Trickery reigns in distressed debt

Good morning and happy Friday! Sujeet Indap, the FT’s Wall Street editor, here filling in for Rob. After a punishing week, yesterday delivered a much-needed lift for stocks, led by a 14 per cent pop in Nvidia. The chipmaker’s chief executive, Jensen Huang, is leaning into the hype around AI, which he said is at an “inflection point”. Until the FT replaces its writers with large language models, you can email me: sujeet.indap@ft.com.

When legal gymnastics beat investing nous

Years ago when I was an MBA student, I was accepted into law school at the same institution and I considered a joint degree which at the time would have taken two more years and perhaps cost another $100k. My roommate at the time was a law student and given how much time he seemed to spend reading thick textbooks alone in the library, however, I thought better of it.

Oddly enough, legal, not finance, training may be the best possible preparation for distressed debt investing, an area which I now write about frequently. When a company is about to run out of money, the ability to parse obscure clauses in loan agreements and bond indentures is almost more critical to making money than understanding discounted cash flow inputs.

Take, for example, a fight under way right now at the mattress company, Serta Simmons Bedding, currently owned by the private equity firm Advent International.

The company’s restructuring plan in its current Chapter 11 bankruptcy hinges on an esoteric dispute between rival lenders where a slim majority of hedge funds and investment firms in 2020 were able to elevate their existing set of loans above other lenders who were previously equally ranked at the top of the capital structure. The majority lender group gets “superpriority” claims over everyone else; the squeezed-out minority gets whatever scraps were left at the bottom of the totem pole.

That majority group, in exchange for its elevation in priority, provided $200mn of new cash to Serta in 2020 that kept the company afloat for a couple of years. The intricate transaction, relying on a series of lawyerly gymnastics, is colloquially known as an “uptier exchange”.

Unsurprisingly, the stranded minority lenders, including titans such as Angelo Gordon and Apollo Global Management, sued. They argued the existing loan contract did not give majority lenders the right to jump the line. The details are complicated, but one argument stands out.

To allow the winning majority to “roll up” or push their existing debt into the higher, privileged tier, Serta relied on a section in the existing loan agreement for so-called “open market purchases” of an existing $850mn in their loans. (The roll-up is crucial because the group providing the new, superpriority $200mn did not want their old debt to be stuck at the back of the line with the losers who were excluded from the uptier exchange.)

The loan contract said that if the company ever paid off existing debt, it had to give all lenders “pro rata” treatment. In other words, a 5 per cent lender could theoretically participate in 5 per cent of the debt buyback. However, there was an exception for a so-called “open market purchase” which did not require pro rata treatment. The implication being that some parties would get the chance to be in the loan buyback but would politely decline.

But at Serta the excluded group argued there was no such genuine “open market purchase” executed in 2020 as Serta and the majority group cut the deal, including the roll-up, completely in secret.

“Open market purchase” to you and me would seem like a pretty straightforward concept. But not if you are trying to make it as a leveraged finance lawyer in America.

The majority group, according to its filings, relied on the Black’s Law Dictionary definition of “fair market value”— an arm’s length transaction between a “willing buyer” and “willing seller”. Of course, “fair market value” and “open market purchase” sound similar but ultimately are different things! Lawyers! Imagine investing hundreds of millions of dollars which completely ride on a judge’s interpretation of three simple words.

Nor are the shenanigans at Serta a one-off. In another one of these so-called “creditor-on-creditor violence” deals, we now know how expensive it is to end up on the short end of the stick.

The chart below, disclosed in a court filing this week in the current Revlon bankruptcy, shows proposed recoveries for creditors in its Chapter 11 restructuring transaction which now awaits creditor and court approval. In the chart, note the creditor classes 4, 5 and 6:

Before a new Revlon loan in 2020, the members of those three groups were all equally ranked. But after a similar gambit like the one seen in Serta, some members of class 4 jumped the line — creating senior classes 5 and 6.

The lenders now stranded in the class 4 group are only set to get 20 cents on the dollar, while the winners in newly created classes 5 and 6 are getting roughly 78 cents on the dollar.

Some fun math (OK, a little finance training is useful!): Imagine a world where the Revlon lender group had not splintered in 2020. What would that counterfactual — of a single, unified lender class — look like?

You can estimate this is by adding the listed recoveries for the trio in the table above and dividing by the total claim. By that math, a unified lender class would have gotten 61 cents on the dollar (top bar below). But instead, on the basis of some financial and legal engineering, the line-jumpers in classes 5 and 6 get an extra 18 cents on the dollar (middle bar), while the stranded group is out 40 cents on the dollar (bottom bar):

Within distressed debt circles, there is concern that market norms are being eroded in these circular firing squads. If every firm in the market is willing to go rogue, there is little chance of any single firm facing reputational damage. Law professors are worried about the ostensible inefficiency of Serta- and Revlon-like mischief.

Meanwhile, judges are having a hard time interpreting contracts and ultimately policing the market. Here is the federal judge who declined to dismiss the complaint of a Serta lender cut out of the uptier exchange:

Indeed, one could reasonably conclude from plaintiffs’ allegations that defendant [Serta] 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.

The uneasiness is understandable. A capital market constantly prone to legal disputes would seem to be dysfunctional.

Still the ascendence of the lawyers might really indicate the opposite: the triumph of market efficiency in distressed debt investing. When traditional business school valuation analysis no longer provides an edge, the only thing left may be to mine loopholes in legal contracts.

The ugliness in distressed debt financings may seem shocking to casual observers. But the players are all sophisticated and tend be winners as much as losers, so don’t feel too badly for any one of them.

Before distressed debt investing emerged 35 years ago, most troubled companies simply shrivelled and liquidated. Today, your friendly neighbourhood hedge funds and PE firms — with the help of clever legal minds — collectively have billions to keep companies operating.

In the meantime, maybe it is not too late to enrol in law school.

One good read

This investigation of sketchy charitable foundations of American football stars finds a consultant who charges the jocks a fee that would make a hedge fund manager blush.