Drop-Down Transactions Have Historically Slightly Reduced RemainCo Leverage, but Bankruptcy Remains a Real Risk

 

Companies reduced gross leverage at their existing credit box, or the RemainCo, by about one turn of leverage on average to 11x from 12x based on our analysis of 15 drop-down transactions that occurred from 2016 through 2024. The leverage reduction was driven by debt exchanges at below-par prices, which accompanied the drop-down, and were partially offset by new-money debt raises and the transfer of EBITDA away from RemainCo creditors.

The table below summarizes post-deal RemainCo leverage, with companies that have filed for bankruptcy at some point after their transactions marked in red text. Post-deal figures in the table below reflect leverage at RemainCo only and not consolidated leverage across all the entities.
 

RemainCo leverage ratios for U.S. Renal Care, Trinseo and Golden Nugget were particularly elevated immediately post-deal, but subsequent refinancing transactions and improving EBITDA extended their maturity walls and led to lower leverage ratios.

Del Monte Foods and Rackspace transferred substantially all of their assets to unrestricted subsidiaries, or unsubs, but holders of $106 million and $235 million of debt, respectively, elected not to exchange into new unsub debt, hence we show “n/a” for post-deal RemainCo leverage as there is no EBITDA at that credit box. We show Envision’s leverage metrics as “nm” because reported EBITDA fell to $60 million in 2022 from $516 million in 2021.

We focus on gross leverage ratios, as opposed to net, due to uncertainty around how exactly cash was used and moved between entities after these transactions. We also made illustrative EBITDA assumptions generally using a two-year average for companies that experienced material year-over-year EBITDA swings around the time of their drop-drown transactions (Envision, Del Monte Foods, Rackspace, Trinseo, Party City, Golden Nugget).

Unsubs On Average Left With High Leverage, Little Margin for Error

After a drop-down, the funds received by unsubs tend to be transferred back into the RemainCo credit box, leaving the unsubs with little additional resources, other than the assets dropped down, to service their new debt. Unsubs in our data set had average gross leverage ratios of about 10x and average cash interest coverage ratios of about 1.4x immediately post-deal.
 

Within this data set, AMC’s Muvico and Del Monte Foods Corp. (representing the unsub entities for the two most recent deals at the time of publication), have particularly high leverage and, in our opinion, need to rely on box office growth and inventory reduction, respectively, in order to grow into their capital structures.

Despite the high leverage placed on unsubs, the new lenders to these entities have protected themselves in some cases by retaining a first lien on RemainCo collateral (AMC, Revlon), in some cases through an intercompany loan (Trinseo, Envision), and/or by getting a pledge or guarantee from international equity (AMC, Trinseo, Revlon).

Of the six bankruptcy filings in this data set, only three included the associated unsub (Revlon, Envision and J.Crew). About 10 months after Party City went bankrupt in January 2023, its unsub Anagram filed for bankruptcy, which may be a cautionary tale about levering a historically stable, cash-flowing business to the point it could not withstand industry headwinds.

Some unsubs, though, have provided significant value to investors. Chewy (PetSmart) and MyTheresa (Neiman Marcus) eventually went public in 2019 and 2021, respectively, becoming worth multiples of the value initially associated with their drop-down transactions. Notably neither had any leverage upon consummation of the drop-downs: Chewy had no debt (but it had negative EBITDA), while MyTheresa was capitalized with $500 million of preferred stock (about 14x post-deal EBITDA).

Half of the Companies in Our Data Set Filed for Bankruptcy at Some Point After Completing Their Drop-Down Transaction

While companies use drop-down transactions to provide capital injections and/or extend their maturity wall, in some cases, these capital injections have proved to be temporary. Additionally, these transactions create litigation risk for the company, and potentially participating creditors, as assets are being moved out of the credit box, which may prompt litigation from RemainCo creditors left out of the transaction.

Of the 18 companies in the data set below, covering 19 transactions with Revlon consummating two distinct new-money drop-down transactions, 50% have subsequently filed for bankruptcy with an average span of about 22 months from the drop-down date to the petition date. Additionally, eight of these companies and/or participating lenders have faced or currently face litigation regarding these transactions.
 

Drop-Down Transactions Have Steadily Increased Over the Last Few Years After a Post-Pandemic Lull

In our review of 19 completed drop-down transactions from 2016 through 2024, we note that deal volume peaked in 2020 amid the onset of the Covid-19 pandemic and since a quiet 2021 has steadily risen each year.

Half of the drop-down transactions from 2016 through 2020 involved retailers transferring intellectual property to unsubs, but this trend has slowed in recent years likely due in part to the addition of J.Crew blockers in debt documents. In more recent years, companies have transferred specific assets, for example, certain better-performing theaters at AMC, certain clinics at U.S. Renal Care and/or substantially all assets (Del Monte Foods and Rackspace) to unsubs.
 

Nearly 80% of the deals in our data set included a new-money component, and 50% involving debt exchanges, with a full 37% of deals incorporating both a new-money component and a debt exchange. PetSmart’s June 2018 transfer of 36.5% of its equity in its Chewy subsidiary did not involve any new money or debt exchange, so the below exhibit includes only 18 transactions:
 

Companies Slightly Reduced Debt Through Drop-Down Transactions, but Consolidated Cash Interest Increased

Companies in our data set were able to reduce their consolidated debt by about 2% on average, but consolidated cash interest increased about 12% on average, as estimated by Octus, formerly Reorg.
 

The amount of new debt raised via each drop-down transaction was dependent on the subject company’s liquidity needs but averaged about $400 million, or 15% of pre-deal debt. The average stated interest rate for new-money debt issuances in our data set was about 12%, although in some cases, borrowers were able to pay a lower cash interest rate by including a higher PIK rate for the first one to two years.

Most new-money debt was issued in the form of term loans as opposed to notes, with the average spread for the four most recent new-money raises in our data set being 800 bps. Generally the new money in these transactions was funded by existing lenders, but Trinseo was a “deal away” with the new money provided by lenders not previously in the structure.

We note an average original issue discount, or OID, of 2% for the five companies in our data set that explicitly indicated the OID in the new-money loan. In many cases, additional fees including commitment fees and backstop fees were mentioned but not explicitly disclosed and came in the form of PIK. The fees figure in the table below reflects a combination of these disclosed fees:
 

A summary of exchange terms for the drop-down transactions in our data set is shown below:
 

Octus reviewed 19 drop-down transactions since 2016, analyzing 15 of these transactions with a focus on evaluating credit metrics and summarizing terms for corresponding new-money raises and debt exchanges. We did not include Cirque de Soleil, Hornblower and Pluralsight because of a lack of sufficient publicly available (or previously reported) data for our analysis. Additionally, we excluded Travelport from our data set because its drop-down of intellectual property in May 2020 was reversed several months later amid a litigation battle.