Risk of Bank Debt and Covenants

[LongHaul]

Does anyone have any knowledge or experience with the risk of bank debt and covenants?

 

The reason I ask is that it seems like bank debt can be very risky.  If a company has value greater than the debt but a temporary downturn in earnings, from any number of things, the banks can just put the company into bankruptcy upon violation of covenants.  If aggressive vulture funds buy the bank debt and want to own the company then they could use the covenant violations as an excuse for putting the company into bankruptcy and trying to convert to equity.

 

I am very interested in any experiences or knowledge on this subject.

 

 

[Guest cherzeca]

Does anyone have any knowledge or experience with the risk of bank debt and covenants?

 

The reason I ask is that it seems like bank debt can be very risky.  If a company has value greater than the debt but a temporary downturn in earnings, from any number of things, the banks can just put the company into bankruptcy upon violation of covenants.  If aggressive vulture funds buy the bank debt and want to own the company then they could use the covenant violations as an excuse for putting the company into bankruptcy and trying to convert to equity.

 

I am very interested in any experiences or knowledge on this subject.

 

my experience may be unusual, but I find this to be a compliance issue...namely some banker "tries too hard" to accommodate a client and the commitment committee for some reason doesn't say no.  and I think banks have become much more compliance focused since FC.  have a look at DB's line to TSLA.  that is a line that should be terminated tout de suite.  how that line was extended tells you everything you need to know about DB. but I don't think this is a widespread issue

[Cigarbutt]

Does anyone have any knowledge or experience with the risk of bank debt and covenants?

 

The reason I ask is that it seems like bank debt can be very risky.  If a company has value greater than the debt but a temporary downturn in earnings, from any number of things, the banks can just put the company into bankruptcy upon violation of covenants.  If aggressive vulture funds buy the bank debt and want to own the company then they could use the covenant violations as an excuse for putting the company into bankruptcy and trying to convert to equity.

 

I am very interested in any experiences or knowledge on this subject.

Your post has at least two lines of thought:

 

1-Are more restrictive covenants associated with bank loans a good thing?

 

A positive aspect is that (like implied with the pressure to perform linked to highly leveraged private equity deals) a tighter leash will tend to help with capital discipline. Covenant breach (or getting close) may prevent some profitable investments and may happen relatively early in the distress game but may also prevent foolish capital allocation and much more pain down the line compared to weaker covenants found in leveraged loans or capital market bonds. It seems to me also that, given an insolvency threat, having bank debt can be a positive factor to come out of distress with lesser costs or for a "successful" out-of-court restructuring. Covenant breaches are quite frequent and, in general, result in negotiated adjustments and not in opportunistic value transfer.

 

2-Can opportunistic investors take advantage of covenant breach situations?

 

Yes and mostly in a "constructive" manner. You can look up for instance what Oaktree Capital did some time ago with Regal Cinemas and Loews Cineplex. You can also see what happened to the Loewen Group (see reference at the end). What you describe though is rare but seems to be happening more frequently: the loan-to-own vulture investors that is looking to precipitate default and the "empty creditors" who make proportionally more $ if the restructuring fails.

 

Looking forward to discussing specific and contemporary examples as these issues tend to be cyclical. Corporate debt has gone up, the proportion of "public" financing has gone up ++ and covenant reach has come down and it is said that those phenomena are related to greater sophistication.

 

http://catalogimages.wiley.com/images/db/pdf/0471405590.01.pdf

[LongHaul]

thx for the posts and info. 

 

I agree most of the time banks adjust covenants and the credit window is open to viable underlevered companies.  Sometimes they are not though during bad economic times, etc.

 

Lets consider the perspective of the company that has about half of its value in bank debt and the economy tanks, earnings tank and the credit window is shut.  Seems very risky to me to be reliant on bank debt

and if the company is violating covenants the company is at the mercy of the lenders - perhaps extremely aggressive ones like vulture funds.  Very long term bonds seem much safer from a probability of default.

 

I would be interested in examples of where the creditors took a lot of the value from equity, when there was real equity value.  Frankly, I think this happened in Lear corp and may be happening with PHI right now.

