Deal to save J.Crew from bankruptcy angers High-Yield Debt Investors

The retailer’s debt-swap deal effectively pushes junior bondholders to the front of the creditor line

Crew Group Inc. averted a bankruptcy filing this summer when it convinced bondholders to do a debt swap that tapped the value of its brand name.

A majority of the struggling retailer’s bondholders agreed to the swap, but the deal angered a few of its lenders, who saw the valuable brand name stripped away from the collateral backing their loans. They sued to block the deal, but so far their efforts have faltered.

Crew, for its part, says it is simply taking advantage of covenants in its debt documents that allow the company to do such a deal.

Distressed-debt exchanges aren’t unusual for companies that are struggling with heavy debt loads, but the J. Crew deal has raised concern among high-yield investors because it effectively pushes J.Crew’s junior bondholders to the front of the line of creditors, ahead of term-loan holders, who were in a superior position before the debt exchange.

Crew does not always make investors happy

“If the J. Crew transaction is allowed to happen it provides a green light for a lot of other companies to do the same thing,” said Duncan Vise, a senior analyst at asset manager Invesco Ltd.Crew, and the private-equity firms that control the company, used provisions in its loan documents that govern so-called permitted investments. The company transferred the intellectual property behind its brand name into a newly created affiliate, where the term-loan holders have no claim. The affiliate then issued new debt to its junior bondholders in a swap. The provision is in many other corporate loans and bonds, especially those of companies owned by private-equity firms.

While most J. Crew lenders gave their consent for the bond exchange, Eaton Vance Management and Highland Capital Management LP are among the few who are suing to reverse it. A final ruling is expected by the end of next year.

Many investors target secured loans and bonds from junk-rated companies precisely because they are supposed to be safer than junior bonds from the same issuers while offering higher interest rates than investment-grade loans. As J. Crew closed in on getting enough investors to pull off the controversial swap, its junior bonds traded at higher prices while its loans traded lower.

The deal will reduce recoveries on the company’s USD 1.57 billion term loan to US 41 cents on the dollar, according to a Fitch report in June. The term loan represents the bulk of J.Crew’s USD 1.7 billion in debt, with the bonds that took part in the swap representing the rest.Crew has argued that the lenders are fighting a transaction that is “expressly permitted” by the terms of the company’s loan agreement, and that ultimately the debt exchange will benefit all of the company’s stakeholders, including the lenders, according to a lawsuit the company filed against a group of loan holders in February.

The credit-document provisions J. Crew cited to support the deal are open to interpretation, according to Kenny Tang, director at S&P Global Ratings. For example, the language on permitted investments that J. Crew invoked is usually thought of as allowing an investment in a new business, but it isn’t explicitly spelled out in the loan documents, Mr. Tang said.

Representatives for J. Crew declined to comment. One of its two private-equity owners, TPG Capital, declined to comment. The other, Leonard Green & Partners, didn’t return calls.

Since the financial crisis, private-equity firms, in particular, have taken advantage of strong high-yield markets to increasingly write in looser terms in bond indentures and credit agreements at their portfolio companies, which has opened the door to deals such as the J. Crew swap.

Crew isn’t the first company to attempt such a deal. Apollo Global Management ’s Claire’s Stores Inc. completed a similar swap last year and has, to date, evaded bankruptcy. Still, this type of deal isn’t a cure-all. Toys “R” Us Inc. also did a swap backed by its brand name, along with a number of other debt exchanges to push out maturities as it grappled with a mountain of debt that was heaped on the company when three Wall Street firms took it private. The moves ultimately failed to save the retailer from chapter 11, however.

Any company with valuable intellectual property could engage in a J.Crew-like swap, but debt-laden retailers buffeted by an industrywide downturn that are still in possession of valuable brands are most likely to try it, said Kelly Iosua, senior credit analyst at Loomis Sayles.

In particular, retailers controlled by private-equity companies—such as J.Crew—could be more likely to engage in such transactions, Ms. Iosua said. Neiman Marcus Group, which is owned by investment firm Ares Management LP and the Canada Pension Plan Investment Board, could potentially do a deal like J.Crew’s, according to a recent report by S&P. Neiman and Ares didn’t respond to requests for comment.

There are signs, however, that the tide could be turning against J.Crew-style debt exchanges. Recently, investors succeeded in removing terms from Staples Inc. debt documents that would have allowed a similar debt exchange when the office-products retailer raised $6.9 billion to finance a buyout by Sycamore Partners, according to S&P.  Sycamore declined to comment.

Even so, PetSmart Inc., a retailer owned by BC Capital Partners, raised almost $2 billion in senior bonds in May—with the same provisions in place—to finance the buyout of online pet retailer

Some investors balked at PetSmart’s terms and demanded tighter covenants, but they were ultimately outvoted by yield-hungry bondholders. The outcome frustrated many high-yield and leveraged-loan veterans especially since still doesn’t turn a profit, according to people familiar with the matter. PetSmart and BC Capital didn’t respond to requests for comment.

Since the summer, PetSmart’s new junior bonds have been trading at around 80 cents on the dollar from the issue price of 100 cents, according to MarketAxess.

“Overall, the market for high-yield debt from retailers is extremely pressured, partly because of J. Crew, as well as other retailers in similar situations,” said Ms. Iosua, the Loomis Sayles analyst.