Illustration by Chester Holme
A paucity of distressed-debt opportunities is sharpening the elbows of creditors.
Investors have been battling over a relatively small pool of companies in financial distress, wrestling for gains in the second-longest bull market ever in the U.S. With fewer bankruptcies, attorneys and financial advisers have more time to spend on each restructuring deal — which has given rise to an increasingly litigious environment.
“Because it’s harder to find good investment opportunities, I think investors have pushed the legal side of things further than ever before,” says David Tawil, president of hedge fund Maglan Capital. “Creditors saw a lot of low-hanging fruit in other cycles, where they wouldn’t necessarily push so hard — or they weren’t as meticulous — when it came to pressing every legal point.”
The Hovnanian Enterprises lawsuit underscores how contentious creditor battles can become, with hedge fund firm Solus Alternative Asset Management suing the homebuilder and Blackstone Group’s debt business, GSO Capital Partners, over a “manufactured default” involving credit-default swaps. Investors worry about the use of CDSs beyond the originally intended use as an insurance against default.
At the Milken Institute Global Conference that ran into early May, the rhetoric was that “this is not cool,” says Tawil. Even GSO — which benefited as a CDS holder when Hovnanian skipped an interest payment as part of its deal with the firm for financing — is now offering to help the market formulate rules around doing this, he says.
“We believe this transaction — which provides critical financial support to Hovnanian and its more than 1,900 employees — is fully compliant with the long-standing rules of this market,” a spokesperson for GSO said in an emailed statement. “As we have previously stated, we stand ready to work with the CFTC, ISDA, and other market participants to make appropriate changes to the standard CDS contract going forward.”
The U.S. Commodity Futures Trading Commission and the International Swaps and Derivatives Association issued statements in April about their concern that manufactured events could damage the CDS market, where investors bet on the ability of companies to meet their obligations to creditors.
Until the market resolves the issue of whether CDSs may be used to manufacture a default, Oaktree Capital Management won’t sell single-name CDSs, according to Rajath Shourie, co-portfolio manager of Oaktree’s distressed-debt strategy.
“It’s a sucker’s game,” he says. “There’s no way to protect yourself.”
In its January complaint, Solus alleged that GSO stood to lose “massive sums” on its CDS investment — unless Hovnanian created an “artificial default.” Solus, on the other hand, was a bondholder that sold credit protection against default through CDS on Hovnanian debt. In other words, Solus was long the homebuilder’s prospects.
In the complaint, the firm alleged that Hovnanian became incentivized to miss an interest payment to its own subsidiary after GSO made a “bribe of below-market financing.”
A spokesperson for Hovnanian said in an emailed statement that the company is “confident that it has acted properly at all times related to its financing transactions with GSO.” The homebuilder has not participated in the CDS market, he said. Solus announced Wednesday evening that it has settled its dispute with GSO. Under the settlement, Hovnanian made the interest payment that it did not make to its own subsidiary on May 1, doing so before the grace period ended.
Just as home insurance does not protect against damages caused by the owner, most creditors did not conceive of CDSs being used to trigger a company’s own default, according to Patrick Nash, a Chicago-based partner in Kirkland & Ellis’s restructuring group.
“We’ll see it happen again,” Nash predicts, as standard CDS documents don’t contemplate companies engineering their own credit events. Over the longer term, though, he expects “CDS documentation will probably evolve to protect against a purposeful default.”
With distressed-debt investors facing low and declining defaults, the brutal competition is likely to endure.
The trailing 12-month U.S. speculative-grade corporate default rate will fall to 2.5 percent by March 2019, from 3.4 percent at the end of the first quarter, Standard & Poor’s estimated in a report this month. The rate has decreased from 4.1 percent in March 2017.
Meanwhile, borrowing costs have generally been favorable for riskier companies. Speculative-grade bond spreads fell to 303 basis points at the end of March, from 328 basis points at the start of the year, according to S&P. And the ratio of high-yield bonds trading at distressed levels was at a 43-month low of 5.3 percent in April, the credit rater said in its report.
These are signs that companies aren’t under much pressure to meet their debt obligations.
“Absolute spreads and yields are tight, so it forces distressed investors to take a different approach to generate alpha,” says Angelo Rufino, co-head of Brookfield Asset Management’s credit opportunities business. “You’re seeing much more proactive efforts by distressed, legal-oriented investors to generate return.”
