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J. Crew 'blockers' still largely absent from loan agreements

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Despite the legal tussles a few years ago over asset transfers from leveraged-loan collateral packages, there remains only a small percentage of lenders that have actively sought to block such moves in document contracts.

According to a recent report from S&P Global Ratings, the rating agency’s review of deals across multiple sectors found only 17% of lenders have provisions that would disallow borrowers from using subsidiaries to transfer collateral assets – such as brands and intellectual property rights – outside lenders’ reach.

Transferring assets became a controversial move after retailers J. Crew and PetSmart used weak covenants in credit agreements to shift intellectual property to other assets – in both cases for initial public offerings of subsidiary brands that could provide cash needed to tackle the high-leverage woes for the parent firms with near-default ratings.

One reason for the low percentage may be the success that these borrowers had in satisfying their creditors and ratings agencies. “J. Crew's planned IPO of Madewell and PetSmart's successful IPO of Chewy are credit positive for the companies' lenders because they will use the proceeds to reduce debt,” said Moody’s Investors Service in an Oct. 10 report.

In June of this year, PetSmart raised nearly $900 million from the IPO for Chewy.com, its subsidiary it acquired a year earlier for $3 billion and financed with nearly $2 billion in secured and unsecured debt. PetSmart had earlier transferred nearly 37% of its stake in Chewy to an unrestricted subsidiary investor group ahead of the IPO.

The money raised from the IPO allowed PetSmart to pay down debt by 15%, according to S&P, as well as see a price boost to its struggling HY bonds that returned to par pricing in the secondary market, per Bloomberg. PetSmart's corporate rating benefited, too, being raised to B3 from Caa1 by Moody's and to B- from CCC by S&P.

The struggling J. Crew chain (which carries a corporate rating of Caa2 from Moody’s and CCC by S&P) is planning an IPO as well for its Madewell brand. J. Crew plans to repay debt as well as negotiate new terms on $1.9 billion of its debt due in 2021, according to Moody’s ,These steps were preceded by the controversial move in 2017 to shift the Madewell brand into an unrestricted subsidiary that could issue new debt ungoverned by the original J. Crew credit agreements, according to S&P.

Elliot Ganz, the Loan Syndications & Trading Association’s (LSTA) chief of staff and general counsel, said that while he does not condone the transfers, they present a nuanced issue given that, similar to “cov-light” deals excluding maintenance covenants, they give borrowers more flexibility.

“If you look at PetSmart and J. Crew, would you rather have the current outcome or instead have the company with less flexibility and filing for bankruptcy?” he said.

Consequently, when the economy sours, there likely will be fewer defaults because of the flexibility provided by weaker or nonexistent covenants and the ability to monetize other assets, Ganz said. He noted that lenders tend to consent to changes in their loan agreements since it is typically in everyone’s interest for borrowers to avoid bankruptcy. However, there’s usually a cost for the borrower and there may be unanticipated changes, such as the lending group becoming more opportunistic and driving harder bargains.

The flip side, he added, is that lenders’ bankruptcy recoveries are likely to be lower than they have been historically. “In the event of default, lenders are probably not going to see recoveries that are 75% to 85% on the dollar.”

Ganz added that the low percentage J. Crew blocker deals found by S&P likely was due to the asset class’s attractive yields and the late stage in the credit cycle, giving borrowers significant leverage in negotiating terms. Nevertheless, he said, the issue has been highly publicized and the deal terms are transparent, so investors are making rational credit decisions under the circumstances.

S&P noted in its report that courts have not ruled on the legality of the transfers, since investors’ legal challenges were settled out of court. The report adds that while many loan investors understand the potentially significant risks of IP-leakage risk, also known as “J. Crew blockers.”

Still, a downturn is looming, and refinancing risk increases when the economy sours and lenders pull back, and that could be especially so if a borrower’s valuable assets have been transferred. During the financial crisis, maturities aligned to create a “refinancing wall,” increasing refinancing challenge. Today, however, most borrowers have recently refinanced their loans and extended their maturities by several years.

“Maturities have been pushed out, so the reality is there’s very little refinancing risk in the foreseeable future,” Ganz said.

Al Remeza, associate managing director in Moody’s structured finance group, said that the rating agency’s frequent discussions with collateralized loan obligation managers and other loan investors have clearly revealed their “particular concern” about asset stripping. He added that some say they won’t touch loans with asset-stripping provisions, and others, given such language has essentially become standard, focus on names they determine to be less likely to default.

“So there are competitive forces at play here, and clearly investors don’t like it,” he said.

Derek Gluckman, senior covenant officer in Moody’s corporate finance group, noted that weak or nonexistent covenants effectively mean lenders have “pre-consented” to asset stripping or other moves favorable to borrowers that previously would have required lender approval. In the end, he added, lenders likely would have consented to such moves in many instances, but by pre-consenting they give up any say over those critical decisions and the fees they received for consenting to them.

“Covenants gives borrowers control over when these things happen,” Gluckman said. “Particularly in a down cycle, lenders get nervous when they start seeing divergence of opinion, but now it’s going to be borrowers controlling the show."

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