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Risks Drive Debt Spreads

The return investors receive for owning a debt instrument, whether a loan or a bond, is driven by the various risks of owning debt.  This Job Aid from Financial Training Partners does a good job in explaining the major risks faced by debt investors.


Click on it to see a larger version.

Primary and Secondary Markets for Corporate Debt

In earlier posts, we compared the pricing of corporate loans and corporate bonds.  Here, we'll look at how these markets interact, both in primary issuance and secondary market trading.  First, some definitions:

• The Primary Market is where financial instruments are sold from the issuer to investors.  This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market).  As part of this process, securities often pass through an intermediary, such as an investment bank.
• The Secondary Market is where financial instruments are sold from investor to investor.  The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).

The Investors

• In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors.
• In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds.

The key to rational pricing in these markets are the crossover investors - institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets.  By analyzing the relative value of loans and bonds, they decide which to buy.  For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans.  This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market.  Eventually, the spread between loans and bonds will narrow.  Thus, the secondary markets for loans and bonds are related.

Likewise, the primary and secondary markets are related.  The spread a company will pay on new bonds or loans should be about the spread at which its existing debt is trading in the secondary market (or, if the company has no debt outstanding, the spread at which the debt of companies with a similar risk profile are trading).

Risk Flows Through All Markets

Thus, if debt investors becomes more risk averse, as happens at the beginning of a recession or credit crunch, we would see it first in the most active market, say the secondary market for corporate bonds, where spreads would widen dramatically.  This would lead to a sharp rise in spreads in the secondary market for corporate loans, and finally to the primary markets for both loans and bonds.  Finally, investors will also be comparing loan and bond prices to the other market for corporate credit risk, credit default swaps (CDS).

Loan - Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond's cost is 50 basis points higher than the loan's cost.  Since both debt instruments were issued by the same borrower, shouldn't they cost the same?

Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).

Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. "high yield") bonds is typically higher than the yield on non-investment grade (i.e. "leveraged") loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:

1. Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds.
2. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have "bullet" maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time.  This longer maturity and lack of amortization make bonds more risky to own than loans.
3. Covenants:  Loans have more (and more restrictive) covenants than bonds.  Thus, as a company's operating performance begins to deteriorate, the loan will default long before the bond.  This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.

Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.

Issuer: Risk vs. Cost
As with Jarden,  for non-investment grade issuers, bonds typically have a higher all-in-cost than loans.  This is because bonds are less risky for issuers and provide issuers additional flexibility.

1. Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it.  If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk.  Companies can reduce their refinancing risk by issuing debt with longer maturities.  The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
2. Flexibility: Bonds place few restrictions on a borrower's operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.

Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.

Loan-Bond Relative Value

When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis.  In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.  

• If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.  
• If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.

Jarden Compares Loan and Bond Costs

Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam.  On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012.  Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities.  Over the next 7 months, it completed two transactions.

August 2009: "Amend and Extend"

• In August 2009, the company extended the maturity of $600 million of Term B loans ("TLBs") from January 2012 to January 2015 through the creation of a "Term B4" tranche.  This new tranche was priced at LIBOR + 3.25%.  The remaining $724 million of term loans remain due through 2012.
• Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.

January 2010: Senior Subordinated Notes

• In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020.  The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
• The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
• The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.

So which is cheaper?

With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond's effective cost is 7.625%.  So the loan is a cheaper source of capital than the bond?  Not so fast!  The loan is floating rate - if LIBOR goes up, the company's interest cost will go up with it.  The bond is fixed rate - no matter what happens to interest rates, the coupon on the bond will not change.  So we cannot just compare the current loan cost of 3.5% to the bond's cost of 7.625% - that would be comparing apples to oranges.

Combining a Loan and a Swap

In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate.  This is done using an interest rate swap.  Let's swap the loan to a fixed rate, as follows:

• Step 1: The company borrows at LIBOR + 325 basis points.
• Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.  
• The current quote for such an interest rate swap is about T+10: 
• The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
• The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract. 
• These transactions can be expressed as follows:

We can now calculate the effective fixed rate cost of the loan-swap combination:

• Payment to loan holders:          LIBOR+325 basis points
• Received from the swap bank:   LIBOR
• Payment to swap bank:            Treasury +10 basis points

The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders.  The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335.  The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.

The Loan is Cheaper

The effective cost of the bond is 7.625% while the effective cost of the loan is 7.125%, so the loan is cheaper by 0.50%, or 50 basis points.

Why is the bond more expensive?  And why would the company issue the bond if it is more expensive than the loan?  Watch the blog for answers to these questions.

