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J. Crew Group Inc. and its private-equity owners pulled off a neat move in 2016. The deeply indebted preppy retailer needed to raise money but didn’t have any fresh assets to pledge as collateral for a loan. Whatever of value it owned was already pledged to existing lenders.
So J. Crew opened a trap door. It put its brand name and some other intellectual property into a new entity in the Cayman Islands that was beyond the legal reach of its existing lenders. Then it used that new entity to borrow $300 million from Blackstone Group LP. The existing lenders, who saw valuable collateral disappear before their eyes, cried foul, but J. Crew argued that its move was perfectly legal under terms of the loan documents. (The issue was never litigated.) Since then, lenders to other companies have worried about being “J. Crewed”—i.e., victimized by a deal that siphons away collateral backing their loans. It rhymes with another word.
The J. Crew story has an interesting denouement. You might guess that the retailer and its private equity backers, TPG Capital and Leonard Green & Partners LP, took the $300 million and paid themselves a fat dividend. But no. That would have been prohibited by other terms in the loan documents. Instead, J. Crew used the money to get the company back on its feet. The prices of J. Crew bonds actually rose significantly after the deal, which indicates that the financial maneuver wasn’t so damaging to existing creditors after all.
This chart tells the story. It shows the price of a senior secured loan—that is, one backed by assets of the company. The pricing data begins after J. Crew’s trap door was opened, so we can’t see the market’s reaction to that gambit. But we do see a powerful rise in the loan’s price in 2018, to more than 90 cents on the dollar in October, which seems to indicate that whatever management was doing was raising the company’s creditworthiness. The price has wobbled since then as the company’s earnings prospects have fluctuated.
The final chapter hasn’t been written. If J. Crew ends up going bankrupt, which seems less likely now than before, the owners of its older debt will have good reason to complain that the trap door in the loan documents harmed them by reducing the amount of value they could get their hands on. But if J. Crew survives and thrives, the creditors may conclude that the trap door worked out all right for them—by giving the company fresh financing that staved off collapse.
“That transaction happened before I started,” James W. Brett Jr. said in a Bloomberg TV interview in September 2018, when he was chief executive officer of J. Crew. “I don’t know if it’s fair or not fair. All I know is that when I started a little over a year ago, I think our debt was trading” at close to 70 cents on the dollar, “and now I think it’s trading at almost a dollar on the dollar.” (It has lost some altitude since that interview.) “So I think that the people that hold our debt are very happy.”
It’s worth keeping the J. Crew story in mind when listening to the debate over leveraged loans. Leveraged loans are simply loans to companies that have poor credit ratings or no credit ratings at all. Most are now “covenant-lite,” meaning they lack requirements that borrowers maintain certain financial ratios such as limits on leverage. Here is a good Bloomberg News article about the risks they pose. Some loans, such as those to J. Crew, are also missing other sorts of restrictions, such as limits on the ability to transfer assets.
The obvious downside of looser loans is that borrowers can get into deeper trouble before lenders have the opportunity to bring them to the table to renegotiate terms or restructure. But loans with lots of restrictive covenants aren’t always great, either. For a borrower, they can be like trying to drive on a highway with guard rails just inches away from the doors on both sides. “No business goes in a straight line. Inevitably there’ll be some hiccup in the business,” says Mark Gold, chief executive officer and chief investment officer of Hillmark Capital Management LLC and NewMark Capital, which invest in syndicated loans through collateralized loan obligations. Lenders can take advantage of those hiccups to seize control of a company.
The rap on collateralized loan obligations is that investors will lose their shirts on them in the next economic downturn, when defaults rise. But that might not be true, either. Volatile periods are actually a buying opportunity for CLO managers, says Thomas Majewski, managing partner and founder of Eagle Point Credit Co. Inc., a big investor in CLOs. Unlike mutual funds, CLOs are closed-end vehicles that don’t have to sell loans to raise money to pay investors who want to bail out. Proponents say ordinary CLOs made it through the last crisis largely unharmed. The vehicles made some of their highest returns on loans they bought at a deep discount in 2008 and 2009, says Majewski.
Leveraged loans with few protections do pose risks to investors and the wider public. But as Federal Reserve Chairman Jerome Powell said in May, “the financial system appears strong enough to handle potential losses.” In the best scenario, companies that borrow on easy terms will use the additional freedom they have to build stronger balance sheets, not just enrich their private-equity backers.
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