Wrangling Term Loan B Investors

According to Bloomberg.com, American Airlines is asking its lenders for a covenant waiver. A conference call was held on June 22 and responses are due by June 25. Why the rush? The covenant would be waived for the quarter ending June 30, so the company wants the amendment done before the end of the quarter.

As we have discussed in earlier entries, many companies are amending their credit agreements to reflect lower than expected operating performance driven by the recession. Airlines have been especially hard hit by the downturn, so the pressure on American's covenants is no surprise. The interesting element of this amendment is the lending group - institutional investors.

Term Loan B

A Term Loan B ("TLB") is a term loan structured for sale to institutional investors, such as collateralized debt obligations (CDOs) and prime rate mutual funds. Traditional term loans, called Term Loan A's, are typically originated by and sold to banks. Here are the main differences between the two:

Negotiating Amendments with Institutional Investors

Amendments to corporate loan agreements happen all the time. When the lenders are banks (as is typical for revolvers and TLAs), the relationship between borrower and lender often goes back many years and may include other business, such as cash management or bond underwriting. As a result, banks are often willing to work with borrowers towards a long-term solution (i.e. banks are more willing to grant waivers). TLA banks are often referred to as "relationship lenders."

Institutional investors are "transaction lenders" - their relationship with the borrower often goes no further than the individual loan. As a result, they are often less inclined than banks to grant waivers or agree to amendments.

American Airlines "Pays Up" for its Amendment

American's proposal to its TLB lenders is to waive the fixed charge covenant this quarter and cut it through the loan's maturity in 18 months. In exchange, the spread on the loan would go from 200bp over LIBOR to 400bp, and there would be a new LIBOR floor of 2.5%. This would immediately increase the interest rate on the $435 million loan by about 3.9%, increasing interest expense by over $16 million per year. In addition, the lenders would get a 75 basis point amendment fee, costing American over $3 million. These terms are not unusual in today's market for "B" rated companies like American.

What Happens After a Default?

With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:

1. Acceleration (i.e. "call the loan") - declare the principal of the loan to be immediately due and payable. This typically would result in the bankruptcy of the borrower since they do not have the cash on hand to repay the loan.
2. Foreclose on collateral - As with acceleration, this would result in the bankruptcy of the borrower.
3. Stop funding unused revolver commitments. Banks will typically continue to allow some revolver borrowings because cutting off the revolver would often result in a bankruptcy.

After a covenant default, banks typically do not exercise their rights - they do not call the loan or foreclose on collateral, and they often allow the borrower to continue to borrower under the revolver. Banks know that these actions would result in bankruptcy, and it is in everyone's interest to avoid bankruptcy.

So what really happens?

Most covenant defaults result in an amendment (or waiver) to the loan agreement. The financial covenants that were breached are loosened in order to get the borrower out of default. Ideally, the company and banks should see the covenant breach coming and work out an amendment before the default happens.

A good example of this is the recent amendment done by Actuant Corporation (ticker ATU), a diversified industrial company headquartered in Wisconsin. The company was forecasting deteriorating financial performance which could have breached covenants. Before the defaults happened, the company negotiated an amendment which increased its leverage covenant from 3.5x to 4.5x (with future step-downs) and reduced its fixed charge covenant covenant from 1.75x to 1.65x.

What do banks get in exchange?

In exchange for giving a borrower more room under its covenants, banks typically get one or more of the following:

1. Increased pricing and/or a one-time fee - to compensate them for the increased risk,
2. Additional collateral - to improve their loss in the event of a bankruptcy,
3. Reduced exposure - if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
4. Additional covenants - to ensure that cash is used to repay debt (e.g. dividend and/or capex limitations) and to better monitor the company's performance.

In the Actuant example, the banks received:

• An amendment fee and increased pricing (spread went from L+250 to L+375; commitment fee went from 40 to 50bp),
• Faster term loan amortization (from $1.5 million per quarter to $10 million), and
• Additional collateral.

Bondholders Agree to Let Bio-Rad Repay Loans First

Bio-Rad Laboratories Inc. is a life sciences company with sales of over $1.7 billion. In May of 2009, it issued $300 million of 7-year notes in a 144A offering through Credit Suisse. The company refers to the new debt as Senior Subordinated Notes. Does this mean the debt is senior or subordinated? How do we know the intercreditor priority of the notes?

