Private equity’s raid on Coles Myer has served as a wake up call to Australian corporates, and is set to have a lasting effect on Australia’s debt markets. LATE ON AUGUST 17 Coles Myer confirmed rumours that a private equity consortium had made an offer of A$17.3 billon for the company. The following day Coles Myer shareholders saw their fortunes climb. In the credit world, however, panic set in.
But by afternoon the 2012 cash spreads were back where they had started. Investors had spent the day mulling over their documents and reconfirmed that the notes did benefit from extensive covenant protection, including a change of control clause and a financial leverage test. A takeover would have limited impact on the value of the Coles 2012 notes. The covenants had worked. Bondholders could breathe easier, but the market was clearly spooked. That investors could witness one of Australia’s iconic corporations being gobbled up by PE raiders – and their bonds buried under a pile of junk – was not only possible but a probable scenario. Promises, promisesA covenant, put simply, is a promise; a commitment to do or not do something and a legal undertaking to comply. “In the case of issued securities, covenants are provided to investors by issuers to ensure they maintain an adequate financial position to meet debt service obligations,” says Craig Saalman, credit strategist at ABN AMRO. This can be achieved in a number ways. Covenant protection ranges in terms of content financial ratios that need to be maintained to behavioural undertakings that ensure bondholders are treated in a certain way. Other operating covenants can be provided to protect investors and banks from a material deterioration in the operating profile of the business or issuer. Covenant protection is a standard feature in the bank loan market with bank creditors demanding financial and operating covenants. They are less common in the corporate bond market, but in an environment where all of corporate Australia is a takeover target, and the risks of noteholders falling down the pecking order are greater, this looks set to change. Takeover protectionCovenants protect investors from adverse occurrences that result in the reduction of their ability to service their debt. There are a number of ways corporate credit can be affected, but the most likely trigger is when the company is a target of a takeover. Takeovers, of course, can be good or bad for bondholders. For instance, the AA rated retail giant Walmart has been linked to an offer for Coles, rated BBB. Such a takeover would significantly increase Coles’ ability to service its existing debt. If Coles did fall victim to a leveraged buyout, the opposite would occur. An LBO typically results in a highly leveraged final entity. As there is a high likelihood of a deterioration of credit risk, the value of the outstanding notes would fall. “For Coles, depending on who the final purchaser is, you have an extreme set of outcomes for the credit profile of the company,” says Sarah Percy Dove, head of credit research markets at ANZ Investment Bank. The value of the Coles 2012 notes, however, have stood firm following early jitters but other corporate credits remain dangerously exposed. Australia uncoveredIn a market where companies have been able to raise cheap money in easy conditions, Australian corporate bond issuance has flourished. As a result additional concessions have taken a back seat; Australian bonds have typically not had strong covenants. “It fell out of favour as liquidity and demand increased,” says Steve Adamek, credit analyst at AllianceBernstein. The irrelevance of covenant protection has been compounded by a market of highly rated issuers. “Because it’s an investment grade market, they are less of a facet,” says Percy-Dove. And the security of covenant protection has served little purpose as investors boldly hunt for yield in a benign credit environment. “On the one hand investors may be well aware that covenants are poor and don’t provide good protection but on the other hand they still want to be in the chase to get hold of decent assets,” said Robin Miller, investment manager at Member’s Equity. “It’s been hard for people to step out of the market and take the highly principled position of not buying because of poor covenants. There has not been a coordinated response from bond market investors,” he explained. “You could put it down to group complacency and unwillingness to give up yield,” adds Percy-Dove. “Investors may have to built a cross for their own back which they will have to wear.” For investors, it has been a time for reflection. As Andrew McLachlan, credit analyst, Perennial Investment Partners, points out, benign credit markets have led investors to be more relaxed on covenants when they should have been paying more attention. “Ironically these are times of higher risk in some ways for investors as the risk of M&A activity, and the possibility of lower ratings attendant with this, is heightened. " Barbarians at the BarbieIn offshore markets, where LBO activity is in full swing, investors have been demanding covenants for some time. “Compared with Europe and the US, Australian bond holders are typically less protected by financial and operating covenants,” says Craig Saalman of ABN AMRO. Many Australian issuers that have accessed other markets are well aware of this. Telstra’s outstanding Eurobonds for instance, carry a 25 basis point step up for each ratings downgrade. “We have been relatively insulated from the other trends that have been detrimental to bondholders. The risks have become quite distant on a lot of these things over time,” says Percy-Dove. But private equity and LBOs have arrived in Australia. The barbarians are at the barbie; and the same risks that scalded European and US investors are now becoming prevalent in Australia’s credit market. “Now they seem a little closer to home and a little more real,“ adds Percy-Dove. But investors may be forgiven for being caught off guard. An LBO for a company the size of Coles Myer has not been done in this market. A successful bid would make it the seventh largest private equity deal in history. The threat, however, has well and truly captured the market’s attention now with corporate credit spreads reacting to takeover talk. “The arrival of large private equity bids to these shores is one of the landmark developments we have seen in these credit markets in recent times,” says Chris Viol, head of fixed income credit analysis, Australia & NZ at Citigroup. “The fear has gripped other names including Fosters, Suncorp Metway, Amcor and Telecom New Zealand, with the market failing to differentiate between trade and financial buyers and the likelihood of an eventual bid succeeding,” says Saalman. Viol believes ‘the local leverage clock’ may now tick faster as more corporates examine their capital structures, and that there will be more covenant-related questions asked in corporate roadshows primarily regarding corporate protection. The effects are already being seen. Mirvac, a recent issuer into the market, incorporated a change of control clause because of investor concerns. The covenant protects investors from an event that results