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PE Firms Race to Block The Exits to Ward Off Vulture Funds

PE Firms Race to Block Exit Doors to Ward Off Vulture Funds

(Bloomberg) -- Leveraged loan investors in Europe face heightened risks of finding their escape route slammed shut, as private equity firms impose stricter rules on sales to distressed funds.

PE firms are tightening rules to make it harder for such asset managers to seize control of their companies in the event of a debt restructuring. About two thirds of loans sold this year faced curbs on selling to such funds, compared with just 29% in 2017, according to Reorg Debt Explained.

"The first thing anyone should do when they walk into a room is check where the exits are,” said Nigel Houghton, managing director at the Loan Market Association, a lobby group. “But investors are not doing this, they’re buying into something they don’t know they can get out of.”

These restrictions have come into sharper focus now as more borrowers are under pressure from weaker earnings, which could trigger a drop in loan prices and threaten managers’ returns. And more pain could be in store as the region’s economy worsens.

PE Firms Race to Block The Exits to Ward Off Vulture Funds

During the financial crisis, distressed funds took control of PE-owned companies including Monier and Eircom after gaining a toe-hold through leveraged loans. Now, private equity sponsors have gained the upper hand in pushing their agenda. They’ve taken advantage of demand for assets persistently outstripping supply, as buyers look for yield in a low interest rate world.

That demand has also allowed sponsors to remove covenant tests that might otherwise have provided lenders with a trigger to negotiate a debt restructuring rather than waiting for default.

The fine print of many European leveraged loans provides a list of acceptable buyers referred to as a "white list" which usually excludes distressed funds that are the most likely buyers of a troubled asset. It may also contain additional language that bars lenders from transferring to any “loan-to-own” funds.

"It’s buyer beware when it comes to white lists," said Azhar Hussain, head of leveraged finance at Royal London Asset Management. “Par investors are going to find it increasingly hard to get out as soon as those positions turn stressed and the cycle is tested."

More Harsh

Some lenders have previously circumvented strict sale rules via a trade called a sub-participation, where a bank’s trading desk holds the position on behalf of the distressed buyer.

But leveraged finance lawyers said sponsors have started to close that option too. However, it’s not clear how a ban on sub-participation would be enforced, and what action would be taken.

The restrictions on sub-participation may prevent a par-based debt fund from hedging its exposure just when it needs to the most, credit research firm Covenant Review said in a report published this week. "Investors should be wary of entering into any derivative transaction without reviewing the underlying credit agreement," the report said.

As rules tighten, transfer restrictions have also begun to apply even where a borrower has defaulted on a loan. Reorg Debt Explained data show 58% of loans sold in 2019 imposed curbs on selling to distressed funds even after certain types of default, compared with just 14% in 2017.

Even so, the impact of trading restrictions in case of a widespread selloff is yet to be tested. Some investors even support the “white lists” knowing they help prevent distressed buyers from taking control and writing off their debt. But signs of stress and the thin liquidity of the secondary market are making investors nervous.

It’s notable that transfer restrictions are more harsh in the sponsor-dominated European loan market than the U.S. They are non-existent in high-yield bonds although increasingly there’s very little to differentiate between the two asset classes in terms of documentation.

"As we’ve seen, loan prices can drop fast in facilities which turn out to be less liquid than assumed," said Luke McDougall, a partner at Paul Hastings LLP in London. “So for ‘par investors’ being able to get out of these stressed positions could be challenging.”

To contact the reporters on this story: Laura Benitez in London at lbenitez1@bloomberg.net;Sarah Husband in London at shusband@bloomberg.net;Ruth McGavin in London at rmcgavin1@bloomberg.net

To contact the editors responsible for this story: Vivianne Rodrigues at vrodrigues3@bloomberg.net, V. Ramakrishnan

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