[Cigarbutt]

PHI is interesting. I would say that valuation of the oil and gas helicopter division requires specialized knowledge and an idea of where the oil and gas industry is going. There are rumors concerning interested buyers but there is a difference between interest and commitment. So far, it seems that enterprise value is less than total debt (unless you see something different). The interesting dynamics in this case is not about non-insider creditor getting the assets on the cheap but more like the prominent insider shareholder trying to get back ahead in line instead of back in the queue which is an example of intra-class creditor fight which may be about conflicted views or conflicted interests.

 

For Lear, with the benefit of hindsight, it seems obvious now that there was residual equity value when they filed in 2009 but going back to the perspective then with GM and Chrysler filing, with other auto parts suppliers falling like dominoes and with the smell of nationalization, given their significant debt overhang, I would say that enterprise value "deserved" then to be less than total debt. I think management did well by acting rapidly and by submitting a pre-packaged bankruptcy with a satisfactory recap. There didn't seem to be other interested material parties to complain then. The problem with retrospective hindsight and the related impression of residual equity at the time of filing is that one tends to forget the frequent problem seen with inadequate recapitalization and further filing(s) down the road for many other participants.

 

There are exceptions but FWIW I think the US (and CDN) bankruptcy process usually does a good job at price discovery but would also "be interested in examples of where the creditors took a lot of the value from equity, when there was real equity value".

 

An example going on right now where creditors may encroach on residual equity value is PG&E but they didn't file because of a covenant breach, they filed because they wanted to renegotiate their "social contract" with the State of California, which makes it a challenge for valuation.

[Jurgis]

The problem with retrospective hindsight and the related impression of residual equity at the time of filing is that one tends to forget the frequent problem seen with inadequate recapitalization and further filing(s) down the road for many other participants.

 

Hear, hear.

 

There's a lot of ownership bias in looking at these situations too. If someone owns debt, they usually clamor for creditors getting more. If someone owns equity (or thinks to invest in equity), they clamor for no BK or equity holders getting more. Since most people on CoBF tend to own equity, there's at least some pro-equity bias.

 

But, as you say, even if someone tries to be 100% fair, it's not easy to do that without knowing the future.

[Spekulatius]

The biggest problem with bank loans is that the conditions/ covenants are in most cases not disclosed. With publicity traded debt they are in the prospectus.

[Cigarbutt]

The problem with retrospective hindsight and the related impression of residual equity at the time of filing is that one tends to forget the frequent problem seen with inadequate recapitalization and further filing(s) down the road for many other participants.

 

Hear, hear.

 

There's a lot of ownership bias in looking at these situations too. If someone owns debt, they usually clamor for creditors getting more. If someone owns equity (or thinks to invest in equity), they clamor for no BK or equity holders getting more. Since most people on CoBF tend to own equity, there's at least some pro-equity bias.

 

But, as you say, even if someone tries to be 100% fair, it's not easy to do that without knowing the future.

The value assessments are sometimes so far apart and do reflect, at least in part, the "strategic" biases that you refer to. An interesting feature of a covenant breach or bankruptcy proceedings is that it introduces a relatively fixed time frame within which one's optimistic or pessimistic outlook (depending where one stands in the capital structure) needs to be realized versus simply buying and holding forever implying that the Market will eventually recognize the value.

 

When I got really interested in USG in 2009 (was impressed concerning how they had "managed" the 2001 bankruptcy related to asbestos claims), I looked back to see what happened to National Gypsum when they filed in 1990. The equity was wiped out. During the adversarial appraisal process, the "senior" group (including vulture funds who had recently bought at a deep discount) valued the enterprise at about 200M. The "junior group" valued the firm at around 1B. So 600M + or - 400M! The senior group's plan was approved and shortly after emergence in 1993, the enterprise value was estimated at 464M. What is amazing is that both groups could have been right. It seems the largest driver behind the "recovery" was the trend in housing activity.

https://fred.stlouisfed.org/series/HOUST

But who knows what today will bring?

Happy Easter to all.

 

 

[5xEBITDA]

Does anyone have any knowledge or experience with the risk of bank debt and covenants?

 

The reason I ask is that it seems like bank debt can be very risky.  If a company has value greater than the debt but a temporary downturn in earnings, from any number of things, the banks can just put the company into bankruptcy upon violation of covenants.  If aggressive vulture funds buy the bank debt and want to own the company then they could use the covenant violations as an excuse for putting the company into bankruptcy and trying to convert to equity.

