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Welshcake: Sirius has made a strong move in CDS - if it hits the right targets

By Welshcake

Friday, May 31, 2019

Among the many fascinating traits of human society, our constant ingenuity to find patterns, solve problems and innovate creative solutions in response is surely the most elevated. By the same token, the most tragic of our traits is the proclivity for these inventions to come back and bite us.

We are a curious species, forever driven by some innate progressive impulse to find exciting new ways to protect what we have and expand for the sake of expansion – even when this progress brings with it a host of new problems that put us closer to self-annihilation. Think Mayan cities and their impact on local water sources, think the Roman empire’s foray into eastern Europe, the proliferation of atomic weaponry, or your mate Gareth in Ebbw Vale voting to leave the EU then finding out who paid for the town’s sixth form college and leisure centre.

When there’s no-one left on earth to chronicle it, the arc of the human experiment may well turn out to be an accumulation of unintended consequences. And it’s not just us either – consider the first wolf to accept meat from an ape by the fire, then the Chihuahua wearing a stupid unicorn costume.

Something innovative is happening in the world of corporate finance that seems to come from a good place of progressive development, but nevertheless has elements of knee-jerk reaction and raises – or should raise – big questions about where it will take us. Better minds than Welshcake ought to be set to work on the necessary calculations, because both the leveraged loan and CDS markets could look fundamentally different as a result by the end of the year.

We’ve talked before (ok, maybe twice) about our misgivings regarding headlines about narrowly tailored credit events. You remember. Despite what you will read elsewhere, CDS has not been fundamentally undermined by these isolated incidents. Far from it, they’ve driven legal discussion that will end up with the product being further strengthened to avoid future recurrence.

Maybe you could say the headlines and accompanying regulatory pressure has served a purpose too. It’s hard to find anyone who uses CDS – other than for nefarious ends – who thinks the recent proposals by the International Swaps & Derivatives Association to address narrowly tailored credit events are not a good thing. Making the probability of success for such stratagems more of a coin-toss will surely discourage them from gaining prevalence.

But an even more recent development in the loan market looks less straightforward, at least on first reckoning. The purported inclusion by Sirius Computer Systems, which is being bought by CD&R, of provisions in its financing package to thwart activist investors who are net short the company through CDS is undoubtedly a strong move, but one has to wonder its origins, its efficacy, and the behaviours it will encourage.

Among the key loan language, as documented in a post by law firm Kramer Levin (who don’t name Sirius specifically), are the following lines:

“Any revolving lender as of the closing date that, as a result of its (or its affiliates’) interest in any total return swap, total rate of return swap, credit default swap or other derivative contract (other than any such total return swap, total rate of return swap, credit default swap or other derivative contract entered into pursuant to bona fide market making activities), has a net short position with respect to the loans and/or commitments (each, a “net short lender”) shall have no right to vote any of its loans and commitments 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.” 

This helps us separate fact from fiction. What the provision aims to achieve is not to stop anyone from hedging their cash exposure to the borrower – a ploy that would be very detrimental to a central purpose of CDS and provide a sure-fire disincentive for lenders with any regard for self-preservation. So disregard any headlines saying this is – once again – the end of CDS.

This is not a doomsday machine. The idea is simply to stop investors who have a short CDS position net of their cash holding from having a say on matters pivotal to the borrower – such as triggering a bankruptcy. Lenders will have to make a representation at the time of any such vote with indemnity for a breach.

Seem fair, right? But it’s also apparent that this is an action that results from an isolated incident that will end up affecting a large number of loan and CDS investors.

The move by Sirius is a direct response to what happened earlier this year when New York hedge fund Aurelius Capital sued US phone company Windstream, on which it held CDS protection, over a bond issue. A Manhattan court said in February that Windstream Services had breached covenants on its bonds during its 2015 spin-off to Uniti Group.

That decision cost Windstream $310 million and led to it filing for bankruptcy protection. Cue a pay-out to those short the name through CDS.

It’s clear why other companies would take note of this lesson. That is why the provisions drawn up by Sirius are certain to be replicated by other borrowers, and quickly – a cut-and-paste job. In turn, activist lenders will naturally shift focus to borrowers that don’t have such protections. Non-activist lenders may take comfort that activist investors are not sneaking in among them in loan deals.

But it should be pointed out that Sirius is not already a name of interest to the CDS market. That makes it an easy testing ground for new language, but borrowers which are widely referenced by CDS should think long and hard about the implications of replicating the approach. Doing so might catch out some otherwise useful lenders, including those that might edge short through basis trades.

Remember too that the number of activist lenders out there is quite small - Windstream was the first instance of this specific manipulation. So borrowers really need to make sure they are not penalising the wrong guys with this. Hopefully, knowing in advance the timing of key votes will allow lenders to unwind any small short positions they temporarily or inadvertently find themselves holding.

Of note – and this may prove instrumental – the language as it stands does not give the borrower the option to waive the clause if it suits them to do so. This seems like a strange oversight on the part of the lawyers, and something maybe future iterations should address.

It remains to be seen – and measured – how the provisions affect the pricing of CDS relative to the cash product. What is unlikely is that it will impact the liquidity of a loan (and hopefully CDS), as people will still mainly hold the two things separately or in a hedged strategy.

Not the end of CDS then, but certainly a new and important addition to the landscape. What that looks like will depend on the forethought of those who are shaping it right now. Let's look forward to new and exciting vistas, hopefully not strewn with unwanted casualties.

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TAGS: CDS High yield bonds Distressed debt Credit derivatives Leveraged loans North America Welshcake