Explaining the Lender-on-Lender Wars

Welcome Back,

It’s time to explain and run through the rise of credit bois turning on each other.

Whether you call it “lender-on-lender” violence or “creditor-on-creditor” wars, this is a growing development over the past few years as recovery-crunched creditors find themselves pulling the knives out to get a few more points of upside. Let’s get into it, although please note the full analysis is for HYH Premium Subs.

We’re going to go through the following key points: Loose documentation, Sponsor instigation, and precedent situations.

Later on, we’ll go through the different types of violence and some of the key examples. This includes the following: 1) Uptier transactions, 2) Drop-Down transactions, 3) Serta Simmons - the perfect example to go over, and 4) the future of Lender-on-Lender violence.

We’ll go through this synopsis as simplistically as possible and with a dash of lender-on-lender memes along the way to keep things interesting.

What drove the start of lender-on-lender:

What initially started the Wars:

The 2010s were a roaring age for leveraged loans. The rise of the well-oiled CLO machine during a lower interest rate environment spurred Sponsor-backed financing. CLOs, HY Analysts, LevFin Bankers, and Private Equity Investors all got some nice deals done during this timeframe. However, one of the weaknesses of the 2010s was that as the growth in credit funds increased, there was more competition for leveraged loans. This led to a deterioration in credit documentation as Private Equity groups now had more supply than demand for the debt of their borrowers. PE groups put their well paid and sophisticated army of lawyers to work in creating some of the most un-godly documentation out there. During the roaring 2010s and early 2020s, loose credit documentation has allowed for trapdoors and loopholes for borrowers to move collateral around.

Two notable cases that shellshocked the market in the 2010s were J. Crew and Chewy. Shoutout to King & Spalding for the two decks laying out those cases. The very quick rundown is as follows: With J. Crew, they desperately needed to raise new debt so they created a “trap door” by utilizing two baskets to move IP into a restricted sub not a part of the collateral package that was then transferred to a new unrestricted subsidiary. Once this was done, they induced lenders into a debt exchange. Now a days following that maneuvering, J. Crew Blockers in credit docs require specific IP protections. Meanwhile Chewy, before it went public, was acquired by PetSmart (backed by BC Partners) for $3B in 2017. In order to extract more value, Chewy was carved out as a guarantor. BC moved 20% of Chewy equity via a dividend while an additional 16.5% of equity was transferred as an investment to a new unrestricted subsidiary. These two acts of aggression scarred credit investors covering retail for life (although I suspect they were scarred even harder by the retail default cycle), but were also turning points in the leveraged finance market to work towards better combatting Sponsor aggression.

As credit investors get stretched thin with new issue and a growing list of portfolio and secondary coverage, they’re very hard pressed to dig deep into dozens of 300+ page credit agreements. Clearly, a solution was needed. As the market has gotten more spooked by loose covenants and the potential for lender-on-lender, resources such as Reorg and Covenant Review have emerged as solutions to help traditional credit investors better understand what they’re signing up for and what levers a distressed company can pull.

While I’ve historically been an avid reader of both platforms, I recognize there’s an inherent problem in the loans & bonds market. Like I called out earlier, credit investors had historically been stretched as new funds ramped up and name count increased. Some firms have been less incentivized to staff up as this plays out, driving less time on a name than one would ideally prefer. My point being, covenants are generally a weaker point for credit investors. Who has time to read a full 300 page credit agreement? It makes sense to have that work abbreviated, but part of me worries that the market broadly leans a little too heavy on credit docs analyzers as opposed to spending more time on it on their own.

The issues are mainly Sponsor and syndication timeline induced though. Loan deals get accelerated, while bond deals can be “today’s business”. It’s almost impossible for super stretched lenders to fight tooth and nails on documentation with an army of lawyers who are actively looking for new and creative ways to screw you over. End of the day, having uniform platforms that help credit investors across the street understand deal-specific documentation helps the buy-side fight back a bit on documentation.

Sponsors have their popcorn out during lender-on-lender wars:

Lender-on-lender violence is ultimately instigated or induced by Sponsors. While a lot of liability management transactions (“LMTs”) ultimately end up as filings or technical distressed debt exchanges, LMTs are usually a preceding step that may delay the inevitable. LMTs refer to the out-of-court restructuring actions Sponsors and Borrowers try to take to effectively manage and optimize their debt and liability obligations. The primary goals of LMTs are to reduce the cash interest burden, PIK interest, extend maturities and kick the can down the road, reduce the total debt, and more likely than not increase the amount of borrowing capacity they have at the super secured, secured, or unsecured level. LMTs were a more regular occurrence in the bond market, but is a little newer in the loans market. Sponsors may approach certain lender groups about an LMT or alternatively, a group of lenders that have been collectively formed with outside counsel may approach the Company and propose solutions.

Lender-on-lender is largely preferrable to Sponsors over writing a large equity check again. Of course when scenarios get tight, Sponsors can also write equity checks, and credit docs have “equity cure” provisions that allow the Sponsor to inject equity into the borrower order to remedy a financial covenant or a shortfall in cash. Providing equity is likely the last thing the Sponsor wants to do if the IRR math isn’t there, so they’d prefer a variety of creative solutions to address the funding gap. This may make a LMT appealing, as lenders can structure a new cap table in a variety of different ways that enhance their recoveries, returns, and/or priority. Obviously, if PIK is proposed as a solution it may eat into equity returns, but if the can is getting kicked down the road it gives the Sponsor more time to turn things around. Even worse of a scenario – the Sponsor may have taken their equity out of the business & some. If they wrote a $1B equity check but took a $1.5B Dividend + management fees, then frankly their “equity” getting a haircut isn’t as big of a deal.

Lastly, there have been so many precedent situations that ultimately make lender-on-lender a viable path on a go forward basis. I will go through the most notable one, Serta Simmons, which etched in stone that lenders left out of a LMT where the documentation clearly allowed it were out of luck. Unfortunately, credit documentation is likely to remain weak enough to never really deter a super majority lender group from engaging in an uptier transaction.

Types of lender-on-lender and key definitions:

In this next section, we’re going to go through the types of lender-on-lender violence. Broadly speaking, the consequences of poorly drafted pro rata sharing clauses, vaguely/broadly written open-market purchase language, and investments carveouts are the key drivers preceding lender-on-lender. Let’s start with priming in general.

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