 

I am very interested in any experiences or knowledge on this subject.

 

This is not really as big of a deal as you might think it is, but as with most things..."it depends" the majority of the time. Its actually in the banks best interest for the company to remain solvent and out of bankruptcy, and they will accommodate (kick the can down the road) most situations.

 

Covenants like maximum debt ratios and minimum interest coverage can be amended and waived by giving a fee to the banks or raising their interest rate (or tightening up other covenants as well).

 

So if a company takes a temporary hit in earnings and becomes in danger of busting a covenant, it will almost always get amended or waived. A bank will only really give a firm "no" if the company has been playing fast and loose for a long time. Like if its the 2nd or 3rd time approaching the bank in a year with a problem or something. Even in situations where a company is on the brink of default I've been amazed how accommodating the banks have been when, in my opinion, they shouldnt have been.

 

I've actually never seen a company put into bankruptcy because they breached their leverage ratio or something. In fact, WIN was not put into bankruptcy because of a covenant breach, the banks were in the process of working out a solution for them but they ran out of time. The majority of the time I see a company go into bankruptcy is because they have a liquidity problem of some sort. Staying with Windstream - they went into default because they had a liquidity crunch that prevented them from financing their ongoing operations and they sought bankruptcy relief to receive debtor in possession financing so they could keep their lights on while they worked the problem. Windstream is a highly capital intensive business with significant working capital needs. They have historically always kept a low cash balance and used their revolving credit facility to finance working capital. When the ruling came out that decided their sale leaseback transaction was a violation of certain covenants it created an event of default. An event of default is not always an automatic bankruptcy, there is sometimes a "cure" period where the company has a month or so to "fix" what is causing the default. The problem here was that Windstream's revolving credit facility becomes inaccessible if an event of default exists. Since they had a low cash balance and could not access their revolver, they could not operate their business. Since they couldn't operate their business they couldn't fix the problem. Therefore, seeking bankruptcy relief was the best option so they could access a new source of liquidity.

 

To your comment "if the company has value greater than debt...banks put the company into bankruptcy anyway" this is not really true. Depends on who owns the bank debt. JP Morgans leveraged finance group (the agent on some leveraged bank debt) is not going to "opportunistically" put the company into default because what benefit would they get for it? They can't own the equity. Some hedge funds that own the bank debt might not even opportunistically put it into default because they'd rather just waive a covenant default in exchange for higher rates and give the company time to work their problem while owning a good piece of paper. Aggressive hedge funds will only do this from the stance of a bank lender only if the company truly has big problems, in which case their is likely zero equity value anyway.

 

Equity investors tend to over value companys, and Im comfortable saying that as a blanket statement. The reason is because they focus on future growth opportunities and value based off that. Even a lot of equity investors that use "conservative" valuations are still aggressive by credit investor standards. So its easy to think that creditors might be pulling the rug out of the equity when you think its worth several turns higher than what they say, but in most cases I'd be they're probably right and you're too aggressive with the valuation.

 

Of course, even credit investors come to different opinions on this. In bankruptcy its called a "valuation fight". It will literally come down to lawyers arguing to the judge the merits of one valuation method vs another. Most on this board are familiar with the ZINC situation - you can read the docket notes and see that the judge's opinion on value came down to cost of capital assumptions in one case. It really just comes down to the motivations of different creditor groups which I'm happy to get more into.

 

This is a lot so far, but I'll round it out with another point. Someone below commented that you can't always see the terms of the bank debt. This is not true. Bank debt agreements are always filed with the SEC - I've never, ever been in a situation where I couldn't find the information publicly in SEC filings.

 

The rabbit hole of credit investing and understanding bank debt covenants is very deep and (rightfully) appears to be a lot for those unfamiliar with it. It can even feel like its unfair. But the fact is that, in my opinion, if you want to be a good investor you absolutely need to understand this stuff. I have seen stock pitches, even on the valueinvestorsclub, where a big part of the pitch is a return of capital to shareholders that was actually prohibited by the bank debt covenants! This was a big reason why I went short equity and long bonds in FCAU last year. Every one bought into it because they expected a massive return to shareholders that was actually prohibited by their bank debt covenants. I figured that the return either wouldn't actually happen or would be smaller than expected.

