A weakness in giant CLO market exposed in tiny stock deal

The struggles of a U.S. electronics recycler looking for a $10 million lifeline is exposing a weakness in the $700 billion market for collateralized loan obligations.

4L Holdings Corp. is seeking a cash infusion that would help it outlast the economic pain the coronavirus outbreak has had on its business. That’s sparking the ire of CLO managers who could see their stakes in the firm wiped away, according to people with knowledge of the matter.

The issue has spiraled into a legal brawl. On one side are a handful of CLO shops, which because of structural limitations, are prevented from pumping more money into the company. On the other are private equity firm Vector Capital and hedge fund Diameter Capital Partners, which would help provide the cash in exchange for 85% of 4L’s equity.

The dispute may be a sign of things to come. Amid predictions of a surge in bankruptcies, CLOs increasingly risk their debt holdings being converted into equity stakes in troubled companies that need more capital. But the vehicles aren’t typically able to provide new equity injections. They’re limited from doing that to prevent CLO managers from being tempted to chase risky investments. That’s creating opportunities for other investors to fill the void, diluting the stakes held by CLOs.

“It’s like watching a game of Pac-Man,” said Vincent Indelicato, a partner at law firm Proskauer Rose LLP. “These transactions have allowed non-CLO lenders to gobble up an outsized share of the reorganized company that otherwise would have been allocated pro rata to the CLOs.”

Representatives for 4L, Vector and Diameter declined to comment.

The current situation has similarities to when Deluxe Entertainment Services Group Inc. filed for bankruptcy last year. Its lenders, also CLOs, were prevented from fronting the company much-needed cash because of restrictions on how much CCC rated debt they could hold.

In the 4L case, the company had already filed for bankruptcy after reaching a deal with its creditors to cut its roughly $644 million debt load. Under the plan, lenders would swap all but $80 million of the company’s remaining term loans into 100% of the equity in the reorganized entity after owner Golden Gate Capital ceded control.

The restructuring capped one of the biggest collapses last year in the $1.2 trillion market for leveraged loans. The value of 4L’s term loan had plunged into distressed levels in July after the company told lenders it lost two key customers and had hired advisers to study its options.

The proposal by Vector and Diameter to invest in additional equity would shut out the CLOs unless some other part of their firm is willing to front that capital per the terms, the people said. The CLO managers argue this deal could have been structured differently so that they could participate.

4L’s lenders have hired Sidley Austin to oppose the deal, while the electronics recycler has hired Kirkland & Ellis LLP, the people said.