Munis Meet Milken as Hedge Funds Dictate Puerto Rico Terms

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Puerto Rico is getting a thorough introduction to Michael Milken’s junk-bond world as it increasingly relies on some of the financial industry’s most aggressive players to solve its crippling financial troubles.

With the U.S. territory’s Government Development Bank saying it will run out of cash by Sept. 30, the island’s leaders have turned to a group of 35 hedge funds that hold the commonwealth’s debt and could recapitalize the bank through a planned $2.9 billion oil-tax bond deal.

For Puerto Rico, the money comes with a catch: The potential investors are bringing their full arsenal of junk-bond tricks with them. The terms they’re asking for, such as payment guarantees and strenuous debt protections, typically aren’t used in municipal bond deals. But they are a regular part of raising money for the riskiest borrowers in the realm of speculative-grade debt, which is where the territory has been for the last year and a half.

“If you come and do a rescue financing for a company, you can ask for anything,” David Tawil, president of New York-based distressed-debt hedge fund Maglan Capital and a former restructuring attorney, said by telephone. “These asks that are potentially shocking to the muni world are by no means shocking to the distressed corporate world. These sophisticated investors are bringing in a lot of developed know-how to these situations.”

Fiscal Vise

The group of investors, led by Fir Tree Partners and Monarch Alternative Capital, have been pressing Puerto Rico’s government and finance officials for months with a list of requirements that they want from the GDB, the island’s lender and the agency coordinating the deal. Proceeds would help repay obligations owed to the GDB, which will run out of cash by Sept. 30 unless the Infrastructure Financing Authority sells the bonds or figures out another rescue maneuver.

Russ Grote, a spokesman for the hedge-fund creditor group at Hamilton Place Strategies in Washington, and David Millar, a spokesman for the GDB at Sard Verbinnen & Co. in New York, both declined to comment.

The hedge fund demands come as Puerto Rico increasingly finds itself in a fiscal vise. It’s saddled with $72 billion of borrowings and dwindling financial resources as the local economy shrinks. Its cash-strapped electric utility also is dealing with another set of creditors to restructure its $9 billion of debt. The power provider known as Prepa has to make a $416 million payment on July 1.

Default Protection

To protect themselves from default, the 35 hedge funds negotiating with the GDB want to be allowed to demand a full, immediate repayment if the island defaults, a clause typically not added to muni deals. They also are asking to be repaid ahead of the GDB.

The firms also want something known in the junk-bond world as a make-whole provision, according to two people with knowledge of the matter. So, if Puerto Rico decides to pay back the debt before maturity, the investors would get full payment with the future interest they would otherwise lose.

They have some other demands too, the people said. They want the debt issued under New York law rather than local. They want to put the commonwealth and its agencies on a five-year plan to close its budget deficit. And they want the island to regularly disclose its financial data.

Volleying Proposals

Puerto Rico officials have said the terms the hedge funds are demanding are unacceptable. Governor Alejandro Garcia Padilla pushed the divide even further in an interview with the New York Times published late Sunday, in which he said creditors must “share the sacrifices” that island residents have already borne.

If creditors “don’t come to the table,” Garcia Padilla said in the newspaper interview, the “economy will get into a worse situation” and Puerto Rico will be “less able to pay them.”

General obligations maturing in July 2035 traded as low as 68.5 cents on the dollar Monday, down from 77.3 cents Friday and the weakest since they were first issued at 93 cents in March 2014, according to data compiled by Bloomberg.

The GDB had volleyed a counter-proposal to the hedge-fund group last month, according to two people with direct knowledge of the matter who didn’t provide details. Puerto Rico officials declined an invitation from the hedge-fund group to meet, either in New York or Puerto Rico, to discuss the terms, the people said.

Standard Demands

Frustration set in last week, prompting a letter from the hedge fund group on Wednesday to Garcia Padilla and GDB President Melba Acosta reiterating the request for a face-to-face meeting. Buyers of distressed debt have been piling into Puerto Rico over the last two years as the island’s traditional lenders fled because of a weakening economy and worsening fiscal woes. The increased possibility of defaults and restructuring talks has driven away traditional municipal investors. This is limiting Puerto Rico’s options as it tries to sell the debt that would enable its highway authority to repay the $2.28 billion it owes the GDB.

“Potential buyers aren’t comfortable with a straight issue the way Puerto Rico had been issuing in the past,” said Joseph Rosenblum, director of municipal-credit research at AllianceBernstein Holding LP. “The first time you smell risk and they come to market, they ask for higher yields. If things get worse, then you start to ask for all these enhanced features.”

While Puerto Rico may be boggled by the demands, they’re fairly standard in distressed-debt financing, said Lee Bogdanoff, co-manager of the law firm Klee, Tuchin, Bogdanoff & Stern LLP, who represented Jefferson County, Alabama, in talks with hedge funds to restructure sewer debt.

“They want to make the possibility of a default as painful for the issuer as possible,” he said.

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