 

Its just a tricky concept. But I'm happy to answer questions over it!

[LongHaul]

Does anyone have any knowledge or experience with the risk of bank debt and covenants?

 

The reason I ask is that it seems like bank debt can be very risky.  If a company has value greater than the debt but a temporary downturn in earnings, from any number of things, the banks can just put the company into bankruptcy upon violation of covenants.  If aggressive vulture funds buy the bank debt and want to own the company then they could use the covenant violations as an excuse for putting the company into bankruptcy and trying to convert to equity.

 

I am very interested in any experiences or knowledge on this subject.

 

This is not really as big of a deal as you might think it is, but as with most things..."it depends" the majority of the time. Its actually in the banks best interest for the company to remain solvent and out of bankruptcy, and they will accommodate (kick the can down the road) most situations.

 

Covenants like maximum debt ratios and minimum interest coverage can be amended and waived by giving a fee to the banks or raising their interest rate (or tightening up other covenants as well).

 

So if a company takes a temporary hit in earnings and becomes in danger of busting a covenant, it will almost always get amended or waived. A bank will only really give a firm "no" if the company has been playing fast and loose for a long time. Like if its the 2nd or 3rd time approaching the bank in a year with a problem or something. Even in situations where a company is on the brink of default I've been amazed how accommodating the banks have been when, in my opinion, they shouldnt have been.

 

I've actually never seen a company put into bankruptcy because they breached their leverage ratio or something. In fact, WIN was not put into bankruptcy because of a covenant breach, the banks were in the process of working out a solution for them but they ran out of time. The majority of the time I see a company go into bankruptcy is because they have a liquidity problem of some sort. Staying with Windstream - they went into default because they had a liquidity crunch that prevented them from financing their ongoing operations and they sought bankruptcy relief to receive debtor in possession financing so they could keep their lights on while they worked the problem. Windstream is a highly capital intensive business with significant working capital needs. They have historically always kept a low cash balance and used their revolving credit facility to finance working capital. When the ruling came out that decided their sale leaseback transaction was a violation of certain covenants it created an event of default. An event of default is not always an automatic bankruptcy, there is sometimes a "cure" period where the company has a month or so to "fix" what is causing the default. The problem here was that Windstream's revolving credit facility becomes inaccessible if an event of default exists. Since they had a low cash balance and could not access their revolver, they could not operate their business. Since they couldn't operate their business they couldn't fix the problem. Therefore, seeking bankruptcy relief was the best option so they could access a new source of liquidity.

 

To your comment "if the company has value greater than debt...banks put the company into bankruptcy anyway" this is not really true. Depends on who owns the bank debt. JP Morgans leveraged finance group (the agent on some leveraged bank debt) is not going to "opportunistically" put the company into default because what benefit would they get for it? They can't own the equity. Some hedge funds that own the bank debt might not even opportunistically put it into default because they'd rather just waive a covenant default in exchange for higher rates and give the company time to work their problem while owning a good piece of paper. Aggressive hedge funds will only do this from the stance of a bank lender only if the company truly has big problems, in which case their is likely zero equity value anyway.

 

Equity investors tend to over value companys, and Im comfortable saying that as a blanket statement. The reason is because they focus on future growth opportunities and value based off that. Even a lot of equity investors that use "conservative" valuations are still aggressive by credit investor standards. So its easy to think that creditors might be pulling the rug out of the equity when you think its worth several turns higher than what they say, but in most cases I'd be they're probably right and you're too aggressive with the valuation.

 

Of course, even credit investors come to different opinions on this. In bankruptcy its called a "valuation fight". It will literally come down to lawyers arguing to the judge the merits of one valuation method vs another. Most on this board are familiar with the ZINC situation - you can read the docket notes and see that the judge's opinion on value came down to cost of capital assumptions in one case. It really just comes down to the motivations of different creditor groups which I'm happy to get more into.

 

This is a lot so far, but I'll round it out with another point. Someone below commented that you can't always see the terms of the bank debt. This is not true. Bank debt agreements are always filed with the SEC - I've never, ever been in a situation where I couldn't find the information publicly in SEC filings.

