Key Takeaways
- • Private debt funds are showing greater willingness than banks did during the 2007-2009 global financial crisis to pursue debt-for-equity swaps with distressed private equity-backed portfolio companies, rather than enforcing security and taking control.
- • Hogan Lovells Cadwalader lawyers John Livesey, Paul Mullen, Tom Astle, Alex Snell, and Graham Nicholson attribute the shift to private debt managers' hands-on lending model, where the originating team typically manages the credit through distress, and to their existing co-investment in portfolio company equity.
- • Executing a debt-for-equity swap is described as highly complex, requiring negotiations with the sponsor, management, regulators and other creditors, extensive documentation, and a detailed tax analysis.
- • Equity stake size is driven by the outstanding lender indebtedness, which must be reduced to a sustainable level, and the lender typically seeks a priority return plus governance rights such as consent rights, pre-emption, tag rights, board representation and information rights.
- • The authors conclude that interest rates may remain high for an extended period, and that private equity sponsors and private debt investors are aligned in viewing debt-for-equity swaps as a sensible response to temporary stress.
Summary
A Hogan Lovells Cadwalader article, the first in a series on private equity portfolio company distress, examines whether the current wave of financial strain among private equity-backed companies differs from the response seen during the global financial crisis of 2007-2009. The authors note that interest rates have risen globally since the end of 2021 as central banks sought to curb inflation following the reopening of the global economy after the Covid-19 pandemic and the war in Ukraine, and that it remains too early to judge the full impact on portfolio companies.
During the financial crisis, the authors write, a common outcome for a portfolio company unable to meet its debt payments was that the private equity sponsor would hand back the keys or that banks would enforce their security and sell the underlying asset. Consensual alternatives such as equity recapitalizations, debt-for-equity swaps and negotiated restructurings occurred but were uncommon, as sponsors had little visibility into demand for their portfolio companies' products and banks generally did not hold equity stakes, preferring third-party sales, often via pre-pack insolvency.
The authors argue the current environment is different in one key respect: private debt funds, which have made significant inroads into the leveraged loan market, particularly in the mid-market, appear more open to debt-for-equity swaps and other negotiated restructurings than enforcement. They suggest private debt managers are more culturally comfortable holding equity, and because the team that originates a loan generally manages it through distress, both sides have an incentive to reach a consensual deal that stabilizes the business. Many private debt funds already co-invest alongside sponsors in portfolio company equity. Sponsors, however, remain reluctant to inject fresh capital unless it clearly supports value recovery.
On process, the article cautions that a debt-for-equity swap requires significant work. A lender may need to conduct its own due diligence rather than relying on the sponsor's, though it may draw on existing knowledge of the target. Negotiations will involve the borrower, the private equity majority owner, management, regulators and other financial and operational creditors. Documentation is complex, covering the equity relationship with the sponsor and management, the swap terms and amended terms for residual debt. If consensus with other creditors fails, parties may need to use a lengthy non-consensual route such as a scheme of arrangement or restructuring plan. The authors also flag tax issues: a release of indebtedness may create a taxable profit for a UK borrower, though exemptions are generally available where shares issued are ordinary shares. Tax consequences for private debt fund investors must also be reviewed. Urgency is likely, the authors note, because some lenders were unable to act early due to covenant headroom agreed in recent years.
The size of the lender's equity stake is primarily determined by its outstanding debt, which must be reduced to a level the company can sustainably service. The stake size also affects available controls and accounting treatment. The lender will generally expect a priority right to income and capital, and the article notes that a UK group structure may require steps to ensure the lender holds shares in the topco. Subordinated or shareholder debt is typically written off, exchanged for equity or subordinated to the lender's priority return. For a sizeable minority stake, the lender may seek consent and class rights, pre-emption rights, tag rights on drag exercises, board or observer appointment and information rights. Dilution of management equity may also prompt a new returns-based management incentive plan.
The authors conclude that it is unclear whether interest rates will fall quickly enough to relieve struggling companies, but that private equity sponsors and private debt investors are aligned in viewing debt-for-equity swaps as a sensible response to what they hope will be temporary difficulties.
During the financial crisis, the authors write, a common outcome for a portfolio company unable to meet its debt payments was that the private equity sponsor would hand back the keys or that banks would enforce their security and sell the underlying asset. Consensual alternatives such as equity recapitalizations, debt-for-equity swaps and negotiated restructurings occurred but were uncommon, as sponsors had little visibility into demand for their portfolio companies' products and banks generally did not hold equity stakes, preferring third-party sales, often via pre-pack insolvency.
The authors argue the current environment is different in one key respect: private debt funds, which have made significant inroads into the leveraged loan market, particularly in the mid-market, appear more open to debt-for-equity swaps and other negotiated restructurings than enforcement. They suggest private debt managers are more culturally comfortable holding equity, and because the team that originates a loan generally manages it through distress, both sides have an incentive to reach a consensual deal that stabilizes the business. Many private debt funds already co-invest alongside sponsors in portfolio company equity. Sponsors, however, remain reluctant to inject fresh capital unless it clearly supports value recovery.
On process, the article cautions that a debt-for-equity swap requires significant work. A lender may need to conduct its own due diligence rather than relying on the sponsor's, though it may draw on existing knowledge of the target. Negotiations will involve the borrower, the private equity majority owner, management, regulators and other financial and operational creditors. Documentation is complex, covering the equity relationship with the sponsor and management, the swap terms and amended terms for residual debt. If consensus with other creditors fails, parties may need to use a lengthy non-consensual route such as a scheme of arrangement or restructuring plan. The authors also flag tax issues: a release of indebtedness may create a taxable profit for a UK borrower, though exemptions are generally available where shares issued are ordinary shares. Tax consequences for private debt fund investors must also be reviewed. Urgency is likely, the authors note, because some lenders were unable to act early due to covenant headroom agreed in recent years.
The size of the lender's equity stake is primarily determined by its outstanding debt, which must be reduced to a level the company can sustainably service. The stake size also affects available controls and accounting treatment. The lender will generally expect a priority right to income and capital, and the article notes that a UK group structure may require steps to ensure the lender holds shares in the topco. Subordinated or shareholder debt is typically written off, exchanged for equity or subordinated to the lender's priority return. For a sizeable minority stake, the lender may seek consent and class rights, pre-emption rights, tag rights on drag exercises, board or observer appointment and information rights. Dilution of management equity may also prompt a new returns-based management incentive plan.
The authors conclude that it is unclear whether interest rates will fall quickly enough to relieve struggling companies, but that private equity sponsors and private debt investors are aligned in viewing debt-for-equity swaps as a sensible response to what they hope will be temporary difficulties.
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