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Posts Tagged ‘Priority’
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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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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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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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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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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Friday, May 8th, 2009 by Ron Carleton
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.
Tags: debt structure, Priority, Subordination
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Thursday, April 2nd, 2009 by Ron Carleton
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.
Tags: Bankruptcy, CAPS, debt structure, Lines Of Credit, Priority
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Monday, March 16th, 2009 by Ron Carleton
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’s 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.
Tags: Bankruptcy, CAPS, debt structure, Lines Of Credit, Priority, Subordination, Wendy's/Arby's Group
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