Contractual Subordination

The notes are governed by an indenture, a contract signed by the borrower and by a trustee (in this case, Wells Fargo) who represents the noteholders. In addition to describing the notes and listing various covenants and defaults, the indenture includes a section on subordination. In that section, the noteholders agree that in the event of the borrower's bankruptcy or a payment default on the borrower's senior debt (or certain other events), the borrower will not make any payments on the notes until the default is cured or the senior debt is repaid in full. This arrangement is referred to as contractual subordination (see also our entries on structural subordination and effective subordination).

The Details Matter

The document creating contractual subordination can be a subordination agreement or indenture (as with Bio-Rad, and commonly used for public bonds and 144A issues), or an intercreditor agreement, which is more common with mezzanine finance and other privately placed subordinated debt. The terms of subordination vary from agreement to agreement. For example, the ability of subordinated debtholders to receive payments after a covenant breach in the senior debt can vary, as can the amount and type of allowable senior debt. Finally, the term senior subordinated debt (which is common for high yield bonds) means that the bonds are subordinated to all senior debt (typically bank loans) but it is senior to any junior subordinated debt (typically, mezzanine finance).

Who Issues Subordinated Debt, and Why?

Subordinated debt is more expensive than senior debt, so why would a company issue it? The big issuers of subordinated debt are:

1. Non-investment grade companies, who often need more debt or longer-term debt than the senior market will provide, and
2. Regulated entities, such as banks, insurance companies and electric utilities, who issue subordinated debt instead of equity in order to satisfy their regulatory capital requirements.

Microsoft's leverage nearly triples!!!

Microsoft borrowed $3.8 billion in the US corporate bond market on May 11, driving its total debt up to $5.8 billion. But there's no need for panic. The company had $36.9 billion worth of cash and investments at the end of March, was producing annualized EBITDA of $23.4 billion, and enjoys triple-A ratings from Moody's and Standard & Poor's.

Cash flow problems?
The question for Microsoft is, why borrow at all? Companies borrow for lots of reasons. One is to make up for weak or erratic cash flows. That doesn't seem to be Microsoft's problem. It's been generating strong free cash flows and stable free cash flow margins.

* Last 12 months as of March 31, 2009

(Free cash flow margin is a concept developed by the Georgia Tech Financial Analysis Lab, a leader in cash flow analytics. For more information go to http://www.mgt.gatech.edu/finlab. We calculate free cash flow somewhat differently from them in this analysis.)

Liquidity Reserves?
Another reason is to build liquidity reserves by borrowing long-term money and keeping the proceeds on hand to meet future needs. But that's typical of lower-grade companies with erratic cash flows or unpredictable cash needs, not a highly rated company with strong cash flow and few financial contingencies, like Microsoft.

War chest?
Another reason to take on more debt is to build a war chest for acquisitions. The likely target for Microsoft is Yahoo, which has a market capitalization of about $21 billion. It might cost Microsoft $25 - $30 billion to acquire Yahoo, but Microsoft doesn't need to borrow money for that. It has $37 billion in cash and investments in reserve.

WACC?
Cost of capital might be the reason. Following the precepts of modern finance, companies like to blend debt with equity in their capital structures to reduce the weighted average cost of capital. Debt is cheaper than equity up to a point, but that point is somewhere around 45% debt capitalization. At only 13.6% debt to capital, Microsoft is a long way from its optimal capital structure.

Market Access?
The last reason for using debt is market access. Companies often borrow to establish themselves in the debt markets. That helps the company's financial managers get familiar with market underwriting standards and practices and gives lenders and investors a chance to become familiar with the company's management, operations, and finances. With this bond issue, Microsoft is now active in the syndicated bank loan, commercial paper, and bond markets.

Microsoft's Motives?
So which reason is it for Microsoft? It's probably a combination of reasons. The prospectus for the bonds says the funds are for "general corporate purposes." We think its most likely for debt market access in anticipation of a major acquisition which might affect liquidity needs.

Risk and Structure
Why does all this matter from a credit risk perspective? Understanding the purpose of the loan is one of the fundamental tenets of credit analysis. For large, investment grade companies the purpose can be very vague ("general corporate purposes"), but for smaller, weaker companies it should be more precise ("working capital financing" or "new equipment purchases").

From a credit structuring perspective, the basic rule is to match the form of the credit to the nature of the need. For a general purpose loan, a revolving credit or a long-term bond would be the best fit (Microsoft's bonds were for 5, 10, and 30 years). For specific needs, the rule of thumb is to match the maturity of the credit to the life of the assets, with short-term lines of credit for working capital and medium-to-long-term loans for fixed assets.