With many loans trading at discount in volatile markets, an emerging trend is for a borrower's equity sponsor (eg. minority shareholder) to trade into (purchase) debt instruments on the secondary market and then to control turnaround initiatives of the company.
Purchasing paper (credit instruments) at a discount may be used to retire debt via a credit swap into equity or to cure a financial covenant default or to avoid an equity cure.
The trade also gives the equity sponsor more influence over future transaction events inside the issuer enterprise, for example to encourage a merger or a credit bid to swap newly acquired debt into equity (subject to "control transaction" restrictions under the Corporations Law, FIRB delays, ASIC issues and ASX requirements, if applicable).
The strategy takes advantage of disconformity between going concern and special situation impaired values caused by singular (and apparently curable) events such as COVID-19.
The strategy is a more sophisticated form of one successfully employed post-GFC by savvy borrowers to buy back credit instruments at discount, for reissue on lower market terms. Fortescue Metals Group provides a useful example.
The strategy makes sense if the shareholder believes near term or existing covenant breaches or equity top up obligations can be cured through longer term business transformation and value uplifts.
The option is attractive to shareholders seeking to gain influence over recapitalisation or restructuring turnarounds, especially if the alternative exit for the existing credit provider is an enforcement process via receivership or other value destroying step (including greater cash reservations or bank guarantees, which tend to constrict cash in the business).
Due diligence is critical to understand any restrictions in credit instruments (loan note security deeds and similar), intercreditor arrangements, including any existing co-operation or good faith workout deeds and any restrictions operative at the issuer level (shareholder agreements, subordinations, turnover trusts for dividends etc). Particular attention must be given to assignment, administrative approval, restricted payment rights and confidentiality clauses within credit instruments require review, as might covenant restrictions, rateable sharing, voting entitlements, information sharing (confidentiality), participation rights.
Intercreditor arrangements and, if applicable, shareholder agreements, may also contain "tag and drag" or "follow me" rights which will need to be considered, along with related party, significant transaction and "position of influence" restrictions in the Listing Rule and Corporations Act.