When I first started reading of “Lender-on-Lender Violence” this year, images of bankers in three-piece suits brawling in the streets of Lower Manhattan came to mind. It turns out that this is a staid legal term for a practice which has been around for some time, but is becoming more common and consequential.

Consider a case where say three lenders (e.g. banks or more likely venture capital funds) have lent money to some startup or struggling company XYZ. Let’s call these lenders A, B, and C. Now XYZ needs even more funding, perhaps because they need to build another factory, or perhaps because things are not working out as they hoped and they cannot pay off the original loans and still stay in business.

Now Lenders A and B get together and cook up a scheme. They will lend some more money to company XYZ to largely replace the original loan, but they contrive to get legal terms for that new loan that give it a higher priority for payment than the original loan. This is called “up-tiering” the new loan.  This has the effect of reducing the market value of the original loan.

Lender C is now hosed. It faces murky prospects for repayment on that original loan. Lenders A and B offer to buy them out of the original loan for 40 cents on the dollar. Lender C proceeds to sue Lenders A and B.

Will Lender C prevail? Probably not, if the course of recent cases is any guide. Unless there is very specific language in the legal “covenant” regarding the first loan forbidding this practice, it seems to be legal.

A similar maneuver would be for a new Lender D to offer a replacement loan to Company XYZ, with legal language giving it priority over the original loan. This is called “priming.”

Yet another tactic by the aggressive lenders includes working with Company XYZ to move its more valuable assets into a subsidiary or shell company, and to get the new loan to hold that as collateral. This again hoses the “victim” lenders, since again the assurance that they will be repaid has gone down.

My Personal Experience with Lender-on-Lender Violence

Some years ago, I bought the bonds of a company called SeaDrill. I bought the bonds instead of the common or preferred stock, for an additional margin of safety. Unlike the stock, the bonds must be repaid in full, right? Both the bonds and the preferreds were paying about 9%, back when general interest rates were much lower than that are now. So, I was a lender to the company.  

Silly me. Times got tough in the oil patch, and the company would have had difficulty paying off its bonds AND paying its management their high salaries. So, they went for Chapter 11 bankruptcy. I had not realized the difference between Chapter 7 bankruptcy, where the company shuts down and liquidates and pays off its creditors in pecking order, and Chapter 11, which is largely a chance for the company to put the losses on its creditors and to keep on operating.

As with the example above, some big institution offered to refinance things with new secured bonds that had priority ahead of the old bonds (which I held). In the end I got about 44 cents on the dollar for my bonds. I was not happy about that, but I did make out better than the hapless preferred stockholders, who got just a tiny crumb to make them go away. It was a learning experience. I did feel, well, violated.

Implications for the Burgeoning Private Credit Market

I will be writing more on the booming “private credit” market. Many of the loans in this space are “covenant-lite.” Back before say 2008, a large fraction of loans to business were through banks, who would insist on strong legal protection for their money. But in recent years, private equity funds have competed for this lending, allowing the borrowers to borrow on terms that give much less protection to the lenders. Cov-lite is now the norm.

Traditionally, loans (as distinct from bonds) to businesses have enjoyed decent recoveries (e.g., around 70%) in case of defaults, thanks to strong collateral backing the loans. But if we face any sort of prolonged recession and elevated defaults, the recoveries on all these loans will be far less than in the past. These are uncharted waters.

A Reference for “Lender-on-Lender Violence”

A solid description  of these matters is found in “ Uptier Transactions and Other Lender-on-Lender Violence: The Potential for More Litigation and Disputes on the Horizon “ at dailydac.com.