Inadequate bond covenants on M&A set to hurt investors

Fri Aug 22, 2014 11:33am EDT

* Takeover battle brings covenant risks into focus

* Issuers retain upper hand as demand outstrips supply

* Weaker change of control covenants increase credit risks

By Shankar Ramakrishnan

NEW YORK, Aug 22 (IFR) - The bidding war for discount retailer Family Dollar has exposed the weaker covenants that have seeped into US bonds issued during the red-hot issuance run of the past few years.

Last week a bidding war over Family Dollar erupted between the two contenders Dollar Tree and Dollar General as they scrambled to solidify their positions in the ultra-low cost retail market, where smaller operators are trying to fend off giants like Walmart.

Both companies are financing their acquisitions, US$8.5bn and US$9bn respectively, in a way that would almost double their current leverage ratios and push credit ratings from investment grade to junk.

But Dollar General's bond investors will lose if the company wins its bid. It has two outstanding bonds totalling US$1.3bn that mature in 2018 and 2023, with very weak lien covenants which means they are at risk of being structurally subordinated.

According to research firm Covenant Review, the covenant only restricts pledging shares of the voting stock of a significant subsidiary to secure debt. So the company and its subsidiaries can freely pledge any of their other assets to secure debt.

If Dollar General does win Family Dollar, and issues new bonds to finance the acquisition, the old ones could be at the bottom of the new capital structure.

Investors in the target company are at risk also. Covenant Review noted the change of control definition in Family Dollar's outstanding 2021 bonds do not protect holders if either Dollar Tree or Dollar General win because the put is not triggered by a takeover by a widely-held public company.

"This is logically inconsistent with the presence of a mergers trigger and would allow a junk-rated public company to structure a transaction to avoid a put right," said Alex Diaz-Matos, an analyst at Covenant Review.

Dollar Tree does not have any outstanding bonds but its Moody's rating of Baa3 is under review for downgrade as its acquisition bid of US$8.5bn supported by committed financing of US$9.5bn will take its pro forma debt to 5.6 times Ebitda from 3.3 times at the end of 2013.

"In a climate where M&A activity has picked up considerably, change of control protection has weakened," said Evan Friedman, vice president and senior covenant officer at Moody's. "This leaves investors susceptible to rating changes, particularly when two or more rating agencies must downgrade the notes in order to trigger the change of control put."

According to data from Moody's High-Yield covenant database, 27% of the 207 North American high-yield bonds issued in 2014 (covered by Moody's Covenant Office) include a change of control provision that will not allow investors to put back the bonds to the issuer unless there is a ratings downgrade. And half of this 27% requires the downgrade of at least two agencies.

The risk of a weak change of control provision is exacerbated as the percentage of high-yield-lite bonds (lacking restrictions on debt incurrence and/or restricted payments) increases because, in such bonds, the change of control provision is one of the few remaining protections keeping companies from engaging in transactions that pose credit risk.

Last week's bidding war was greeted by a sharp fall in Dollar General's outstanding bonds as its leverage would approach the 5.0x range - a significant increase from the mid-2.0x in the 12 months through its latest quarter.

Dollar General's outstanding 3.25% 2023s last Monday fell to 91.0-91.25 from 94.75 on the previous Friday. Family Dollar's 2021s were quoting at a G spread of 210bp/215bp which was about 15bp to 20bp wider than in July.

Family Dollar last week rejected Dollar General's bid but was still in support of the lower bid by Dollar Tree.

DEMAND OUTWEIGHS SUPPLY

Despite price action and the apparent credit risks, there is little chance of bond investors being able to strengthen covenants on new issues because the demand-supply dynamic still weighs in favor of issuers, said bankers.

"In a market where an issuer comes asking for US$1bn and gets US$4bn of orders, why would anyone agree to restrictions in the form of covenants?" said Edward Marinnan, co-head macro credit strategy, Americas at RBS.

"Covenants have loosened considerably but investors are not in a position to push back in an environment where demand clearly outstrips supply," he said.

Another banker said that investors could take comfort in the fact that such aggressive M&A situations were still unusual and many companies had a clear game-plan to get back to investment-grade ratings, if they lose it.

Dollar General committed to return to an investment grade profile probably within three years of completing the acquisition, which is quicker than the five-odd years that Dollar Tree thought it would take to reach leverage levels akin to investment grade.

"IG ratings are valued by these companies because you need to be able to fund yourself in all areas of a market cycle," said a syndicate banker. (Reporting by Shankar Ramakrishnan; editing by Alex Chambers)

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