August 15, 2018

Net Short Debt Activism: Hunting Covenant Defaults for Fun & Profit

Earlier this week, I blogged about how activist strategies are evolving to target different parts of a company’s capital structure.  This Wachtell memo discusses an example of just such a strategy – “net short” debt activism. This excerpt summarizes how it works:

The playbook of the net-short debt activist starts with the investor identifying a transaction, no matter how old, that it can claim did not comply with a covenant in an issuer’s debt documents. Next, the investor amasses both a short position in the company’s debt (in some cases through a credit default swap that collects upon a default) and a long position in the debt, albeit one that is smaller than the short position, so the investor is “net short.” The investor, finally, asserts the alleged default, often in a public letter; and if its long position is large enough (usually 25 percent of a bond tranche), it can also serve a formal default notice, triggering a high-stakes litigation.

Net-short debt activism can be highly effective, in part because of the asymmetric risk that it presents to the target company. Even without a formal notice of default, a public letter asserting a covenant violation can by itself increase the value of a short position and affect the target company’s ability to transact in the markets. And once a notice of default is served, the company has the burden of going to court to demonstrate that no default has occurred.

The memo notes that this strategy can really throw sand in a company’s gears – not only is it exposed to claims from the activist based on alleged defaults, but the allegations may raise the specter of cross-defaults and make counterparties hesitant to deal with the company until the situation is resolved.

John Jenkins