Book: A Pragmatist’s Guide to Leveraged Finance
Author: Robert Kricheff
- YTW and YTM are the same for a bond when it’s trading at a discount, but can differ when it’s trading at a premium.
- Two identically B-rated issues can be 1,000bps apart (and can be more for C-rated issues), so clearly the market doesn’t give too much value to the rating agencies’ opinion, but it can be very useful when it’s a cross-over point to the IG-realm. In the cases where there’s the cross-over possibility, is important to look at the criteria that the agencies look at for the upgrade.
Basics of Loans
- Due to absence of a central exchange, loans can be hard to put a traditional short against
- Revolvers tend to be held the by commercial banks due to the undrawn function, but bank loans are traded widely (though, compared to bonds, which are almost always distributed away to buy-side investors, loans are almost always partially held by the lead agent).
- Loans for IG-rated issues are much more likely to have required amortization than HY-loans; loans often have a required cash-flow sweep where part of the FCF is required to pay down the debt (very unusual to see this in bonds).
- Though there are no hard rules, TL-As are usually held by the banks whereas TL-Bs are often held by institutional buyers and CLOs. TL-A tranches often have slightly better terms (such as shorter maturity and higher C/F sweep).
- Bank loan repayments are often required to be done pro-rata across all the tranches, as opposed to bonds which can be called individually (though there are “first-out” tranches that need to be repaid in case of an IPO etc.)
- Usually, bank agreements don’t allow for buybacks of the loans when the loans are trading at a discount, though in some cases, waivers have been given. But, generally, companies look at retiring HY-notes before the loans, because notes are usually higher-yielding, and thus, more expensive for the company.
Deferred Payment Bonds
- Discount Bonds
- issued at discount; accretes to par as it gets closer to maturity
- increased in accreted value will show up in the I/S as an interest expense
- in bankruptcy, the claim is only for the accreted value at the point
- In the HY market, typically this happens for 5 years (cannot be more than 5 years for U.S. tax reasons) after which the note starts paying cash interest (called “step-up” notes). The notes usually step-up to par at the time when it starts paying cash interest.
- PIK notes
- after each PIK payment, the interest is calculated based on the new outstanding PIK amount
- in case of a PIK Toggle note, where the issuer has the option to pay in more notes or cash or both, unless the issuer announced that it’ll pay in cash, the note doesn’t trade with the accrued interest (but the price increases with the implied interest accrual and then drops on the payment date).
- If an issuer’s leverage is 3.4x and its comps have a leverage of 5x, then it can be said that its equity cushion is ( 5/3.4 – 1 ) = 47%. This means that the company has value that is 47% greater than the debt.
Maturity, Calls and Puts
- Bonds usually mature after loans; if loans mature before the bonds, bank lenders often require “springing maturity” (if the bonds are outstanding, say 6 mos., before they are due, bank loans become due immediately; this allows senior lenders to have control over forcing cos. into bankruptcy etc.)
- Banks loans usually don’t have the same level of call protection as bonds; at times, they’ll be callable at 103 of the face amount in the first year, 101.5 in the second year and par after that, but usually they’re callable at par at all times.
- Equity Clawback: this is a specific type of call option, where the issuer can call back 35% of the notes with the proceeds from equity issuance, given that 65% of notes remain outstanding (to ensure sufficient liquidity). This is usually an expensive option (usual call price being par + coupon), and available usually for the first 3 years, when the usual call structure is not in effect. Typically, the issuer’s bank agreement requires that the proceeds are used to reduce bank debt, but issuers can often get a waiver.
- Cash Flow Sweep: Mandatory usage of cash flow to service debt. Usually, annual, so as to be tied to audited #s.
- AHYDO (applicable high-yield discount obligation): factor for most deferred-pay HY instruments. This is applied when the notes have (a) significant OID, (b) were issued at a yield >500bps over the reference rate, and (c ) have maturity of >5 years. To maintain certain tax attributes after the 5th year, the issuer can make “catch-up” payment by retiring some bonds (usually at par).
Rankings of Debt
- Bank loans are usually more senior, but occasionally notes can be pari passu or even senior to loans.
