Lycra dropped some assets, who picked them up?
- Brian Dearing
Imagine you own a big company and you need to fund your operations — you incur some debt, perhaps in the form of a high yield bond or HY bond-style syndicated loan. You have tons of diffuse creditors who don’t really want to meddle too much in your business day-to-day, but they want some reasonable protections. As a result your debt, which is considered “market”, has covenants that restricts your ability to incurmoredebt, as well as your ability to make dividends or investments (your creditors are ok for you to takesomecash out of the business, but not all of it!). Those pesky creditors also want some guarantees from important subsidiaries in your corporate structure, as well as security over your key assets to ensure that if things go south they have some hard assets that increase the likelihood they get at least a bit of money back.
This is all fine and normal, anyone reading this on 9fin will be familiar with what I’ve just described. Now, let’s imagine your company starts doing poorly (not your fault obviously), and you need to raise more money.
Unfortunately your current creditors aren’t keen to put more of their money in to your business, and your business is doing so poorly (again, not your fault!) that even if your debt documents allow you to go raise more debt, no one is excited to give you money on the same terms because the risk is just too high.
How do you make them feel safe enough to do the deal anyway? Perhaps you could entice someone by providing them a better deal than your current creditors are getting. Imagine if the new debt could be secured against some part of your business that no one else is allowed to touch — that’s great! Maybe as a result you can get a deal done and keep your business going. The trouble is you’ve already given your current creditors security or guarantees over most of your business so that you could get the last deal done.
What can you do? Well, what if you could claw back some of the assets that secure your current creditors, hide them behind your back, and then hand them to your new creditors? Your old creditors might be upset, but hey, you got the new deal done and you get to keep running your business. This is colloquially known as a “drop down” transaction and one just (sort of) happened.
Technically speaking, a drop-down is achieved by designating a subsidiary as an “Unrestricted Subsidiary”, thereby moving assets outside of the “Restricted Group” (i.e., no longer subject to the covenants). As part of this designation, the entity may be released from any guarantees or security it had previously provided. As a result, Unrestricted Subsidiaries are essentially free to do whatever they want, and that’s where the fun starts.
Below is a graphical representation of how this kind of a transaction might work.
9fin Educational on various forms of priming debt, including drop-downs available here.
As reported by 9fin’s Bianca Boorer, Lycra entered into a new privately placed bond deal in order to refinance some very current debt (it literally matured the day of the refinancing). Lycra paid through the nose to get this deal done (after OID, all-in cost is in the mid-20s), but even that wasn’t enough for their new mystery creditors.
Following the refinancing transaction Lycra still has some existing debt outstanding that is secured and guaranteed by subsidiaries holding most of the group’s assets (79% as of 31 Dec 2017, per the bond OM).
Simple drop-downs get a lot of attention as they often feel wrong, but in reality they are just using the documents in perfectly expected ways. In Lycra’s case, they used bog-standard Restricted Payments and Permitted Investments capacity (see baskets in 9fin’s Covenant Explorer here) to designate certain subsidiaries which contained IP (valued at ~$75m) as “Unrestricted Subsidiaries”. Following the “customary” way a drop-down transaction is achieved, they could have incurred new debt at the Unrestricted Subsidiary, securing it on the assets of that entity. But this isn’t what Lycra did.
Lycra’s financing won’t be outside the Restricted Group — it’s going to be inside the Restricted Group. As a result, the new debt will benefit from the same security and guarantees as the existing debt, after all they were simply refinancing some other existing debt. But the new debt also gets a sweetener in the form of security and guarantees from the assets that were placed outside the group (see the graphic above again if this isn’t clear!).
This “sweetener” is possible because the “Limitation on Liens” provision in the existing debt no longer applies to the Unrestricted Subsidiaries. If it did apply, any assets the company has that is not securing other debt could only secure new debt to the extent: (1) the documentation has a specific carve-out allowing it to do so (the carve-outs in Lycra’s docs aren’t big enough for this transaction), or (2) the old debt is provided the same security / guarantees (but this just really isn’t the point of what your new creditors want!). Also, if you’re worried about the intercreditor agreement, it doesn’t block this structure as the additional security is not from the “Credit Group”, see here.
The “Lycra variant” of the drop-down is relatively novel, and is something for both creditors and issuers to think more about going forward. In the typical drop-down it would probably be hard to raise enough debt to refinance a significant amount of debt because the company is only able to provide the new debt with limited security and guarantees (limited to however many assets you managed to get outside the group). But because in Lycra’s case the new debt gets the same benefits as the existing, plus some, they were likely able to raise significantly more than they would have otherwise.
Transactions like this are always surprising to some, but really none of this is particularly controversial. Lycra simply used it’s ability to make Restricted Payments and Permitted Investments to place some assets outside of the reach of its current creditors and covenants, and then used the value of those assets to give extra support to new debt as a sweetener to encourage those new creditors to give them money. This kind of a transaction doesn’t happen that often, but when they do creditors get miffed. But it’s important to remember that almost every high yield bond and HY bond-style syndicated loan in Europe or the US includes some Restricted Payments and Permitted Investments capacity that could be used for this purpose. Lycra just decided to actually use it!
Further Reading
For further reading on how some of the concepts discussed above work please see the following 9fin Educational’s:
- The Restricted Group
- Unrestricted Subsidiaries
- Priority of Debt — Getting Primed
- J-Crew blockers
- Restricted Payments (Part 1 and Part 2)