After all, LevFin investors are well educated and well versed on the possible outcomes from looseness in deal documentation. A number of legal services (including 9fin, naturally better than the rest) have over the years analysed bond (and loan) docs and their various covenants, baskets, clauses and definitions, and assessed their potential uses and abuses. 

You can see the evolution of the docs race to the bottom, via a string of deals, which at their respective times represented a new low watermark, such as Merlin Entertainments (2020), Arxada (2021) and Covis Pharma (2022). However, some might not be viewed as aggressive via a 2023 lens — it’s all about having a decent sense of perspective.

One of our peers last week produced a report for a magical bond issuer with 37 mentions of the phrase “extremely off market” with liberal blocks of CAPS in their report and frequent urgings that investors “should push back on this.” 

Unlike a number of our peers we see the ever greater looseness in docs as part of the market evolution and a component of the commercial discussion between investors, leads and the respective sponsors. 

We rarely explicitly say what investors should do with regards to key terms or basket language, preferring to point out what the potential effects could be, and for investors to make up their own minds. 

For example, our take on Covis Pharma — ”there is significant scope for value leakage, including via a clause for uncapped permitted investments so long as the Total Net Leverage does not deteriorate pro forma.” 

You don’t really need our advice on what to do when you read this. 

How often do the final documents change substantively during marketing? 

Not very. EBITDA definitions might be watered down and the add-back period might get cut from 36-months to 24 and the number of leverage ratchets from three to two, in the final OM. But we know that this is a game most issuers play, and agreeing to these small changes often allows them to keep “off-market” language in elsewhere and sometimes everywhere. 

Rarely do we see more substantive changes being made. 

According to our covenant pushback tool and our lawyers who see a number of pinks, it’s almost never. Not even early this year, when markets were more challenging, when you would have thought bond investors had more power to dictate tighter docs terms. Similarly for all the early talk from investors that upcoming A&E discussions would be used as an opportunity for creditors to revisit and tighten-up terms, anecdotally, we haven’t seen this happen. 

Just in case you were curious about whether the lawyers were able to work their magic. The result of their spell in CAPS saw none of the 37 ‘extremely off market points’ altered from the pink to red to black. 

Loose Lose

It feels like the docs only matter to investors when the business is going into distress, and/or something happens behind their back. 

Serves them right for not taking a closer look at the docs earlier on. However, I do have some sympathy for the victims of some of the more aggressive uptiering transactions. 

Yes, some might know what could happen under the docs regarding permitted liens and basket capacity for deals which they are invested in. But investors thought, perhaps naively, that some key definitions such as Open Market Purchases, together with wider legal implied covenants of good faith and fair dealing would protect them from the worst excesses. 

Serta Simmons was arguably one of the most egregious examples of an uptiering transaction. 

Under the transaction Serta’s majority lenders exchanged their existing first lien term loans for new super-senior term loans, with minority lenders effectively left with subordinated debt. The aggrieved lenders (which included big names such as Apollo and Angelo Gordon) claimed a breach of the implied covenant of good faith and fair dealing (under NY law) by having their sacred rights stripped away.

Judge Katherine Failla of the Southern District of NY said in April 2022 (refusing a motion to dismiss by Serta on a legal challenge from the group of ‘downtiered’ lenders) that the court found that the term “open market purchase” was ambiguous in this case because the transaction did not take place in a open market and was closed to certain participants. This set up the prospect of a hearing on the substantive issues sometime in 2023. For a detailed review, see Arnold & Porter’s piece here.

But as many of you might know, Judge David R. Jones of the Southern District of Texas created a lot of waves in March with some good ol’ southern straight talking in his summary judgment hearing — he is presiding over Serta’s Chapter 11 case. 

In a apparent dig at Justice Failla, in a blunt verbal summary judgment, he said that it was very easy for him to determine that the phrase [open market purchase] unambiguously validated the uptiering transaction. 

But he didn’t give a detailed explanation for his reasoning, and we had to wait until last Tuesday, when Judge Davie Jones took a written memorandum of opinion out of his locker. 

As Petition amusingly note in their substack post this week, he divulged that he used the Merriam Webster dictionary to define what is a ‘purchase’ and what is a ‘open market.’ 

Purchase — something obtained especially for a price in money or its equivalent. Open Market — an economic market in which prices are based on competition among private businesses and not controlled by a government. 

Jones said:

“An open market purchase is therefore defined as something obtained for value in competition among private parties. The 2016 Credit Agreement defines the scope of the market as it limits buyers to existing holders of the Debtors’ loans.”

As Petition quips:

“We’re still not 100% sure that we understand what “open market” means or how that proposed definition would create a meaningful distinction from, let’s say, a “closed market purchase” provision, but, you know, it’s always good to see what Webster’s Dictionary thinks. We’ll have to see if that justification is enough for the Fifth Circuit, where the non-participating lenders’ appeal is currently sitting. We also can’t imagine that the loan markets, which have been waiting three years for clarification on this issue, are too thrilled that the first judicial resolution has this much in common with a mediocre Best Man speech.”

