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Rosa O'Hara

Will Caiger-Smith

This article is part of our forthcoming service, 9fin Private Credit. If you're interested in a free trial, contact subscriptions@9fin.com

There’s a new docs debate in private credit, and it centers around an area of finance that can be just as opaque as private credit itself, and often more complex — derivatives.

According to 9fin sources, in recent weeks investors and lawyers have been poring through loan documentation to figure out whether lenders might be entitled to a paydown when companies generate cash by unwinding swap arrangements.

A couple of years ago, monetizing a portfolio of derivatives contracts might not have created that much buzz. But in today’s environment, where liquidity is tight, generating cash by any means is popular — and as Altice has shown, unwinding swaps can provide much-needed upfront cash.

Similarly, the idea that lenders would care about what happens to the proceeds from such a sale might have seemed far-fetched this time last year. But there’s a renewed focus on docs in today’s difficult markets, as borrowers look for wiggle room and lenders for vulnerabilities.

Over recent months, this debate has intensified in both direct lending and syndicated markets. For example, we recently wrote about how borrowers could potentially securitize assets like intellectual property, as Exela set itself up to do a couple of years ago.

This latest covenant brainteaser hinges on whether or not monetizing in-the-money currency swaps qualifies as an asset sale. This could impact whether lenders are entitled to a paydown from any proceeds, under the asset-sale sweep provisions in their loan agreement.

Does a derivative even count as an asset? And if it does, would selling it trigger asset-sale sweep provisions?

A glib answer to the first question is that a derivative is an asset if it’s in the money, and a liability if it’s out of the money (we’re papering over a lot of nuance here, but that’s the gist). Derivatives can be financial or non-financial assets/liabilities; this guide from PwC classifies interest rate swaps as financial assets.

As for the second question — whether generating cash by selling derivatives should trigger a paydown for lenders — there are philosophical answers and technical answers, and they’re kind of intertwined.

“The asset-sale bucket is intended to pick up true asset sales that should trigger a paydown,” said a private equity lawyer. “You’re generating cash from collateral that lenders had a claim on, so if you sell that thing to someone else, the lenders should see some benefit.”

“Just unwinding a swap and generating upfront cash from it, in most cases that does not change the lenders’ collateral,” the lawyer added — although noting that some credit agreements might have enough leeway for lenders to argue that the asset-sale sweep does apply to derivatives.

Two other lawyers suggested that credit agreements may not explicitly provide guidance on whether or not selling derivatives counts as an asset sale. There may be more variance in the private credit market, where terms are less standardized than in broadly syndicated debt.

“It’s generally quite clear from the documentation, [but] all of these agreements are somewhat bespoke,” said one.

This debate over derivatives has gained new relevance for credit investors in today’s rocky environment. Whether a borrower is a going concern or in bankruptcy, the answer to this question could theoretically impact trading levels of its debt, or recoveries on it.

More broadly, there is an obvious historical precedent to suggest that investors are willing to squabble over derivatives and their monetary value: Lehman Brothers.

“A tremendous amount of the claims that were traded on in the bankruptcy of Lehman were derivatives claims,” said a derivatives lawyer. “There were years of claim tradings. People were trading on the receivables generated from derivatives.”

That doesn’t answer the question of whether or not the asset-sale sweep applies to derivatives, but it is a useful reminder of how stressed markets can create friction between borrowers and lenders — and between lenders themselves.

“With borrowers experiencing liquidity crunches, and lenders having less of a willingness to put in more incremental debt, there’s going to be a battle in the split-lien environments,” said a lawyer with private credit experience. “I think there’s going to be a lot of battles.”

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Can you sweep a swap? Derivatives debate hits private credit

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