 

The rabbit hole of credit investing and understanding bank debt covenants is very deep and (rightfully) appears to be a lot for those unfamiliar with it. It can even feel like its unfair. But the fact is that, in my opinion, if you want to be a good investor you absolutely need to understand this stuff. I have seen stock pitches, even on the valueinvestorsclub, where a big part of the pitch is a return of capital to shareholders that was actually prohibited by the bank debt covenants! This was a big reason why I went short equity and long bonds in FCAU last year. Every one bought into it because they expected a massive return to shareholders that was actually prohibited by their bank debt covenants. I figured that the return either wouldn't actually happen or would be smaller than expected.

 

Its just a tricky concept. But I'm happy to answer questions over it!

 

Interesting stuff.

 

Seems to me that all else equal a company is in a position of weakness if it needs to maintain certain financial ratios.

If the company does not maintain the ratios then it is at the mercy of banks/vulture funds and the "value" at the time of bankruptcy.  If the equity claim has a call option for the upside on the company, bankruptcy could transfer that call option or value to the creditors - and unfairly so.       

 

The first 4-5 pages were interesting then 71-72 has examples of senior creditors undervaluing businesses in bankruptcy.

https://www.hbs.edu/faculty/Publication%20Files/Valuation%20of%20Bankrupt%20Firms_ec9b67e7-4286-4581-a1d0-eb2c2a3a7ffe.pdf

 

There was also a line on page 2 that I liked: "US bankruptcy law resolves valuation through negotiation."  I would add sometimes "or judge" to that.

[5xEBITDA]

 

 

Interesting stuff.

 

Seems to me that all else equal a company is in a position of weakness if it needs to maintain certain financial ratios.

If the company does not maintain the ratios then it is at the mercy of banks/vulture funds and the "value" at the time of bankruptcy.  If the equity claim has a call option for the upside on the company, bankruptcy could transfer that call option or value to the creditors - and unfairly so.       

 

The first 4-5 pages were interesting then 71-72 has examples of senior creditors undervaluing businesses in bankruptcy.

https://www.hbs.edu/faculty/Publication%20Files/Valuation%20of%20Bankrupt%20Firms_ec9b67e7-4286-4581-a1d0-eb2c2a3a7ffe.pdf

 

There was also a line on page 2 that I liked: "US bankruptcy law resolves valuation through negotiation."  I would add sometimes "or judge" to that.

 

Disagree. Its a common feature of credit agreements to incorporate "maintenance' covenants - leverage / interest coverage ratios as protection for banks. Does not mean a company is at a point of weakness. However, in frothy economies it becomes more common for bank debt to be "cov-lite" with little to no covenant protection baked in to the credit agreements, this is more often a bad thing. But like I said, if ratios get in the way of the company from doing something that they want to do they can get a waiver or amendment from the bank most of the time if they are in good standing.

 

If the company does not comply with the ratios, then why shouldn't they be in bankruptcy or face penalties? The ratios are put in for a reason, to protect lenders. Why would you want to invest in the equity of a business that disregards the protection of their lenders? More often than not, whatever they do which is harmful to creditors is likely going to end up bad for shareholders even if it results in a short pop in the stock price.

 

If the equity upside is transferred from the old equity to new equity (creditors) that is not unfair, that is understanding the letter of the law and playing it to your advantage. Equity owners who get wiped out always view this as being unfair, but it isn't. I think they're just salty most of the time.

 

Pages 71-72 of your linked doc were interesting - but, the senior creditors undervalued the Company relative to what? To what junior bondholders / equityholders proposed? Of course the latter will propose a higher valuation because it is in their best interest, but that doesn't mean it is an appropriate valuation.

 

 

 

 

[Cigarbutt]

^Several data points suggest that we are in a significant corporate bond bull market. The banks remain the most important lender but the growth of bank loans has been relatively subdued. It is just hard to compete with such a thin credit spread. I think the low interest rate environment has a lot to do with present circumstances.

 

If you have run a small business and if you have gone to a bank for a loan, you have realized that you can get a lower interest rate if the banker gets to know you (creditworthiness) and a way to get the rate down is to accept tighter covenants. The dynamics of the "deal" is to reconcile the different priorities of the two agents. You want to get a return on your capital and the banker wants a return of capital with a satisfactory contractual fee.

 

As an equity holder, you can't have your chocolate cake and eat it too (risk and reward) and I agree with 5xEBITDA's point of view although, at times, because of contractual reasons, some of the potential return to shareholders is forgone but managers with vision tend to be able to avoid being caught between a rock and a hard place.

