Sunday, February 11, 2007

Change of Control Covenants

In a previous post about credit default swaps, I briefly mentioned how leveraged buyouts(LBOs) can cause stress for bondholders of the target firm.

With all of the easy money floating around in the economy, LBOs have been on the rise for the past few years.

For those of you who aren't familiar with LBOs (wikipedia), they are basically transactions where one company borrows a whole bunch of money to buy another company. The new debt ends up on the books of the target company.

New debt makes existing debtholders very unhappy, because it means the company has even more fixed obligations (ie principal and interest payments) to pay, which makes it less likely that any single debtholder will get the interest and principal they have coming to them. When the bond becomes more risky, the market price declines, causing a paper loss for the holder.

Something I've been hearing a lot about in the credit markets lately is designed to combat this "LBO Risk" that bondholders face, and this is the addition of so-called "change of control" covenants ( in bond documents.

Basically, investors have been pushing to include provisions (called covenants) in new bond issuances that say the company selling the bond must agree to do certain things, such as maintain a certain debt/capital ratio, interest coverage ratio, or some other metric that would prevent it from taking on too much additional debt and in effect screwing the current debtholders over.

"Change of control covenants" have been getting a ton of notice in the investment community lately due to the increased LBO activity. These covenants are specifically geared towards the threat of leveraged buyouts and in general they say that the bondholder has the right to "put" the bond back to the company if there is a "change of control" event, ie a buyout. This gives them reassurance that they can sell their bonds back to the company for essentially 100% of face value if the company gets bought out. If they didn't have such a provision and the company became the target of an LBO, the only way they might be able to unload their bonds would be for something less than 100% of face value (75% maybe).

According to a story in the Feb 8 issue of the Wall Street Journal ("Bondholders Fight Back as Deals Raise Debt Risks") recent issuers that have included change of control provisions include Home Depot, Black & Decker, Alcoa, Xerox, Federated Department Stores, and Owens Corning.

Fitch, one of the 3 big bond ratings agencies, put out a piece assessing Motorola's LBO Risk, and determined that some of MOT's debtholders would be out of luck in the event of an LBO. The article gave a specific example showing how two of MOT's debt issuances have some LBO protection, but the others do not:

"In terms of change of control provisions, while the indentures related to the
$400 million 7.5% debentures and $400 million 6.5% debentures enable bondholders to put the bonds to the company upon a 50% change in ownership, the bond indentures related to the $1.2 billion 4.6% senior notes and approximately $530 million 7.625% senior notes lack any change of control provision."

For those of you who invest in bonds, you might want to take a second look at your indentures and at least be aware that your bonds could lose considerable market value if the company that issued them becomes the target of a leveraged buyout. If you have some kind of a change of control covenant in the indenture, you can be assured that you have additional protection against what many consider to be a "worst-case scenario" for bondholders (an LBO without any covenants).

For those of you who just appreciate being kept up to date on current topics in the world of finance, you might want to read some more about this topic.

Here's a research report with a decent take on LBO Risk (.pdf).

Here's a recent Bloomberg piece on the market's reaction to Gap Inc.'s percieved LBO risk.

And finally, another Bloomberg piece that talks about how investors are paying up for change of control covenants.

A final thought, most people I know who follow the bond/credit markets agree that we are at a high point in the cycle. Yields are low, spreads are low, t is incredibly cheap for risky companies to borrow money, LBO activity is high, corporate debt issuances are on the rise, and as with everything else, "what goes up, must come down."

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