Sirius Computer Solutions: An Analysis of Net Short Debt Activism Safeguards
In April 2019, Sirius Computer Solutions (Sirius), an IT solution integration company, was acquired by the private equity firm Clayton, Dubilier & Rice (CD&R). Originally, this acquisition was structured as a normal leveraged buyout transaction. A total of $1240 million in debt was issued, divided as follows: $190 million in a 1st-lien senior secured revolver, $750 million in a 1st-lien senior secured term loan, and $300 million in senior unsecured notes. At an adjusted debt-to-EBITDA of roughly 6.0x at closing, Moody’s deemed the ratings of the secured loans at Ba3, and the unsecured notes at Caa1: non-Investment Grade, but stable and far from the risks of default. At first glance, this appeared to be a normal debt issuance. However, through further scrutiny of the deal’s credit documents, an essential provision comes up, it reads as follows:
“ …any Lender (other than (x) any Lender that is a Regulated Bank and (y) any Revolving Lender as of the Closing Date) that, as a result of its interest in any total return swap, total rate of return swap, credit default swap or other derivative contract (other than any [such swap] entered into pursuant to bona fide market making activities), has a net short position with respect to the Loans and/or Commitments shall have no right to vote any of its [loans] and shall be deemed to have voted its interest as a Lender without discretion in the same proportion as the allocation of voting with respect to such matter by Lenders who are not [net short lenders]”
In summary, the debtor strips the voting power of creditors who, as result of having a larger position in credit default swaps (CDS) or other derivatives that benefit from a decrease in the value of the debt, are overall net short (have more to gain from the debt declining in value). This is an interesting defense against the recent rise in what is known as net short debt activism.
In this article, I will achieve the following: I will explain the strategy behind net short debt activism and why it may be an issue for debtors and creditors; I will analyze and identify relevant misconceptions that commonly appear within research reports and financial media; I will then offer my opinion regarding this peculiar covenant package, and why it will likely have minimal impact on debtors and creditors alike.
OVERVIEW OF NET SHORT DEBT ACTIVISM
Net short debt activism is a strategy where an investor takes both a short position in a company’s debt and acts as an activist in pursuing legal action against the company. The strategy was most prominently employed by the distressed debt hedge fund Aurelius Capital Management in 2017. They had purchased a stake in the debt of a company called Windstream Holdings but had also simultaneously purchased a significantly larger amount of credit default swaps against the company. Aurelius then alleged that the company had violated covenants two years prior when they had spun off key assets into a subsidiary, thus stripping debtholders of valuable assets during a potential liquidation. The resulting lawsuit forced Windstream into bankruptcy. Aurelius profited by first pocketing payments from their CDS, and then subsequently receiving a premium payment from the debt once the court ruled in Aurelius’ favour in early 2019.
Another strategy that has been grouped with net short debt activism is the “manufactured default” strategy employed by Blackstone GSO. In this, the investor reaches an agreement with a company where extremely favourable financing is provided, contingent upon the company declaring bankruptcy. The investor then buys CDS on the company and profits from the CDS payout upon the prearranged bankruptcy. However, due to reasons that I will mention shortly, this should not really be classified as net short debt activism at all.
As expected, net short debt activism is not viewed positively. For the non-net short creditors, the allegation of the company being in default, even without forcing the company into restructuring, would drop the market value of their debt significantly. And if a payout does ensue for the net short activist, the credit support for all other creditors would be materially diminished. Unfortunately, certain recent legal developments have encouraged net short debt activism as they increased the upside of this strategy. In 2016, a precedent was set during the court ruling of Wilmington Savings v. Cash America. The creditors of Cash America have alleged that the Company breached covenants by spinning off a subsidiary (in the same style as Windstream). The court ruled in the creditors’ favour — more than just that, in fact. They were not only given the full payout of the bonds, but also a redemption premium, as the court ruled the action of spinning out the subsidiary to be equivalent to the company willingly redeeming its bonds early. This meant that for companies that have taken actions to violate incurrence covenants, any activist seeking to push for accelerated payment of their debt would not only receive the full-face amount, but they can use this precedent to demand further redemption upside.
Because of the success Aurelius and Wilmington had in their respective lawsuits, debtors have become more cautious due to the prominence of net short debt activism. Recent trends in new issuance covenant packages have included language seeking to prevent that from happening. For example, there has been language that only allows creditors to pursue breaches that occurred within a fixed time span (because Aurelius pursued a breach that occurred 2 years prior, 2 years is the normal time span set in these packages). This was the credit environment CD&R faced when they finalized the terms of their acquisition debt in April 2019.
THE MISCONCEPTION OF NET SHORT DEBT ACTIVISM
Despite the multitude of discussions that have been done on net short debt activism, few have realized that the issue is far less prevalent than people might think. Generally, net short debt activism seems as though it is not a major concern creditors and debtors should have at all.
Manufactured defaults should, firstly, not count as net short debt activism. In a manufactured default, the hedge fund benefits the debtor by giving them favourable financing after the debtor purposefully defaults, and the profit comes at the cost of the CDS sellers, not so much at the cost of other creditors and the debtor as the company’s fundamentals have not changed. A net short debt activist, on the other hand, does not work with the debtor at all and seeks to undermine their legitimacy. Instead, their main goal is to force the debtor to accelerate their payment rather than working with the company during their restructuring. The following table sums up the major differences between the two strategies:
This distinction is of essential importance. Manufactured defaults have drawn a lot of ire and regulatory scrutiny in recent years because it is seen as unethical and borderline “insider trading”. While this is not a discussion on the ethics behind different investment strategies, net short debt activism at least does not have run-ins with security regulations since it is akin to other activist strategies. Moreover, the scrutiny that manufactured defaults has drawn, perhaps because of how outrageous this strategy seemed to the public, overblew the impact of net short debt activism as well — it is a far smaller issue than what people may think.