 

[LongHaul]

^Several data points suggest that we are in a significant corporate bond bull market. The banks remain the most important lender but the growth of bank loans has been relatively subdued. It is just hard to compete with such a thin credit spread. I think the low interest rate environment has a lot to do with present circumstances.

 

If you have run a small business and if you have gone to a bank for a loan, you have realized that you can get a lower interest rate if the banker gets to know you (creditworthiness) and a way to get the rate down is to accept tighter covenants. The dynamics of the "deal" is to reconcile the different priorities of the two agents. You want to get a return on your capital and the banker wants a return of capital with a satisfactory contractual fee.

 

As an equity holder, you can't have your chocolate cake and eat it too (risk and reward) and I agree with 5xEBITDA's point of view although, at times, because of contractual reasons, some of the potential return to shareholders is forgone but managers with vision tend to be able to avoid being caught between a rock and a hard place.

 

Fair points.  To me long term bonds (if possible) are like financial catastrophe insurance vs bank debt or other short term debt.  The company may pay more but it less likely to be forced to file if the credit window is shut at the wrong time.

[5xEBITDA]

^Several data points suggest that we are in a significant corporate bond bull market. The banks remain the most important lender but the growth of bank loans has been relatively subdued. It is just hard to compete with such a thin credit spread. I think the low interest rate environment has a lot to do with present circumstances.

 

If you have run a small business and if you have gone to a bank for a loan, you have realized that you can get a lower interest rate if the banker gets to know you (creditworthiness) and a way to get the rate down is to accept tighter covenants. The dynamics of the "deal" is to reconcile the different priorities of the two agents. You want to get a return on your capital and the banker wants a return of capital with a satisfactory contractual fee.

 

As an equity holder, you can't have your chocolate cake and eat it too (risk and reward) and I agree with 5xEBITDA's point of view although, at times, because of contractual reasons, some of the potential return to shareholders is forgone but managers with vision tend to be able to avoid being caught between a rock and a hard place.

 

Fair points.  To me long term bonds (if possible) are like financial catastrophe insurance vs bank debt or other short term debt.  The company may pay more but it less likely to be forced to file if the credit window is shut at the wrong time.

 

Interesting perspective, but can I ask why you view bonds as better insurance vs. bank debt? Structurally, bonds are subordinated to bank debt and bonds don't always* have security in the form of assets which would likely mean they are at risk of lower recoveries than bank debt in the event of default.

 

According to JP Morgan's most recent default monitor issue, the 25 year average recovery rates for all bonds was 41.4 cents vs. 66.4 cents for 1st lien bank debt.

 

Another feature of bank debt which I view as more attractive than bonds is the lesser chance of being "primed". To be primed means that the Company issues more debt that is structurally senior than you.

 

Lets say you have a $1,000mn EV company with $400mn bank debt, $400mn bonds, and $200mn equity that trades at 10x $100mn EBITDA. Through the bank debt my leverage is 4x and bonds are 8x.

 

You invest in the bonds because you view the worst case scenario as the Company being worth 8x EBITDA, so your bonds are covered at 100%.

 

The Company decides to utilize a $200mn incremental bank debt facility (were assuming 0 benefit to EBITDA here just to keep it simple). Now, there is $600mn bank debt ahead of your $400mn bonds. At 8x EBITDA, your bonds are now only covered at 50% while the bank debt still receives a 100% recovery. The incremental bank debt is senior to your bonds, but equal (known as "pari passu") to the existing bank debt so their claim on value is the same.

 

 

The point here is that bank debt typically offers you more of a cushion for the Company to pull different levels without potentially impairing your value.

 

The trade off is usually a lower total return vs. the bonds but bank debt may be better risk adjusted return given the downside protection offered by covenants and structural seniority in the capital structure.

 

[LongHaul]

^Several data points suggest that we are in a significant corporate bond bull market. The banks remain the most important lender but the growth of bank loans has been relatively subdued. It is just hard to compete with such a thin credit spread. I think the low interest rate environment has a lot to do with present circumstances.

 

If you have run a small business and if you have gone to a bank for a loan, you have realized that you can get a lower interest rate if the banker gets to know you (creditworthiness) and a way to get the rate down is to accept tighter covenants. The dynamics of the "deal" is to reconcile the different priorities of the two agents. You want to get a return on your capital and the banker wants a return of capital with a satisfactory contractual fee.

