Friday, May 8, 2009

Michael Foods Term Loans Avoid Effective Subordination

When Thomas H. Lee Partners purchased Michael Foods in 2003, it financed the deal with a combination of term loans and bonds.  All parties agreed that if there was ever a problem, the term loans would be repaid before the bonds.  In exchange for agreeing to take this higher risk, the bondholders receive a higher return than the term loans.

Contractual Subordination
To ensure the term loans are repaid first, the bond documents include a subordination agreement.  This contract between the bondholders and the borrower says that if the company ever defaults on its debt, it must repay the loans in full before it pays anything to the bondholders.  This arrangement is referred to as contractual subordination: the bonds are called subordinated and the loans are called senior (see also our discussion of structural subordination).  Contractual subordination can also be accomplished via a contract between lenders called an intercreditor agreement.

What's the Problem?
The loans had an original maturity of 6 and 7 years, so they are due in 2009 and 2010.  The company is now looking to refinance these loans with new loans with maturities in 2014 and beyond.  These new loans will still be contractually senior to the original bonds, which don't mature until 2013.  The problem is that the new (senior) loans mature after the (subordinated) bonds.  If all goes as planned, the bonds will now be paid before the loans, defeating the purpose of the subordination agreement.  This situation, where subordinated debt is repaid before senior debt because it matures first,  is referred to as effective subordination (a banker friend of ours calls this "first in time is first in line").

What's the Solution?
Michael Foods will need to refinance the original bonds before they mature in 2013.  The new term loans include an "acceleration feature" that will bring the maturity date of the loans forward if the company can't refinance the bonds.  Thus, the loans will always come due before the bonds, avoiding effective subordination.


Anonymous said...

great blog.

Anonymous said...

Do the bond holders need to consent to the inclusion of the acceleration feature. Does this depend on the terms of their bond agreement?

Ron Carleton said...

I haven't read this particular bond indenture, but subordinated bondholders typically have no control over the terms of the senior debt.

Bond covenants are typically incurrence tests. For example, it could say that if leverage (either total or senior) goes over a certain level, say 3.5x EBITDA, the company can not incur new debt (but they can refinance existing debt). But as long as the company stays under that level, they can pretty much do what they want. Even if the company goes over the covenant level, it is not a default (i.e. the bonds are not accelerated). It just prevents the borrower from issuing more debt.