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Sponsors try to tame net short activists with covenant magic

Lawyers in the US have had a busy 2019 drawing up tough documentation to protect borrowers and sponsors from CDS investors — net short activists — trying to get their say on the future of a company. With these provisions spreading to Europe, 2020 could be an even busier year

Sponsors and borrowers are increasingly worried over the power wielded by credit default swap investors who buy into bonds or loans to get their say on the future of a company. These net short activists have an incentive to vote against a restructuring plan or call a default, potentially pushing a viable business into bankruptcy. 

In May this year, the fears were realised when the first provision designed to curb net short activists appeared in a loan document for Sirius Computer Solutions, a US data services company which was being acquired by private equity firm Clayton, Dubilier & Rice. The sponsor was advised by lawyers from Kirkland & Ellis, which is widely seen as one of the firms associated with the erosion of investor protections in leveraged loans and high yield bonds.

Since then, net short provisions have been appearing regularly in the US and making their way to Europe too — including in Merlin Entertainments’ buy-out financing in October. 

“The net short provisions are here to stay,” says Todd Koretzky, a partner at law firm Allen & Overy in New York. “Conceptually, they are a justifiable attempt to dig a moat around a company. But it’s an elaborative process between the lawyers, arrangers, sponsors and the companies to ensure that a balance is struck so that lenders won’t shy away from the credit.”

The net short provisions were born out of the bankruptcy of US telecommunications company Windstream. It lost a court battle in February against hedge fund Aurelius, forcing Windstream to default on its bonds. Aurelius is reported to have pocketed about $310m over the collapse of the company. 

John Williams, a partner at law firm Milbank, now sees net short provisions “a couple times a week” in the US — either in leveraged loans, direct lending or high yield bonds. 

“About two-thirds of the time the provisions get taken out. The remaining third of the time our comments are ignored, and the provision stays. It’s very rare that people actually try to engage and improve the language,” Williams says. 

Creditors’ upper hand

The provisions are much more likely to clear in the loan market than in the bond market, Williams says — adding that they are almost always removed in the direct lending space, where the creditors still maintain an upper hand over the covenants. 

Broadly syndicated loans tend to be bought by passive institutional investors who are often not invested in CDS instruments at all, explaining why the provisions have the easiest time clearing in this market. However, according to Koretzky, some of the loan investors dislike the provisions because of the additional work they cause.

Koretzky and Williams have worked on different modified versions of the net short provisions that would provide clearer definitions on what qualifies as “net short” and a simpler way for the investors to prove that they are long on the company. This includes tough calls on which affiliates of the investor will be included into the calculation.

Williams has so far seen 30-40 deals in the US with a proposed net short provision in them, and he’s not happy with the muddled language of the documents. His suggestions include limiting the consequences of the provisions to just disenfranchising the net short investors — in other words, taking away their voting power in creditor decisions.

“We are adamant that any further consequences, like triggering a default or forcing [the company] to sell, should be removed from the documentation,” Williams says.

For lenders that are already inclined to be passive, net short provisions give them an additional reason to avoid voting — which in certain situations could harm the borrower. 

In Europe, net short provisions are still exotic visitors. Bain-backed market research company Kantar and Apax and Warburg Pincus-backed satellite operator Inmarsat were forced to flex the terms of their buy-out bonds this autumn, after the investors pushed back on net short and other covenants. 

UK theme park operator Merlin, which is being bought by Blackstone, Lego billionaires and Canadian pension fund CPPIB, managed to squeeze through net short provisions for its bonds and loans in October, in addition to a laundry list of other aggressive covenants — slammed by analysts as the worst ever. 

Merlin is not necessarily representative of the European sentiment, says Jane Gray, head of European research at Covenant Review. “Investors spend more time on documentation concerns than ever before,” she says. “Unless the credit is really well liked, investors are consistently pushing back on the terms. But Merlin was so heavily oversubscribed on the bond and the loan that there was no bandwidth to push back.”

The bond investors see the CDS market as “integral to the success of the functioning bond market”, says Shoshanna Harrow, a senior analyst at Covenant Review. 

“Because net short provisions are so new, they are very close to the top of the list of things that the investors want to push back on,” she says. “The problem is that lawyers can now say there’s a precedent with Merlin.”    GC