Beware the Trapdoor as Borrowers Retreat in Europe Loans FaceoffBy
Investors push back clauses to divert value in companies
Strong demand for loans help in including such provisions
A contentious clause in some European leveraged loan documents that’s rankled investors in recent weeks has been shelved for now after borrowers backtracked in the face of opposition. But the red hot market conditions mean provisions to divert significant value in companies from the reach of investors may be sneaked in once again.
Etraveli AB, Paysafe Group Plc., Theramex SpA and TMF Group Holdings BV removed the carve-out clauses last week before closing the deals. Such provisions are dubbed the “J. Crew trapdoor” after the U.S retailer used the loophole to shift assets and cash flow out of reach of secured creditors and into a new shell company at the end of 2016 and incurred new debt against it.
Soaring demand in the loans market has stoked intense competition among banks and lawyers to provide attractive terms to private equity sponsors and companies, including the insertion of ‘trapdoor” through fineprints in their documents. While such clauses could be advantageous for borrowers, investors are wary that their standing as senior creditors could be diluted.
"We are surprised that sponsors are still trying to get the J Crew trapdoor clause through," said Richard Kitchen, a London-based partner at Paul Hastings LLP said. "We expect to see a temporary pause in seeing these loopholes in deals for the next few months and for the market to reset, but with so much investor demand and the market being so hot we wouldn’t be surprised to see them re-emerge again soon."
Devil in Details
Unlike the J Crew loophole which had a capped limit on the assets and cash flow that could be diverted to unrestricted baskets, the recent provisions seen in the loan market have gone one step further.
"These (recent investment) carveouts can be uncapped, so, with the “J. Crew loophole” borrowers are completely free to make unlimited investments to unrestricted subsidiaries outside of the lenders’ reach," said Jane Gray, co-head of European Research at Covenant Review.
And loan investors aren’t alone in pushing back such provisions, with high-yield bond investors too rejecting the controversial clause in Europe twice this year. Superior Industries International Inc. was forced to close the loophole in a bond sale in June, while cleaning products company Diversey Inc. removed it from a bond in July.
According to Gray, loan investors can no longer rely on term sheets to expect all key terms because these loophole provisions can be hidden in long form documentation, and that together with the clause itself being considered inappropriate.
“But unfortunately, taking the loophole out doesn’t mean that there isn’t still an enormous amount of flexibility to spin assets into unrestricted baskets and out of the control of the lenders,” said Gray.
— With assistance by Ruth McGavin