So far, so amusing, but what about the implied covenant of good faith and fair dealing?

Judge Fallia had said:

“Plaintiffs ascribe bad faith to the manner in which Defendant exercised its contractual power to amend the Agreement and engage in debt exchanges because the economic reality of the Transaction suggests an intent to harm a subset of first-lien lenders by subordinating their debt. Indeed, one could reasonably conclude from Plaintiffs' allegations that Defendant systematically combed through the Agreement tweaking every provision that seemingly prevented it from issuing a senior tranche of debt, thereby transforming a previously impermissible transaction into a permissible one.”

As Petition notes, this raises the question of how aggressive does an uptier have to be to trigger a breach of the implied covenant, i.e at what point does it become commercially unacceptable? 

Our Texas Judge appears to have little sympathy for this argument, as we are all big boys here:

The parties were keenly aware that the 2016 Credit Agreement was a “loose document” and understood the implications of that looseness. The Objecting Lenders acquired the majority of their loan holdings long after the original issuance and in anticipation of negotiating and executing a PET [Position Enhancing Transaction] to the exclusion of the PTL Lenders — exactly what they complain was done to them using the same provisions of the 2016 Credit Agreement. No evidence of an improper motive on behalf of either the Debtors or the PTL Lenders was presented. The Debtors always remained transparent in their goals. Likewise, the PTL Lenders acted defensively and in good faith.

And then he delivered his killer line:

“On the scale of equity, it is the conduct of the Objecting Lenders that raises an eyebrow…”

Adding:

“That the parties could have easily avoided this entire situation with the addition of a sentence or two to the 2016 Credit Agreement. They did not. And this litigation ends with each party receiving the bargain they struck — not the one they hoped to get.”

Boom.

So, the TLDR from Judge Jones ruling is Big Boys Don’t Cry 

As Robert Smith says — no, not the one from the pink un — but the front man from The Cure:

Putting out the Unitrash

Followers of 9fin’s social media channels will be well aware of our recent push into private credit. 

From the outside Private Credit is seen by many as an extremely hot sector, developing and evolving fast, as recent stories such as Private Credit CLOs coming to Europe and David Brooke’s excellent The Unicrunch piece on NAV lending to PE funds. 

But despite the well reported dash for Unitrash, as Private Credit’s March to LevFin domination and disintermediation continues apace, beneath the surface all may not be as well as it appears. 

Firstly, direct lending funds are struggling to generate the returns they promised back in 2018 and 2019. Their original premise was that most of their loans would be refinanced in two-to-three years and that sponsors would be able to exit their investments in three-to-five. But in many cases that hasn’t happened — admittedly some of this delay was due to Covid — so many of these loans are still in place, reducing the IRRs. Not having enough exits and successful outcomes hampers fund raising, which we hear is a lot harder at the moment for all but the biggest and highest profile managers. 

Worse still, many of their borrowers’ floating rate loan exposures weren’t hedged, and in a rising rate environment with many of these businesses not deleveraging according to plan, it makes a refinancing near impossible. Many direct lenders are yet to mark these loans down, as their reporting is backward looking, meaning LPs may not be aware of the full extent of the problem. 

For direct lenders, when the crunch point eventually occurs, it creates an dilemma. Do they take impairments, offer interest free grace periods, refinance on worse terms to grab weighty arrangement fees, or if they have credit opps funds, offer say junior PIK debt to take the strain?

As we noted in the Leaders in Private Credit Roundtable, having a small group of supportive lenders might seem to be beneficial, but in some of the larger deals, there is a bigger club of direct lenders, and not all are able to provide new money, or be as supportive, or be as aligned. 

“The concept of credit fund X refinancing credit fund Y isn’t going to happen,” noted William Allen from Marlborough Partners. “If you subscribe to the view that an A&E is going to be unlikely given where the asset sits, say in a fund which is out of its reinvestment period, and there is no way that Barings will refinance Permira, this creates a dynamic that you haven’t seen before.”

And all of this will diminish IRRs and exit periods. This is reflected in the burgeoning market in private credit secondaries which I’m reliably informed by our Private Credit Editor Josie Shillito are trading on average at 15-20% discounts to face value, as LPs seek to reduce their exposure. 

The key question is this enough, and are further disappointments on the horizon?

It was only just over a year ago when Private Credit finally crossed the rubicon, by first becoming lender of last resort, taking down a number of hung LBOs. In hindsight the funds might have got their pricing wrong in some cases, been slow to read changes in the competitive landscape, and failed to adjust their terms by enough.

Fast forward a year, the hung deals are mostly gone and direct lending funds are much less competitive on pricing and leverage, with banks returning to underwriting on more favourable terms. But luckily direct lenders’ input is still needed on larger deals as the CLO arbitrage is so poor, meaning any other loan buyers will be required to get them away. This has led to hybrid deals with sidecar facilities, as Josie wrote about in Taking the Credit last week. 

