US private-equity firm Clayton Dubilier & Rice has moved to curb the influence of credit default swap holders in the financing for its latest acquisition, following a string of controversies involving aggressive lenders agitating for company defaults.
Legal fine print in CD&R’s nearly US$1bn leveraged loan funding its buyout of data services provider Sirius Computer Solutions prohibits investors that own CDS positions from voting on company matters, according to sources familiar with the loan credit agreement.
The provision aims to prevent investors that are net short the company through CDS from pushing the company into default to trigger payouts on their CDS contracts, a move that would benefit their own bottom line potentially at the expense of the borrower and other creditors.
In the future, companies may also consider blocking such CDS holders from owning their loans altogether, two sources said.
The move to include the new tougher language follows a series of controversies involving CDS holders influencing debt restructurings. That includes two highly-publicised US court cases, one involving homebuilder Hovnanian and the other telecoms services provider Windstream.
It is yet not clear whether clauses restricting lenders from holding CDS positions will become widespread in the US$1.2trn leveraged loan market. But such provisions have been debated on a number of draft deal documents recently, said Adam Freeman, head of the leveraged finance practice for law firm Linklaters in London.
“That is very new and very controversial,” he said.
“Essentially, it’s the same aim – the sponsors seeking to control who it is that owns their debt, for obvious reasons.”
AGGRESSIVE
Private-equity owners have taken advantage of easy borrowing conditions in recent years to limit how much aggressive investors, such as distressed funds, can own their debt to give them greater leeway if the company runs into trouble.
Default swaps in effect provide insurance for investors who own a company’s loan or bond. If a company defaults on its debt, 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 tip the related company into default.
That has prompted companies to try to tighten loan documentation to limit aggressive investors from pushing agendas that benefit their CDS holdings, but harm the company.
“This is part of the broader recent narrative of clamping down on ‘misuse’ of CDS,” said one credit strategist at a major bank.
It would also appear to be a pre-emptive move from CD&R, given that there currently aren’t CDS prices quoted on Sirius, according to data provider IHS Markit.
INVESTORS DIVIDED
The Sirius provision has divided investors. A number are concerned that some proposals, especially one that completely blocks CDS holders from owning the loan entirely, could limit the buyer base. That could make it more difficult to sell the debt, especially in a distressed situation. But others said they took comfort in knowing their fellow lenders would not have conflicting loyalties.
“It helps if everyone tries to work out the best solution … and not have one party at the table that tries to make a huge gain at the expense of everyone else,” said Galina Goryacheva, a credit analyst at Prosperise Capital, a London-based credit hedge fund.
Sirius included the CDS language in its credit agreement for a US$940m loan financing to back CD&R’s acquisition of the company from Kelso & Co that wrapped up last week.
The credit agreement was tweaked last Tuesday to appease CLO managers that felt they could be unfairly penalised under the original terms of the deal as it stated that any investment manager that bought the loan that also owned CDS, regardless of the type of fund (including CLOs), then all the funds managed by that manager could not vote.
After the CLOs successfully argued that they are managed separately from their firm’s distressed debt and hedge funds, Sirius amended the terms so that any hedge fund that buys the loan and has CDS is unable to vote, but if the CLO also bought the loan (and does not own CDS) it can vote.
The prohibited votes in the Sirius agreement will be deemed to have voted with the majority of holders that do not have CDS positions.
TRIGGER WARNING
Regulators have raised concerns about the perverse incentives that could arise from lenders buying CDS protection and then seeking to engineer a so-called manufactured default.
Some lenders appear to have done just that. Solus Alternative Asset Management filed a suit last year after Blackstone Group’s GSO Capital Partners helped to arrange a financing package for Hovnanian that would prohibit the homebuilder from making its next interest payment, triggering CDS payouts. GSO had allegedly built CDS positions that profited from the defaults.
The International Swaps and Derivatives Association subsequently proposed updates to credit derivatives documentation aimed at preventing otherwise healthy companies from defaulting on their debt to benefit CDS holders.
In a separate case, Windstream filed for bankruptcy in February 2019 after a court ruled in favour of Aurelius Capital Management, which 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, encouraging it to argue that Windstream had defaulted.
Additional reporting by Christopher Whittall
