Bondholders Want More Protections in Big LBOs

Amid the hoopla of the current wave of mega-buyouts, bondholders in some of the target companies are not happy campers. Although some market forces are working against them, these creditors are starting to push back against capital structures that they claim favor newer debt investors as well as shareholders and are demanding increased protections in fear of company failures. “With the availability of private equity money and the movement toward maximizing shareholder value at the expense of bondholders, there will be increased pressure to strengthen covenants,” says Premila Peters, head of high-yield research at KDP Investment Advisors. LBOs have always posed problems for bondholders because the financing levers up the target company to make debt the predominant element in the capital structure. But another aggravator in the LBO equation for some debt holders is that pre-LBO debt issued at investment-grade ratings gets pushed down in the capital structure in comparison to post-LBO debt issued with high-yield ratings. Once an LBO occurs, the investment-grade bonds are reclassified as high-yield, or junk caliber. Even worse, these newly downgraded bonds don’t carry the covenants and other protections that are customarily attached to high-yield bonds. “When the original issue was done at investment grade, and then an LBO is done, it can cause problems for the holders,” Peters says. In the $33 billion HCA Inc. buyout, the company has said that its current bondholders will become subordinated to the $16 billion in new debt the buying consortium will float to fund the buyout. In the HCA deal, the potential concern faced by the pre-buyout generation of debt holders is complicated by the fact that the hospital giant straddled the investment-grade and high-yield markets while it was publicly traded. Investment-grade bonds traditionally have lacked protective provisions, such as making principal payments come due on a change in control, that often are in high-yield bonds because they are deemed less risky. Peters thinks that with the surge in LBOs, it would make sense to apply some high-yield protections to investment-grade issues. And there have been a few instances where that occurred. In August, Cintas Corp., maker of work uniforms, went to the market to sell $250 million in investment-grade, 30-year bonds. Investors were able to negotiate a covenant that would protect them from a change in control at the company. That same week a $150 million offering of 10-year bonds by Carlisle Cos. Inc. also included change-in-control protection. Whether this kind of accommodation will become more common is unclear. Robert Carey, a Partner at Bingham McCutcheon who frequently represents issuers and underwriters, says he hasn’t seen high-yield protections leaking over to investment-grade issues. He noted that such a move would reduce companies’ operating flexibility. Another reason it may not be occurring is that there’s a lot of competition among banks to underwrite bonds. If adding protections to investment-grade bonds displeases issuers, they could take their business elsewhere. Debt holders’ hands are also somewhat tied because of the existence of a large and liquid market for leveraged loans, which sponsors can tap into to finance buyouts if they don’t like provisions attached to the high-yield debt their deal would create. Carey said that in a hot market, such as we have now, the LBO sponsor has the clout. It’s easier for sponsors to win the struggle for fewer covenants, he says, when there are more than enough potential buyers for the deal paper. The balance of power shifts, and leverage flips to the buyer, he says, if underwriters are having trouble selling the instruments. One thing that could change this relationship is if an issue blows up in a big company failure. But until a large-scale negative-credit event occurs, bondholders may continue to complain, but for the most part, they probably won’t be able to substantially increase their demands for more protections as long as buyouts remain popular. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com