2025 Distressed Outlook: Serta, Mitel Rulings Herald Changes to Non-Pro-Rata LME Structures; Consumer, Healthcare to Dominate Distressed Headlines

Nothing ever stays the same. Two landmark court decisions, handed down on Serta and Mitel just hours before the ball drop in Times Square, portend further metamorphoses in the way non-pro-rata liability management exercises will be structured in 2025.

Compared with the much telegraphed Serta decision, which may only affect credit agreements with the same “open market purchase,” or OMP, language at issue in that case, Mitel gives blessing to the fundamental concept of non-pro-rata transactions as long as the specific language backing the exceptions to pro rata sharing are convincing, including any “purchases,” according to leveraged finance and restructuring experts interviewed by Octus, formerly Reorg.

This means non-pro-rata uptierings could continue for corporates with credit agreements that do not feature the OMP wording, experts say. It also goes without saying that leveraged finance and restructuring advisors will continue to find innovative ways to structure non-pro-rata deals, including circumventing the restriction in the debt documents with OMP, as well as other new avenues.

Granted, the Serta opinion presages changes in the liability management landscape. “Layer cake” deals dependent on the OMP language either live or in the pipeline may have to be shelved or structured differently, experts say. Companies with failed uptiering LMEs that now face chapter 11 filings have to deal with expected objections to the rejigged capital structure prepetition, and new credit agreements and bond indentures may be drafted differently. Cooperation agreements may become more important than before because of a heightened risk of companies using the threat of the deal-away to coerce existing lenders into accepting an inferior offer, they noted.

House, Step, Yard

Non-pro-rata LMEs evolved over the past couple of years from leaving minority creditors completely behind to kinder, gentler iterations in which everyone can participate but potentially on different terms. The Serta decision may further push the needle toward the pro rata end of the spectrum. LMEs have been compared to hosting an event at a house. “Recently we have seen a mix of lenders already inside the house, some on different parts of the front steps waiting to enter, and some not even invited onto the property. Today, there is a vigorous effort by sponsors and the most critical lenders in a capital structure to invite as many inside the house as possible,” Jayme Goldstein, co-chair of Paul Hastings’ financial restructuring group, said.

This does not necessarily mean that large creditors that have to go restricted to negotiate a deal will not get rewarded. “Differential economics can be accomplished via backstops of new money to account for meaningful individual or aggregate position sizes or ‘sweat equity’ earned via transaction structuring,” Goldstein of Paul Hastings said.

Uptiering is also not the only game in town. “We expect to see a shift towards other forms of priming financing including, for example, sale leasebacks, securitizations and various drop-down transactions as well as a focus on language in the docs with respect to ‘open market repurchases’ to address the court’s view on the definition of ‘market,’” Hend Chambers, the managing director at Guggenheim Securities, said.

“The specific impact of these decisions will depend on the unique facts and circumstances and debt documents of each situation,” Jay K. Sinha, a partner at Ducera Partners, said. “The Fifth Circuit’s excision of the indemnification provision from [Serta’s] plan may prompt more conservative behavior among investors due to increased concerns about potential future liability. But I firmly believe that liability management remains a valuable tool for both issuers and investors. As we move into 2025, we can anticipate the continued use of liability management transactions, underscoring their enduring relevance and utility in the financial landscape.”

Serta could also precipitate more chapter 11 filings and increase restructuring costs. Creditors’ hesitation to structure uptierings because of worries about potential litigation or other future liabilities may make it harder for sponsors to extend runway on distressed businesses, according to Goldstein of Paul Hastings. Decreased out-of-court deal certainty will translate to protracted timelines and rising professional and other transaction costs, which had previously been a critical driver of out-of-court LMEs, he added.

“Some companies and their sponsors may take caution in light of the decision, and either take a wait-and-see approach to determine the impact of the Fifth Circuit’s decision or seek to pursue more pro rata-like structures, to avoid the risk of a more protracted outcome,” Jeffrey Finger, the co-head of Jefferies Group’s U.S. debt advisory and restructuring group, said.

“Issuers will likely spend more time exploring non-uptiering strategies, including third-party deal-away alternatives as leverage against all creditors in a particular class,” Alex Raskin, a managing director in Houlihan Lokey’s financial restructuring group, said.

It remains to be seen whether recoveries for the creditors that have been disadvantaged in non-pro-rata LMEs will improve in distressed situations, if sponsors are discouraged to engage early because they can no longer capture maximum discount or in general agree on a deal with creditors and instead wait until the last minute to toss the key, or if the “deal-away” proliferates.

Part Deux

LMEs sometimes get a bad rap not only because of differential treatments. A failure to right-size the balance sheet, including not deleveraging enough and sometimes even adding debt, means the troubles do not end when the transactions close. LMEs are oftentimes used as a “bridge solution,” which means they are designed to help a company “bridge” to a more sustainable capital structure, whether that is achieved via organic means, such as internal development and growth initiatives, or inorganic strategies, such as M&A, Sinha of Ducera Partners said.