The lifeblood of the converging private credit and LevFin markets is fresh LBO deals, and currently M&A activity remains limited. Worst still, another big source of deal flow, the recycling of assets passing from one sponsor to another via secondary and tertiary deals, is much diminished. Other exit routes are also closing, such as IPOs, and the outcomes of auction processes have been disappointing, as rising financing costs reduce bid multiples. 

Fund to Fund Fun

So, what can PE sponsors do? 

Arguably they’re in the same boat as the direct lenders, returns are below what they’d hoped, and they are failing to churn their assets fast enough to deliver exits, as many of their funds near end of life. 

Their latest default position (no pun intended) is to sell portfolio companies to their newer funds. Ideally at a high(ish) but still believable multiple. 

This has numerous benefits for the PE firm. It realises a better return than via a straight exit at a lower multiple; the newer fund is able to create another three-to-five years of runway — PE firms love optionality and prize it highly. And arguably best of all, it helps keep deal multiples (and therefore other portfolio valuations) high, creating an illusion of performance. 

This came into sharp focus last week with Infopro Digital.

It was widely reported that majority sponsor Towerbrook had put the business up for auction in 2022, but bids fell short of the 13x reported multiple it wanted. 

But running the numbers on the fresh financing from the fund to fund transfer, we get 12.5x. I have no inside track, but I suggest most sponsors wouldn’t dick for a tick to sell an asset they have owned since 2016, and are really that worried about that half turn. 

Anyway, proceeds from the refinancing increased the debt burden by €163m, and also paid a €193m shareholder distribution post completion, nice work. The deal was helped by having portability below 5.5x, which it narrowly squeaked through at 5.2x LTM EBITDA to end-March 2023. 

With the business has hardly de-leveraging, if at all, under Towerbrook’s seven-year ownership, what is their plan to grow value?

From what I can see, it is trying to convince prospective investors that it should attract a higher multiple given the switch to digital and the attractiveness of an asset-lite model. The company has high retention rates, moderate capex and modest FOCF generation. But this isn’t a fast growing digital media or SaaS business, revenues are growing in mid-single digits at best, with stable margins. What multiple would you ascribe to this business? 

And here’s the rub. 

With ZIRP gone, interest costs rising and deal multiples contracting, sponsors will need to step up and show off their expertise and prove they can create inherent added value in their portfolio companies. Luckily the looser documentation is allowing them to maintain optionality for a little longer while allowing for value leakage at the same time. 

What is the attraction for investors who want to invest in NAV lending to private equity firms at this point in the cycle? Are they being seduced by historical returns (often juiced up as they don’t take into account management fees)?

And how comfortable can they get with PE funds valuation marks? Are they getting in just as many existing PE LPs are starting to get twitchy?

I can see the attractiveness to PE firms, as it allows them to recycle cash attracting new money — increasingly from retail investors — who are at a significant informational disadvantage as reported performance is often far in the rear view mirror. 

I’m in agreement with Howard Marks that we are approaching a crunch time for Private Credit and arguably also for Private Equity. Defaults are rising fast — particularly in the US — and recoveries are poor, which will test the resilience of their funding models and strain the supposed special relationships with key lenders in the private credit space. 

I will leave the last word to William Allen:

“As an observation, I would say private credit is woefully set up for distress, for prolonged distress. There’s only one major credit fund that I can think of that has a fully functioning 10+ person team that’s in place to deal with this. And that is a worry for me.”

What we are reading, watching, this week

Unfortunately while most of my colleagues were at the Global ABS conference in Barcelona, I was laid up with a bad back for the first couple of days, neglecting my editing cover duties. 

But this, and the lack of interesting earnings releases failed to dampen my colleagues’ content drive. I particularly liked our latest Cloud9fin podcast from pod debutants Hazik Siddiqui and David Orbay-Graves musing upon SBB, with Hazik taking pronunciation lessons from resident Swede Hannes on our engineering team. 

One financial advisor was less impressed, as last Friday’s piece on the alleged covenant breach blew-up his SBB investor pitch scheduled for early this week, as we revealed a bunch of information which wasn’t in the public domain and was in his materials! 

Sticking with Sweden, the FT blames Beyonce for stubbornly high inflation — Bills, Bills, Bills, her Stockholm shows drive up hotel prices, contributing to the higher than expected reading for May!

Sometimes a headline is curious and bizarre enough to just click — h/t 9fin’s Brian Dearing 

What’s This About Disney, and King Charles III and Ron DeSanctis?

I don’t think that residents of this Scottish village are as idiotic as their local paper suggests:

As you know, I like to look for left field events which could upset the Macro consensus. The return of El Nino for the first time since 2016threatens Economic Destruction according to Bloomberg,could cause the hottest year ever, says the FT, with Atlantic ocean temperatures off the charts.

Selecta’s ESG intern appears to have made a rookie error in their latest presentation

Today’s Workout is out nice and early on a Summer Friday, as it’s my Birthday and I’m off to Lewes, the home of some of my favourite beers, BEAK and Harveys, amongst others.

Saturday will be working off a mild hangover and some of the self-inflicted Friday damage by walking 10-15 miles across the nearby South Downs — I hope your weekend will be as enjoyable.