‘Net short debt activism’ or ‘narrowly tailored credit events’ have caused a stir since at least 2013, when GSO’s intervention in Spanish gaming company Codere’s restructuring prompted a segment on “The Daily Show”.
But this year, efforts to restrict CDS-based fun and games has entered high gear — the International Swaps and Derivatives Association has tried to tackle narrowly tailored credit events with a new set of contracts, regulators have got involved — and borrowers themselves have tried to take steps to prevent CDS positioning from interfering with a potential restructuring.
That didn’t stop CDS dynamics affecting the collapse of Thomas Cook earlier this month — the troubled travel company tried to default by filing for US Chapter 15, which would have allowed some bondholders to collect on their protection payments, freeing them, in turn, to support a consensual restructuring.
One fund, reported the Financial Times, positioned long through the bonds and through selling protection, even tried to offer Thomas Cook rescue financing, on condition that it structured the rescue to avoid triggering CDS contracts.
For sponsors, though, the greatest worry is the fate of Windstream, which was pushed into bankruptcy by Aurelius Capital Management, in a court case presumed to be driven by the CDS Aurelius had bought.
Several deals so far have therefore introduced provisions to prevent a fund which is ‘net short’, through CDS or other instruments, from influencing a restructuring.
A leveraged loan for Sirius Computer Solutions had this provision in first, but now two of the biggest LBOs to hit the European market are trying it. Investors forced the provision to be dropped from the dollar-denominated bonds backing Apax’s take-private of Inmarsat — but it is not yet clear whether euro bond buyers will hold the line for deals for Kantar and Merlin Entertainment and strike down these terms.
Whether or not they end up in bond docs, it’s far from clear that the provisions would actually work.
In both deals, the language is identical, and works like this: investors seeking to trigger an event of default, an acceleration or take any other action will have to represent that they are not ‘net short’, provide the issuer information required to verify this claim, and provide a ‘verification covenant’ attesting this.
If the issuer has “a reasonable basis to believe” an investor is in breach of its position representation, the cure period for any event of default will be automatically stayed until directed by a court. A majority of noteholders can choose to waive any existing default and rescind any acceleration.
While this addresses some of the likely problems with adding net short language to bonds, it remains vulnerable to a determined player. A hedge fund wanting to direct a default might be perfectly happy to see it play out in court, expecting that, regardless of their “verification covenant”, a default is a default. The “verification covenant” and position disclosures are also legally questionable, untested and could still be vulnerable to gaming — and it remains to be seen how trustees, who will be responsible for enforcing these provisions, will react.
More importantly, it risks antagonising even investors who have no intention of putting on short positions to run activist strategies. Many funds would be deeply uncomfortable disclosing their positioning to Blackstone or Bain simply to exercise their bondholder rights and have a seat at any restructuring discussion.
It would also render basis trading strategies in which an investor goes long the cash bond and short through CDS markedly less attractive. The point of the strategy is that the cost of hedging a position is sometimes lower than putting the position on, so there’s an arbitrage profit available. But if the issuer becomes distressed, this leaves basis funds automatically 'net short' just because of market value.
Nonetheless, the provisions, if they do find their way into the final deal terms, do not have to be watertight. The point is not that ‘net short’ strategies become impossible — just very, very difficult will do fine. It’s already a high risk, niche strategy, despite the profile of the cases where it succeeded. Even if the new language can’t kill these approaches off entirely, they raise the barriers to entry even higher, and for Bain and Blackstone, that might be enough.