 

As an equity holder, you can't have your chocolate cake and eat it too (risk and reward) and I agree with 5xEBITDA's point of view although, at times, because of contractual reasons, some of the potential return to shareholders is forgone but managers with vision tend to be able to avoid being caught between a rock and a hard place.

 

Fair points.  To me long term bonds (if possible) are like financial catastrophe insurance vs bank debt or other short term debt.  The company may pay more but it less likely to be forced to file if the credit window is shut at the wrong time.

 

Interesting perspective, but can I ask why you view bonds as better insurance vs. bank debt? Structurally, bonds are subordinated to bank debt and bonds don't always* have security in the form of assets which would likely mean they are at risk of lower recoveries than bank debt in the event of default.

 

According to JP Morgan's most recent default monitor issue, the 25 year average recovery rates for all bonds was 41.4 cents vs. 66.4 cents for 1st lien bank debt.

 

Another feature of bank debt which I view as more attractive than bonds is the lesser chance of being "primed". To be primed means that the Company issues more debt that is structurally senior than you.

 

Lets say you have a $1,000mn EV company with $400mn bank debt, $400mn bonds, and $200mn equity that trades at 10x $100mn EBITDA. Through the bank debt my leverage is 4x and bonds are 8x.

 

You invest in the bonds because you view the worst case scenario as the Company being worth 8x EBITDA, so your bonds are covered at 100%.

 

The Company decides to utilize a $200mn incremental bank debt facility (were assuming 0 benefit to EBITDA here just to keep it simple). Now, there is $600mn bank debt ahead of your $400mn bonds. At 8x EBITDA, your bonds are now only covered at 50% while the bank debt still receives a 100% recovery. The incremental bank debt is senior to your bonds, but equal (known as "pari passu") to the existing bank debt so their claim on value is the same.

 

 

The point here is that bank debt typically offers you more of a cushion for the Company to pull different levels without potentially impairing your value.

 

The trade off is usually a lower total return vs. the bonds but bank debt may be better risk adjusted return given the downside protection offered by covenants and structural seniority in the capital structure.

 

I agree with your analysis from the creditors perspective.  Being in a first position secured with bank debt is better than an unsecured bond position all else equal. 

 

My quick comment was from the perspective of a equity holder of the company where I would want an almost 0 chance of

being wiped out in a financial crisis or deep economic downturn.

[dwy000]

A couple of other thoughts here (from someone who worked in leveraged debt finance for the better part of 15 years).

 

- banks aren't really the lenders anymore.  Most loans are now underwritten by banks and syndicated out to a very broad group of institutional investors and funds.  Banks ususally are left holding the revolving facility because the borrowers want to know the money is there to draw down if things so south (and even that is changing);

 

- given the extreme reach for yield by lenders, most large leveraged loans these days are "covenant lite".  That means they have no covenants at all or the covenants are set so far below projections they are almost worthless.  Take a look at some of the writings by Howard Marks and Oaktree on this topic (Oaktree is a huge leveraged lender).  It is irrational and stupid but lenders will do just about any crazy thing to get a couple of extra basis points.

 

- 5x makes some great points.  One thing to add is to be very careful of secured loans vs. senior bonds.  Technically, both are pari passu (equal in ranking) as senior obligations of the lender (along with payables, contracts, etc. etc).  The difference is that the loans have security interest in some/most/all of the assets.  If the value of those assets are less than the secured debt, the remainder is arm in arm with the bonds.  Bonds are only subordinated to bank debt if they are expressly "subordinated debt".

 

- as its been pointed out, covenants are rarely used to force a company into bankruptcy.  In fact, loan lenders will typically give temporary waivers to keep the company out of technical default to avoid any cross default with the bonds.  The real intention of covenants is to allow the secured lenders to force the company to raise additional equity, provide additional security or in some other way make sure the bank debt is "money good".  If it's bad enough they can also provide the time needed to get the house in order to file for bankruptcy (bankruptcy is almost always filed voluntarily by the company and not forced upon them by the lenders)

 

- most bank loans these days (at least big ones) are fairly liquid and when the company gets into trouble the debt will trade down and generally into the hands of distressed buyers (many primary buyers cannot buy debt under 90 cents on the dollar because it's deemed "distressed").  These buyers can sometimes, but rarely, be "loan-to-own" buyers who want to own the company (see Liberty's offer for IHeartRadio) but usually it's just distressed investors looking to buy high yielding assets they deem have sufficient security coverage (they play the price of the debt not the ownership of the company).