in over 50 per cent of the company changing hands and the notes falling to below investment grade. Transurban, the first major corporate to visit the market since the Coles announcement, has also ensured that investor’s demands were met by adding extensive covenants to its five year issue. “In some respects, issuers need the covenant to maintain market price and to maintain where they expected to issue. They have had to give it away,” says Percy- Dove. Origin Energy, the integrated utilities company, is another recent issuer that faced questions from investors on covenant protection. The notes did benefit from financial covenant protection in the form of gearing and interest cover ratios that need to be maintained. Broken promises Investors are not only asking for covenants but questioning the effectiveness of covenants themselves. Are these promises worth the paper they are drafted on? AllianceBernstein’s Adamek is sceptical. “Generally they are either so far from actuals as to be meaningless, for ratio controls, or poorly thought through leaving obvious gaps in structure and definitions,” he says. Saalman agrees: “Material Adverse Change (MAC) clauses are most often vaguely defined which leaves bond investors in a quandary with issuers.” For Adamek the issue is not with the poorly construed covenants themselves, but in the market’s ability to come to terms with pricing and valuing covenant protection. “An investment grade bond can overnight become a sub-investment grade credit on the consummation of an LBO. This type of risk is difficult to quantify and price at time of issuance,“ says Saalman. But if issuers do give up spread to investors in place of protection, does this adequately compensate investors? “Some pressure over the last month is seeing spreads in general moving out. But to date, issuers have not seen any pricing benefit for giving covenants,” adds Adamek. “Investors are not being compensated for the underlying credit risk let alone event driven risk,” says Percy-Dove. Covenant crazyLBO Mania has arrived but it might not be appropriate for Australia to go covenant crazy. Viol agrees and many of the LBOs being touted will not eventuate. “We don’t think investors should get too carried away. We would be amazed if there were more than two major completed LBOs in our local CDS/bond universe by the middle of next year,” he said. There will be speculation and scares though which creates trading opportunities in the CDS and bond markets. Also as Saalman points out, many credits in the market are unlikely to ever fall within the private equity radar. “Because of their market caps and business profiles, some issuers, for example trading banks, kangaroos and corporate names like BHP will be spared these demands (for greater covenant offerings),” he said. Lazy balance sheetsWhile issuers and investors come to terms with covenants, there is a larger issue at hand. The arrival of private equity looks set to shake up corporate Australia and change the profile of its debt capital markets. “We see PE interest in Coles as a precedent event in local credit markets, and it’s our view that as a knock-on effect, the local leverage clock could well start to tick faster,” says Viol. One of the appeals of many of Australia’s corporates is their ‘lazy balance sheets’. Companies that have not fully utilised their capacity to take on debt financing have become attractive targets because of the amount of leverage they can withstand. This creates another puzzle for investors: the better the credit quality of the company, the more vulnerable it may be to a takeover. Credit risk and event risk can be on opposite sides of the coin. Covenant protection may be more relevant where it appears not be. “Ironically, there are times when you can accept the risk of weak covenants in a highly leverage business more so than for a high quality name with a lazy balance sheet. It has probably been easier to advance the need for good covenants to the treasurer of a marginal investment grade borrower than to an apparently stronger business. Sometimes people may have been looking for strong covenant standards in the wrong places,” said Miller. “There will be other boards and corporates revisiting their capital structures,” says Viol. “As our equity guys point out, if local corporates don’t gear their capital structures efficiently, private equity will be quite happy to do it for them. “ Australia Gas Light (AGL) has acted with this in mind. “They have effectively LBO’d themselves when they have moved from A to BBB flat because if they didn’t do it there was a high likelihood that someone else would,” says Percy-Dove. Aussie Corporate Bond Covenant ChecklistA list of 23 Australian corporate credits, their takeover and acquisition potential and the covenants they have in place. Many of the notes benefit from ‘negative pledges’ which prevent subordination of the notes. Information provided by Westpac Institutional Bank’s capital markets research team. (Michael Phillip, head of capital markets research and David Goodman, analyst)
Poison pillWhile issuers may be reluctant to issue covenants, they could potentially be used to ward off unwelcome suitors. By adding covenants that compensate noteholders, the issuer can create additional expenses for the acquirer. This is known in M&A lingo as a ‘poison pill’, which the buyer must effectively swallow. “I still think short-termism prevails. The treasurer gets most of his brownie points from basis points rather than constructing barriers of protection,” said an observer on why covenants are unlikely to appear in this form. There could be other reasons. One observer suggested that a takeover is “not the worst thing” for senior management, who may receive payouts and be able to exercise share options. Also under ASIC regulations, certain actions that could be regarded as inhibiting a takeover must be brought to their attention. In this case, issuers may prefer a looser covenant package if it results in less difficulty. Asian attractionAs private equity coffers continue to amass cash, the region is attracting the attention of the some of the industry’s big guns. “Asia generally is emerging as a region of interest. Locally we have stable political, economic and regulatory regimes, and in many industries we have duopoly or oligopoly type concentrated industries that are attractive,” said Viol from Citigroup. Australian credit is sliding. The average credit rating has transitioned from a high A to the cusp of low BBB. The threat of LBOs, as much as LBOs themselves, look set to accelerate the process. “You can expect the credit quality of corporate Australia to continue to decline. Potentially it’s going to open up a high yield market,” says ANZ’s Percy-Dove. Corporate Australia and its lenders are now facing a world they had not contemplated before August 17. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Cash spreads on Coles 2012 notes blew out. Credit default spreads on Coles also spiralled from 30 points to 100 points. A private equity takeover, the market assumed, would place a heavy debt burden on the company and severely devalue existing debt.
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