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‘Tyranny of the majority’: creditor infighting comes to $1.4tn leveraged loan market

When a debt-laden company gets into financial distress, the fights between creditors are often ugly, but investors in leveraged loans could usually watch from the sidelines while more junior claimants haggled over what they would be repaid.

Not any more.

A recent court decision threatens to escalate creditor-on-creditor violence in a normally sedate $1.4tn corner of the financial markets that is critical to funding big private equity deals and the operations of lowly-rated businesses.

The ruling, in the Texas bankruptcy case of Serta Simmons, blessed a controversial 2020 debt swap that only a slim majority of the mattress maker’s senior lenders had approved. Other holders of the company’s loans, including Angelo Gordon and Apollo, were pushed further back in the queue to be repaid and the value of the loans they held crashed when Serta ultimately went bust.

By confirming that the debt swap and refinancing package did not need unanimous support from all loan holders, Judge David Jones effectively opened the door to more deals that will pit lender against lender, industry veterans say.

“It’s the tyranny of the majority taking advantage of the minority,” one restructuring adviser said. “If you’re in the 51 per cent in the right case . . . it can be very lucrative and it has created this dynamic of people competing. Do you get to sit at the cool lunch table or do you have to sit with the maths majors?”

One distressed debt fund manager said aggressive investors such as his firm would benefit if other jurisdictions followed the Serta precedent.

“This will completely throw the leveraged loan market into chaos,” he said.

In a restructuring, creditors are ranked by priority and receive payouts commensurate with their standing. Traditionally, loans used in a private equity buyout were senior to lower-ranked bonds and claims from unsecured creditors.

That attracted “long-only” asset managers and vehicles that bundle hundreds of loans together to create what are known as collateralised loan obligations, or CLOs.

But the loan market has become a much bigger part of the financing mix for leveraged buyouts over the past decade, and there has been less junior capital to absorb losses in a bankruptcy or restructuring.

Moody’s estimates first-lien loan holders recovered about 95 cents on the dollar in restructurings from 1987 to 2019. That figure plunged to 73 cents in 2021 and 2022, with the rating agency warning that in this “new world of LBOs . . . even first-lien lenders will experience material impairment”.

With bigger risk comes more incentive to pursue aggressive tactics, and the growth of private credit funds has also brought new players more comfortable with playing aggressively.

Before the global financial crisis, “the bond market was the favoured instrument for private equity leveraged buyouts”, said John McClain, a portfolio manager at Brandywine. “And leveraged loans took that mantle pretty aggressively.”

Before, “you didn’t really have the opportunity for this type of behaviour”, he added.

The changes have been accompanied by a big increase in loans without historical investor protections — so-called covenant-lite loans. Although the balance of power has shifted in investors’ favour this year as financing markets have become tighter for borrowers, the effects of the revolution will be felt in debt restructuring fights to come.

Nearly 70 per cent of leveraged loans in a Credit Suisse index appear to allow for a Serta-like financing transaction, according to credit analysis service Covenant Review.

“Weaker covenants mean that a borrower has more room to indulge audacious theories of its own rights without risking enforcement of remedies,” said Wharton professor Vince Buccola, adding that the sheer number of lenders now in the market had eroded social norms of co-operation.

Litigation over such fights had offered mixed guidance on the legality of such deals as New York courts have been slow to issue final decisions.

The Serta case hinged on the definition of an “open market purchase” and whether the company was allowed to only buy debt from a select group of lenders. It bought their debt and exchanged it for new, more senior loans and $200mn in extra funding for its ailing business.

Angelo Gordon and Apollo had challenged Serta Simmons and the majority lenders who led the refinancing. The pair had argued that so-called “sacred rights” embedded in all loan contracts did not allow for unequal treatment in loan pay-offs. A New York federal judge agreed in 2022 that Serta creditor claims should go to trial to determine what constituted an open market purchase.

However, the litigation in New York was ultimately paused after Serta filed for bankruptcy protection in Texas, leaving the recent bankruptcy court decision as the most consequential guidance for the corporate credit market.

Not everyone thinks these aggressive refinancing transactions are worth the time, expense and reputational damage.

Cosmetics group Revlon, like Serta Simmons, raised rescue capital at the outset of the pandemic from a slim majority of lenders, but it ultimately filed for bankruptcy in 2022. It is set to emerge from bankruptcy this spring but the case has cost $250mn in legal fees. Shareholders were wiped out and the majority lenders ultimately took control.

“Very few of these liability management transactions have been successful,” said Mike Harmon, a former investor at Oaktree Capital who now teaches at Stanford University. “In the overwhelming majority of cases, these transactions have just served to delay the inevitable.”

Others are sure the floodgates are open, even if it will be some time before it is clear whether other courts respect the Texas decision. One lawyer who has advised on a number of these transactions noted that “no one has smacked down a company or lender group for doing this type of transaction”.

For now, the lawyer added, “no one is putting the brakes on [these] . . . deals”.

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