- There are two ways in which traditional seniority can be circumvented:
- Structural Subordination: this happens when debt is issued at OpCo, which subordinates the HoldCo debt. Even if such cases, HoldCo debt needs to be considered (esp. if the HoldCo debt is convertible) because the management is focused on taking care of the equity holders, and may want to service the HoldCo converts.
- Subsidiary guarantees: this happens when new notes are issued and are guaranteed by subsidiaries, thus ranking them higher than existing debt. This is often done to avoid “negative pledge” covenants of existing notes, which require that if any new additional debt is being issued at the same seniority, the existing note gets secured. To avoid securing the existing notes, the new notes will be issued at a junior level to the existing notes, but will have subsidiary guarantees. When this happens, the existing notes are said to be primed and often trade down.
- Sometimes Secured Notes and the loans may be pari pass, but there may be a clause that gives priority to the Revolver in case of a bankruptcy (called a first-out clause).
Covenants can often show what a company plans to do in the future. Affirmative covenants (interest coverage etc.) for bank loans often have significantly more add-backs when compared with similar covenants for the bonds; the maintenance covenants usually have 20-25% cushion built into them.The following are the most common covenants –
- Debt Incurrence: usually these are defined by simple leverage or coverage ratio tests, but the bulk of the covenant are conditions called carve-outs that will allow incurrence even if the tests are not met.
- Restricted Payments: has two parts: (a) the ratio test(s) that feed off the incurrence test and (b) basket, which build over time (need to understand if -ve net income is counted/ignored, whether equity offerings contribute to the basket etc). RP usually have many more carve-outs than debt incurrence does. One needs to look at the permitted-investment covenant which can allow for money to leave the entity even if RPs are not allowed.
- Change of control: Usually, if change of control occurs, the issuer needs to redeem the notes at 101 within 90 days. Usually, there are carve-outs for permitted holders, which can include family members of the controlling shareholder, or another company that already has a significant stake.
- Restrictions on asset sales: defines the form asset sales can take (cash, securities, asset exchange etc.) and what can be done with the proceeds
Drop-away covenants: defines covenants that become inoperative if the one or more rating agencies upgrade the notes to investment grade.
A feature found in bank covenants is called Springing Maturity, which says that if outstanding junior debt is not retired or refinanced 6 months before it is due, then the bank debt becomes due immediately and will trigger default.
If the company has Restricted and Unrestricted entities, the issuer is required to report the results of the Restricted entities separately even if the issuer is reporting the consolidated reports publicly.
Amendments, Waivers and Consents
These are much more common in bank debt compared to bonds, because (a)bank debt tend to have more covenants, (b) fewer holders of bank debt makes agreement easier, (c) bank debt is usually senior and hence they’re usually more flexible, in exchange for fees. Plus, when it comes to maintenance covenants, bank lenders have a lender’s liability, which is an obligation not to act in a manner that is detrimental to the issuer. An example of waiver is one for Change of Control, which is often negotiated in case of M&A.
Issuers rarely default because of a “technical default”, and one of the ways to avoid a technical default is to do an Equity Cure, where the owner (happens mostly in case of a PE owner) adds in some equity capital to “cure” a technical default (e.g. adding $50.0 mm to the LTM EBITDA to meet the leverage test). If the holders are commercial banks, they are more focused on the relationship with the issuer than other kind of holders are and are more likely to reach relatively favorable agreements with the issuers. On the other hand, distressed investors are more likely to be aggressive and focused on N-T returns.
An alternative to a straight amendment, waiver or consent is an Exchange Offer, where the notes are exchanged for new notes with modified covenants and terms. Exchange Offer has some incentives for a holder to exchange vs. hold-out, most notably, if a certain %age (usually 50.1%) of notes are exchanged, then the old notes do not protection of the old covenants. Then there are obvious considerations such as whether the old notes are being primed, whether new notes have a shorter maturity, have a higher coupon etc. Plus, there’s a consideration for liquidity.
