Liability Management Exercises (LMEs): The “quiet default” that is reshaping credit markets

As credit markets adapt to a post-zero-rate world, a less visible but increasingly significant trend is unfolding: a rise in Liability Management Exercises (LMEs) and Distressed Exchanges. These events are reshaping outcomes for creditors – not through headline defaults, but through complex restructurings that can quietly dilute value and alter creditor positioning. Understanding how these situations are handled has become a relevant factor in evaluating resilience, return potential and governance standards within credit portfolios.

What are Liability Management Exercises (LMEs), and why have they become increasingly common?

An LME is a preemptive restructuring of an upcoming debt maturity and is typically used to address some type of weakness in a borrower's ability to meet their obligations and extend the runway of their equity value. Often, borrowers engaging in an LME are facing deteriorating equity values and will take advantage of covenant-lite documents to raise cheaper, senior debt at the expense of current creditors. These transactions are not technically defaults but can share some characteristics of defaults such as principal losses and the exchange of existing debt for new debt/equity (i.e. a restructuring).

A growing number of corporate borrowers are finding themselves caught between slowing cash flows and looming debt maturities. In response, LMEs have become an increasingly common tool among struggling borrowers who are attempting to maintain equity value. As a result, LME activity as a percentage of total defaults and LME volume has increased notably in the last few years.

A shifting playbook in leveraged credit

The LME boom kicked off with the rise in interest rates during 2022 and the subsequent struggles of floating rate borrowers in addressing interest payment headwinds. Many of these borrowers took on leverage during a zero-interest rate policy (ZIRP) environment and became over-levered during the higher rate environment that has persisted in recent years. Those borrowers were often backed by private equity sponsors willing to engage in aggressive financing practices to protect their equity values at the cost of creditors.

In response, creditors began to form committees prior to an actual default to have some type of unified group to contend with an aggressive borrower. The result was a bifurcated outcome between those on the committee and those outside the committee.

Creditors on the committee often negotiate from a position of strength and receive the best restructured securities. For example, the debt is usually the most senior in the capital structure with an attractive yield and rigorous credit documents that ensure better creditor protections should an actual default occur in the future. Additionally, various types of equity participation can be on the table as a further sweetener.

Creditors outside the committee have often seen significant principal losses relative to those on the committee. Additionally, their seniority can be pushed lower, resulting in less attractive credits on the secondary market and an increased likelihood of a less favorable outcome in the event of a default.

Potential implications of Liability Management Exercises (LMEs) for institutional portfolios

This new dynamic raises important considerations for asset owners who allocate to credit through third-party managers. As the rules of engagement between borrowers and creditors continue to evolve, visibility into how managers respond to these complex situations becomes increasingly relevant. Understanding how these decisions play out in practice can help investors assess whether their portfolios are exposed, protected, or positioned to take advantage of these evolving market dynamics.

Where there is disruption in markets, there is also opportunity. The disruption caused by higher interest rates and LMEs presents several paths forward:

1. Some investors may seek to avoid LMEs, though this can be challenging
2. Investors may benefit from managers who can proactively engage through creditor committees
3. Tactical flexibility may help investors navigate shifting market dynamics
4. Specialist strategies may provide ways to access value in distressed or defaulted credits

At WTW, our focus is on selecting third-party managers with the insight, flexibility and governance mindset who are best positioned to perform well in a variety of market environments. By looking beyond surface-level performance and understanding how managers operate when markets are less orderly, we aim to help our clients build credit portfolios that are not only resilient, but also well-positioned to uncover opportunity amid dislocation.

Footnote

2. Source: Fitch Ratings, “Liability Management Transactions Drive Down U.S. Recoveries in 2024.” Return to article