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Junk Bonds in Europe Bolster Defense Against Hedge Fund Shorts

Laura Benitez and Sally Bakewell

(Bloomberg) -- Companies in Europe are about to take a leaf out of the U.S. playbook on credit default swaps by making it harder for hedge funds to profit from a company’s collapse.

Junk bonds financing the buyout of Merlin Entertainments Plc include terms in their documentation that prevent investors holding ‘net short positions’ with CDS contracts from voting on amendments, waivers or default notices. The provision follows similar efforts by high-yield borrowers in the U.S. sidelining speculators with an interest in seeing a company going bust.

“This is the first time the provisions have been seen in European deals,” analysts at Aggredium Finance Ltd. said. “Put simply: If you bring a notice of default, you have to promise that you’re not banking harder on the company’s failure to pay its debt than its ability to sail through to maturity.”

CDS contracts typically insure bond or loan holdings against the risk of default and are frequently used by hedge funds betting on companies running into trouble. Some investors buy default protection in excess of their underlying credit exposure -- hence ‘net short’ -- to profit as the company’s credit risk worsens or to receive a windfall if the borrower goes bankrupt.

In recent years that has led to manufactured defaults, where hedge funds have enticed companies to miss bond payments they could otherwise make to pocket a payment on swaps. Some of the most high-profile cases involved U.S. homebuilder Hovnanian Enterprises Inc. and Spanish gaming company Codere SA.

This type of hedge fund manipulation is leading to closer scrutiny of the $10 trillion credit derivatives market that already fell out of favor after being blamed for exacerbating the global financial crisis. More recently, swaps have found themselves at the heart of restructuring procedures such as the ongoing attempt to rescue Thomas Cook Group Plc, which CDS holders are threatening to block.

Read more: Thomas Cook’s Rescue Tests Reputation of Default Protection

Net-short language “is still untested so it’s anyone’s guess how the provisions will impact bond prices, liquidity, or even whether the company will even be able to figure out if a holder is net short or not,” the Aggredium analysts said.

U.S. Precedent

Merlin’s $982 million bond financing, which backs the buyout by the Danish family behind Lego in a consortium including Blackstone Group LP, is expected to launch in the near future, according to people familiar with the matter, who asked not to be identified discussing a private matter.

Another deal for U.K. satellite company Inmarsat Plc is also adopting the language. It’s offering $1.125 billion of bonds due in 2026 that include same net-short terms, according to documents seen by Bloomberg News.

Proceeds from Inmarsat’s bond sale will finance its acquisition by Warburg Pincus, Apax Partners and two Canadian pension funds. That transaction also includes a time limit on covenant enforcement, which is also aimed at mitigating risks from net short activists, according to debt research firm Covenant Review.

Representatives for Merlin and Connect Bidco, the consortium bidding for Inmarsat, both declined to comment.

Net short language has been only been seen in U.S deals so far -- the first high-yield bond offering with a net-short disenfranchisement provision was a $300 million issue by Sirius Computer Solutions in June.

--With assistance from Katie Linsell.

To contact the reporters on this story: Laura Benitez in London at lbenitez1@bloomberg.net;Sally Bakewell in New York at sbakewell1@bloomberg.net

To contact the editors responsible for this story: Vivianne Rodrigues at vrodrigues3@bloomberg.net, Charles Daly

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