Distress & Turnarounds

Drop-down Financings and the Trapdoor

Follow the exact basket-by-basket path a company uses to move its best collateral outside the reach of its lenders, and learn to price that path before you lend, not after.

  • Expert
  • 13 min total
  • 13 chapters

What decision this helps you make: Whether the covenant package you are about to sign, buy, or enforce permits the borrower's most valuable assets to be moved beyond your collateral and used to raise debt ahead of you.

What this topic is

A drop-down financing moves valuable assets out of the group of entities that guarantee and secure existing debt, into a subsidiary the credit agreement no longer restricts, and then borrows against those assets at the new entity. The old lenders keep their liens on everything that remains. What left is gone from their collateral, and the new lenders sit in front of it. The "trapdoor" is the two-step route that makes it possible: assets move first to a subsidiary that is restricted but is not a guarantor, and then out to an unrestricted subsidiary using a different basket.

Why it matters

Every leveraged credit agreement and high-yield indenture contains investment baskets and a mechanism to designate subsidiaries as unrestricted. Those provisions exist for ordinary purposes: joint ventures, acquisitions, ring-fenced projects. Since 2016 they have been used for something else: to carve the crown jewel out of the collateral package of a company heading for trouble. If you hold the debt, the size and shape of those baskets is not a technical detail. It is the ceiling on your recovery.

Who should learn it

Credit investors and analysts, high-yield and leveraged-loan underwriters, restructuring lawyers and advisers, private-credit funds negotiating documentation, and sponsor and portfolio-company finance teams who need to understand what their documents permit and what it costs to use it.

What you will understand

  • What an unrestricted subsidiary actually is and how designation changes the covenant package
  • The precise basket path of a trapdoor transaction and where the capacity comes from
  • How the J.Crew, PetSmart, Neiman Marcus and Envision structures each differed
  • Which legal challenges have traction (covenant breach, fraudulent transfer, fiduciary duty) and which mostly do not

Prerequisites

Common misconception

"Our collateral package covers substantially all assets, so we are protected." It covers substantially all assets of the loan parties, as those parties exist from time to time. A credit agreement is a moving definition, not a photograph. If the borrower can designate a subsidiary as unrestricted, that subsidiary stops being a loan party, its guarantee is released, its assets leave the collateral pool, and its debt stops counting against the covenants. Nothing was stolen. A definition was updated using capacity the document gave the borrower on the day you signed it.