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‘Net short’ language crosses a line

By Owen Sanderson
09 Jul 2019

Leveraged loan and high yield bond documentation is starting to see a new feature creep in — anti “net short” language, which attempts to stop creditors that are short the company from getting a place at the table in a restructuring. The funds targeted by the new provisions aren’t exactly the cuddliest citizens of the capital markets, but they won’t be the only casualties.

The CDS market is having an existential panic, driven by a series of situations where, instead of operating as a hedge to a corporate debt exposure, it acted as a tool to allow some funds to manipulate corporate bankruptcies and restructurings to benefit their derivatives positions.

Sometimes, this took the form of offering financing to keep companies going longer; on one other occasion, that of Aurelius Capital Management and Windstream, it meant forcing a solvent company under with a court judgment.

CDS traders, under the umbrella of trade body the International Swaps and Derivatives Association, are making efforts to stop these strategies working through tweaking the mechanics of CDS contracts. They are under pressure from regulators, who unveiled as-yet-unspecified “collaborative efforts” to address these approaches, which apparently raised “various issues under securities, derivatives, conduct and anti-fraud laws”.

But companies raising new leveraged credit facilities are taking matters into their own hands. Loans backing Clayton Dublier & Rice’s buyout of Sirius Computer Solutions contained language to deprive “net short” creditors of a place at the restructuring table, as will the bonds financing Blackstone & CPPIB’s buyout of Merlin Entertainments.

Both deals have been documented by Kirkland & Ellis — and use very similar phrasing.

But in both cases, the new clauses could damage market participants beyond the intended targets.

The difference between a credit fund that researches a leveraged company carefully, takes up a short position using CDS, and then wants to maximise its pay-off in the subsequent auction, and a company that wants to “manipulate” this auction, having previously gone short, is a question of intent — and one for the philosophers.

Perhaps some tactics, such as Aurelius dragging Windstream through the courts, to the detriment of other creditors, forcing the company into insolvency, look more aggressive than others.

But frankly, all distressed debt strategies run the risk of turning nasty. The pie isn’t big enough for everyone that wants a slice — otherwise the companies wouldn’t be distressed.

Trying to deprive certain creditors of their rights also deprives active fund managers from doing the detailed, difficult, high conviction research required to put on a large CDS short position in a single name.

This is bad for markets — rewarding people for being better informed than others is precisely how the price mechanism is supposed to work. Restrict the rewards to short selling (or layer this with legal risk) and you make market prices less functional.

Now, acting on the CDS side of the market is a different matter. They are contracts supposed to hedge against default. If hedge funds can pull tricks like that involving house builder Hovnanian’s “selective default” and off-market financing rigged to trade below par, these contracts no longer work properly.

That’s a matter for the CDS market to agree on, and it’s working on it. But it’s not constructive for companies, or their private equity backers, to start trying to undermine the whole concept of writing CDS on corporate debt from the other side.

Leveraged credit buyers can perhaps accept the repeated erosions of various other creditor protections — that’s just one regrettable part of a market with more buyers than sellers — but there ought to be a line drawn where sponsors want to restrict trading.

It’s one thing to say “buy our debt, here are the terms” but quite another to restrict how their creditors can act and trade afterwards.

Good thing, then, that it might not work.

By Owen Sanderson
09 Jul 2019