Excesses of cheap money era are provoking ‘creditor-on-creditor violence’

The writer is a former investment banker and author of ‘Power Failure: The Rise and Fall of an American Icon’

The end of some 13 years of nearly free money in financial markets has exposed excesses that seem utterly baffling in hindsight.

Take, for instance, the tsunami of so-called cov-lite, or covenant-light, leveraged loans that investors flocked to with reckless abandon. At the end of 2023, the amount of these loans outstanding, which lack the typical protective covenants designed to be an early warning system for lenders, ballooned to $1.25tn, according to law firm Paul, Weiss.

It was quite a party, especially for the issuers of the loans, who were able to borrow lots of money with minimal checks and balances. And now the lenders and investors who provided those loans are paying the price, in a phenomenon on Wall Street dubbed “creditor on creditor violence”.

How apt. The carnage is nearly everywhere in the important leveraged loan market. Essentially, issuers of the loans with few or no covenants — often highly indebted companies on the verge of default or a bankruptcy — have been seeking to restructure their balance sheets to stave off financial calamity and sometimes to try to extract value for the benefit of equity holders at the expense of debtholders.

These hijackings are often occurring with the consent of one group of creditors at the expense of another group of creditors. And there is very little the creditors who are losing out can do about it because they made the loans knowing their rights had been gutted from the outset. “Anticipating a borrower’s default, secured lenders have recently used aggressive legal tactics to extract value from other secured lenders,” said a Harvard Business School research paper in May.

Take, for instance, the sad saga of Advent International’s 2012 buyout of the parent company of mattress makers Serta and Simmons. In 2016, the renamed Serta Simmons Bedding refinanced its existing debt through the issuance of $2.4bn of new cov-lite loans, allowing for a sweet $670mn dividend to be paid to shareholders.

But by 2020, the deal had started to come a cropper due to declining revenue, thanks to the pandemic and growing competition from online mattress sales. In June 2020, the company reached an agreement with the majority of its secured lenders, including mutual funds Eaton Vance and Invesco, to exchange their debt for new “super secured” debt. The deal included a cash injection of $200mn into Serta to help it through pandemic stresses.

Incredibly, other lenders, including the likes of sophisticated investors such as Apollo Global Management and TPG Angelo Gordon, the holders of $600mn Serta debt, claim they were not given the opportunity to exchange their first-lien secured debt on the same terms.

As a result, they suddenly found themselves subordinated to the new debt. Serta Simmons filed for bankruptcy anyway. And Apollo and Angelo Gordon sued Advent and several of the mutual funds to overturn the deal.

In an ironic twist, the wise-guy Wall Street types who are usually the ones inflicting the pain were accusing the normally more placid mutual funds of pulling a fast one designed to eviscerate their rights and subordinate their loans. But the bankruptcy judge in the case ruled against Apollo and Angelo Gordon, arguing that they should have known the risks of their cov-lite loans.

That ruling came last year, but the Serta case is just one of many recent examples in which buyers of cov-lite loans are experiencing the consequences of their foolish investment decisions. “This is happening every day in the credit markets,” one hedge fund investor told me.

One infuriating recent example involves Lionsgate Entertainment, ironically the studio behind a film series called The Hunger Games. It spun off its TV streaming business Starz this year through a merger with a special-purpose acquisition company. A bare majority of bondholders joined together to move their security to the Lionsgate level.

Other creditors, who were not given the chance to participate in the deal, were left down at the Starz subsidiary, which is viewed as less creditworthy. The transaction benefited, among others, Steven Mnuchin, the former Treasury secretary, who is both a Lionsgate creditor and one of its biggest shareholders.

The widespread filleting of what were typical creditor rights by other groups of creditors may be decried by those who lost out. But as with any period of euphoria in which investors lost their collective minds, a careful reading of the loan documents would have made unambiguously clear the risks of these idiotic investments.