Liability Management Transactions (LMTs): Ignore Them at Your Peril

Overview

Despite their unremarkable moniker, Liability Management Transactions (LMT) or Liability Management Exercises (LME) have increasingly been in the leveraged finance headlines. LMTs are a way for Broadly Syndicated Loan (BSL) debtors to leverage the liberal language of cov-lite loans (ie loans with limited investor protection) in CLO governing documents to short-circuit traditional creditor protections. As CLO's represent ~70% of BSL investors, CLO governing docs have been a leading force for enabling and defining the limits of LMTs.

LMTs have resulted in a dramatic reduction in recoveries and security protection for CLO investors. LMTs strip assets from senior secured loan investors in some cases while in other cases they effectively render existing senior debt subordinate to new debt. Investors ignore this topic at their peril.

In this article, we discuss two types of LMTs: Uptier Priming and Dropdown transactions. These are two of the most common and coercive types of LMTs and both have dominated headlines related to adverse consequences of cov-lite loans. We use Semeris Docs, an AI-assisted document review platform to rapidly navigate through hundreds of CLOs docs and extract the critical language needed to assess how CLO deal documentation addresses LMTs. In addition, to discussing these topics, we provide a deep dive into how Uptier Priming transactions are addressed in CLO deal docs.

The chickens of cov-lite loans are coming home to roost as most recent loan defaults are now resolved via LMTs thereby exposing CLO investors to adverse recovery prospects. Further complicating the analysis is that resolutions resolved via LMTs are often a temporary fix as many non-bankruptcy/LMT resolutions ultimately end up in bankruptcy.

As BofA noted in recent research:

"With almost 60% of restructurings returning to bankruptcy within 4 years, long term recoveries are likely to remain low at around 40%." Hence it's important for investors to focus on how CLO documentation addresses LMTs.

What is Uptier Priming?

Uptier Priming transactions involve a distressed debtor that issues new loans that are senior to existing loans. Existing creditors may or may not participate in the new transaction. Those who don't participate (so called Excluded Lenders) are relegated to a subordinate debt position with greatly diminished recovery prospects (often zero), while the new lenders are called Participating Lenders. The process and rights of existing lenders (e.g. a CLO) exchanging their existing debt and rolling it up into new, super-priority debt is referred to as "uptiering". While the new prime debt enables the company to raise new senior debt funds, the real risk to existing lenders is not so much the new money raised, but rather being stranded as a non-participating lender in the now newly subordinated existing loan.

The chart below illustrates 7 specific cases of Uptier Priming and the impact on recoveries. (source: S&P, June 15, 2021). The blue bars represent expected recoveries before uptier priming and the orange bars represent the recoveries on loans that were subordinated because of uptier priming. While many post-uptier priming bars appear to be missing, it is in fact due to recoveries being a donut (or a bagel if you are a tennis fan).

What are Dropdown transactions?

Dropdown transactions involve the removal of critical assets from a troubled company and moving those assets to a separate legal entity (e.g. an "Unrestricted Subsidiary") thereby stripping BSL CLO investors of critical assets and exposing the deal to much higher losses. These Unrestricted Subsidiaries are, by definition, not subject to the Credit Agreement of the BSL loan.

The assets stripped, or dropped down, can include intellectual property or entire divisions (e.g. PetSmart stripping valuable subsidiary Chewy from the holding company that issued the debt). The Unrestricted Subsidiary is then free to issue debt backed by the transferred assets. One critical difference between dropdown related debt and Uptier Priming debt is that Uptier Priming debt is the same issuer as that held by the CLO, whereas dropdown debt is issued by a completely distinct legal entity.

LMTs/Uptier Loans and CLO Documentation

Using Semeris Docs, we explored how the CLO governing docs address the Dropdown transactions for about 60 deals that include references to Uptier Priming.

Reviewing data we extracted from Semeris Docs reveals that specific definitions for Uptier Priming began appearing in 2022 deal docs and this accelerated into 2024 (see chart below), with over 50% of deals including Uptier Priming definitions or similar.

There could be several reasons why some deals from 2024 don't have the language despite the potentially obvious need. Here we are speculating a bit as we haven't gone through every deal missing the language, but a perusal of the documents not including the language reveals potential reasons:

1. Deal Type: some 2024 deals may be a refinance from an earlier vintage, and the language wasn't updated to reflect the risk;
2. Collateral type: One of the deals not including the language, was an Ares direct lending (middle market) deal. It's possible that a direct lending deal may already have loans with adequate covenants or other reasons for not including it;
3. Manager Preference or CLO Investor "Ask" to remove (see below); and
4. Other defined terms adequately cover the risk.

With 4) it's possible that including the defined term "Uptier" isn't necessary as other terms such as Workout or Distressed Exchange or Current Pay, etc may already encompass such permissions. Further, some investors may prefer the language not to be included as it may encourage investments that are more vulnerable to LMTs.

The questions for CLO investors include:

1. Are LMTs specifically defined, and if so, how;
2. What limitations are imposed on the manager on participating in LMTs;
3. How the resulting LMT loans are treated for purposes of over-collateralization (OC) calculations; and
4. What is the governance mechanism for CLOs to participate.

In this article, we largely focus on 1 and 2.

