Most-Hated Credit Trade Turns Into a Big Winner for Hedge Funds

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

The Lumen CFO was in the process of carrying out one of the largest and most controversial distressed-debt exchanges ever, and creditors stuck on the outside looking in were furious.

For those at the gathering, nothing captured the tension more than the sight of a man in a buttoned-up 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 through the market: “creditor-on-creditor violence.”

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

Backing the transaction was the upstart Diameter Capital Partners, a growing force in credit markets with about $20 billion in assets. The New York-based firm founded by Scott Goodwin and Jonathan Lewinsohn, like virtually everyone else, could tell that Lumen’s debt situation was dire.

But inside the all-but-insolvent telecommunications company, Diameter saw an opportunity. Level 3 Communications, a struggling provider of high-bandwidth fiber connections for businesses that Lumen had bought in 2017, was turning the corner.

Diameter piled into Level 3’s debt at deeply discounted prices. Then came a break.

Lumen, another fund discovered, may have violated a clause in its debt documents which would put it in default. Diameter paired up with the likes of Silver Point Capital, PGIM Fixed Income and BlackRock Inc. to negotiate an out of court deal that extended Lumen’s maturities and provided fresh financing. Ken Griffin’s Citadel was one of the main organizers of the group and put in over 10% of the new money for the deal, while PGIM contributed more than 25%.

In exchange, they received priority claims on assets, stripping other debt holders of their collateral in the process.

The trade has racked up big profits. For Diameter, it was the firm’s single largest wager at the start of the year. At Silver Point, it was one of their biggest positions as of the end of the first quarter.

Yet they haven’t been the only winners. With its debt woes behind it for the time being, Lumen has repositioned itself as a player in the artificial intelligence boom, igniting a surge in its bonds and loans that’s juiced returns for creditors across the board. Firms like Hamza Lemssouguer’s Arini, which wasn’t part of the initial negotiations, have notched double-digit gains after snapping up more of the notes in recent months.

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

Zox says he remains skeptical, but there’s no denying that those who got in on the deal and stayed put have enjoyed big returns.

A spokesperson for Lumen said in a statement that the company’s role as an emerging trusted network for AI is validating the support of its debtholders. Representatives for Diameter, Silver Point, PGIM, BlackRock and Citadel declined to comment, while Arini didn’t respond to requests seeking comment.

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

It was May of last year when Diameter’s Goodwin took the virtual stage and pitched Level 3 as a top trade idea at the Sohn Investment Conference. Its bonds, he argued, were undervalued largely because of the struggles of its parent company, which had about $20 billion in long-term debt. Level 3 had a manageable debt load and 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 free it.

Buried inside the labyrinth of credit agreements governing all the subsidiaries of Lumen, Paloma Partners discovered an investor safeguard that had been breached due to a procedural misstep, according to people with knowledge of the matter, who asked not to be identified because they’re not authorized to speak publicly.

This breakthrough 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 didn’t respond to requests seeking comment.

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An initial restructuring proposal in early November infuriated investors who were left out of the transaction, in no small part because of Goodwin’s recommendation just months earlier. Only holders of about $7 billion of debt initially signed on to the transaction.

“It’s really about jockeying to be one that gets the better deal versus the one that’s getting the worse deal,” said industry veteran Jason Mudrick, who oversees more than $3 billion and wasn’t involved in the trade. “People on the wrong side of the deal are losing. They’re getting value extracted from them into the hands of the creditors on the other side of the deal.”

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

“It was a very dark period, people lost quite a bit of money and no one was too happy with what was going on,” said Jeff Peskind, chief investment officer of Phoenix Investment Adviser.

Following months of prolonged negotiations, Lumen cut a deal in late January that allowed more creditors to participate in the new money raise tied to the Level 3 unit. The revised agreement ultimately won support from holders backing $15 billion of debt, allowing the company to extend over $10 billion of maturities and secure more than $2 billion in new financing, Stansbury said on Lumen’s earnings call earlier this month.

For its role hammering out the restructuring, Diameter and other negotiating creditors earned hefty fees on top of claims to the company’s best collateral.

In the aftermath of the deal, Lumen has been able to tap into growing demand for its fiber network among AI-focused firms. The company in early August said it secured $5 billion in new business, including a pact with Microsoft Corp. to expand its network capacity, and is in talks for another $7 billion in sales.

Its stock has surged more than 400% since a low in June, while some of its distressed bonds have almost doubled in price. New 11% bonds due in 2029 issued by Level 3 as part of the exchange now trade near 110 cents on the dollar, according to data compiled by Bloomberg.

“Their debt is further out than it had been previously, and the AI win that they’ve had more recently is positive,” said Rob Galtman, a senior director at Fitch Ratings. “It’s a substantial sum of money in deal flow.”

Diameter acknowledged in its letter to investors that the market saw the deal as “fratricidal” and one that companies would never have done in the past because it erodes trust across the market.

“Norms are always evolving and will continue to adapt to the current environment,” Diameter wrote in the letter. “For now, however, the best bet is to size positions assuming that you can be screwed.”

--With assistance from Eliza Ronalds-Hannon and Nishant Kumar.

(Updates with PGIM role in eighth paragraph)

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