Using Subordination to Define Intercreditor Priority

The November 2009 issue of The RMA Journal, The Journal of Enterprise Risk Management, includes an article entitled "Using Subordination to Define Intercreditor Priority" by Ron Carleton and Tim Delaney of Financial Training Partners. The RMA Journal is published by the Risk Management Association, a leading organization of professional credit, market, and operational risk managers.

Today, with credit portfolios under growing stress, minimizing losses is more important than ever. "Using Subordination to Define Intercreditor Priority" explains the different types of subordination and how lenders can structure debt to protect themselves in case of a default. For a free copy of the article and more information on

Financial Training Partners, visit www.fintrain.com/publications.

Amend and Extend or Amend and Pretend?

In the last 6 months, we've seen a number of "amend and extend" transactions. Typically they involve:

• The extension of the maturity of a term loan and/or revolver (typically for syndicated, non-investment grade loans). This is only for lenders who agree to the extension (i.e. some lenders may keep the original maturity).
• Increasing loan pricing for lenders who agree to extend (to reflect current market conditions and the higher credit risk of the borrower) and an amendment fee.
• Covenant relief for the borrower (reflecting operating performance below original the targets).

Why an Amend and Extend?

During normal economic times, a borrower would do a new syndication as the maturity date for an existing facility approaches. So why are we seeing amend and extend agreements rather than new facilities? Because many of these companies would have a hard time getting a new syndication done. The loan market is much more selective for high risk credits, and many of these companies have high leverage and weak cash flows.

Amend and Pretend?

It is clear why a borrower would want an amend and extend (despite the higher cost) - they get covenant relief and one or two more years to turn around the business and generate cash for debt repayment. But why are lenders agreeing to these transactions? Do they really

believe the borrowers will be able to repay the loans 2 years later, or are they just deferring the day of reckoning - the day when the borrower will need to do a major financial restructuring (or even a bankruptcy) and the lenders will have to write down the value of the loans? Is it an "amend and extend" or "amend and pretend" (that the loan will actually be repaid some day)?

How to Increase Loan Returns: LIBOR Floors and OID

High Credit Spreads Match High Credit Risk

Since the credit crisis began in the summer of 2007, and especially since the credit markets fell of the cliff in the fall of 2008, we have seen credit spreads in the loan and bond markets increase dramatically. Some investment grade companies today are paying spreads that were reserved for high yield companies just 3 years ago. Of course, the higher spreads correspond with increasing credit risk brought on by the recession and by investors' declining appetite for risk.

Lower LIBOR is Good News for Borrowers ...

One piece of good news for borrowers is the dramatic decrease in LIBOR, the basis over which most corporate loans are priced. Although there have been some disruptions in the LIBOR market (like the fall of 2008), this rate generally tracks the Fed Funds rate. As a result, LIBOR has come down from over 5% before the crisis to well under 1% today.

US$ LIBOR

Source: Bloomberg

... But Loan Investors Still Get Paid

Loan investors, especially institutional investors, feel the pain when LIBOR goes down. So in addition to higher spreads, loan arrangers are using these two structures to increase the returns on term loans (especially Term Loan B's) and jump-start the market:

• LIBOR Floor: Borrower and lender agree that the basis for the loan will be THE GREATER OF actual LIBOR (currently under 0.50%) or the agreed upon floor. Floors in the market today range between 2% and 3%.
• Original Issue Discount (OID): The loan is sold to investors below par and repaid at par. The difference is the OID, which in todays market is anywhere between 1% and 10%. You can think of the OID as another form of an upfront fee for investors.

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.

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.

We're All Cash Flow Lenders Now

Loans to non-investment grade and middle-market companies are typically secured by the borrower’s receivables, inventory, and fixed assets. Pledging this collateral, however, does not reduce the borrower’s likelihood of default. Security should reduce the loan’s loss given default, but not necessarily in the way you expect. Here’s how.

How Are Loans Repaid?

Banks that make secured loans do not expect to foreclose on the collateral to repay the loans. Loans are typically repaid from cash flow from operations or by refinancing with new debt. Foreclosing on collateral is a last resort. Some lenders, such as those that provide asset based loans, equipment finance, or mortgages, are expert in disposing of foreclosed assets, but most banks are ill-prepared to seize assets and sell them.

So Why Take Collateral?

Most secured lenders to bankrupt large corporate and middle-market companies never take possession of their collateral. Instead, the companies are reorganized or sold using the bankruptcy system (e.g. Chapter 11 or Chapter 7 in the U.S.). Proceeds from the bankruptcy, either cash or new securities, are then distributed to creditors. Secured creditors have a higher priority when these proceeds are distributed, giving them lower losses than unsecured creditors.

