Why pay off your debt when it's cheaper to owe it to yourself?
14 April 2008
The legitimacy of sponsors buying back their debt in the secondary market for leveraged loans has sparked an intense debate in the legal market.
The UK and US legal markets are now divided on the issue as more loan buyback deals look set to hit the market.
The credit crunch has placed banks and borrowers under tremendous strain since last summer, creating a new environment in which banks are desperately attempting to sell debt. At the same time, borrowers are attracted by the cheaper price of debt on the secondary market.
In January this year Credit Suisse sold off $1bn (£507.88m) of its loan book associated with the $27.8bn (£14.12bn) acquisition of US company and Latham & Watkins client Harrah's Entertainment by private equity houses Apollo Management and Texas Pacific Group.
Credit Suisse, which was part of a Cahill-advised bank syndicate including Bank of America, Citigroup, Deutsche Bank, JPMorgan and Merrill Lynch, sold a portion of this debt ahead of the syndicate's agreed schedule.
This deal, as well as angering other banks in the syndicate, set a precedent for lenders seeking to offload their debt books. The prospect of the borrowers themselves entering into debt buyback arrangements with specific lenders in a syndicate instantly became controversial.
According ;to ;the ;lender community and its advisers at firms such as Clifford Chance, loan buybacks are prohibited by the Loan Market Association (LMA). From the sponsors' point of view, however, they are valid. Allen & Overy partner Tim Polglase said: "Our position is rather less forthright. It all comes down to what the loan documents on any particular deal say."
With lender and sponsor lawyers at odds over how buybacks should be handled - and, crucially, whether they should be allowed at all - will more firms be prepared to take a stand one way or another?"I suspect it will take some time for it to be resolved," says Linklaters banking partner David Ereira. "This is important because debt is being priced significantly below par and this clearly creates issues with other banks involved in the syndicate.
"You have to consider a number of things here, including the impact on voting rights. This is why there is such debate."
Syndicate banks, many of which have been trading debt at significant discounts, are clearly not in support of borrowers attempting to eliminate their debts via loan buybacks. But that does not mean the practice is untenable.
"My view is that, providing the documentation does not prohibit a buyback and cause issues in some way, then it's perfectly acceptable and legal," Ereira says. "However, this issue will not just disappear and I suspect we will see more discussion on the subject."
There have been only three public deals at this point. Danish telecoms company TDC, owned by Simpson Thacher & Bartlett clients ;Apax ;Partners ;and Kohlberg Kravis Roberts (KKR), bought back e200m (£159.54m) of its senior debt in March. Willkie Farr & Gallagher advised PAI Partners when it bought back second-lien debt associated with the e1.96bn (£1.56bn) acquisition of a roof construction business from French company Lafarge. And US borrower Citadel Broadcasting went to its bank syndicate last month with the aim of buying back $200m (£101.57m) of debt at a discounted rate.
"There have only been three publicy reported debt buybacks that we're aware of - TDC, Lafarge and Citadel in the US," says Kirkland & Ellis banking partner Stephen Gillespie. "However, there are many ways in which the economic substance of these transactions can be disguised, so it's possible there may have been many more."
Kirkland & Ellis's paper and Clifford Chance's published opinion on loan buybacks represent the two sides of the debate.
While Gillespie and fellow Kirkland banking partner Neel Sachdev ultimately conclude that debt buybacks are legitimate and are the fair consequence of living in a free market, Clifford Chance represents a slightly different view. Clifford Chance, which sought an opinion from Robin Dicker QC of 3-4 South Square, highlights the fact that standard loan documentation prevents any prepayment by a borrower except on strict terms, which do not include any discounts to par value.
"The controversial issue is whether debt buybacks by borrowers somehow go against the spirit of syndicated lending," admits Gillespie. "The counterargument is that it's a free market and, provided the buyback is permitted under the loan documentation, there is nothing to stop a willing seller from selling its debt participation to a willing purchaser - and that purchaser can just as easily be the borrower, or an affiliate of the borrower, as anyone else."
Meanwhile, the LMA, which sets the industry standard in loan documentation, has also entered the debate. "We are in the early stages of discussion on this matter," says LMA executive director Clare Dawson. "It's a real issue of debate at the moment because it's not something that has had to be dealt with before. Given the state of liquidity in the secondary market, some borrowers are seeing interesting opportunities, and therefore people are having to address the issue."
Dawson adds that the LMA has not yet reached the point of deciding how it will be participating or issuing an opinion on the loan buyback trend.
The differing views of lender and sponsor lawyers look set to fuel continued discussion of the matter as the market remains in the appropriate condition for more loan buyback transactions to take place.
"On the one hand you have bank lawyers like Clifford Chance saying it's not legal," says one UK lawyer. "Of course they are going to say that. Borrower lawyers are clearly going to say the opposite. I suspect the debate will continue because these lawyers will continue to reflect the interests of their biggest clients."
The lack of liquidity in the market has fuelled the desire for borrowers to seek cheaper ways of clearing their balance sheets.
The ability to complete mega-leveraged buyouts, such as Ontario Teacher's Pension Plan's C$34.8bn (£17.42bn) acquisition of telecoms company BCE, is concerning given the current state of the market.
Market commentators are asking whether banks and private equity houses can really be committed to taking these deals to the ultimate conclusion.
While lender and sponsor firms in the UK and the US battle over whether borrowers should be given this cheaper alternative, the credit markets will continue to suffer - thereby encouraging borrowers to seek out such opportunities.