As stated above, investors may believe explicitly defining and thus permitting Uptier Priming or dropdowns may also incent managers to buy debt with weaker covenants that are more susceptible to LMTs. Nevertheless, restricting deals from investing in these transactions may render CLO investors vulnerable to dramatic degradation of collateral position if they do not have the ability to participate or are limited by existing Workout buckets.

Deep Dive: Uptier Priming and CLO Documents

Defining the terms

Our review of Uptier Priming in deal docs reveals several defined terms related to Uptier Priming. These include "Uptier Priming Debt", "Super-Priority New Money Debt" and "Rolled Senior Uptier Debt", "Select Uptier Priming Debt". See example below.

"Uptier Priming Debt": Any Superpriority New Money Debt and any Rolled Senior Uptier Debt acquired by the Issuer resulting from, or received in connection with, an Uptier Priming Transaction.

These various terms may be synonyms or subsets. For example, Select Uptier Priming Debt is a subset of Uptier Priming Debt. See two examples below (Semeris Docs' handy copy feature automatically includes deal name, document, page, and location):

benefit34-indenture (p85) / 1. DEFINITIONS / 1.1 Definitions.

"Select Uptier Priming Debt": Any Uptier Priming Debt that satisfies the Additional S&P Uptier Priming Debt Criteria.

anchorage6r3-indenture (p86) / ARTICLE I DEFINITIONS / Section 1.1 Definitions.

"Select Uptier Priming Debt": Any Uptier Priming Debt with a Market Value of at least 90%; provided that such Market Value is determined solely pursuant to clause (i) or (ii) of the definition thereof.

Uptier Priming Debt Limitations

Below, we show several examples of how limitations on Uptier Priming are defined.

Considering that nearly 80% of collateral can be cov-lite these days, investors should consider whether it's a positive to restrict the amount of such loans as limitations could prevent CLOs from participating in new Uptier Priming loans once the limit is reached. Understanding limitations across a portfolio for investors, law firms, and issuers alike can be very labor-intensive when viewed across dozens or even hundreds of deals.

With an intelligent, flexible, AI-optimized search function, Semeris Docs simplifies the process to find similar language across a portfolio of holdings or any customized subset of the deals covered on the platform. The ability to export to excel for further analysis also enhances the ability to extract additional value insights.

According to BofA, most recent defaults are resolved via LMTs. Assuming 60% of defaults are via LMT, under a high 5% CDR, this would mean ~3% of loans default each year via LMT workout. As a result, these Uptier Priming buckets could be filled within 2-3 years, thereby exposing more senior CLO classes to a plunge in recoveries since the CLO Manager could be prevented from further participation in Uptier Priming debt. One CLO Manager we spoke to noted that they are often able to accept Uptier Priming debt under other defined loan categories so it isn't necessarily the case that every Uptier Priming transaction would consume the Uptier Priming bucket. Such iterations can get very complicated to evaluate, particularly when considered across dozens of deals.

For deals that include Uptier Priming definitions, the limitations as a percentage of Collateral Principal Amount range from 2.5% to 10.00% with limits often as sub-limits of other loan categories such as DIP loans, Workout Loans or Current Pay loans. To fully understand the limitations of Uptier Priming loans, it's important to carefully parse the language in the OC.

Semeris Docs proved very useful here: In reviewing the deal docs via Semeris Docs' Market Compare (see screenshot above), we identified essentially three flavors of Uptier Priming restrictions:

1. simple standalone "point in time" definitions,
2. restriction as part of a subcategory (e.g., Workout Obligations) and
3. those with cumulative restrictions.

And if you are interested in searching across documents for similar language in deals where a defined term may not be explicitly defined, Semeris Docs' READ-FIND-COMPARE comes in handy once again. The screenshot below shows the Text Search screen from the Semeris Docs platform with an Uptier Priming Debt search. Simply pasting an example of target language and setting the text search to 'broad match', a user can quickly find all documents in a user-defined basket that have similar language, with results ranked by similarity. Such comparisons would be very time-consuming or nigh impossible using a conventional pdf "Ctrl-F" based search, with a lot of copy and paste. In our analysis for this article, we had the core results available for download in seconds with a few simple mouse clicks. See the screenshot below.

Semeris Docs subscribers have access to our deep-dive language examples.

Conclusion

When cov-lite exploded on the scene as the dominant collateral type in CLOs, the risk was theoretical. Debates raged about the degree of risk of cov-lite loans. Now, the debate is over, the risk is clear - with most defaults resolved outside of bankruptcy, understanding LMTs is more critical than ever. As our article discussed, most defaults are resolved through LMTs and failure to properly understand the deal doc dynamics can lead CLO Managers caught behind the LMT 8-ball. With recoveries often zero for Uptier Priming transactions for non-participating CLOs, subtle deal doc language can mean the difference between zero and 60% recoveries.

Failure to consider this risk by CLO investors or managers can result in grave loss increases as LMTs lead to cratering of recoveries. Uptier Priming and Dropdowns are two types of LMTs that have caused investors and CLO managers alike to lose sleep. Despite the risk being a clear and present danger, we are still perhaps in the early innings of a very long ballgame. To market participants our message is this: Know your deal docs and associated definitions and rights backwards and forwards. Do not wait until a flood of LMTs requires rapid assessment of dozens of PDFs with their complex, manifold definitions.

With Semeris Docs at your side you can keep calm and carry on. Rapid analysis of dozens of docs across complicated deal definitions and sections makes Semeris Docs a critical tool in your doc analysis.