For instance, litigious creditors are scrutinizing companies’ bond indentures to find potential covenant breaches, says Rufino.
One example: A disagreement between New York-based hedge fund Aurelius Capital Management and Windstream Holdings over a bond contract will be tried in court this summer.
Aurelius sent a letter to Windstream in September alleging the telecom company had violated a bond indenture when it spun off assets in 2015, according to Windstream’s first-quarter earnings report. In November, Aurelius said the company’s distressed-debt exchange, in which it was seeking to swap the bonds in question with new notes with the same coupon, was prohibited because of the claims made in its September notification.
A trial date is set for July 23, according to a spokesperson for Aurelius, who declined further comment about the litigation. “We’re glad to get that trial date,” Windstream’s chief financial officer, Bob Gunderman, said in remarks made May 23 at the Barclays High-Yield Bond and Syndicated Loan Conference in Colorado Springs, Colorado. “We remain very confident in our position.”
Distressed-investing opportunities have been drying up over the past couple years, resulting in more aggressive behavior among fund managers seeking gains in that part of market, according to Andrew Brady, head of the distressed group at research firm CreditSights.
The firm counted just 31 bonds trading at 80 cents or less on the dollar at the start of this year, down from 162 securities at those levels at the beginning of 2016.
“There are a lot of people picking over a few names,” says Brady. “There are just too few opportunities.”
Energy, retail, and health care have been the most distressed sectors — though energy companies have been faring better lately with the recovery of crude, according to Brady. “If oil prices keep going up, there won’t be much more to do,” he says.
Exacerbating the problem of few restructurings is that industries such as retail are in a secular decline, making a turnaround more difficult, according to Maglan Capital's Tawil. That’s pushing distressed investors to the point where a lot of the “value” they see is predicated on litigation, he says.
Last year’s bankruptcy filing by Toys “R” Us — the retailer owned by Bain Capital, KKR & Co., and Vornado Realty Trust — will likely result in legal battles among creditors, Tawil predicts.
As capital structures have become increasingly complex, creditors are generally finding more gray areas to dispute — or exploit, given the nine-year bull market doesn’t lend itself easily to credit events.
“There are bondholders who are trying to create their own catalyst,” says Robert Paine, co-head of Brookfield’s credit opportunities business. “They’re trying to take advantage of the actual letter” of the law.
In a restructuring, creditors fear being disenfranchised and can become contentious when left holding worthless, junior debt, according to Kirkland & Ellis attorney Nash. “There’s a mutually shared suspicion among different members of the capital structure,” he says. “When they find themselves in a situation where there’s a chance to make money,” adds Nash, they become more aggressive in trying to squeeze out the biggest possible return.
In bankruptcies, distressed-debt investors are forming ad hoc steering committees that increasingly give themselves “much more favorable new money terms than similarly situated creditors,” according to Rufino. “You can have really juicy enhanced economics as a result,” he says. “It becomes almost debilitating if you’re not involved in some of those” steering committees.
In the restructuring of Claire’s Stores, Paul Singer’s Elliott Management Corp. is sponsoring a plan with significant preferential economics for a group of creditors, according to a person with knowledge of the effort. A spokesperson for Elliott declined to comment.
Claire’s, a specialty retailer for young women and girls, filed for bankruptcy protection in March, about 11 years after its 2007 leveraged buyout by private equity firm Apollo Global Management.
Strong credit markets in recent years have helped private equity firms obtain favorable terms for the financing backing their deals, including more flexibility in areas such as permitted investments, dividend payments, and asset sales.
“As a debt investor, or a distressed investor, you just constantly need to be on the lookout for loopholes in credit documents, credit agreements, indentures that could ultimately have value leak out of your collateral pool,” says Rufino.
Legal landmines may be plenty, and investment opportunities few, but distressed-debt managers still saw strong fundraising last year, attracting $28 billion from investors globally, according to Preqin. The data tracker says distressed-debt funds raised $9.5 billion this year through April, including the $7.4 billion GSO Capital Solutions Fund III.
Investors may be anticipating that a market correction will soon benefit distressed funds. In the meantime, the competition for alpha remains fierce.
“Inter-creditor battles are definitely intensifying,” says Oaktree’s Shourie.
“There are not as many bankruptcy cases and there are, frankly, a lot of bankruptcy professionals,” he says. “When they do get a case, the case becomes litigious,” he adds. “They are going to fight every issue to the death.”
