By Jen Saarbach & Kristen Kelly, Co-Founders of The Wall Street Skinny
One of our followers reached out this week with a great question. They’d seen a story in the FT about Apollo buying credit default swaps on First Brands, the company that has become a huge story in the private credit world due to some questionable accounting practices and recent bankruptcy (see article above).
Our follower asked us if that meant Apollo was an investor in the company. Given Apollo’s footprint in private credit, it was a fair assumption. After all, if a firm that is known to be a big investor in private credit is in the same news article as a heavily indebted company, the default assumption is usually that they’re involved in the loans.
But when we looked into it, the story turned out to be much more interesting.
Apollo wasn’t a lender at all. In fact, First Brands had actually blacklisted Apollo from their list of potential lenders.
Rather than putting capital into the company, Apollo essentially did the opposite. They bought First Brands CDS (credit default swaps), which effectively constitutes a short bet on First Brands’ credit.
This therefore leads to a few questions.
First, why would a borrower blacklist someone like Apollo in the first place? “Disqualified lender lists” are a common feature in leveraged loans. use them to keep competitors or aggressive distressed investors out of their capital structure. Apollo also owns Tenneco, one of First Brands’ rivals in the auto parts market. If Apollo were allowed to buy into the loans directly, they’d get access to the lender data room, confidential financial information, and potentially a seat at the table in any restructuring or amendment vote. Blacklists also allow company owners to avoid dealing with investors they consider difficult to negotiate with in the case of any kind of restructuring. If you haven’t read Caesars Palace Coup or listened to our 3 part podcast breakdown of the book by author and FT writer Sujeet Indap, we get into just how aggressive Apollo can be in the world of restructuring.
Regardless of the motivation, the blacklist was meant to keep Apollo from being an investor in their debt.
But being blacklisted from the loan doesn’t mean you can’t bet against it. That’s where credit default swaps come in. CDS is essentially insurance against a borrower’s default. If the credit deteriorates, the CDS appreciates in value. If the company defaults, the buyer of protection (in this case, Apollo) receives a windfall.
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Owning CDS allows Apollo to profit from First Brands’s credit deterioration or increased risk of default without trading their debt. But there’s a catch.
For big companies with publicly traded debt, the CDS markets can be relatively liquid. For private credit borrowers like First Brands however, they’re virtually nonexistent. Therefore, Apollo had to enter into a bespoke CDS, a custom derivative contract written by a bank that references the company’s loans. A trade like this isn’t done casually; it’s illiquid, expensive, and typically only available to the largest, most sophisticated players.
First Brands tried to keep Apollo out of the capital structure, but instead seems to have incurred their wrath. Not only was Apollo able to take a view on the company from the sidelines, but they likely profited considerably from First Brands’ collapse.
The moral of the story? Be careful whom you anger in the credit markets….
If you want a deeper dive into how CDS actually works, we run through all the mechanics in our Fixed Income Course!