The Coronavirus (COVID-19) pandemic currently sweeping the globe has brought with it unprecedented chaos not seen before in this lifetime. While it may be months or even years before the economic effects of COVID-19 are fully realised, many businesses both domestically and globally – and their financiers and other stakeholders – are already, understandably concerned about what the future may hold, should there be one. As is evident from recent newspaper reports, debt is once again beginning to trade and we are likely to see a lot more of it over the coming weeks and months. In this article, we provide a brief guide to debt trading and answer the critical questions relating to the buying (or not) of debt; when a financier might consider trading its debt, why an investor may consider buying debt at sub-par, and how a debt trade is documented.
When to consider a debt trade?
Traditional financiers that have debt exposure are likely to consider trading their debt, either at par or below par, when they form the view that they are unlikely to achieve their original return on investment or full repayment of secured moneys when required. Other factors may include difficulties with enforcement or a need to recycle capital for other purposes (including to meet Basel III requirements for bank lenders).
Debt trading is most likely to occur when the performance of a company, or the value of its underlying assets, are impacted by an economic downturn (as is the present case), or there is a risk of the borrower defaulting on the debt (which may be indicated by a loss in revenue or key contracts of the borrower, requests by the borrower for extensions or waivers, or the financier forming the view that the borrower is at risk of a key financial covenant breach). If any of these circumstances occur, a financier may take the view that it is safer to exit their exposure via a debt trade, rather than wait for a default to occur and take enforcement action where:
the financier is concerned about reputational damage if the security is enforced;
the financier requires certainty as to their return on investment or recovery from the debt exposure (noting that an enforcement scenario may cause costs to balloon and affect amounts recoverable, and will also be impacted by other economic factors such as whether there is a liquid market for the secured assets);
the proposed restructuring may require financiers from a syndicate, who choose to remain post-restructure, to convert some of their debt to an equity position which may be difficult for a financier from a fund mandate or capital adequacy perspective; or
the financier has limited resources available to run an enforcement process.
Often debt will trade in such circumstances at sub-par or below the face value of the debt reflecting both the change in the value of the asset base and the ability for a financier to recover the money that was originally lent.
Why buy debt?
There 3 key reasons why an investor may consider buying debt, are outlined below:
A prospective investor may consider buying debt at sub-par where they consider there is a likely chance of the economic prospects of the borrower being turned around within a fixed time-frame, and the prospective investor intends to re-sell the debt, a make a profit from the upside, within that period (or indeed be refinanced at, or close to, face value as the borrower recovers).
A prospective investor may also buy-into debt at a sub-par rate where they have loan-to-own ambitions because they can see potential equity upside. In such circumstances, once an investor obtains a sufficient level of debt that provides them, from a voting perspective, either positive or negative control in the syndicate (if there is a syndicate), the investor can use a range of options to negotiate either a consensual restructuring that gives it control of the company, or use one of the many restructuring tools to force the other financiers and the company to restructure. A creditors’ scheme of company arrangement or a deed of company arrangement (or “DOCA”) are examples of such restructuring tools.
In certain circumstances, debt may be traded at par (rather than below par), if the incoming investor has a positive view on the underlying industry or sector, and believes that the terms and conditions set out in the existing finance documents are more favourable to the financier.
How is a debt trade achieved?
Traders of debt in the Australian market usually rely on one of two methods for documenting a trade:
the Loan Market Association (LMA) has a suite of precedent secondary trading documents that allow debt trading transactions to be documented extremely quickly (with some adaptation required for the Australian market as discussed below); or
bespoke documents can be negotiated between the financier and the incoming investor.
While the LMA suite of documents is well understood and are often used to achieve speed and minimise cost when doing a trade, there are a number of limitations involved in using such documents. The LMA documents rely on a set of standard terms with any deviations documented in a short form confirmation. The standard terms often don't cater for all transaction types and therefore extensive drafting can be required in such circumstances (thereby undoing any economies achieved by using standard form documents to begin with). It can also be difficult to negotiate bespoke warranties or other key terms when an LMA document is used as the starting point for negotiations. Finally, it is important to note that LMA documents are based on English law and are therefore not always appropriate for use in the Australian or other global markets (or require further amendments to be made in the confirmation document to conform to Australian market requirements).
For the reasons stated above, some investors prefer to use bespoke documents which allow for greater flexibility and negotiation of key protections. Additionally, if the debt being traded is a portfolio or a structured arrangement, bespoke documentation may well be required to effect a debt transfer.
It is also worth noting that, in addition to the above, there are a number of “synthetic” methods of achieving the same economic and/or control outcome for an investor as a debt trade including sub-participation and total return swaps.
Things to consider
While debt trading may conjure negative connotations, in many circumstances new investors in the debt stack could provide a positive catalyst to assist a company to restructure, undergo a turnaround and/or de-leverage their debt. This has particularly been the case in recent times when more traditional bank financiers can be reluctant to enforce, provide additional liquidity or take action, leaving companies powerless and unable to trade out of poor conditions.
However, there are still a few things to consider when it comes to debt trading whether you are an existing financier, an investor or a company including:
Greenmailers: in documentation that contains no restrictions on the types of investors that could buy the debt, there is a risk that a potential greenmailer could end up buying in for the purpose of seeking a ransom payment. For this reason, borrowers are becoming more mindful of restrictions around who can buy debt when negotiating documentation; however these restrictions are not in all documents and, even if they exist, they sometimes fall away on an event of default. It is important to note that, depending on how a document is drafted, some investors could still buy into the debt through synthetic arrangements like sub-participation.
Borrowers buying debt: one strategy that some borrowers have deployed is to buy a negative control stake (either directly or through a related subsidiary) in their facility to ensure that the remaining syndicate lenders cannot force through a restructure. Again, some facility documentation now contains provisions that discount the voting of a related entity holding the debt to prevent a borrower from using this strategy to frustrate the ability of the lenders to act of a default.
Impact on interest-rate hedging linked to a syndicated loan: in recent years, strong borrowers have negotiated orphaned hedging provisions into syndicated loan documentation, with the effect being that a syndicated financier who sells their lender position in a deal may nonetheless be obliged to keep their hedging on foot with the borrower, thereby exposing that financier as an orphaned hedge provider in a syndicated deal. The risk with this scenario is that the hedge provider often does not have a voting right under the loan documentation until an event of default has occurred, and therefore has no say in other decisions of the lenders prior to a default being triggered. The orphaned hedge provider may also risk not having the right to be provided with access to the same financial information in respect of the borrower as the syndicated financiers are entitled to receive.
Reputational risk: while the reputational risk of enforcement may be a reason that some financiers trade out of their debt positions, if details of the trade are leaked to the market there may still be some reputational repercussions for the original financier.
The Hamilton Locke finance, restructuring and insolvency team have a broad range of top-tier experience acting for a variety of stakeholders in distressed scenarios. For more information on debt trading, distressed investing and finance, or advice on insolvency, distressed debt and restructuring generally please contact Zina Edwards (Zina.Edwards@hamiltonlocke.com.au) and Nick Edwards (Nicholas.Edwards@hamiltonlocke.com.au).