Does Collateral Mean the Loan Will Be Repaid?

Unfortunately not. Even if the value of the collateral exceeds the amount of the loan when it is made, it is likely that the value of the pledged assets will be substantially lower when the borrower is in financial distress. After all, an asset is only worth what someone will pay for it, and, as we’ve seen, many assets decline in value in a recession.

What’s the Lesson?

As a lender, by all means take collateral when you can get it - just don’t rely on the collateral as your primary (or even secondary) source of repayment. Instead, analyze the company’s ability to generate cash flow to repay its debt. Remember, taking collateral doesn’t mean the company or its assets will retain their values. Unless you are an asset based lender, the biggest benefit you get from collateral is that it moves you to the front of the line in a bankruptcy.

Eddie Bauer Can't Step Down

Eddie Bauer did not have a good fourth quarter of 2008.  Reflecting the worsening economy, sales were down 5.7% compared to the forth quarter of 2007.  Still, adjusted EBITDA for the full year 2008 was almost $53 million, up over 25% from 2007.  As for liquidity, the company ended the year with over $60 million in the bank, zero drawn on its $150 million revolver, and with no principal payments due on its other debt (a $193 million term loan and $75 million in convertible notes) until 2014.  What could go wrong?

Covenant Compliance 

The company’s debt agreements contain covenants limiting certain activities and requiring the company to maintain certain ratios.  The most restrictive covenants are in the term loan, which required (as of year-end 2008) senior leverage to be no greater than 5x EBITDA and fixed charge coverage to be at least 0.9x (as well as limiting capital expenditures, dividends, new debt, and new liens).  As of December 31, 2008, the company was in compliance with its debt covenants.

Now For the Step-Down

On March 18, 2009, Eddie Bauer announced it is "seeking an amendment to the term loan agreement to provide covenant relief and flexibility to manage through a recessionary economy."  The problem is not that the company expects leverage to go above 5x or coverage to go below 0.9x; the problem is that the financial covenants in the term loan agreement step down.  As of March 31, 2009, leverage must be at or below 4x, compared to the 5x requirement just 3 months earlier.  The coverage requirement also increases, eventually hitting 1.1x in 2012.  Why did the company and its banks, led by Goldman Sachs and JP Morgan, include these changing covenant levels in the loan agreement?

Covenants Should Reflect the Business Deal

Setting loan covenant levels is an art not a science.  Ideally, covenants should reflect the shared expectations of the borrower and lenders.  In the case of Eddie Bauer, the company and its banks clearly expected the retailer to improve cash flow and bring down leverage, and set the leverage and coverage covenants at levels that both sides thought were achievable.  When a company's performance is materially worse than both sides expected when they did the deal, there should be a covenant default.

What Happens After a Default?

Rarely does a covenant breach in a corporate loan agreement result in foreclosure or bankruptcy; usually the borrower and lenders agree on an amendment.  The borrower gets looser covenants, but what do the lenders get?  It varies, but the amendment can include more collateral for the lenders, higher interest rates, an amendment fee, and additional restrictions on the borrower, all intended to reduce the lenders' risk and increase the return on the loan.

So far, Eddie Bauer has not reached agreement with its lenders, but the amendment under discussion includes an 8% amendment fee (with 5% of that deferred until 2014), warrants for almost 20% of the company's stock, and a significantly higher interest rate.  Quite a cost for failing to step up!

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.

See also our entries on contractual subordination and effective subordination.

How to Package a Bankruptcy

Why does a company go bankrupt? We often point to factors such as the economy, high leverage, bad management, falling asset values, or strong competition. While all of these can be contributing factors, ultimately a company will file a bankruptcy petition when it can't generate enough cash to service its operating and financial obligations - when it runs out of cash.

Does this mean a bankrupt company has no value and should be liquidated? Not at all. The purpose of Chapter 11 (and similar provisions in other countries) is to allow companies to reorganize and continue to operate. A debtor can use the bankruptcy process to improve operating cash flow by canceling burdensome contracts and leases and closing or disposing of underutilized or unprofitable assets. Just as important, however, a company can use the bankruptcy process to reorganize the liabilities and equity side of its balance sheet to reflect the new reality of its asset values and cash flow.

The Journal Register Company Faces a New Reality

The Journal Register Company publishes 20 daily newspapers and over 150 (mostly weekly) other publications. It has been hurt by the general decline in the newspaper industry, which was greatly accelerated by the recession. The company responded by cutting costs, closing money-losing operations, and selling assets. Still, its margins and cash flow have been declining since 2005.

