Distressed Debt Exchanges

In the past few years, we have seen an increase in the number of debt exchanges offered by companies. In short, a debt exchange offers one type of security for another at a certain price.

An illustrative example: Let's say XYZ Company has 100 million of bonds outstanding due June 30th, 2009.  These bonds trade for 20 cents on the dollar. The company has no money to speak of and isn't generating any cash flow. In order to stave off a bankruptcy, XYZ may offer to its bond holders the chance to exchange all the bonds at 40 cents on the dollar for new bonds with a later maturity.  Many times these exchanges roll subordinated debt into second lien or secured debt depending on the ability of the borrower to issue new debt in accordance with their covenants.

You may be asking why has there been such an increase in the past few years? The short answer is that much of the debt issued in 2006 and 2007 was issued "covenant lite."  My definition of covenant lite is different than what is generally reported in the press.  Most people define covenant lite as a company with no maintenance covenants, i.e. the requirement to maintain certain leverage and interest coverage ratios. But lets be honest; if a company is currently running at 4.0x leverage, and their covenant is 8.0x - that is covenant lite. So many deals in 2006 and 2007 were issued with egregious covenants that you simple had to laugh at.

That being said, these corporate debt exchanges will continue. So much leverage was put on in the credit boom that it would be impossible for companies to refinance their debt when it comes due. Do you really think anyone is going to lever up First Data Corp at 10.0x again? We probably saw peak credit (in terms of cash flow to debt multiples) in 2007 - and private equity, with the option that is the equity piece in an over levered capital structure, will do what it takes to move that option in the money.

A detailed analysis of the covenants is imperative in evaluating distressed debt. If a debtor, influenced by their private equity owners, wants to reduce debt or extend maturities via a debt exchange, and are able to under their covenants, they will most certainly do so. The problem is compounded with the fact that hold outs for these exchanges are crushed.  Why? 

1. New senior debt has been layered above them...making recovery even worse.
2. Covenants of the existing bonds (the ones the hold outs own) will be stripped
3. Significantly less trading liquidity

So, you ask...why wouldn't every borrower do this?  There are a few reasons, and one of those reasons are tax implications. If you buy back bonds at a discount, you have a gain. Gains are always taxed. Same thing with a debt exchange. The debtor will be taxed on the difference between the par value of the original bonds and the market value of the new bonds.

That was the case until February 17, 2009.  On that day, H.R. 1, otherwise known as The American Reinvestment and Recovery Act was enacted.  Under H.R.1, corporations can elect to defer this gain resulting from debt exchanges and debt buybacks until 2014, and then take their sweet time (5 years - equal payments per year) to pay off the resulting taxes. Now this stipulation is for year 2009 and 2010. So it may roll back. But I have to think, given the amount of debt maturing in the 2011-2013 period, many of company and private equity sponsors will be lobbying for an extension.

We will see a lot more distressed debt exchanges in the coming years. This is going to hurt everyone but private equity sponsors. Lenders will see their collateral diluted, bond holders will be forced to extend maturities, rogue holdouts could get crushed, and the day of reckoning, that is a Chapter 11 filing, will be pushed out again and again.