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US levfin buyers get piecemeal progress in fight for better terms

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By David Bell
14 May 2018

New terms are emerging in US leveraged finance documentation, as investors try to push back against the loosening of investor protections, but critics claim such provisions are too narrow and too ineffectual to stem the tide of a seller’s market.

The actions of US clothing retailer J.Crew in 2016, when it moved valuable intellectual property assets out of the borrower group and used them to raise new debt, has prompted some investors to try and stop new borrowers from using the same tactic in new deals.

The so-called “J.Crew blocker” has been included in a handful of deals since March this year, according to credit research firm Covenant Review, including new offerings from Guitar Center, McDermott, P.F. Chang's, and a deal from Platinum Equity-owned WS Packaging, which closed on March 29.

The J.Crew trapdoor, as it’s known, is now on some investors’ checklists as a forbidden provision, meaning they don’t buy the deal if it’s included.

“People are really turned on to the risk of it now, both in new issue deals and also when looking at the risk in companies that have the [trapdoor] risk sitting there,” said Adam Cohen, founder of Covenant Review.

Not widespread

But there’s also scepticism over how widely the blocker is used, and how effective it is at preventing the transfer of intellectual property. The term also has little impact for companies that have limited IP, other sources have pointed out.

Justin Smith, managing director at Xtract Research, said that the J.Crew blocker has only emerged in 14 credit agreements out of 730 the firm has analysed since the J.Crew manoeuvre. “This is clearly not widespread,” Smith wrote in a note to clients last Friday.

“There’s a disconnect between what investors think companies can do, and what an aggressive sponsor could actually do if they wanted to take action under the terms of the documentation,” Smith told GlobalCapital.

Borrowers are allowed some degree of flexibility to move assets around their business, in and out of the borrowing entity, in order to manage their business effectively. But investors ideally want some kind of restriction on this, to protect the collateral their debt is secured on.

One loophole that is concerning investors is where a borrower can use “investments” in unrestricted subsidiaries to get around restrictions on paying dividends back to a parent company, for example.

“The concept has really broadened in terms of what an investment is. This can be used to do a distressed exchange, or pay off debt at the holding company. Often sponsors are able to say, technically, the documents allow this, even if it wasn’t the original intent,” said Smith.

The scale of the erosion of investor protections is such that some critics argue the focus on the “J.Crew blocker” on intellectual property is too narrow. A lawyer at the LSTA/LMA joint conference in New York last week said that there would need to be a broader range of blockers depending on what kind of assets each borrower has.

But Cohen said that progress was more likely to be made on a specific basis, rather than aiming too broadly.

“You can get people focused on a particular problem when a specific bad thing has happened,” he said. “If you try to focus on too much it can go nowhere.” 

Drastic change required

The success of such efforts seems dependent on supply/demand dynamics in the loan and bond markets.

“Investors have become more aware of these issues and that meant that there were more changes to the documentation during a recent bout of market weakness. But one month from now that could all be forgotten,” Cohen said.

That was echoed by a CLO manager. “We’ve passed on deals where [certain loose terms] haven’t been changed. But it’s a seller’s market, so docs are getting more liberal. Whether it’s liberal restricted payment tests, or the ability of borrowers to incur incremental debt, we’re seeing it all,” he said.

“Sometimes we do have success when everyone moves in the same direction, but other times when it’s a higher quality deal, people don’t pay as much attention to it,” he added.

Smith said it was unlikely to see any significant improvement in investor protections until there’s a “drastic” change in the supply-demand dynamic. According to JP Morgan, gross loan issuance of $344.3bn in the year to date is down $95bn from last year’s figures, although net issuance is tracking 14% ahead of last year’s pace, the bank said.

But that’s still not enough to keep up with surging demand from CLO managers and mutual funds that need to put cash to work.

“There are plenty of investors waiting in the wings to invest on these terms,” said Smith. “It’s credit that folks are looking at at the moment, not the covenants.”

By David Bell
14 May 2018