Finding Signal in the Bankruptcy Noise

Two high-profile bankruptcy filings by leveraged US borrowers—both of which face allegations of fraud—have reverberated across financial markets and raised questions about the stability of alternative credit. When considering the implications of these bankruptcies for lenders and investors, we believe it’s important to understand the instruments involved.

The headline-grabbing troubles of Tricolor Auto Group and First Brands Group, for example, primarily impacted broadly syndicated loans and other more esoteric forms of credit. Syndicated loans—also referred to as bank loans, leveraged loans, tradeable credit and other terms—are extensions of credit to noninvestment grade borrowers that are arranged and administered by large banks, who solicit participation in the deals by institutional investors like mutual funds and collateralized loan obligations (CLOs).

Given that the institutions participating in these syndications are not negotiating the terms of the deal, gaining access to information that supports due diligence efforts can be a challenge; many leveraged borrowers are private companies with limited public disclosures, and direct engagement with borrower management teams is often not available. Moreover, competitive dynamics in recent years have eroded the structuring power of syndicated lenders, resulting in an increasingly “covenant lite” market. In their efforts to offset these limitations, institutional investors generally construct broadly diversified loan portfolios.

Syndicated loans should not be confused with direct lending, which refers to the direct origination of loans by nonbank lenders. Direct lenders partner with borrowers—typically, noninvestment grade borrowers smaller in size than those who participate in the syndicated loan market—and their private equity sponsors to originate customized financing solutions, enabling one-on-one access to management teams and significant influence over loan structures.

The nature of the direct lending relationship generally enables lenders to apply more rigorous underwriting discipline, ensure greater protections in loan terms and act more proactively when signs of stress emerge. As a result, direct lending historically has experienced lower default rates and higher recovery rates than syndicated loans.¹