Minority Creditors: Managing Debts Out of Their Depths
By: Roy Zhang & Peter Matthews
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
A Broken Covenant
As interest rates fall globally and the United States Federal Reserve continues to emphasize expansionary monetary policies in the wake of the COVID-19 pandemic, investors have become desperate to find attractive yields in the credit markets. Since 2005, the private credit market has expanded dramatically. Regulations imposed on banks following the crisis limited their ability to distribute capital to companies, forcing businesses to seek out alternative forms of financing. These factors culminated in the expansion of the private credit market from approximately $300 billion in 2010 to over $750 billion in 2018. Today, the private credit market is estimated to exceed $1 trillion, and this growth is expected to persist indefinitely as risk continues to shift off the balance sheet of regulated banks. However, with over $250 billion in uninvested capital sitting in private credit funds, it will be difficult for these firms to find returns that justify their fee structure.
Over the past decade, these factors have led creditors to become more flexible in structuring debt. Adam Cohen, Managing Partner at Caspian Capital, remarked that funds were so focused on growth that they often neglected the structure of the credit documents—legal documents outlining the term, cost, structure and covenants of the debt. This is evident through the expansion of covenant-lite loans since 2012. The LCQI score is a proprietary Moody’s measure of covenant protections provided to investors in the leveraged loan market. It scales from 1 to 5, with 5 denoting the greatest disregard for covenants; this indicator has risen from 3.2 in 2012 to over 4.0 in 2020. Additionally, a Bain Capital report in 2019 observed that 80 percent of outstanding loans by market value were deemed covenant-lite, compared to just 20 percent in 2012.
Another contributing factor to changes in debt structuring is the current market stage of the credit cycle. The expansion of credit markets following the financial crisis has been robust, and as a result of the liquidity crisis caused by the global pandemic, corporate and high-yield debt issuances have continued to achieve record highs. As the volume of debt issuances increases, the opportunities to invest credit in the future with a reasonable risk-return profile will become less prevalent. Therefore, credit investors are being compelled to infringe on the value of other creditors’ stakes to enhance their returns. This environment has made “loophole investing,” a phenomenon coined by Adam Cohen, possible.
Jumping Through Loops
Before understanding how creditors use these loopholes to generate returns, it is important to understand the mechanics of bankruptcy. Bankruptcy occurs when a company faces a liquidity event in which it cannot make the required payments such as principal on debt or interest payments. When a company declares bankruptcy, it enters into an automatic stay, which prevents creditors from taking action to retrieve value from the debtor. Bankruptcy gives companies the opportunity to “restructure” their capital structures by eliminating debt to remain operational. In restructuring procedures, a plan of reorganization that outlines the company’s recovery strategy and new capital structure must be presented and approved by creditors. This plan will always involve Debtor In Possession (DIP) financing. If the plan of reorganization is approved, the company emerges from bankruptcy with a capital structure that can support the future operations of the business.
Loophole investing occurs during a bankruptcy restructuring process when credit investors abuse the lack of covenant protection or use creative interpretations of credit documentation to force their capital into a more senior position within the capital structure. In these scenarios, credit investors in a company bear the risk of being wiped out, creating incentives for them to find ways to move up the capital structure and artificially increase the seniority of their debt. Loophole investing allows investors with equivalent levels of seniority to obtain collateral or additional rights at the expense of other creditors. Similarly, many debtors have also been actively seeking creative means to deprive creditors of value. Cohen suggested that investing in credit right now focuses more on legal loopholes than value investing—a viewpoint that is becoming common sentiment within the credit investing industry.
This practice is evident in several high-profile debtor-creditor and creditor-creditor disputes, including those surrounding J. Crew, NYDJ Apparel (NYDJ), TravelPort and Serta Simmons. In the case of J. Crew, the debtor moved the J. Crew brand name and several other intangible assets to a subsidiary in the Cayman Islands and was subsequently issued a $300 million loan from Blackstone with these assets serving as collateral. The original creditors, who believed they were entitled to the J.Crew brand name, were shocked to see they no longer had access to these assets, and consequently were forced to settle for a deal with J. Crew. NYDJ, Travelport and Serta Simmons are more recent examples of right infringements in bankruptcy events.
Ultimately, loophole investing has created an unhealthy environment within the credit community that prevents investors from seeking collaboration and mutual benefit. These developments could have important consequences for all stakeholders, as this form of investing often leads to time-consuming procedures within restructurings that put the company’s actual recovery at risk. Instead of working together to create solutions for a troubled business, investors focus on esoteric legal maneuvers to increase the value of their investments at the expense of others. These practices have led to reputational damage among investors that hinders cooperation and returns in future investments.
