Among those who study corporate financial distress and reorganization, the notion that senior lenders are in control is deeply ingrained. Celebrated papers in the law and corporate finance literatures attribute lender influence during periods of distress to blue-sky contracting practices.[1] When extending credit, senior lenders take a blanket lien on the borrower’s assets, and the borrower agrees to strict financial maintenance and other covenants. The covenants are designed to hem in the borrower. If its performance declines or it wants to pursue new opportunities that materially alter risk, the borrower has to renegotiate. Lenders use renegotiations to force changes in the borrower’s business that reduce their risk. They prefer not to push the borrower into a bankruptcy, but they can, and that can induce preemptive compliance. To the extent that a borrower might seek—or be forced into acquiescing in—bankruptcy relief, the lenders’ liens give them a quasi-monopoly power to offer financing and so direct the course of the case. There is no escape.

In a new article, however, I argue that the lender control heuristic no longer adequately explains reality in a broad range of recent stressed and distressed situations. Two changes have been especially important. First, as many commentators and market participants have pointed out, non-price loan terms have loosened for leveraged borrowers.[2] This isn’t just about covenant-lite institutional term loans. In a variety of ways, lenders today have weaker contractual rights and hold more porous collateral packages than they once did. They no longer hold the big sticks on which the lender control story depends.

Second, private equity sponsors have become the key strategic decisionmakers in the typical large, distressed business. As a (predominantly) equity investor, a sponsor will tend to be biased toward postponing events such as a sale of the distressed business or a bankruptcy. In that sense, sponsor incentives are a mirror image of senior lender incentives. A chapter 11 case, besides extinguishing the option value of equity interests, can also mean the end of advisory fees and an enhanced threat of litigation against a sponsor and its representatives. A sponsor’s concern for its reputation with creditors might moderate its incentive to avoid a reckoning, insofar as reputation could affect the terms on which portfolio companies borrow in the future. But, because a sponsor’s own prospective investors can judge its past returns much better than its future borrowing costs, even a sponsor focused on the long term will not fully absorb the costs of a degraded reputation. And the people in charge at portfolio companies have powerful incentives to protect the sponsor in a way that the independent directors on a public-company board, say, do not have with respect to out-of-the-money shareholders. Postponing an event that would wipe out the sponsor’s interest becomes paramount, even if the means to do so entail negative expected enterprise value and substantial litigation risk.

A “sponsor control” model thus better accounts now for the path of distress resolution in many situations where a financial sponsor is involved. Among other things, the new balance of power can help to account for the explosion of so-called liability management exercises in the last decade. It is not only that transactions designed to subordinate ostensibly first-lien credits, such as the unrestricted subsidiary dropdown (e.g., J. Crew, Neiman Marcus, Envision Healthcare) and the non-pro rata uptier exchange (e.g., Serta Simmons, Boardriders, Incora), emerged in an environment where lender power was waning. Sponsor fingerprints are all over the deals. Sponsor-backed companies have been responsible for almost every dropdown (including every such transaction that creditors challenged in litigation), and they have been responsible for every non-pro rata uptier. All told, sponsor-backed companies have executed 18 of 19 such hardball priming transactions since 2016.

To say that sponsors are often now “in control” is not to suggest that lender interests have become irrelevant. When a sponsor’s equity interest is sufficiently out of the money, lenders who value a chapter 11 resolution may be able to strike a Coasean bargain, memorialized in a restructuring support agreement, according to which the sponsor capitulates in exchange for a cheap release from potential liability to the company and its junior creditors. In such cases, lenders and sponsors may share an interest in a speedy case with minimal opportunity for junior creditors to probe. The result can be a debtor-in-possession financing agreement that appears to, and in a sense really does, give lenders the ability to drive a bankruptcy process.

The full implications of the changing balance of power in distress remain to be seen. A start is to recognize that in many situations financial sponsors, not senior lenders, now set the restructuring agenda.

ENDNOTES

[1] Early law papers laying out pieces of the story include: Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209 (2006); David A. Skeel, Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. Pa. L. Rev. 917 (2003); Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751 (2002). Influential corporate finance papers on the subject include: Greg Nini, David C. Smith & Amir Sufi, Creditor Control Rights, Corporate Governance, and Firm Value, 25 Rev. Fin. Stud. 1713 (2012); Greg Nini, David C. Smith & Amir Sufi, Creditor Control Rights and Firm Investment Policy, 92 J. Fin. Econ. 400 (2009); Michael R. Roberts & Amir Sufi, Renegotiation of Financial Contracts: Evidence from Private Credit Agreements, 93 J. Fin. Econ. 159 (2009); Sudheer Chava & Michael R. Roberts, How Does Financing Impact Investment? The Role of Debt Covenants, 63 J. Fin. 2085 (2008).

[2] See, e.g., Thomas P. Griffin, Greg Nini & David C. Smith, Losing Control? The 20-Year Decline in Loan Covenant Violations (December 2021) (unpublished manuscript); Mitchell Berlin, Greg Nini & Edison G. Yu, Concentration of Control Rights in Leveraged Loan Syndicates, 137 J. Fin. Econ. 249 (2020); Bo Becker & Victoria Ivashina, Covenant-Light Contracts and Creditor Coordination (Mar. 2016) (unpublished manuscript).

This post comes to us from Professor Vince Buccola at The Wharton School of the University of Pennsylvania. It is based on his recent paper, “Sponsor Control: A New Paradigm for Corporate Reorganization,” available here.