Coercive, non-pro rata debt restructurings – widely known as “liability management exercises” (LMEs), just like their pro rata siblings – have become a central tool for distressed borrowers. Proponents of the non-pro rata restructuring often argue that it gives the company time to turn around and take off, reduce financial distress, and typically avoid bankruptcy.
In a new paper, we argue that this expectation is overstated: On average, non-pro rata LMEs buy a shorter, more fragile runway than proponents suggest; most such non-pro-rata LMEs in our sample ultimately default again or file for bankruptcy anyway.
An LME, broadly, is an out-of-court debt renegotiation – yesterday’s “workouts.” In recent years, the neutral LME label has displaced the blunter “creditor-on-creditor violence” descriptor for transactions in which debtors pit creditors against each other and align with winning coalitions to shift value from others (“dropdowns”) or elevate participating creditors’ priority (“uptiers”) in exchange for runway extension. The post-financial-crisis low-interest-rate environment saw many creditors competing to lend, and “strong” bank lenders giving way to “weaker” dispersed creditor groups. This led to vulnerable debt contracts across the market, especially as “strong” private equity sponsors seek to extend option value by delaying bankruptcy.
Some creditors lose in non-pro-rata LMEs, others win. Some lose in this deal but win in the next. But, proponents argue, these are typically sophisticated, diversified investors, and coercion is needed to break coordination and free-rider problems that would otherwise push firms into bankruptcy. In restructuring circles, well-known “success stories” are celebrated: runway extended, bankruptcy avoided, operations revived.
Some coercive, non-pro rata LMEs do benefit firms and stakeholders. But does the celebratory story reflect typical outcomes?
First, we show that the structural imperatives of a coercive LME deal militate toward a more complex capital structure, with limited deleveraging and limited debt-to-equity conversions. To make the uptier work, the majority creditors typically need higher priority debt, not lower priority equity. If these forces are strong, they can impede balance-sheet stabilization. And shifting value from excluded creditors to the dealmakers can benefit owners and favored creditors, even if the firm is no better off – and, in theory, even if it’s made worse off.
Hence, the abstract incentives could produce good operational outcomes and more stable balance sheets. Or they could just shift value with limited benefits to the firm.
We examine what’s happening on-the-ground. Ours is the first study to test average firm-level effects, based on a hand-collected dataset of 89 coercive, non-pro rata LMEs.
The results are sobering.
Within one year of an LME, fewer than half avoided bankruptcy or re-default. Within two years, only 22% avoided both. Among firms with at least two years of post-LME history, 56% had already filed for bankruptcy. These figures sit uneasily with the bankruptcy-avoidance narrative.
For comparison, the LME relapse rate far exceeds our estimated relapse rates for prepackaged bankruptcies, which are often achieved with similar levels of creditor support.
The average firm-level benefits are also unclear. Credit ratings remain largely flat for two years after an LME, reflecting persistently high default risk as assessed by rating agencies.
Debtors sometimes secure new money, but aggregate leverage doesn’t decline – indeed, deleveraging is well below typical prepackaged-bankruptcy outcomes. Instead of stabilizing balance sheets through debt–equity swaps, LMEs often elevate favored creditors, leaving thin equity cushions with distorted incentives. More cumbersome capital structures prolong debt overhang and can make a full turnaround and takeoff harder.
Finally, LME debtors that go bankrupt spend, on average, two-to-three times longer in bankruptcy than non-LME prepacks or PE-backed debtors. Many post-LME bankruptcies are complicated by creditor infighting and litigation to clear the capital structure.
If the features we uncover are material, non–pro rata LMEs generate less value for distressed firms – and more scope for rent-seeking – than commonly assumed. Distorted incentives can delay efficient recapitalization and capital reallocation, inducing overinvestment, in the finance vernacular. But the future of coercive, non-pro rata LMEs is not foreordained.
Stronger covenants limiting coercive LMEs are emerging in the post-LME market segment – that is, in documentation negotiated between borrowers and creditors that have benefited from them – and are sometimes migrating to the primary debt market.
Systemic tides in the American financial system may yet reverse or, maybe, strengthen the “strong equity, weak(er) creditors” environment that allowed coercive LMEs to flourish. If interest rates rise and borrowers compete more for funding, if dispersed lending is replaced by banks (when they find ways to side-step the post-crisis regulation) or private credit in high-risk segments of the market, or if private equity loses funding sources and plateaus in size, the debtor-creditor balance may shift back to the “weak equity, strong creditors” environment. That is, the primary ingredients for coercive LMEs come from outside the LME world – the supply of credit, bankers, and securities regulation. As these change, the LME world changes.
Some qualifications. We evaluate non-pro rata LMEs, not plain-vanilla pro rata restructurings, whose incentive structures give fewer reasons to expect inefficient outcomes. And we don’t evaluate coercive but pro-rata restructurings. We rely on leading industry information sources, but some coercive LMEs may go unreported. Lastly, most reported LMEs involve private firms that do not disclose operating data (EBITDA, sales, and so on). Comparing these measures pre-LME and post-LME would be more probative of their success or failure. All that said, the best evidence available now is in our paper, and it undermines the coercive-LME celebratory story.
Mark J. Roe is the David Berg Professor of Law at Harvard Law School, and Vasile Rotaru is a Research Fellow at Harvard Law School. This post is based on their recent paper, “Liability Management’s Limited Runway: Corporate Restructuring Today,” forthcoming in the Yale Law Journal and available here.