Some borrowers are strengthening disqualified (DQ) lender restrictions in loan documents to block unwanted lenders from acquiring exposure through derivatives. These provisions typically prohibit assignments of loans and commitments to DQ lenders, as well as the sale of participations to such lenders.
The expansion of DQ lender provisions highlights growing sensitivity among borrowers that blacklisted lenders can gain economic exposure to loans, and access to non-public information about the borrower’s business, by using derivatives, which threatens to undermine existing restrictions. Specifically, some borrowers are concerned that provisions designating such lenders as “disqualified” or “DQ” lenders do not go far enough, and that derivatives create a backdoor through which unwanted lenders may gain access to non-public reporting and covenant compliance information, or potentially influence amendments, waivers, restructurings and enforcement.
Historically, DQ lender provisions targeted a borrower’s direct competitors and consisted of a list of named institutions. Over time, borrowers began to target distressed debt firms and expanded that list to include certain “blacklisted” entities. Recently, some borrowers have expanded the DQ lender definition to include broader categories, such as all organizations pursuing “loan-to-own” investment strategies, whether specifically identified or not. The DQ lender concept has also expanded over time to include affiliates of institutions on the list, although this is typically limited to affiliates that are reasonably identifiable by name and excludes bona fide debt fund affiliates.
Today, the derivatives ecosystem provides debt investors with a variety of options for gaining exposure to a credit without direct loan ownership or participation, outside the purview of traditional DQ lender restrictions. This has increased the focus from sponsors and borrowers on ensuring that parties who are prohibited from becoming lenders or participants are also barred from achieving a similar position through the use of derivatives.
To address this, in some recent loan documentation, sponsors and borrowers have begun adding explicit language preventing lenders from entering into total return swaps (TRS), credit default swaps (CDS), or other derivatives transactions with disqualified counterparties that would not otherwise be restricted by more traditional DQ lender provisions.
Though this is still an emerging feature of the market, it appears with increasing frequency in larger sponsor-driven transactions in the broadly syndicated loan market and has also started to appear sporadically in other parts of the leveraged finance ecosystem.
Total return swaps in the spotlight
TRS are the type of derivatives exposure on which borrowers have focused the most, as a TRS effectively transfers all the economic benefits of an underlying loan to another party.
A disqualified distressed debt firm, for example, may enter into a TRS with a bank to become the effective economic owner of a loan, even though the bank remains the lender of record. This is concerning for some borrowers who wish to exclude these investors from the lender group entirely.
CDS are also on borrowers’ radars, although for different reasons. A CDS is used to transfer the credit exposure of loans but, unlike a TRS, does not require ownership of the underlying debt. Parties may offset CDS positions through hedging strategies, instead of taking ownership of the loan.
Borrowers have paid more attention to TRS structures, as they potentially offer a more direct pathway into the lender group, but CDS trades present their own concern in the form of so-called “net short” risk. In those cases, a lender that purchases substantial CDS protection can end up being economically incentivized to trigger a default or another credit event rather than support a consensual workout or preserve enterprise value. Provisions prohibiting or otherwise restricting the rights of lenders with “net short” positions have been a feature of sponsor loan documentation in the broadly syndicated loan market for several years.
Practical complexity
While DQ lender restrictions for TRS and CDS are becoming more common, they remain difficult to effectively implement in practice.
Derivatives trading desks and loan operations teams at investment and commercial banks often sit in separate silos. As a result, the team entering into a hedging transaction may not have visibility of DQ lender lists and may inadvertently enter into a derivative transaction with a blacklisted lender.
In addition, certain derivatives trading platforms dealing with CDS can be opaque, with counterparties matched anonymously in high-volume fast-paced trading. An institution entering into a CDS may be unaware that the counterparty is a DQ investor until late in the negotiation process (if at all). Counterparties are more transparent in TRS structures, as they typically involve direct negotiations and credit-specific due diligence.
Overall, restrictions on TRS and CDS trades with barred lenders can create an administrative burden for banks. In some recent deals, the list of DQ lenders has run to almost 100 names. Where DQ lender restrictions also encompass broader categories, such as distressed investors, and cover the unnamed affiliates of blacklisted lenders, extensive due diligence is necessary to ascertain whether a prospective counterparty is compliant.
Lenders may face material risks if they make a mistake. In deals with restrictions on entering into derivatives with DQ lenders, a lender trading a derivative with a DQ counterparty can lose voting rights, be treated as a defaulting lender, or face mandatory assignment provisions forcing them to exit their position, sometimes at suboptimal pricing.
For borrowers, oversight and enforcement are also far from straightforward. Tracking every derivatives deal of every lender is impractical, if not impossible, and exposure might only emerge in restructuring situations when derivatives holders attempt to exert influence.
Toward standardization
Loan markets are beginning to move to address the practical complexities of these terms. While prohibitions on derivatives transactions involving a DQ institution are still relatively rare and concentrated in larger sponsor-led deals, standardized negotiating positions around these clauses are already emerging.
For example, large commercial and investment banks that provide revolving credit facilities and operate separate derivatives trading units and public loan sales teams have negotiated operational carve-outs covering situations where DQ lender lists cannot practically be shared with public-side trading desks, or in some cases, they have been successful in carving themselves out entirely from compliance with the provision.
Some borrowers, meanwhile, are adding representation requirements to monitor compliance. In these circumstances, lenders must represent that they are compliant with prohibited lender terms when they exercise their voting rights.
While these restrictions are currently largely confined to larger, sponsor-backed broadly syndicated loans, market stakeholders recognize that they are likely to expand. Borrowers do not just want to limit who directly holds their debt, but also who may gain economic exposure to it and access to related non-public information. Accordingly, the prevalence of these restrictions is likely to increase further.
