Hedge fund Blackstone GSO appears to have pulled off a major coup on its credit investments in Norske Skog, after it emerged an apparently ill-fated sale of default protection ahead of a recent credit event is unlikely to lead to significant losses.
Credit market participants were left scratching their heads last week after an ISDA Determination Committee ruled unanimously that an April agreement to reduce Norske Skog debt through a bond exchange with GSO and Cyrus Capital Partners was a restructuring under ISDA’s 2003 and 2014 credit derivatives definitions.
Bondholder GSO had also sold significant volumes of CDS on Norske Skog, suggesting the DC decision would land the fund with a large payout and considerable egg on its face after it masterminded the exchange that precipitated the CDS liability.
As it turns out, that may not be the case. Due to the quirks of the auction process that will determine payouts on US$281m of net notional outstanding Norske Skog CDS, the fund may be left relatively unscathed.
“Restructuring is a special credit event which is seen to be less severe than a straightforward failure to pay,” said a lawyer with knowledge of the situation. “For that reason slightly more protection is given to the seller of protection, which is manifested through the auction process used to value the CDS.”
Under the ISDA 2014 definitions the auction following a restructuring divides the restructured company’s bonds into buckets depending on their maturity, with those buckets strictly deliverable against CDS of similar tenors. That means if a company sells one-year CDS then the most likely bonds to be deliverable into that contract will be those with one-year maturities and, crucially, nothing else.
In the course of a New York court case, in which funds – including BlueCrest – that had bought credit protection on Norske Skog sought to block the restructuring, it emerged that GSO has sold short-dated protection on Norske Skog. At the same time BlueCrest alleged that GSO had also bought longer-dated protection.
That means its exposure on its short-dated CDS will be calculated by a mini-auction of a bucket of shorter-dated bonds, which are trading at or near par. As the CDS payout is a function of the difference between the auction price and par (or the loss to bondholders) it can be assumed that the GSO CDS liability will be minimal.
According to some market participants, GSO will have foreseen that a credit event was likely following the restructuring, but would have sold CDS anyway having calculated that the bucket system under the restricting auction process would work in its favour.
“The 2016s are trading near par because they (GSO) own a massive amount of them,” said one hedge fund manager. “They’ve designed it so there’ll be no deliverables – it’s a mechanical thing so they don’t care whether it triggers or not.”
GSO declined to comment.
Another concern, said the fund manager, was the auction process itself, which appears to allow investors that accumulate positions in bonds and CDS to ensure they don’t get hit by credit events.
“There’s no transparency about these auctions,” he said, “So the regulators just have no idea…. and don’t have a clue what it means when there’s a really high recovery in a certain bucket.”
A spokesperson for ISDA was not immediately available for comment.
Under the terms of the April exchange, Norske Skog offered to swap €218m of its 7% notes due in 2017 for notes due 2026, perpetual notes and the right to subscribe to shares. Some 77% of the notes were tendered, exceeding the 75% threshold required to bind all 2017 notes to the terms of the offer.
GSO and Cyrus are the largest holders of Norske Skog unsecured bonds and aside from the exchange have provided additional finance for the company through an 11.49% equity stake purchased in December and a €95m securitisation facility. Much of that cash will be used to meet a US$121m June repayment on the Norske Skog 2016 bonds.