 

- what is rarely discussed but hugely important these days is the credit derivative market.  This is hedge funds and others buying and selling credit derivatives on a company that are usually referenced against the bank debt.  In some circumstances the credit default volume can be 10x the size of the underlying loan.  There have been bank loans trading at 50 right before bankruptcy that have traded up well above 100 upon filing for bankruptcy because the credit default market needed to buy the reference asset to deliver. 

 

that may be more detail than you were looking for.  But wanted to give some background and perspetive.  Hope it helps.

 

[Cigarbutt]

^Interesting thoughts and discussion.

 

In the context of a significant rise in corporate debt (compared to GDP) and declining credit quality (leverage and coverage measures, weaker covenants overall including the rise of the covenant-lite loans) many suggest, based on past experiences and basic logic (an opinion I agree with) that the eventual downturn will be associated with lower recoveries.

 

Then, if bond financing is the way to go, under any circumstances, to obtain "an almost 0 chance of being wiped out in a financial crisis or deep economic downturn", how can this be reconciled with the above statement?

 

With the absence of relevant (covenant) triggers isn't there a risk 1-that the cycle is magnified (both ways)? and 2-that zombie firms continue to limp along for longer than they should?

 

Take, as a specific example, what happened to Mattel, the toy manufacturer. It is inappropriate to reduce the firm's downward trajectory to a single variable as there were poor operational decisions, poor acquisitions and an environment of deep secular changes but I would say (just like with Toys R Us) that a fundamental flaw was capital structure and access to easy debt (with insufficient covenants, either as explicit bank covenants or as implicit covenants that management should have considered in terms of capital allocation decisions). Mattel came out of of the 2008-9 episode with relatively low leverage along most measures and with a benign debt profile (short-term senior notes). Then it maintained (2009-2018) an average 58% payout ratio and one way to see the capital movements is to equate the difference (total CFO-dividends) with capex and some acquisitions. From 2010 to 2018, Mattel increased debt by 1.66B and bought back (2010-2014) 1.71B worth of stock. Note: the dividend yield was mostly higher than the cost of debt! The company increased debt ++, lengthened the maturity profile ++, maintained a covenant-like posture with banks and its cost of debt (crude measure: interest expense over total debt) actually went down (from 4.7% to 3.1%). So, following LongHaul's line of thinking, equity holders in Mattel should have felt secure about the lack of strict covenants on the bank loans. In 2018, the cost of debt has doubled (6.1%), Mattel is highly levered and is trying accomplish a most difficult transformation. And now covenants are part of the discussion.

 

I would say Mattel, from a capital structure and capital allocation point of view, would have been better off, had it followed extrinsically or intrinsically imposed restrictions (covenants) instead of falling for easy money and access to cheap covenant-lite long-term debt, in the end, will have made the firm's survival less likely, by a wide margin.

 

[LongHaul]

Dwy and Cigarbutt- great comments.  very helpful on current climate.

 

Let me clarify something - what I was most concerned with was a company with modest debt - perhaps 3x normal EBIT or so that hits a rough patch.  How to structure that capital structure to minimize the chance of default is the puzzle.  However it is done - seems like the equityholders and company would want minimal chance of triggering bankruptcy which could transfer the upside to the creditors.  Bank debt with weak covenants could also be the way to go if the covenants are in practice non-existent.  Depends I guess. 

 

I wonder what the long term cycle effects of having bank debt covlite and having non banks own them.

I think Cigarbutt is right that easy lending will exacerbate the cycle.  At least that has been the history of credit cycles for 200+ years.  And like Mattel (great example) with easy money some will (and be allowed to do) some really dumb things, in fact the more money lenders will give the more it will be spent.  So much for learning anything from the financial crisis. 

 

Quick article on ballooning debt

https://www.marketwatch.com/story/these-5-charts-warn-that-the-us-corporate-debt-party-is-getting-out-of-hand-2018-11-29