The worst credit trade turns into a big winner for hedge funds

(Bloomberg) — Chris Stansbury may have been the ugliest person in the room when he made the rounds at one of Wall Street’s biggest leveraged finance conferences late last year.

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CFO Lumen was in the process of conducting one of the largest and most controversial distressed debt swaps ever, and creditors stuck on the outside looking in were furious.

For those in the gathering, nothing captured the tension more than the sight of a man in a button-down suit, backpack slung over his shoulder, appearing to guard Stansbury as he worked the room. Some attendees joked that his presence brought to life the phrase buzzing in the market: “creditor-on-creditor violence.”

Fast forward to today, and the deal has become one of the most successful distressed deals of the year, even for those left behind.

Backing the deal was upstart, sharp-edged hedge fund Diameter Capital Partners. The New York firm, founded by Scott Goodwin and Jonathan Lewinsohn, like virtually everyone else, realized that Lumen’s debt situation was dire.

But inside the near-insolvent telco, Diameter saw an opportunity. Level 3 Communications, a struggling provider of high-bandwidth fiber connections to companies that Lumen had bought in 2017, was about to turn the corner.

Diameter collected in Level 3 debt at very reduced prices. Then there was a pause. Lumen, another fund discovered, may have breached a clause in its debt documents that would put it in default. Diameter has partnered with companies such as Silver Point Capital and BlackRock Inc. to negotiate an out-of-court settlement that extended Lumen’s maturities and provided fresh funding. Instead, they received priority claims on the assets, stripping other debt holders of their collateral in the process.

The trade reaped big returns for Diameter, whose bet on the company was the biggest bet at the start of the year. At Silver Point, it was one of their biggest positions since the end of the first quarter.

However, they were not the only winners. For now, with its debt woes behind it, Lumen has repositioned itself as a player in the artificial intelligence boom, sparking a surge in its bonds and loans that has generated profits for lenders in general. Firms such as Hamza Lemssouguer’s Arini, which was not part of the original negotiations, posted double-digit gains after taking more notes in recent months.

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“The idea of ​​pitting creditors against creditors is offensive. It becomes a giant game instead of the priority of claims,” said Bill Zox, portfolio manager at Brandywine Global Investment Management. “It bought the company more time and created theoretical value at a time of euphoria around artificial intelligence.”

Zox says it remains skeptical, but there’s no denying that those who took the deal and stayed put enjoyed big returns.

A Lumen spokesperson said in a statement that the company’s role as an emerging trust network for AI validates the support of its debt holders. Representatives for Diameter and Silver Point declined to comment, while BlackRock and Arini did not respond to requests for comment.

This story is based on conversations with conference attendees, people familiar with the positions of Diameter, Silver Point and Arini and investor letters seen by Bloomberg News.

It was last May when Diameter’s Goodwin took the virtual stage and presented Level 3 as a top business idea at the Sohn Investment Conference. Its bonds, he argued, were largely undervalued because of the struggles of the parent company, which had about $20 billion in long-term debt. Tier 3 had manageable debt and a more favorable revenue mix than other communications firms.

It was a “solvent zombie inside an insolvent one,” according to Diameter’s first-quarter investment letter, a copy of which was seen by Bloomberg.

Not long after, a hedge fund found a way to release it.

Buried in the maze of credit agreements that govern all Lumen subsidiaries, Paloma Partners discovered an investor warranty that was breached because of a procedural misstep, according to people with knowledge of the matter, who asked not to be identified because they are not. authorized to speak in public.

This discovery gave the funds the leverage they needed to bring Lumen to the table and position themselves to get the best deal.

A representative for Paloma did not respond to requests for comment.

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An initial restructuring proposal in early November angered investors who were left out of the deal, largely because of Goodwin’s recommendation months earlier. Only holders of about $7 billion of debt initially signed off on the deal.

“It’s really playing to be the one who gets the better deal versus the one who gets the worse deal,” said industry veteran Jason Mudrick, who oversees more than $3 billion and was not involved in the transaction. “People on the wrong side of the deal lose. They get value extracted from them in the hands of the lenders on the other side of the transaction.”

In the wake of the announcement, worried creditors rushed to sell the company’s debt. Several banks’ trading desks began separating the bonds that were part of the new deal and the notes that were to be left behind in quotes sent to investors, the people said at the time.

“It was a very dark time, people lost quite a bit of money and nobody was too happy with what was going on,” said Jeff Peskind, chief investment officer of Phoenix Investment Adviser.

After months of protracted negotiations, Lumen struck a deal in late January that allowed more lenders to participate in the new fundraising related to the Level 3 unit. The revised deal ultimately won the support of debt holders $15 billion, allowing the company to extend more than $10 billion in maturities and secure more than $2 billion in new financing, Stansbury said on Lumen’s earnings call earlier this month.

For its role in resolving the restructuring, Diameter and other negotiating creditors earned sizeable fees in addition to claims to the company’s best collateral.

Following the deal, Lumen was able to take advantage of growing demand for its fiber network among AI-focused firms. In early August, the company said it had secured $5 billion in new business, including a deal with Microsoft Corp. to expand its network capacity and is in talks for an additional $7 billion in sales.

Its shares are up more than 400% from a June low, while some of its distressed bonds have nearly doubled in price.

“Their debt is further along than it had been previously, and the AI ​​gain they’ve had more recently is positive,” said Rob Galtman, senior director at Fitch Ratings. “It’s a substantial amount of money in the trade flow.”

Diameter admitted in its letter to investors that the market saw the deal as “fratricide” and one that companies would never have done in the past because it erodes confidence in the market.

“The standards are always evolving and will continue to adapt to the current environment,” Diameter wrote in the letter. “For now, though, your best bet is to size positions on the assumption that you can be cheated.”

–With assistance from Eliza Ronalds-Hannon.

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