Financial engineering will be tried in bankruptcy courts
US corporate bankruptcy attorneys may suddenly have to cancel their summer vacations. They can’t object because most of them have been vacant for at least two years.
Although equity markets have been declining throughout the year, financial conditions have only recently tightened markedly. The result is that several companies facing a cash flow or supply chain crisis have not been able to raise new rescue capital so easily, money that would have flowed easily at any time during the last decade.
Lacking cash, companies like Revlon, Scandinavian Airlines and Voyager Digital were recently forced to hastily file Chapter 11 bankruptcy. Their court documents described how quickly distress overtook them, providing evidence of the speed with which a recession could approach.
As for the bankruptcy cases themselves, expect many of them to be inherently compelling. Years of low interest rates after the financial crisis inspired all sorts of financial engineering and, in the case of cryptocurrency, a new financial paradigm. Much of this innovation was not fully understood at the time, but will now have to be unraveled with lawyers and judges.
In late May, a distressed debt ratio calculated by S&P showed that less than 3% of the corporate credit securities it tracks were trading at yields 10 percentage points higher than US Treasuries. , indicating a high risk of default. By the first week of July, the ratio was close to 9%. The effective yield of the lowest-rated junk bond class tracked by Intercontinental Exchange and Bank of America is now 15%, more than double a year ago.
The higher cost of debt shows how scarce capital has become. Several investors pointed to Avaya, the telecommunications hardware company that recently borrowed $350 million in the form of a senior secured loan at a whopping 15% annual cost. A hedge fund executive says with the recent sell-off in risky assets, there’s been enough dislocation in high-quality corporate debt there’s little need to stand a chance on the dregs .
Swedish air carrier SAS found out the hard way. The company, in the midst of a work stoppage, filed for bankruptcy in New York without agreeing to further financing or a revised agreement with aircraft lessors. Companies that file for bankruptcy often prefer to reach an agreement with creditors in order to get out of the process quickly.
Similarly, cosmetics maker Revlon filed for bankruptcy when negotiations with creditors for an out-of-court settlement broke down, as its suppliers became increasingly reluctant to deal with the struggling company.
The company had raised $880 million in cash in 2020 to avoid sinking amid Covid. This new loan required pitting a group of hedge funds against each other in a transaction known as a “superior swap.” In such transactions, a disadvantaged group of formerly senior lenders sees their debt reduced in order of seniority. This structure has become increasingly common among highly indebted companies, although it is also legally controversial. And sorting out the relevance of this maneuver is an obstacle to the resolution of Revlon’s bankruptcy.
Further bankruptcies will also put the overall increased complexity of capital markets under the microscope.
“There’s a lot of hidden influence in the system,” says Elizabeth Tabas Carson, a lawyer at the law firm Sidley Austin. She referred to esoteric structures with names like retro-leverage, NAV financing, and subscription financings that have yet to be tested in a “bear market.”
The most innovative resolutions will almost certainly be in the world of crypto. Last week, Canadian crypto broker and lender, Voyager Digital, filed for bankruptcy in New York after suspending account holders from withdrawing assets from their accounts. Voyager had loaned $650 million worth of crypto to a hedge fund, Three Arrows, which itself had gone bankrupt.
Voyager had hired the prominent law firm Kirkland & Ellis to represent it in the proceedings and, although the bankruptcy was filed under duress, Voyager said in court documents that it already had a tentative restructuring plan. Account holders would be reimbursed in the form of crypto “coins” and “tokens,” litigation proceeds from Three Arrows, and equity from revamped Voyager. The bankruptcy process determines the priority of creditors and the valuation of assets, tasks unheard of in the crypto world. Now is not the time for experts to go on vacation.