When it comes to “actual” net short debt activism, cases have been extremely limited. Examples that critics and investors have brought up include the Cash America lawsuit and Safeway, where actions the debtor had performed in 2016 were challenged by creditors in 2018 to have breached covenant. And yet, none of these examples feature a net short activist. They are just regular creditor-debtor disputes. Aurelius v. Windstream is possibly the only actual example of net short debt activism.
There is nothing new about how creditors are going to react differently to a company that has breached covenants. Some are going to choose to work with the company as it is, and some are going to choose to take a hard-line approach. Activists or not, creditors are always going to be fighting with each other and the debtor due to their differing motivations. To paint net short debt activists as the bad guys, while the same legal debacle occurs in most other restructurings/distressed situations/covenant breaches, is just quite baffling.
WHY SIRIUS’ NEW COVENANTS ARE INEFFECTIVE
Having said all of that, I personally think Sirius Computer Solutions’ new covenant package is downright ineffective. As I said, not only is net short debt activism is a very small issue for creditors in general but when it comes to preventing it, these covenants do not do the job very well.
Let us look at how they have chosen to describe how they determine whether a creditor is “net short”:
1. derivative contracts with respect to the Loans and Commitments and such contracts that are the functional equivalent thereof shall be counted at the notional amounts thereof…;
2. [notional amounts will be converted to dollars];
3. [derivatives referencing an index will be disregarded] so long as (x) such index is not created, designed, administered or requested by such Lender and (y) [the borrower’s or any other loan party’s obligations account for less than 5% of such index]; and
4. [standard CDS contracts will be deemed short positions if, under such contract] (A) such Lender is a protection buyer and (B) (x) the Loans or the Commitments are a “Reference Obligation”, (y) the Loans or the Commitments would be a “Deliverable Obligation”, or (z) [the borrower or any other loan party] is a “Reference Entity.”
The point about an investor’s “net” position being determined using notional amounts of derivatives and debt is what I want to focus on here. To explain it with an example: if an investor buys $1000 in face value of debt, and then buys CDS that would result in the payout of $1000 should the company default, the investor would be “net-neutral” as the notional amount of “short” derivatives equate the notional amount of the investor’s long position. So long as the face value — notional amount — of the derivative payoff is not greater than the face value of the debt, the investor is not classified as a net short investor and retains all rights.
There are three major issues with this:
Firstly, say you are an investor who has purchased $1000 in face value of debt at a discount. You then buy CDS protection that would give you a payoff of $1000. By the language of this covenant package, you are not a net short investor and has all rights. Yet: for you, your interest and motivation would be the same as any net short debt activist. Because you did not buy the debt at par, you profit from the company going into default, since the payout from the CDS is $1000 while your purchase price was lower on the debt. These covenants would not stop you from filing a formal default notice as a creditor or vote on the restructuring.
Secondly, a net short debt activist does not necessarily have to be “net short” to have similar intentions. Because of the Cash America precedent, an activist has more to gain than just the face value of the debt. Even if the activist in question has only established a long position at par, if they can identify a covenant breach and pursue litigation, they profit by being awarded an early redemption premium.
Thirdly, and most importantly: this covenant package defines a net short position as one that is achieved with derivatives such as CDS. An activist could be shorting the debt in other ways than just a CDS. Say this is an activist that is going long on the debtor’s term loan while shorting the debtor’s subordinated bonds or equity. Under the definition of this covenant package, they would not count and still retain all rights.
WHAT COULD SIRIUS ACTUALLY DO?
Realistically, the best way for Sirius to protect itself is to avoid doing anything that may be interpreted as a violation of covenants. If Sirius and its private equity sponsor are looking for ways to potentially strip the value available to creditors for their own gain, they should not be focusing on limiting the legal rights of their creditors. Rather, they should focus on ways to loosen covenants relating to the conditions they maintain on their assets.
For example, instead of making it harder for creditors to pursue legal actions against the debtor’s removal of assets from the pledged group, the debtor should just make it easier for themselves to remove the assets altogether. From the credit trends of 2019 quarter 1 debt issuances, debtors have generally been able to reverse a lot of the “J. Crew Blocker” clauses that have been popular in 2017–18 to prevent asset leakage from guarantor to non-guarantor restricted groups. By implementing covenants that allow asset leakage from the guarantor group, or even the restricted payment group, would be far more effective at preserving value from creditors than the language that Sirius currently has in place.
The document language in Sirius Computer Solutions’ new debt issuance is quite fitting of recent covenant trends where the creditor’s rights to pursue legal actions are being restricted. This draws similarities to PetSmart, where creditors forfeit their litigation right, or can no longer take action based on breaches once a specified amount of time has elapsed. Sirius sets a precedent that could be reused in later documents of other issuances. Having said that, this covenant package is probably the weakest in terms of its ability to actually limit creditors actions. For non-net short intending creditors, in fact, this covenant may even be beneficial since it inadvertently discourages manufactured defaults. Hedge funds that would have otherwise come in with a large CDS position to manufacture a default would find their rights stripped away contractually, and hence would see no material benefit. At the end of the day, as an astute credit investor in an environment where terms are becoming increasingly creditor-unfriendly, one must be discerning to find investments with the safest terms. Sirius Computer Solutions may just be one of those examples where, underneath the seemingly strict covenants and clauses, there rests nothing but a defenseless “paper tiger.”
My analysis focused more on the feasibility of overcoming Sirius’ provisions. For a more in-depth legal analysis on these provisions, please read Milbank LLP’s research report on the covenant package:https://www.milbank.com/images/content/1/1/v2/116063/Client-Alert-6.11.19-Net-Short-Lender-Disenfranchisement.pdf