pursuing a Corporation LL.M. at the New York University School of Law as a Dean’s Graduate Scholar. Prior to attending NYU, Stanislav practiced corporate law for nine years with a focus on mergers and acquisitions, joint ventures, private equity, venture capital, and other cross-border transactions at prestigious law firms in Russia and as an independent consultant.