Liability Management Transactions (Part II): Drop-down Transactions

As we discussed on Part I of this series, liability management transactions have become commonplace in the restructuring arena. Both “uptier” and “drop-down” transactions are often viewed as viable options for distressed borrowers. Here in Part II, we address drop-down transactions and some representative cases where a borrower’s ability to implement a drop-down has been tested.

Drop-down Transactions

In a drop-down transaction, a borrower utilizes basket capacity under existing investment and restricted payment covenants to transfer collateral away from the restricted entities to an “unrestricted subsidiary.” Being unrestricted, the subsidiary is typically not required to be a guarantor (and, accordingly, does not pledge its assets as collateral), nor is it subject to the covenants in the financing agreements. Thus, the unrestricted subsidiary is often free to issue new debt, which is then secured by the newly transferred assets.

Unlike uptier transactions, drop-down liability management transactions do not necessarily require the consent of the majority creditors, although subsequent ratification of the transaction is often sought and obtained from participating majority creditors to avoid litigation. Recent drop-down transactions highlight how many borrowers and sponsors perceive financing agreements to be extremely flexible, providing ample room to undertake these transactions.