Monday, March 16, 2009

I'm Thinking Structural Subordination

Wendy's/Arby's Group, Inc. (ticker WEN) was formed in September 2008 through the merger of the Wendy's and Arby's fast food chains. In March 2009, WEN announced it had redone its main loan agreement to reflect the merger. Nothing unusual there. The surprise is that Wendy's/Arby's Group, Inc. is not a party to the loan agreement. Here' why.

Holdco - Opco Structure
Wendy's/Arby's Group, Inc. is a holding company ("holdco") - it has over 60 direct and indirect subsidiaries that actually own, franchise, or operate the restaurants (the operating companies, or "opcos").
  • The opcos have real assets (buildings, inventory, receivables, contracts, etc.) and hopefully generate cash flow from their operations.
  • The holdco's assets are stock in the opcos, and the holdco's primary source of cash is dividends from the opcos.
A Quick Lesson on Bankruptcy
Under the absolute priority rule, a bankrupt company must repay its creditors (i.e. lenders, suppliers, employees, etc.) in full before it can distribute any cash to its owners. So, if WEN and its subsidiaries ever went bankrupt, who would be repaid first: lenders to the holdco (i.e. Wendy's/Arby's Group, Inc.) or lenders to the opcos (i.e. the 60 subsidiaries)? Answer: the opcos, since they have the assets and cash flow and must repay their creditors before paying dividends to the holdco.

Structural Subordination
The idea that opco creditors are paid before holdco creditors is referred to as structural subordination. Because of structural subordination:
  • Lenders to high risk companies (such as WEN) often prefer to lend to operating subsidiaries rather than to a parent company.
  • Loans to holdcos often include a subsidiary debt limitation and upstream guarantees in order to limit the impact of structural subordination.
  • The rating agencies typically rate the debt of a holdco lower than the debt of its operating subsidiaries. For example, Standard and Poor's rates Wendy's/Arby's Group, Inc. "B-" but assigned the slightly higher "B" to the loans of its subsidiaries.


Anonymous said...

This holdco-opco structure is very common in Europe, where you rarely see contractual subordination (I think it is a legal thing).

Anonymous said...

With a little embarrassment and a bruised ego, this was a lesson I learned a quarter of a century ago, when my CCO turned down a holdco loan to a long standing customer. We held, as collateral, the stock of the major subsidiaries but in addition to the holdco credit there was a substantial amount of credit at the subsidiary level. Thus the credit declination. The end result was the company is still operating and to my knowledge none of its subsidiaries have filed Chapter.

In a case where a holdco loan is under consideration, the free cash flow of the subsidiaries should be analyzed to ensure that the holdco loan can be serviced through dividends or upstream loans. Notwithstanding, holdco loans to enterprises that do not withstand stressing downward projections of subsidiary performance should be avoided.

The upstream guarantees make a nice structure but only come into play in a default situation and if the subs file XI, they can be emasculated.

The credit ratings of the agencies should be immaterial and the decision should be based on internal analysis and metrics.

If at all possible, all credit should be expended at either the sub level or at the holdco level but never both. However, this is not a perfect world and I agree with the suggestion that holdco lenders limit the amount of sub debt.

Anonymous said...

Certainly in continental European leveraged/buy-out transactions, rules on financial assistance prohibit the opcos from providing security or upstream guarantees to holdcos (as this would disadvantage any of the opcos existing unsecured creditors). A partial solution is normally to look to refinance any debt in the opcos, thereby allowing you to benefit from a limited amount of guarantees or security.

Anonymous said...

Some of the comments above are not entirely accurate, from a technical point of view.

> holdco-opco structure is very common in Europe, where you rarely see contractual subordination

Holdco-opco structures are indeed very common in Europe, for various reasons, including tax efficiency, management incentive schemes, and lender subordination. However, you will always see contractual subordination, in addition to structural subordination, through the intercreditor agreement, in any LBO.

>credit should be expended at either the sub level or at the holdco level but never both.

Reality is that typically in major European LBOs, in the structures being discussed here, opco senior loans will typically rank pari passu with holdco senior loans and lenders will go into both holdco and opco borrowers pro rata.

>A partial solution is normally to look to refinance any debt in the opcos.
This is not sufficient to solve financial assistance issues. In most jurisdictions, the only way for the opco to lend or guarantee loans to holdco is to demonstrate that the loan or guarantee serves a corporate purpose to the opco. There are structuring tricks that are standard in European P2Ps to allow this. Other jurisdictions, like the UK, have a "whitewash procedure" which bypass financial assistance issues altogether.

I have 8 years experience in European leveraged finance. Feel free to contact me if you have any questions on these matters, and their impact on successful restructurings.

jean-philippe maltais

Keanu said...

I believe from October 2008 the UK has abolished white wash procedure suggesting that financial assistance is no longer an issue in UK transactions.

Anonymous said...

Yes, European LBOs have contractual subordination in form of Inter-creditor agreements, but none of them have ever been tested in any legal system. So thats why investors will always prefer structural subordination.

Peter Andre said...

Seems odd that inter-creditor agreements havent been tested in a legal system or even that they should have to be tested given that they are supposed to contractually bind all parties to a certain liquidation process