Minority creditors are particularly exposed to these risks because of their lack of power—they have less influence on any voting processes that occur throughout the restructuring. However, there remains viable strategies for minority creditors to pursue which can protect them from loopholes and the unreasonable demands of majority creditors. Minority creditors need to be proactive in partnering with other stakeholders to prevent their value from being eroded in a restructuring. By effectively aligning all creditor and debtor interests together during these processes, all parties can and will benefit in a restructuring
NYDJ: Debt Used to It
The NYDJ restructuring of 2017 is an iconic example of how covenant-lite developments have allowed loophole investors to infringe on the value of other creditors. Two creditors that held a majority of the debtor’s term loans presented a deal that additional financing would be given, provided that their repayment was prioritized before the others within the same term loans. Many of the minority creditors were not even aware of this change until after the transaction had already taken place. By that point, the value of their debt investment had changed and they were forced to sell their stakes at a discount to the majority creditors.
There are two important things to note from this restructuring. The first is that it would have been illegal if stricter provisions were in place. NYDJ’s provisions could be described as a form of “populism” where a majority of creditors strip a minority of creditors of important rights through voting. Additionally, since the majority creditors offered the debtor a deal that would alleviate their situation, the debtor acquiesced to their demands. Hence, NYDJ provides a model for understanding factors minority creditors must consider. Namely, whether they have the backing of the credit documents on their side, and whether they can offer the debtor a better proposal that could protect them from attempts from others to bully them into submission. In general, this type of situation—where a majority creditor uses voting power and loopholes to strip value away from minority creditors—has become known as non-pro rata treatment.
In the event that minority creditor groups are unable to propose a better solution due to limited economic capacity, they should consider reaching out to unsecured or junior creditors. In most situations that deal with non-pro rata treatment, the unsecured and junior creditors are insulated from the conflict. This is because any dispute over the distribution of the collateral assets would not affect them regardless, as they would not have had access to the value of the collateral assets. However, if a minority secured creditor can offer any value to the unsecured or junior group in their proposal, it would involve them in the discussion and offer additional allyship to the minority secured creditors.
Travelport: Combatting Debt-trimental Practices
Recently, Travelport Worldwide Ltd. (Travelport), a U.K.-based travel booking company owned by private equity firms Elliott Management (Elliott) and Siris Capital Group (Siris), entered into a restructuring agreement. Initially, Elliott and Siris attempted to move Travelport’s valuable intellectual property and brand through a “trap door” to become collateral for the $1 billion rescue loan. However, lenders including Blackstone, Bain Capital and Mudrick Capital believed this action violated the terms of the loan agreement and that they were entitled to the intellectual property as collateral. In response, Travelport sued its creditors with Kirkland & Ellis, a prominent law firm, eventually resigning as a result of hostile negotiations. Amidst this, Travelport warned that it may be forced into a defensive bankruptcy. However, the company reached a deal with existing creditors to pledge its intellectual property and brand that had been collateral for Elliott and Siris’s rescue financing. This resulted in a $500 million capital injection by existing creditors.
This process was significant as it reflects how, by taking proper measures to protect their investments, creditors have the ability to enforce their rights against loopholes. Had the creditors not stepped in, they would have lost key collateral and seen their loans plummet in value. When entering covenant-lite investments, credit investors need to weigh the risk of other parties using loopholes to steal value and identify opportunities where their rights will be protected.
Serta Simmons: Cooperation is a Credit
Serta Simmons presents a third situation where the lack of strict covenant documentation sparked a legal conflict over creditor value. For the restructuring of the struggling American mattress maker, financing proposals were offered by two distinct groups of creditors: the smaller group was led by Apollo Global Management, a firm known for its shrewdness in capturing covenantal loopholes, while the larger group was led by a collection of mutual funds. The company went with the latter proposal, even though it would infringe the value of Apollo and other excluded creditors by letting the mutual funds skip to the front of the repayment line. While this proposal violated commonly-held conventions to payment priorities in a restructuring, the court denied Apollo’s request to terminate the proposal, as it was legally permissible.
It is unclear why Apollo was excluded from taking part in the proposal of the latter group of creditors, but its reputation as being an uncollaborative creditor ally may point to the reason why. Because the credit investing community is so tight-knit, actions pertaining to one investment will lead to consequences with another. This case study presents an uncomfortable and yet important truth: the minority creditor cannot always rely on legal protection, as much of that has been stripped away. Moreover, negotiation and reputation management can be extremely important. Achieving consistent returns over a long period of time might require compromise and cooperation since selfish acts are not forgotten.
Minority Strategies That Will Pay Off
As funds continue to flow into the private credit markets, it is unlikely that market forces will drive out loophole investing. This trend has created an environment that favours self-preservation over mutual collaboration. However, as investors seek out returns through legal maneuvers and loopholes, the industry as a whole could pay the price. Reduced collaboration and longer periods of time spent in bankruptcy will significantly decrease a company’s chances of recovery, resulting in lost value for all parties. In addition, such actions have deteriorated the reputations of investors and have impeded future investments, as seen in the case of Apollo. The recommendations presented outline practices that, if made commonplace, could ultimately reverse this hazardous trend of loophole investing.
