The Intersection of Private Credit and Restructuring

Private credit is booming. Once a niche form of financing for smaller-middle market companies or lower-quality borrowers, private credit has become a trillion-dollar industry and it is expected to keep expanding. This has ramifications throughout the financial world. One product of more private credit deals? More private credit restructurings.

What is Private Credit?

Good question. In fact, it’s easier to define private credit by what it is not—it is not a syndicated loan facility provided by a banking institution. Private credit generally involves a loan underwritten and provided by non-bank lenders, including alternative asset managers, insurance companies, and private equity funds. Typically, in a private credit transaction, the financing comes either from a single direct lender or from a “club” of lenders.

Not surprisingly, then, relationships are key. In most private credit deals, the sponsor already has a relationship with the lead arranger or lead lender who wants to cement such relationship for future deals, and the arranger and other lenders likewise know each other. This is in contrast to a syndicated loan facility where an arranger may underwrite the entire deal initially, only to sell down completely at closing and thus the lenders may have no direct relationship with the sponsor, much less one another. Also, unlike with a syndicated loan, there is little trading in the secondary market, which means there is less risk that the lenders at the negotiating table rotate out.

Private credit loans can be assigned, but given the aforementioned importance of relationships and the need for borrower consent (absent a payment or bankruptcy event of default), assignments generally occur to lenders that have a relationship with the sponsor or the existing lenders. There are also significant restrictions on transferring loans, similar to the syndicated market. For example, private credit loans often include extensive disqualified-lender lists or even blanket restrictions on assignments to certain categories of market participants—say, no assignments to distressed investors. Such restrictions reinforce the premise of private credit: Lenders are in it for the long haul.

Why has private credit exploded in popularity? In large part because it can offer benefits in terms of flexibility, confidentiality, and speed of execution. In particular, private credit lenders can provide borrowers and sponsors with deal structures that are more tailored to their specific needs and potentially more forgiving in a downside scenario than banks, such as the ability to PIK debt or defer cash interest, as well as the ability to hold equity. Unlike regulated banks, many direct lenders approach underwriting from an enterprise value perspective rather than traditional asset-based underwriting.

Restructuring Private Credit Loans

One thesis behind private credit is that it may allow a borrower to avoid bankruptcy altogether. It is certainly true that a borrower with a single lender or a club of closely aligned lenders will have more restructuring options. The key parties can often come together quickly to find a solution—whether that is an amend-and-extend or perhaps for the sponsor to hand the keys over to the direct lenders. Also, since private credit funds may have more flexible mandates and are more likely than banks to view these loans as long-term investments (i.e., from “cradle to grave”), private credit lenders may be willing to support a company through a restructuring when lenders in the syndicated market might not.

While private-credit restructurings are often streamlined and less costly, lenders should be aware that this may not always be the case. If the borrower’s issues are operational in nature, a quick balance-sheet restructuring won’t fix it. In that scenario, the borrower may need to take advantage of more expansive bankruptcy-related powers, including the ability to reject burdensome contracts and restructure legacy liabilities.

In addition, as the private credit landscape has expanded, so has the number of lenders in any particular deal. It’s not unusual today to see a private credit deal with more than 12 unaffiliated lenders—approaching what some have called “broadly syndicated private credit.” Obtaining lender consensus with larger lender groups may prove challenging. Because successful out-of-court restructurings often involve loan modifications that impact a document’s “sacred rights” (such as a debt for equity exchange), they may require unanimous consent of the lenders.

Another key consideration: there are now thousands of new private credit lenders, each with their own personality, risk profile, and mandates. Many of these lenders have never been through a downturn and how they respond largely remains to be seen. With so many new private credit lenders competing for business, it will be interesting to see if the “club” nature of private credit can remain intact.

Less LME Risk

Private credit has been flourishing while liability management exercises (“LMEs”) have been making waves in the syndicated market. Companies with near-term maturities or liquidity issues have used LMEs to reduce or manage their overall debt. They have employed various strategies, including allowing certain creditors to exchange their existing debt for longer-dated maturities, higher priority, and other amended terms. LME use has accelerated in recent years as macroeconomic conditions, such as high interest rates and tight credit markets, have brought more credits closer to default.

Many LMEs are structured on a non-pro rata basis, meaning that they offer different terms to similarly situated creditors. Those lenders in the favored group disproportionately benefit at the expense of minority holders—giving rise to what the industry refers to as “lender-on-lender” violence. As new LME technology is constantly being employed by borrowers and ad hoc groups in borrower-friendly credit agreements, LME risks are particularly difficult for lenders to assess. This is another reason that private credit has piqued interest in the debt-financing market. Given the close relationship that is the foundation of private credit, non-pro-rata LMEs are exceedingly rare, although they can still occur. For example, in early 2024, the private-credit world was stunned when education software company Pluralsight implemented a non-consensual “drop-down” transaction.

For now, Pluralsight appears to be an outlier and private credit continues to present an attractive option for lenders looking to mitigate LME risk.

Conclusion

Private credit restructurings are expected to grow even more in the years to come. In light of the smaller number of players involved in most transactions, along with the close relationship that is a trademark of private credit, we can expect to see many of these restructurings completed outside the formal bankruptcy process. It will be interesting to see if, as private credit deals proliferate and more market participants get involved, this trend will continue.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Matthew P. Kremer, an O’Melveny partner licensed to practice law in New York; Glen K. Lim, an O’Melveny partner licensed to practice law in California and New York; and Brian S. Stern, an O’Melveny partner licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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