The request from Allied Universal to its lenders last month seemed innocuous and logical enough.
With the deadline rapidly approaching to phase out LIBOR as the benchmark for trillions of dollars of floating-rate debt, the provider of security guards and janitors wanted to start using a replacement to set the rate on more than $4 billion of loans. Under the terms of its credit agreement, the company didn't even need its debt holders to formally sign off on the plan; it just needed more than half of them to refrain from objecting.
It couldn't even manage that.
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The surprise repudiation by Allied Universal's creditors was the culmination of months of brewing frustration over what's seen as a growing effort by some borrowers to use the transition to a new reference rate to stealthily tilt the economics of deals in their favor, according to multiple investors and market participants.
By offering terms that don't compensate lenders for the fact that the alternative benchmark—the secured overnight financing rate (SOFR)—consistently prints below LIBOR, companies have been able to reap significant savings. With roughly 80 percent of the U.S. leveraged loan market still needing to make the switch, the value of interest payments on more than $1 trillion of debt is at stake ahead of the much-maligned reference rate's phase out mid-next year.
"Almost all of these types of amendments are getting done at an economic benefit to companies and a cost to lenders," said Scott Macklin, director of leveraged loans at AllianceBernstein. "Companies have all the incentives in the world to continue to accelerate the process of transitioning from LIBOR to SOFR if lenders continue to allow them to save money doing so."
A representative for Allied Universal didn't respond to requests for comment, while representatives for Credit Suisse Group AG, the agent bank on the loan, and Warburg Pincus, the company's private equity owner, declined to comment.
Recent clashes over how much investors should get paid when borrowers switch to a new benchmark are a small part of a much larger struggle by global regulators to shift markets away from the scandal-tainted London interbank offered rate. LIBOR was once the go-to reference rate for everything from student loans and mortgages to eurodollar futures. But as markets evolved, the trading that helped inform the benchmark dried up, and the rate was found to be routinely manipulated by big banks.
Until this year, virtually the entire leveraged loan market was tied to the floating benchmark. U.S. officials banned new loans from using LIBOR, starting in January, but gave existing contracts until the end of June 2023 to ditch it. Yet SOFR, LIBOR's replacement in the United States, has proven an imperfect alternative. Since the start of the year, three-month term SOFR has printed anywhere from 8 basis points (bps) to 43 bps below LIBOR. CLOs, or collateralized loan obligations, are particularly vulnerable to the risk of a mismatch between rates on the loans they buy and the bonds they sell to investors.
That's set the stage for borrowers and lenders to haggle over how to make up a gap of more than $1 billion in annual interest payments.
Battles over Benchmarks
While Allied Universal's proposal was one of the first benchmark amendments to be shot down by investors, many say it won't be the last.
Companies are grappling with the fastest monetary policy tightening in decades, as the Federal Reserve raises interest rates to tame runaway inflation. That's left highly indebted firms dealing with a spike in their borrowing costs, which is hurting cash flow just as a potential recession looms. Some borrowers had already sought to skip on so-called credit spread adjustments earlier in the year, before rates took off, but now, many see leaving them out as a way to chip away at that extra interest burden.
For months, lenders largely let them get away with it. The reasons varied. Opinions differed among investors on which deals were worth fighting over, and some saw diminishing returns from quibbling over a few basis points when the Fed was jacking up rates.
Moreover, they simply weren't organized enough to block the proposals, especially those tied to loans with so-called 'negative consent clauses,' which comprise about 30 percent of the market, according to Covenant Review data. Those clauses, which Allied Universal had, require more than half of creditors to actively vote to reject amendments, in contrast to a typical loan where debt holders must vote 'yes' for an amendment to pass. But that may be starting to change.
Investors are increasingly weighing the economics of each offer as the pace of amendments accelerates and the deadline to pivot from LIBOR nears, market watchers say.
"If lenders in fact start paying attention and blocking the amendments that have either no spread adjustment or lower spread adjustments, then borrowers will have to come back with better terms," said Ian Walker, a legal analyst at Covenant Review.
In fact, Allied Universal returned to its lenders with a revised amendment earlier this month that included another 10 bps, the investors familiar with the transaction said, asking not to be named discussing a private deal. It passed.
Most conflicts, however, aren't expected to be resolved so quickly.
In September, Petco withdrew an amendment to transition a $1.7 billion loan, which did not include a credit spread adjustment, to SOFR. The company only recently brought forward a new amendment proposal that included a credit spread adjustment in line with previous recommendations from officials overseeing the LIBOR transition, people with knowledge of the transaction said.
Those adjustments offer compensation depending on the tenor of the benchmark used to underpin the loan, including 11 bps for one-month term SOFR and 26 bps for three-month. Petco's revised proposal also passed. Representatives for Petco, private equity owner CVC Capital Partners, and agent bank Citigroup Inc. declined to comment.
Delay Is Dangerous
For some, the prospect that prolonged negotiations over credit spread adjustments may delay the shift away from LIBOR is adding to concerns over a potential mad rush to amend agreements ahead of the benchmark's phase-out.
About 80 percent of the $1.4 trillion U.S. leveraged loan market still needs to pivot to SOFR, according to JPMorgan Chase & Co. data, and there's already expected to be a significant administrative logjam for borrowers, lenders, lawyers, and bankers in the run-up to the deadline. That could ultimately produce a scenario where some companies aren't able to transition in time, leading to self-inflicted tumult in the market.
Alternatively, the deluge of amendments could overwhelm lenders and leave them without sufficient time to evaluate each proposal, allowing many to automatically pass, Covenant Review's Walker said.
Ultimately, both borrowers and lenders should want to shift to SOFR well before the deadline, according to Tal Reback, who leads the LIBOR transition at KKR & Co.
As mid-2023 approaches, LIBOR will become less reliable as activity informing the benchmark dries up further. That increases the risk that the rate could suddenly gap higher or behave in unexpected ways, and it poses a bigger problem than a temporary mismatch between CLO assets and liabilities, she noted.
"Liquidity is the Achilles' heel of the market, so I would want to be where the liquidity is," Reback said. "And that is undoubtedly SOFR."
—With assistance from Lisa Lee.
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