“We are going to see a lot of failed LMEs coming back in 2025 for part deux,” Scott Greenberg, global chair of Gibson Dunn’s business restructuring and reorganization practice group, said. “These transactions are meant to fix balance sheets, and they don’t fix businesses. For the businesses that can’t turn themselves around, assuming there’s not a huge interest rate reduction, we are going to see a decent percentage of these back for a second step conversation.”

“We are going to see LMEs evolving into more full recap situations with a lot of consensus to avoid repeats,” Chambers of Guggenheim Securities said. “The out-of-court full fixes, typically seen in an in-court process, would require a lot of creativity and looking at debt documents in different ways than in the past.”

“What I find interesting is that all of the focus on LME transactions is on the liabilities, not on what the company is going to do to perform better,” Mo Meghji, the founder and managing partner of M3 Partners, said. “Time is rarely articulated as much as it should be, in terms of what the company is going to do with it. The rosy projections need to be backed up, and investors and others should be asking, ‘How are you going to get there?’ and focus more on the value creation part of the game instead of the zero sum part.”

Co-Op: From Secret to Mainstream

Cooperation agreements have evolved from a secretive defensive measure accomplished via lockup agreements, as seen in Ultra Petroleum, Frontier Communications and Travelport, to an offensive measure featuring all sorts of economic terms and rights, in a sense creating bylaws for an ad hoc group of lenders without the borrowers’ involvement, according to Goldstein of Paul Hastings.

The role of co-ops as part of the liability management universe may become even more prominent after Serta. The risk of collateral loss and aggressive behaviors on the company side in general necessitate a united front to engage with companies and sponsors early, at a time when companies and sponsors seek to add co-op prohibitors upfront and when they ask creditors to go restricted, the experts say.

“Co-ops come up because lenders are worried about the deal-away and the third party risk,” Greenberg of Gibson Dunn said. “Pragmatically, if the company and sponsor engage and keep an open dialogue with its largest lenders, that will avoid lenders having to fear the unknown and prevent the mindset that makes lenders think they need a co-op to protect themselves.”

But the unknown may be the company and sponsor’s best weapon. “The main thing you can do to diminish the power of the co-op is to have great options that don’t require cutting a deal with the co-op group,” John Sobolewski, a partner in Wachtell’s restructuring and finance group, said.

“The company can also get ahead of lenders and act early, especially if lenders are expected to coalesce around a particular idea or the company senses that a group could grow quickly,” Debra Sinclair, co-chair of Willkie’s restructuring department and chair of the company restructuring and reorganization practice, said. “Have advisors on the scene and figure out what kind of flexibility is in the debt documents. Once you are familiar with what’s available in your toolbox, you as the company can take that out to the lenders before they’re too far down the path of coming up with their own idea that a large chunk of lenders are already supporting.”

But co-ops can be useful for the company side as well. “It delivers a large percentage of lenders to the company in a neat package. So when the company ultimately gets to that deal, they can deliver what you need. You just have to get to that deal,” Chambers of Guggenheim Securities said.

For creditors, the design and limits of co-ops have to be considered as well, because the larger the co-op group, the greater the chance that people disagree with each other on the path forward. “Creditors generally want to sign a co-op to enhance the prospect of an agreed deal with their group on terms they find reasonable, not to make it so that the noisiest one in the room is constantly dragging everyone else back,” Sobolewski of Wachtell said.

Cooperation agreements, similar to other contracts and now even potentially resembling transaction support agreements without the company’s involvement, continue to mature. “The typical tensions within a co-op are allocation of economics and terms being too restrictive for certain members, especially as multiyear coops start to be more commonplace,” Raskin of Houlihan Lokey said. “I expect more technology will be developed to address those issues as co-ops’ nature and their purpose continue to evolve.”

Old Catalysts, New Uncertainties

Healthcare, including life sciences, and the consumer retail and technology, media and telecom, or TMT, sectors are expected to see the most stress and distress in 2025. Lackluster reimbursement rates, elevated labor costs and regulatory uncertainties will continue to haunt healthcare companies. Onerous leases, inflation, tariffs and consumers’ changing habits still challenge retailers. Cord-cutting, competition, lower demand and high leverage will drive TMT activities.

In addition, “the shifting political landscape and the disruption of the status quo are bound to create significant fallout, which will inevitably have a ripple effect on the strategic environment, marketplace behavior and capital structure solutions,” Sinha of Ducera Partners said.

That does not mean stressed issuers will not be able to access capital markets, especially in creative ways. “The trend of companies raising capital in the form of, say, a new senior piece and a preferred below that, will continue,” Finger of Jefferies Group said. “There’s an ever-increasing number of private equity firms and asset managers that have developed hybrid investing strategies.”

Another trend to look out for is the issue of cessation of business event of default across the pond and any potential litigation. Milbank has emerged as a leading advisor for creditors on this matter, representing creditor groups in Annington, Global Switch and Just Eats.

Octus is hosting a webinar on Jan. 14 covering the LME trends of 2024 and a roundtable on Jan. 16 to discuss what may be in store for 2025.

Further Reading: Octus’ Opinion Analysis detailing Serta’s ramifications for non-pro-rata debt exchanges; “The Year in LMEs: Uptiers Down, Drop-Downs Up and Dec. 31 Serta Decision Throws a Monkey Wrench.”