When Creditors Collide: The Rise Of "Creditor-On-Creditor Violence"

In the evolving landscape of corporate finance, "creditor-on-creditor violence" has emerged as a significant concern, particularly in distressed debt situations. This term refers to aggressive tactics employed by certain creditors to improve their position at the expense of others within the same debt structure. Such maneuvers can disrupt traditional expectations of equal treatment among creditors and have profound implications for debt markets.

What Is Creditor-on-Creditor Violence?

Creditor-on-creditor violence involves actions where specific creditors, often in collaboration with distressed companies, restructure debt agreements to prioritize their claims over others. Common strategies include:

• Uptiering: Elevating certain debt to senior secured status, thereby subordinating existing debt.
• Drop-Down Transactions: Transferring valuable assets into unrestricted subsidiaries, placing them beyond the reach of existing creditors.
• Distressed Debt Exchanges: Offering select creditors improved terms in exchange for their support in restructuring, disadvantaging non-participating creditors.

These tactics exploit gaps in credit agreements, enabling certain creditors to enhance their recovery prospects while undermining others.

The Rise of Liability Management Exercises (LMEs)

Liability Management Exercises (LMEs) have become increasingly prevalent as companies seek to manage their debt obligations without resorting to formal bankruptcy proceedings. LMEs can involve exchanging existing debt for new instruments, raising additional capital, or shifting assets—all aimed at gaining time to improve financial standing. However, these exercises can have dramatic consequences for existing debt holders, potentially leading to litigation between creditors.

The proliferation of covenant-lite (cov-lite) loans has played a critical role in the rise of creditor-on-creditor violence by significantly weakening traditional protections for creditors. Cov-lite loans, which now dominate the leveraged loan market (over 90% as of 2024), lack maintenance covenants that require regular financial testing, giving companies more flexibility to engage in liability management exercises (LMEs). This has enabled distressed companies, often backed by private equity sponsors, to restructure debt aggressively through mechanisms like uptiering or asset transfers without the usual constraints imposed by stricter covenants. These tactics often prioritize the interests of controlling creditors or equity holders at the expense of other creditors, fostering an environment ripe for disputes and litigation​.

Factors Contributing to Creditor-on-Creditor Violence

Several factors have contributed to the rise of creditor-on-creditor violence:

1. Erosion of Covenant Protections: The proliferation of covenant-lite loans has weakened traditional lender protections, making it easier for companies to engage in aggressive debt restructurings. Data indicates that 90% of leveraged loans lack proper maintenance covenants, facilitating such maneuvers.

2. Economic Pressures: High interest rates and economic slowdowns have increased financial distress among companies, prompting the use of aggressive liability management strategies to avoid bankruptcy.

3. Legal and Structural Differences: Variations between U.S. and European legal frameworks influence the prevalence and nature of creditor-on-creditor violence. In Europe, stronger creditor protections and different restructuring practices have, to some extent, insulated debt investors from the more aggressive tactics seen in the U.S.

Implications for Investors

The rise of creditor-on-creditor violence presents both challenges and considerations for investors:

• Increased Risk: Traditional assumptions about the equal treatment of creditors are being challenged, introducing new risks for investors in distressed debt.

• Due Diligence Importance: Investors must conduct thorough due diligence, scrutinizing credit agreements for potential vulnerabilities that could be exploited in liability management exercises.

• Legal Recourse: In some cases, excluded creditors have sought legal action to challenge aggressive restructuring tactics, leading to complex and protracted litigation.

Hedge funds have increasingly engaged in creditor-on-creditor violence, employing aggressive strategies to enhance their positions in distressed debt situations, often at the expense of other creditors. Such maneuvers have become more prevalent with the rise of cov-lite loans, which lack stringent covenants, allowing dominant creditors, often hedge funds, to restructure debt in ways that favor their interests, thereby intensifying inter-creditor conflicts.

Conclusion

Creditor-on-creditor violence reflects a shift in the dynamics of debt restructuring, with significant implications for the investment landscape. As companies and certain creditors employ increasingly aggressive tactics to manage financial distress, it is essential for investors to remain vigilant, understand the evolving legal frameworks, and engage in comprehensive due diligence to navigate this complex environment.