Debt Investors Take Action After Suffering Millions in Losses from Libor Transition

Last month, Allied Universal made a request to its lenders that appeared to be reasonable and sensible.

As the deadline to phase out Libor as the benchmark for trillions of dollars of floating-rate debt draws near, the provider of security guards and janitors is looking to start using a replacement to set the rate on more than $4 billion of loans. According to the terms of its credit agreement, the company does not need its debtholders to formally approve the plan, only more than half of them to not object. It was unable to accomplish that.

The creditors of Allied Universal were taken aback by the unexpected rejection of their offer. This was the result of a long period of discontent among investors and market participants, who have noticed a pattern of borrowers attempting to manipulate the switch to a new reference rate to gain an advantage.

Companies have been able to take advantage of the savings that come with offering terms that don't take into account the fact that the Secured Overnight Financing Rate is usually lower than Libor. With 80% of the US leveraged loan market still needing to make the switch, the interest payments on more than $1 trillion of debt are in jeopardy before Libor is phased out in the middle of 2021.

Scott Macklin, director of leveraged loans at AllianceBernstein, noted that most of these amendments are being done to the advantage of companies and to the detriment of lenders. He went on to say that companies have a strong incentive to keep transitioning from Libor to SOFR if lenders permit them to save money in the process.

No response was received from Allied Universal when requests for comment were made. Credit Suisse Group AG, the loan's agent bank, and Warburg Pincus, the private equity owner of the company, both declined to comment.

Recent disputes concerning the amount of money investors should receive when borrowers switch to a different benchmark are only a minor element of the much larger effort by international regulators to move away from the London interbank offered rate, which has been tainted by scandal.

Libor was once a widely used reference rate for a variety of financial products, such as student loans, mortgages, and eurodollar futures. However, as markets changed, the trading that was used to calculate the rate decreased, and it was discovered that major banks had been manipulating the rate.

Until 2021, the leveraged loan market was almost entirely linked to the floating benchmark. In January, US authorities prohibited new loans from utilizing Libor, but gave existing contracts until the end of June 2023 to switch to another benchmark.

The US has replaced Libor with SOFR, but it has not been a perfect solution. Since the beginning of the year, the three-month term SOFR has ranged from 8 to 43 basis points lower than Libor. This poses a risk to CLOs, or collateralized loan obligations, as the rates on the loans they purchase may not match the rates on the bonds they sell to investors.

This has created an opportunity for borrowers and lenders to negotiate how to bridge the more than $1 billion gap in annual interest payments.

Investors rejected Allied Universal's proposal, which was one of the earliest benchmark amendments to be presented. However, many anticipate that this will not be the only one to be turned down.

Businesses are struggling to keep up with the rapid increase in interest rates by the Federal Reserve, which is attempting to control inflation. This has caused a rise in borrowing costs for companies with high debt, which is making it difficult to maintain cash flow as a potential recession approaches. Some borrowers had already attempted to avoid credit spread adjustments earlier in the year, and now many are using this as a way to reduce the extra interest burden.

For a long period of time, lenders allowed borrowers to get away with it. The explanations for this varied. Investors had different views on which deals were worth arguing about, and some felt that it was not worth the effort to argue over a few basis points when the Federal Reserve was increasing interest rates.

Furthermore, Allied Universal's creditors were not able to effectively oppose the proposals due to their lack of organization, particularly those related to loans with negative consent clauses. These clauses, which make up approximately 30% of the market according to Covenant Review, require more than half of the creditors to actively vote against any amendments, as opposed to the standard loan where creditors must vote in favor of the amendment for it to pass.

Changes have been made to shift leveraged loans from Libor to SOFR. It appears that this may be beginning to alter.

As the time to transition away from Libor approaches, investors are becoming more mindful of the financial implications of each offer they consider, according to market analysts. The rate of amendments is also increasing.

According to Ian Walker, a legal analyst at Covenant Review, if lenders begin to take notice and reject amendments that have either no spread adjustment or lower spread adjustments, borrowers will need to present more favorable terms.

Recently, Allied Universal presented a revised amendment to its lenders that included an additional 10 basis points. According to investors familiar with the transaction, the amendment was accepted. They requested to remain anonymous due to the confidential nature of the deal.

In many cases, it is unlikely that disputes will be settled in a short amount of time.

In September, Petco decided to not go through with an amendment to switch a $1.7 billion loan to SOFR that did not include a credit spread adjustment.

Recently, the company proposed a new amendment that included a credit spread adjustment in accordance with the prior suggestions from the authorities managing the Libor transition, according to individuals familiar with the deal.

The adjustments proposed provide varying levels of compensation based on the benchmark used to support the loan. For example, one-month term SOFR would receive 11 basis points, while three-month would receive 26 basis points. The revised proposal was approved.

No one from Petco, CVC Capital Partners, or Citigroup Inc. was willing to provide a comment.

For some, the idea of having to go through long discussions about changes to credit spreads is causing worry about a possible rush to modify contracts before Libor is eliminated.

JPMorgan Chase & Co. data suggests that a large portion of the $1.4 trillion US leveraged loan market has yet to transition to SOFR. This could lead to a considerable amount of administrative work for borrowers, lenders, lawyers, and bankers as the deadline approaches.

This could result in certain businesses not being able to adjust quickly enough, causing disruption in the market due to their own actions.

Walker from Covenant Review suggested that the large number of amendments could be too much for lenders to handle, leaving them without enough time to review each one, which could lead to many of them being accepted without proper evaluation.

Tal Reback, the leader of the Libor transition at KKR & Co., believes that both borrowers and lenders should make the switch to SOFR before the deadline.

As the year 2023 progresses, the Libor rate is becoming less dependable due to a decrease in activity that informs the benchmark. This raises the possibility that the rate could suddenly jump or act in an unpredictable manner, which is a more serious issue than a short-term discrepancy between CLO assets and liabilities, according to the speaker.

Reback stated that liquidity is the weak point of the market, so it is best to be in a place with a lot of liquidity, which is definitely SOFR.