Source: The Journal Register Company

It became clear by late-2008 that the company was insolvent. Its stock was at $0.10 and it was in default on its debt. The company received a 3-month forbearance from its lenders and hired a Chief Restructuring Officer. On February 21, 2009, the company announced it reached agreement with investors holding 77% of its debt on a restructuring, and it filed a "prepackaged" Chapter 11 petition.

How Does a Prepackaged Bankruptcy Work?

In a prepackaged bankruptcy, the debtor negotiates the key elements of a plan of reorganization before filing for bankruptcy. If all goes as planned, the bankruptcy can be completed relatively quickly; perhaps in 6 months instead of the 18-24 months typical for a large-company Chapter 11. The Journal Register's plan provides for the company to continue to operate as usual and for existing shareholders to get wiped out. The company's existing $695 million of debt will be converted into:

• $175 million term loan A
• $100 million term loan B (with an option for pay-in-kind interest)
• The common stock of the reorganized company

Thus, the debt load of the company is reduced by $420 million to a level the reorganized company expects to be able to service, the company's creditors receive a combination of new debt and stock, and the old owners get nothing. While it doesn't ensure that the Journal Register can survive the secular downturn in the newspaper industry, this reorganization is how the bankruptcy process is supposed to work.

Bridge Loans Make Large Acquisitions Possible

For many companies, financing an acquisition is a two-step process.  The long-term strategy might call for raising cash using syndicated term loans and revolvers, bonds, equity, and asset sales. However, many companies use bridge loans to initially fund acquisitions, then repay those loans with other financings and/or assets sales.  In fact, according to Reuters, the largest syndicated loan in the U.S. in 2008 was the $14.5 billion one-year bridge loan backing Verizon Wireless' acquisition of Alltel Corp.

What is a Bridge Loan?

A bridge loan is a term loan where the expected source of repayment is a specific event, typically a debt or equity financing and/or asset sale.  These loans typically have a bullet maturity (i.e. no amortization) of 1 year or less.  As an incentive to borrowers to refinance bridge loans quickly, they typically include interest rate increases and "duration fees" tied to how long the loan is outstanding.  For example, the Altria bridge loan (described below) calls for the interest rate to increase by 0.25% and for an additional 0.75% fee if the loan is not repaid within 90 days (with additional step-ups and fees each 90 days thereafter).  Bridge loans are typically underwritten by a small group of banks rather than being widely distributed in the syndicated loan market.  These underwriting banks typically also manage the "takeout financing" (e.g. the bonds issued to repay the bridge loan).

Altria Uses a Bridge Loan

On September 8, 2008, Altria Group, Inc., the parent company for cigarette maker Philip Morris USA and other companies, announced an agreement to purchase UST Inc., a leading manufacturer of smokeless tobacco.  The transaction, scheduled to close within 4 months, called for Altria to pay UST shareholders $10.4 billion cash and to assume $1.3 billion of UST debt.  The company's plan was to finance the purchase with $11 billion of long-term, public bonds.  However, at the time they announced the acquisition, they also announced a $7 billion dollar commitment (split between J.P. Morgan and Goldman Sachs) for a 364 day bridge loan which, when added to the company's existing unused credit facilities, could fund the entire purchase.

Here's the timeline:

• September 8 - Altria announces agreement to buy UST and $7 billion loan commitment.
• November 4 - Altria issues $6 billion in 5, 10 and 30 year bonds.
• December 18 - Altria issues $775 million in 18 month bonds.
• December 19 - Altria closes (but does not draw down) on $5 billion 364 day bridge loan (reduced from the original $7 billion commitment).  The bank group expands from JPM and Goldman to include 6 other banks.
• January 6 - Altria closes on the purchase of UST and draws down $4.3 billion from the bridge loan.
• February 3 - Altria issues $4.225 billion in 5, 10 and 30 year bonds (bringing the total bond issuance to the planned $11 billion) and repays the bridge loan.  The 8 banks that underwrote the bridge loan are all joint book-running managers on these bonds.

Early Warning Signs at Satyam

We mentioned the absence of early warning signs in our earlier post on Satyam – especially the lack of a gap between earnings and cash flow. It turns out there were a few. We can classify them either as behavioral or financial.

Behavioral Warning Signs
Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire - without proper shareholder approval and at an inflated price - two struggling companies controlled by Chairman Ramalinga Raju’s family.

Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.

On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”

This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.

Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.

In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.

If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.

The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.

But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.