Saying No: The Power and Peril of the LME Holdout

Some par investors and opportunistic credit funds are turning down the “consolation prize” in non-pro-rata liability management exercises, or LMEs, and they are getting what they want – a par recovery.

In the LME 3.0 era, deal architects, including principals, lawyers and bankers that represent companies, sponsors, and creditors’ steering committees, are fine-tuning their ability to find the sweet spot where the “in-group” transfers just enough value to minority creditors for them to accept the second- or third-best terms and not litigate.

Some investors, however, facing a growing list of punishments to recalcitrants, have chosen to sit out. Their rationale includes: the transactions are illegal and wrong, their take-back paper may be below the fulcrum in a subsequent chapter 11, the need to stop the vicious circle of getting left out, and the belief that they could get a better deal by opting out.

To have an effective holdout strategy, it is essential for the investors to have a comprehensive war plan and keep innovating, commit to the fight and have patience, according to interviews with Jennifer Selendy, a founding partner of Selendy Gay; David Coon, a litigation partner at Selendy Gay; and Anne Beaumont, a litigation partner at Friedman Kaplan.

Crying Baby Gets the Milk

There is an idiom in Mandarin, “to pick out and squeeze the soft persimmons,” which means to bully the weak. As layer-cake transactions become commonplace, “if a lender has never fought back before and just went along and took the consolation prize every time, that is a pretty good indication to companies and advisors considering an LME that the lender will do the same on the next deal too,” Coon of Selendy Gay said. “Holding out is a signal that this lender will fight, which may help avoid having a target on their back and being left out every single time in the future.”

Another calculation on investors’ minds, as they deliberate whether to “hold their noses” and accept the second- or third-tier offer or go to battle, is how their new paper will fare in a bankruptcy later, as the market gets more data points on LMEs ultimately landing in chapter 11. “If a company is in real distress, value may break at the upper tranches, and if a previous consolation prize offered you paper in a tranche below, you might be completely wiped out in bankruptcy,” Coon of Selendy Gay said.

Del Monte Foods holdout lenders, which directed the administrative agent Black Diamond Commercial Finance, represented by Friedman Kaplan, to take a series of actions, were taken out with the proceeds of incremental first-out loans funded by participants in a previous LME as part of a settlement. Less than three months later, the canned vegetable maker filed for bankruptcy, and the new-money first-out loan may be the fulcrum, considering the stalking horse bid, and the second-out and third-out loans may be flushed.

Granted, holding out is a risky gamble and may fail, too, either by holdouts receiving only “bread crumbs” in a restructuring by being at the bottom of the capital structure or losing in court challenging the transaction. As a holdout, you have to accept the possibility that you may lose the fight. Quietly refusing to participate and then passively waiting to collect interest and be repaid at maturity may not work either, since interest payments are often delayed to maturity by aggressive exit consents, and the earliest maturity on the stub debt may become a restructuring trigger if performance has not turned around.

‘Not for the Faint of Heart’

To a certain extent, holding one’s ground and clashing with the company, sponsor and the creditor in-group is about intestinal fortitude as much as it is about contract interpretation. Backbone is needed, according to Beaumont of Friedman Kaplan, especially with the sponsors’ and required lenders’ ever-expanding arsenal to scare and deter rebels. This includes extending grace periods on missed coupons until maturity (an issue expected to appear in oral argument in STG Logistics’ LME-related lawsuit next month), restricting assignments, using weaponized nondisclosure agreements and no-action clauses, stripping covenants, and launching the step-two phase of the deals during holidays with short consent windows.

“We make sure our potential clients know that holding out and fighting non-pro-rata LMEs is not for the faint of heart, and it is trench warfare,” Jennifer Selendy of Selendy Gay said. “Everybody who got the ‘goodies’ wants to keep them and is not going to give them up easily.”

Holdout lenders to Better Health, the first deal post-Serta, including Saratoga Investment Corp., represented by Selendy Gay, received par treatment including a mix of paydown, first-out and second-out paper as part of a settlement, compared with the in-group’s par treatment and 85% and 70% recovery for second-tier and third-tier lenders, respectively, according to sources.

As LME technologies evolve, new tactics and arguments by holdouts are emerging as well. “You have to be informed by the playbook but not constrained by it,” according to Beaumont of Friedman Kaplan.

“We have upped the ante in terms of asking the questions of, was the company already insolvent at the time you did the deal? Did the directors breach their fiduciary duties? And was there tortious interference? In addition to the typical breach of contract, good faith and fair dealing issues,” Selendy said.

The Serta decision also helped. “We view it as ‘fool me once, shame on you; fool me twice, shame on me’ situation, because the ‘open market purchase’ justification was shut down by the Fifth Circuit in Serta, and lenders that are faced with new deals are asking, ‘Why should I believe that the new post-Serta technology will hold up in court?’” Coon of Selendy Gay said.

Existential Threat to Smaller CLOs

Looking at the bigger picture, smaller CLOs may go extinct over time if they keep underperforming their larger peers by constantly accepting inferior economics in non-pro-rata LMEs, as it would be hard to convince their own investors to stick with them, Coon said.

Additionally, yield chasing means many CLOs cannot invest solely in BB rated junk debt, and “dealing with non-pro-rata LMEs by picking good credits” likely will not work because of how ubiquitous LMEs are, Selendy said.

The CLO market, and asset management space at large, having realized that size matters, have seen a series of mergers and acquisitions. Assured Guaranty acquired BlueMountain in 2019, and a tie-up of Assured’s asset management business with Sound Point in 2023 created the fifth-largest global CLO manager by assets under management at the time. First Eagle bought THL Credit in 2020 and Napier Park in 2022. Blue Owl bought Par-Four in 2023 and Wellfleet in 2022.

The non-pro-rata LME music may finally stop if the syndicated market only has sizable investors and resembles the private credit market, because every large creditor knows each other and nobody wants to be taken advantage of. Instead, creditors may look to the equityholders of distressed companies to help deleverage and ask for higher interest rates on the front end to compensate for the risk of taking a haircut in a workout later on.

But for now, the non-pro-rata LME music is very much still on, and the flavor du jour in the post-Serta world, extend and exchange, or “amend and pretend,” as some call it, will be litigated eventually, Coon said. “The driver of many of these deals is economics, and then companies, sponsors, and advisors try to come up with a contractual excuse to make it happen. The supposed contractual justifications are simply a means to an end,” he said.

“We have gotten away from actually solving companies’ problems, and gotten overly focused on how to be clever with the documents,” Beaumont said. “At some point, we should get back to restructuring principles and think about, what does the company really need, and get real about bankruptcy, which is there for a reason.”

Better Health and Saratoga Investment Corp. did not respond to requests for comment.