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Posts Tagged ‘debt structure’
Tuesday, November 22nd, 2011 by Ron Carleton
We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.
Tags: Covenants, debt structure, Liquidity
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Tuesday, December 28th, 2010 by Ron Carleton
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy - Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
2) Investing in People – While bank compensation levels haven’t necessarily returned to 2006-07 level (or most), we certainly see a lot of hiring at the analyst and associate levels, and more business and opportunities for more senior professionals.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
Tags: Cash Flow, Covenants, debt structure, Early Warning Signs, financial fraud, financial institutions, Financial Strategy, Leverage, Liquidity, Liquidity Position, Priority, Problem Credit, Risk Management
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Wednesday, May 26th, 2010 by Ron Carleton
For the 7th time in 10 years, Wal-Mart is #1 on the Fortune 500 list (in the other 3 years, it was #2). The company is the largest private employer in the U.S. and accounts for 8% of total retail sales in the US. As big box retailers (including Wal-Mart, Target, The Home Depot and others) have gained market share over their smaller competitors, consumer products companies feel the need to sell to these large retailers in order to grow sales. For some companies, however, selling to the big box retailers has a darker side – what we call “Wal-Mart Risk.”
Customer Concentration Risk
The risk is customer concentration – that a significant portion of a company’s sales are to one company. The dangers of customer concentration include:
1) Credit risk – the risk that the customer will go bankrupt and the company will be unable to collect its receivable.
2) Switching risk – the risk that the company will build capacity to satisfy a large customer, and then the customer switches to another supplier, leaving the company with significant excess capacity (and perhaps unsold inventory).
3) Buyer power – the risk that the customer uses its position as a large buyer to drive down the price it pays the company for goods.
In order to address customer concentration risk, revolving credit agreements that include a borrowing base often exclude accounts receivable from customers above certain concentration limits (say 10% of total receivables). This provision significantly limits revolver availability for some borrowers and does not protect lenders from the main risks of customer concentration – switching risk and buyer power.
How is Wal-Mart Risk different?
How should we look at customer concentration risk differently when the large customer is Wal-Mart or one of the other big box retailers?
1) Credit risk is significantly reduced. It is unlikely that Wal-Mart will go bankrupt and not pay its suppliers.
2) Wal-Mart takes advantage of its buyer power more than most. The downside of selling to big box retailers is that they will demand lower prices, leaving their suppliers with lower margins. In addition, Wal-Mart is well known for setting other strict terms for its suppliers in terms of product quality, inventory levels, distribution and returns.
Can we “structure around” Wal-Mart risk?
So how should lenders address the ever-increasing Wal-Mart risk among their borrowers?
1) Waive concentration limits for receivables from high quality vendors, like Wal-Mart, but consider lower advance rates to account for the higher dilution likely from aggressive return and warranty claims.
2) Consider the impact of the loss of a large customer on the borrower. Does the company have a contingency plan? Will it be able to bring down costs and capacity to match lower sales?
3) Lower leverage! Companies with significant customer concentration have higher business risk than companies with a diverse customer base and should thus have a more conservative financial strategy – that means less debt.
Have you seen companies and/or their lenders address this risk? Tell us how – we welcome your comments.
Tags: CAPS, Competition, Covenants, debt structure, Financial Strategy, Leverage, Risk Management, Wal-Mart
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Wednesday, May 19th, 2010 by Ron Carleton
The problems of the last leveraged buyout bubble are still with us. From 2004 through 2007, the U.S. experienced an unprecedented level of LBO activity. That all ended with the collapse of the debt markets in the summer of 2007 (and the disappearance of the debt markets after the Lehman bankruptcy).
LBOs are funded primarily with debt – somewhere between 60% and 80% of the capital structure. These are the debt products used:
- Institutional Term Loans (also know as “Term Loan B” or “TLB”) – often the single biggest tranche of debt, these loans are sold to institutional investors, such as collateralized debt obligations (CDOs) and prime rate funds. They have very little principal amortization and a final maturity of 6-7 years.
- Pro-rata Loans (comprised of a revolving credit facility and a Term Loan A) – these loans are sold to banks and typically make up a smaller part of the capital structure than the TLB. Standard terms for a Term Loan A include significant principal amortization and a final maturity of 5 years.
- High Yield Bonds – are sold to institutional investors. They have a bullet maturity (i.e. no principal amortization) and a final maturity longer than the Institutional Term Loans, typically 7-10 years.
The Debt is Coming Due!
Starting in 2012, we will see significant amounts of LBO debt coming due. Knowing the typical maturities of the debt products and counting forward from the boom years of 2006 and 2007, first we’ll see large amounts of pro-rata loans come due, then institutional term loans, then high yield bonds, as this chart shows:
What is the solution?
Highly leveraged companies have been working on this problem for some time. Given their earlier maturities, much attention has been focussed on refinancing the loans. Companies have issued new loans (with longer maturities) and high yield bonds in order to repay existing loans and extend their debt maturity profiles. There have also been many “amend and extend” agreements whereby existing lenders extend the maturity of their loans (in exchange for fees, increased interest spreads and other consideration).
Looking out into 2012 and beyond, the question is whether or not there will be capacity in the loan and bond markets to refinance all of the maturing debt. The jury is still out on this question.
Tags: Amend and Extend, debt structure, Financial Strategy, Flexibility, Leveraged Buyout, Liquidity, Refinancing Cliff, term loan b
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Tuesday, February 16th, 2010 by Ron Carleton
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.
Tags: Credit Training, debt structure, Priority, relative value
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Tuesday, February 9th, 2010 by Ron Carleton
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).
Tags: debt structure, financial institutions, relative value, term loan b
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Monday, February 1st, 2010 by Ron Carleton
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:
- 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.
- 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.
- 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.
- 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.
- 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.
Tags: CAPS, Covenants, debt structure, Financial Strategy, Flexibility, Interest Rate Swaps, Jarden, Priority, relative value, term loan b
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Tuesday, January 26th, 2010 by Ron Carleton
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%.
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.
Tags: Amend and Extend, CAPS, Covenants, debt structure, Financial Strategy, Interest Rate Swaps, Jarden, term loan b
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Thursday, October 29th, 2009 by Ron Carleton
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 this page.
Tags: Covenants, debt structure, Priority, Subordination
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Monday, October 19th, 2009 by Ron Carleton
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)?
Tags: Amend and Extend, Covenants, debt structure, Lines Of Credit, Problem Credit, Turnaround
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Tuesday, August 11th, 2009 by Ron Carleton
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.
Tags: debt structure, term loan b
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Wednesday, June 24th, 2009 by Ron Carleton
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.
Tags: CAPS, Covenants, debt structure, term loan b
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Wednesday, June 17th, 2009 by Ron Carleton
With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:
- 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.
- Foreclose on collateral – As with acceleration, this would result in the bankruptcy of the borrower.
- 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:
- Increased pricing and/or a one-time fee – to compensate them for the increased risk,
- Additional collateral – to improve their loss in the event of a bankruptcy,
- Reduced exposure – if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
- 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.
Tags: CAPS, Covenants, debt structure, Turnaround
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Wednesday, June 10th, 2009 by Ron Carleton
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:
- Non-investment grade companies, who often need more debt or longer-term debt than the senior market will provide, and
- 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.
Tags: debt structure, Priority, Subordination
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