Provisions aimed at curbing the influence of derivatives holders could soon find their way into leveraged loan documents in Europe, lawyers say, suggesting these clauses may become more widespread following a string of controversies involving aggressive lenders.
Language explicitly barring investors with net short positions through derivatives from voting on company matters recently appeared in the fine print for US private-equity firm Clayton Dubilier & Rice’s nearly US$1bn leveraged loan funding of its buyout of Sirius Computer Solutions.
That deal represented the first high-profile move from the private-equity industry to safeguard investments from aggressive lenders building short positions in a company through credit default swaps and then agitating for the company in question to default on its debt.
Leveraged finance lawyers on both sides of the Atlantic have taken note and are considering including such provisions on more deals in the future.
And even though they are not being discussed on current European loans, London-based legal practitioners say it is only a matter of time.
“It’s definitely coming,” said Chris Kandel, a partner at law firm Morrison & Foerster in London. “I think you will inevitably see this in loan documentation” though not in bonds, he added.
BORROWER FRIENDLY
Rampant demand for loans in recent years has allowed private equity firms to control how easily investors such as distressed debt and hedge funds can buy their loans. That is to give the PE shops more wriggle room if the company they own runs into trouble.
But it is the actions of a handful of aggressive debt funds in some one-off cases involving credit default swaps that have sparked the latest efforts to protect their investments.
CDS in effect insure investors against a company missing a payment on its loans or bonds. If the company defaults, the contract is triggered and the owner receives a payout. The worry for borrowers is that investors could buy CDS protection and then seek to push that company into default to turn a profit.
In one notable case, US telecoms services provider Windstream filed for bankruptcy in February 2019 after a court ruled in favour of Aurelius Capital Management. Aurelius had alleged that a 2015 spin-off of the company’s telecommunications network assets violated its agreements with bondholders. Aurelius had also allegedly built a CDS position, potentially encouraging it to argue that Windstream had defaulted.
In another high-profile case, Blackstone Group’s GSO Capital Partners allegedly built up a CDS position in US homebuilder Hovnanian and then helped to arrange a financing package for the company that would prohibit it from making its next interest payment, triggering CDS payouts.
“We have seen a few provisions recently that are undoubtedly responses to the issue of the net-short debt activist in general,” James Wallick, a US-based senior covenant analyst at Xtract Research, wrote in a report last week.
EXPLICIT BANS
It is already commonplace in European loan documents to include provisions designed to stop lenders transferring the exposure of a loan to another investor that the private equity firm doesn’t want to own it - either through derivatives or other financial instruments.
Lawyers say it is highly likely more private equity firms will look at explicitly banning funds that have built up a short position in the company through the derivatives market from voting on company matters.
Still, some doubt it will become widespread. For one thing, investors may push back against anything that could hamper the ease of buying and selling the debt in the secondary market.
“People are very focused on the liquidity” of loans, said one senior London-based lawyer.
Some also point out that such provisions may be difficult to enforce in practice as private equity firms would have to rely on the investor buying the loan to self-certify that they didn’t hold a net short CDS position.
Even so, that is unlikely to prevent more private equity executives from trying to include these provisions in future deals.
“It’s a relevant consideration for sponsors given what’s happened in the States” with CDS holders, said Adam Freeman, global head of the leveraged finance practice for Linklaters in London.
“This focus on trying to restrict transfers and control who owns the debt is a continuing battleground” between borrowers and lenders, he added.
(Additional reporting by Prudence Ho.)
(This article has been corrected to clarify that the legal provisions in question seek to bar investors with net short positions via CDS from voting on company matters. An earlier version of this article stated that lawyers were looking to stop CDS holders from buying loans altogether.)