In an amend and extend, even if 90% of the loan-holders agree, they cannot force the other 10% to extend the timing of the loan, and the issuer may end up with two tranches of the original loan. For changes to money terms (coupon, maturity, amortization requirements), usually 100% participation if required.
Acquisitions and IPOs
In case of an acquisition, more interesting scenarios occur when change-of-control will not end up being a factor (bonds are already trading above 101). The acquirer considers the following reasons when deciding whether to redeem the notes of the acquired company: (a) lower interest rate for outstanding debt, (b) to get relief from the existing covenants, and (c) the acquirer may not want separate reporting requirements. If the acquirer leaves these notes outstanding, it is useful to check the covenants on the credit agreement and secured notes of the acquirer to see what can be RP’ed from these acquired notes and how much of new debt can be brought on, priming the acquired notes. If the acquirer is paying for the acquisition using stock, it is financially neutral, but the payment is in cash, new leverage needs to be taken into account.
In case of an IPO, one needs to see the number of shares sold by the company (proceeds will likely go to reduce debt) vs. shares sold by the PE company (proceeds for which will go to the PE firm and not the company). If the bonds are being redeemed, the issuer can (a) simply call them if the notes are callable, (b) call 10% of the notes annually at 103, if the clause allows for it (exists in case of Secured notes), (c) tender for the notes, though this is not common, or (d) claw the notes, if the covenants allow for it. A blended price for all these options can be found out by multiplying the price in each case with the %age of notes being redeemed in that fashion.
If the IPO gets pulled, one needs to consider what the management may do: (a) sell assets, (b) do a leveraged recap (issue new notes to pay dividend to the owners), which will hurt the existing notes’ trading levels, or (c) do nothing and bide its time.
Management and Ownership
History of the management can tell us whether the management were cost-cutters, acquirers or asset sellers.
One way to calculate relative value is to divide the STW (not YTW, as that is affected by varying maturities) by the leverage to show how much basis points of spread one is getting paid for the additional leverage. It is always useful to compare with an investment-grade comparable, if available. When finding an index, beyond the standard HY index and the industry HY index, it may also be worth comparing it to traceable CDS indices.
Distressed Credits and Bankruptcy
An example of a distressed company may be a “good company with a bad balance sheet” which may be doing okay operationally, but just not enough to service its existing debt, perhaps because it was leveraged during good times or maybe the financing had a lot of deferred-pay coupon instruments.
In case of bankruptcy, issuer’s obligation is the principal (accreted value, not the face value, in case the debt was issued at an OID, or if the bonds were a zero-coupon issue) and any accrued but unpaid interest. Usually, interest does not accrue during the bankruptcy process, though there is a concept of post-petition interest, which usually is true only in case of secured debt.
In bankruptcy, if the class is getting impaired, it gets to vote on the bankruptcy because it is assume that the class that is unimpaired will vote yes to any bankruptcy plan. If it is deemed that a class will not get anything in any case, it is also not given a vote as it is assumed that it will vote no to any plan. If a class is impaired, 2/3rd of the class’s $ amount of claims and 50% of all holders must approve the bankruptcy plan. Thus, if an investor has 33.4% of the outstanding class, it is said to have a blocking position. If the impaired class cannot vote on a plan, a court can cram down a plan, but the court doesn’t like to do so, and hence sometimes other classes that do not have the requisite seniority can sometimes get a token stake in the reorganization.
Most senior class of security that is impaired and is not getting paid in full is called the fulcrum security and often ends up with the equity post bankruptcy.
If the company is being put to sale during a reorganization (under Section 363), the court likes to get a starting bid (usually by the creditors) to begin with. This is called the “stalking horse” bid and is used as the floor for the further auction.
Usually, the creditors and issuers both want to avoid bankruptcy and most of the discussions happen outside the court. It may not be possible for all parties to agree, and in some cases the holdouts may end up jeopardizing the entire process. To avoid this, a company may have a pre-packaged bankruptcy plan, pre-agreed by 2/3rd of the creditors, and the court can force a quick 90-day proceeding in such a case.
Note that a debtor-in-possession loan ranks senior to all pre-petition issues.