There's a dangerous new type of activist investor betting on companies to fail - and that behavior could permanently change how firms raise money
- A new type of bearish investor is becoming more common - one that bets against a company's ability to pay back debt.
- Those in the group, known as "net-short debt activists," claimed their latest victim on Monday as rural telecom company Windstream Holdings filed for bankruptcy after losing a crucial legal ruling.
- In a recent memo, a group of attorneys from the law firm Wachtell, Lipton, Rosen & Katz lamented the recent rise of this investment practice.
- The lawyers from Wachtell Lipton also formulated some recommendations for companies looking to avoid the fate of Windstream.
As short sellers in stocks attract the lion's share of media attention, a new breed of bearish investor is threatening to upend the status quo elsewhere in markets.
The sights of these investors are instead firmly focused on the debt market - a space not normally associated with the type of activism that can torpedo a company's wellbeing.
And while it may seem like an innocuous development at first blush, the threat this group poses is very real, according to a recent memo from the law firm Wachtell, Lipton, Rosen & Katz, which was published in the Harvard Law School Forum on Corporate Governance and Financial Regulation.
The main reason why stems from one key difference in how bearish activism is done in stocks versus bonds. While equity investors have influence over the board of directors and major transactions, bondholders are singularly concerned with a company's ability - or inability - to pay back debt.
As such, this subset of investors - known as "net-short debt activists" - are incentivized to hasten a corporation's default. Here's a quick rundown of how they operate:
Step 1: Net-short debt activists identify a transaction that they can claim violates specific covenants in a company's debt documents.
Step 2: Those activists build a position in the company's debt, while also amassing a larger short position. The short is often built through the use of vehicles like credit-default swaps (CDS), which provide insurance on bond defaults.
Step 3: The net-short debt activist raises the alleged default, often in a public letter. If the investor's long position is big enough, it can bring about a crucial period of litigation.
Here are a few other interesting wrinkles associated with this investment practice:
- Net-short debt activists can impact their target company even without a formal notice of default. In many cases, a simple public letter can be enough to hurt.
- In the event that a notice of default is served, the onus is on the company to go through legal proceedings to clear their name.
- As Sujeet Indap of the Financial Times pointed out in a recent piece, this practice seems to be occurring with increased regularity.
The Wachtell Lipton study agrees with that last point: This type of behavior is becoming more commonplace. As a result, it's become a growing worry for many companies whose existing debt deals could contain troublesome covenants - ones that could be dug up and used against them.
"In recent years, we have seen the rise of a new type of debt investor that defies the traditional model," the group of Wachtell Lipton attorneys wrote in their memo. "This investor buys 'long' positions in corporate debt not to make money on those positions, but instead to assert defaults that will enable the investor to profit on a larger 'short' position."
Windstream's recent bankruptcy
So why the sudden urgency around the rise of net-short debt activists? Because a high-profile example is playing out in markets right now.
The company in question is Windstream Holdings, a rural telecom firm that, until very recently, carried a market value of roughly $140 million. After being targeted by bond activists, Windstream ended up losing a February 15 court ruling over covenants stemming from a spinoff it conducted in 2015. Its market cap has since plummeted to roughly $22 million.
In this case, the net-short debt activist is a firm called Aurelius Capital Management, which won a $310 million judgment - one large enough to trigger the type of bankruptcy that would turn their CDS holdings profitable.
What's more, Windstream's other creditors are now entitled to demand immediate repayment on their debt holdings. It's a domino effect that will surely have Windstream wishing it had more carefully vetted the covenants attached to its ill-fated spinoff.
On a broader basis, it's a cautionary tale for companies looking to issue bonds for any reason.
The Windstream situation "exemplifies the risks that short-term debt activism can pose to companies," the Wachtell Lipton attorneys wrote.
They continued: "While short sellers in the equity markets might 'talk down' a stock, they have no similar legal mechanism to inflict such wide-ranging harm on a target."
What companies can do to fight the trend
Although the lawyers at Wachtell Lipton are troubled by what they're seeing in debt markets, they say companies still have the power to make sure they don't become ensnared in a similar situation.
They put together a three-part checklist for firms looking to avoid a Windstream-type ordeal. All quotes attributable to the firm's recent memo:
- "At the debt issuance stage, companies are well-advised to avoid covenants that lend themselves to 'technical' breaches based on notice and delivery obligations and to draft covenants as precisely as possible, with due regard for anticipated transaction structures."
- "After issuance, it is important for companies to cultivate relationships with long-term debt investors, whose support may be essential in addressing any claims brought by net-short investors."
- In all events, preparation is critical, and companies that may be vulnerable to covenant-default claims, including by net-short investors, should be ready to address those claims quickly and decisively both in the markets and, if necessary, in court."