As the level of default and the volume of distressed debt start to climb again, the next round of corporate debt restructuring will have very different dynamics to those seen during the last peak in default rates in 2001-03.

Many of the early defaults in the last cycle arose in new technology companies funded with large amounts of public high-yield bond debt and, often, no significant bank debt. The European high-yield bond market had grown from a few billion dollars in issue at the end of 1997 to more than $50bn (£26.27m) by the end of 2000. Of this, 70% was concentrated in technology, media and telecoms, including long distance cable, such as GTS and Viatel, and local exchange providers, such as Energis, Versatel and Song Networks. Subsequent restructurings of large companies such as Marconi, British Energy and Drax also involved substantial levels of bond debt.

By contrast, most of today's large distressed companies are the product of leveraged private equity buy-outs funded by buy-out debt. At the same time, the volumes of debt traded on the secondary market – both senior and junior – have increased dramatically as hedge funds and proprietary bank investors have stepped up their investments in distressed debt. These changes will have a significant effect on the dynamics of debt restructuring negotiations.

. Most high-yield bonds issued in the period up to 2003 were structurally subordinated to any senior bank debt, but contractual subordination was very rare. Buy-out debt, on the other hand, is generally composed of several layered facilities all secured at the same level and subject to contractual subordination. These arrangements will create the potential for complex intercreditor dynamics.

. The increase in second lien debt and more complex financing structures will result in complicated and probably confrontational restructuring negotiations as senior, second lien and mezzanine debt trades into the hands of secondary investors with differing motivations and goals, often holding debt in each layer.

. Maintenance covenants in bank facilities are generally tripped long before the looser 'incurrence' covenants typical in bond instruments, but intercreditor provisions can force junior creditors to wait many months before they can take action.

. The presence of a strong controlling shareholder introduces a highly-motivated stakeholder into the piece – a stakeholder which is able to exercise direct control over management.

. The availability of capital over the past few years to finance secondary buy-outs, and to refinance stressed capital structures, will mean that companies may be in serious financial difficulty by the time they commence discussions with their creditors.

. The involvement of large numbers of secondary investors, with active trading strategies and often holding sub-participations in debt, will make it difficult to operate traditional bank steering committees or to conduct confidential behind-the-scenes negotiations with creditors.

In the US, senior creditors whose economic interests are fully covered by the company's assets have virtually no say in the approval of a Chapter 11 plan of reorganisation. In the UK, and most of Europe, on the other hand, senior creditors enjoy extensive powers, even when they face almost no risk of impairment. The legal rights of senior lenders are invariably reinforced in the European buy-out market by one-sided and comprehensive intercreditor agreements that confer on senior lenders a monopoly right of enforcement for several months following a default.

As a result, junior creditors have to look to senior creditors, particularly senior agent banks, for support in restructuring discussions to help them drive through debt-for-equity swaps or refinancings. However, a wide variety of financial institutions are now investing in senior debt on original syndication. Moreover, senior debt which would previously have remained in the hands of commercial banks for the duration of a restructuring has been trading in increasing volumes, at increasingly high prices and at an increasingly early stage. Secondary investors will often buy senior secured debt at a time when the company is commencing discussions with its second lien or mezzanine creditors, even if the senior debt is trading at par and fully covered by the available assets. This is because senior debt gives them a great deal of control with little economic risk. In the Jarvis work-out, for example, the commercial banks sold out all of their debt, at relatively high levels, long before the final restructuring was concluded.

The active trading of debt at all levels of the capital structure means that extensive rights of senior lenders, traditionally held by the major commercial banks, are now found in the hands of secondary investors with different goals and motivations.

The Vantico restructuring in 2003 saw a private equity firm acquire a blocking stake of more than 34% in the senior secured debt of a European chemicals company, the day after bondholders announced a debt-for-equity swap of their bonds for 95% of the company's equity. Although bondholders were ultimately able to arrange a refinancing of the senior debt, they did so under considerable pressure. It was recognised that, in other situations, subordinated creditors could face serious losses if senior creditors sold out early to secondary investors intent on gaining control of the company. In that case, the entire steering committee of banks, other than the agent bank, sold all of their debt within 48 hours of their first meeting with bondholders.

The withdrawal of the main banks during a restruc-turing can also cause significant changes to the negotiating dynamics. Lenders lose the leadership of an agent bank or steering committee which would have dedicated experienced personnel to long hours of negotiations, research and documentation. The company loses its principal source of short term and revolving facilities that enable it to continue trading while negotiations continue. An ad hoc committee of secondary lenders is often less well equipped to carry out these functions.

In other cases, as happened during the restructuring of Queens Moat Houses, the agent bank divests all its economic interest in the debt and only remains in office due to the practical difficulties of appointing a replacement agent. In these circumstances, performance of the agency function becomes more strained as the agent will naturally become more risk averse.

Even when the original lenders hold their debt, in some recent restructuring deals, creditors have perceived a reluctance on the part of agent banks and senior creditors to take steps that might offend the private equity sponsors. Secondary investors complain that the commercial banks have an eye to the next deal where they may be competing to provide debt finance to deals sponsored by the same private equity funds. Senior banks are also accused of being more interested in the opportunity to refinance the company's debt – and earn large refinancing fees – than achieve the best outcome for all creditors.

The close relationship between equity sponsors and management has a major influence on the dynamics of debt restructuring negotiations. Creditors frequently grumble that directors of insolvent companies exercise their powers as managers to strengthen the bargaining power of shareholders to the detriment of creditors, despite their legal obligations to act in the interests of creditors. Where a company's equity is listed or widely held, it is difficult for shareholders to become personally involved in debt restructuring negotiations, and management acts as a proxy to represent their interests.

In private equity-backed companies, however, where a single equity holder is in direct control of the composition of the board, directors find it more difficult to ignore the demands and interests of the equity sponsors by whom they are appointed. They may owe their next job to the whim of the very sponsor who has appointed them in this case.

This relationship can allow shareholders to press their interests disproportionately strongly during negotiations. While shareholders of an insolvent company generally have the right in this country (and elsewhere in Europe) to withhold their approval of a debt-for-equity swap, creditors can be prejudiced if management deny them co-operation and assistance in those negotiations. It is generally critical in these cases that the private equity sponsor ensures separate representation for the company and itself. Once the company has independent advice as to its own position, a negotiation can take place with its creditors, on terms that more fairly reflect the different stakeholders' rights and economic interests.

Although the buy-out market remains vigorous, there has been a discernible increase in the number of failures. Subordinated creditors, who are generally those most affected by delay and expense in the restructuring process, want the opportunity to rescue companies once equity sponsors' efforts have failed. If lenders, private equity sponsors and management can overcome the challenges created by increased debt trading and more complex debt structures, less time and energy may be wasted on fruitless confrontation among the different stakeholders, at a time when the company needs urgent support to preserve the value in its business and customers.

James Roome is managing partner of Bingham McCutchen in London and co-head of the firm's financial restructuring group.