Arriving at a business in your area that is struggling with a cash shortage: creditor-on-creditor violence

American companies struggling to repay below-investment-grade bonds and loans are increasingly trying to squeeze concessions from lenders, pitting them against each other. Private equity firms and the wealthy individuals who own most of the companies call these deals “liability management exercises,” or LMEs. Debt investors call them “creditor-on-creditor violence.”

Companies using these tactics—or preparing to do so—run the gamut from telecommunications provider Altice USA to cloud-computing company Rackspace Technology and aerospace equipment provider Incora. Some funds are fighting back by joining forces to preempt such tactics. Lenders to radio broadcaster iHeartMedia recently organized, said fund managers who participated in the groups. But even in such alliances, debt investors can turn on each other, they said.

“We believe the LME will become even more controversial from here,” Barclays credit analyst Corry Short wrote in a July report, the bank’s first systematic analysis of the phenomenon. He said about $155 billion of bonds and loans are trading at distressed prices and could be subject to future liability management.

The clashes reflect, in part, the pressure of sharply higher interest rates. Many of the companies involved took out loans and bonds to pay for private-equity acquisitions. Rising interest rates have simultaneously made debt more expensive and eroded the returns private-equity firms deliver to their own investors. Private equity returned about 6% last year, compared with 24% for the S&P 500, according to MSCI data.

Owners can prolong control of ailing companies and defer losses by playing the financial equivalent of Game of Thrones with creditors. Owners persuade some lenders to exchange debt that is due for a smaller amount of long-term debt, giving them preferential treatment — at the expense of other creditors who are not privy to the arrangement. Once most creditors agree, owners can impose stricter terms on remaining loans and bondholders.

Historically, defaults have been overseen by bankruptcy courts, but in the current cycle, most of them are playing out in the backrooms of debt management. Private equity firms can now push out-of-court deals because loan investors have been giving up legal protections in exchange for higher returns for years.

Such restructurings bolster the valuations that private equity firms assign to companies, protecting the management fees they charge investors. They also lower companies’ costs and give them time to potentially recover.

But these findings can only go so far to help troubled companies. Companies that have already defaulted are four times more likely than average to default again, and 35% of distressed companies will default within two years, according to S&P Global Ratings.

The deals also worsen ultimate recoveries for debt investors, who recovered 47% in bankruptcies of firms that previously had exposure to the LME last year, according to Fitch Ratings. Debt recoveries for firms that had no exposure to the LME averaged 60%.

“These acts of financial warfare were presented as attempts to rejuvenate a financially troubled company, but they apparently did little more than provide private equity backers with additional fees and a better position,” Wake Forest University law professor Samir Parikh said in a recent article.

The market for below-investment-grade bonds and loans has nearly doubled since 2010 to about $3 trillion as low interest rates encouraged companies to borrow. The default rate on loans has roughly tripled since 2022 to about 4.5% as borrowers grappled with inflation and higher interest rates.

The debt is primarily owned by institutions — pension funds, insurance funds, hedge funds and the like — but individuals have also been buying through mutual funds, exchange-traded funds and business development companies, or BDCs.

One consequence of forced exchanges is lower returns on secured loans, which typically do better than junior loans and bonds in restructurings because they have a first claim on corporate assets. Bondholders and junior lenders outperformed junior loan investors in 12 of 20 liability management exercises that Barclays reviewed.

“It’s a small part of our market that adds a lot of uncertainty,” said Andrew Sveen, who manages $30 billion of loan investments at Morgan Stanley Investment Management. The unpredictability makes investors more likely to sell loans at risk of collateral management unless they have a large stake that gives them leverage in negotiations, he said.

Private equity firm BC Partners was among the first to pit creditors against each other in 2019 to restructure its PetSmart business. BC announced the deal, saying it would be available only to the first 51% of loan holders who accepted it — the majority it needed for legal reasons — and all other lenders would be left out.

Loan holders initially informally agreed to reject the deal. Then a major lender, Apollo Global Management, broke ranks, and within hours the coalition fell apart.

“One by one they dropped out,” someone from the informal group said. “It was a disaster.”

More companies have adopted the tactic since the pandemic, including KKR-backed Envision Healthcare and restaurant provider TriMark USA, backed by Centerbridge Partners and Blackstone. Investment banks like Moelis and PJT Partners have begun building deal-design practices, and law firms like Gibson Dunn and Paul Weiss have specialized in the lawsuits that have resulted.

As the tactic became more common, even more traditional debt investors began to make deals that were bad for other creditors. In the case of Advent International’s mattress maker Serta Simmons Bedding, mutual fund managers Eaton Vance and Invesco made deals with the company.

Private equity backers have increasingly turned to distressed stock exchanges, in part because they have had difficulty selling companies they own as higher interest rates have cooled merger and acquisition activity. They have also been reluctant to lower valuations of companies they still own.

“That has meant sponsors have had to get more creative with their returns,” Barclays’ Short said.

Debtholders began preemptively forming cooperative groups, signing binding agreements pledging not to accept any exchange offers from companies unless they all agreed. In 2023, Apollo Global Management and Pacific Investment Management successfully teamed up to prevent a forced exchange by online car retailer Carvana.

They negotiated a deal that gave the company time to streamline operations and strengthen creditor protections. The restructuring worked, and both debt and stock prices rebounded.

Once rare, alliances are becoming common, with more than a dozen formed this year, debt fund managers said. Companies affected include pharmaceutical company Bausch Health and movie theater chain AMC Entertainment.

Soma Biswas contributed to this article.