Advanced Distressed Debt Lesson - Permitted Holders Carveout

Over the past week, many high yield and credit strategist put out a number of pieces on the recent rise of LBOs. What has driven this renewed interest in the LBO space? Lower cost of debt capital in the form of all time low yields across the B and BB space. While we have not seen LBOs like we did in the first half of 2007, conditions are ripe for a dramatic increase in the number of take private transactions for the rest of the year and into 2011 - especially if the Fed continues keep the curve at near all time historic lows.

With that said, high yield investors have started to review the indentures and credit agreements of current outstanding debt to understand better what would happen if a portfolio investment was taken over in an LBO or an MBO. In market parlance, the protection most investors seem to rely on is the change of control covenant or CoC. While the definitions of a change of control vary dramatically between indentures, a change of control covenant, all else being equal means that if XYZ company gets taken over, bondholders have the option to put the bond back to the company at 101.

Before I begin to dig into further details on CoC covenants, one interesting dynamic has created an interesting situation for bond investors. That is, because the treasury curve is so tight, many BB and B credits are trading well above 101. I do not have the statistic in front of me but I believe the average BB credit is trading around 105 right now. If there are no other covenants protecting you (outside a change of control), and an LBO goes forward, you are then faced with the choice of losing, on average, 4 points on your portfolio (105-101) or letting it ride in a now more levered, more speculative credit. Fun.

Getting back to the change of control covenant, as noted above, indentures vary dramatically between issuers and even in different bonds of the same issuer. For instance, in many cuspier investment grade credits, the change of control covenant may be worded that not only must their be a new ownership structure, but the company must also be downgraded to below IG by all rating agencies. From here, all sorts of legal ramifications and irregularities start to take hold. For instance, what if at the time of the takeover, one rating agency already had the company at below IG - then the "Change of Control Event" may not be fully satisfied according to the indenture and hence you are SOL.

With that said, one of the biggest carve outs under the change of control covenant you will see in indentures are the "Permitted Holders" carve outs. Let's look at some language to see what I am talking about here.

In August 2010, Expedia placed a 5.95% Senior Note due 2020. In the 8K announcing the deal, here is what the company had to say about change of control:

"The Company may redeem the notes, in whole or in part, at any time or from time to time at a specified make-whole premium. Upon the occurrence of a change of control triggering event (as defined in the Indenture), each holder of notes will have the right to require the Company to repurchase such holder’s notes, in whole or in part, at a purchase price in cash equal to 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The Indenture contains covenants limiting the Company’s ability and the Company’s subsidiaries’ ability to create certain liens, enter into sale and lease-back transactions, and consolidate or merge with, or convey, transfer or lease all or substantially all the Company’s assets to, another person. However, each of these covenants is subject to certain exceptions."

Unfortunately, 8k's mean nothing in the legal world. For the real juice, we need to look at the indenture (my emphasis added)

“Change of Control” means the occurrence of any of the following events:

(1) any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act), other than one or more Permitted Holders, is or becomes the “beneficial owner” (as defined in Rules 13d-3 and 13d-5 under the Exchange Act), directly or indirectly, of more than 50% of the total voting power of the Voting Stock of the Company;

(2) individuals who on the Issue Date constituted the Board of Directors of the Company (together with any new directors whose election by such Board of Directors or whose nomination for election by the shareholders of the Company was approved or ratified by a vote of a majority of the directors of the Company then still in office who were either directors on the Issue Date or whose election or nomination for election was previously so approved or ratified) cease for any reason to constitute a majority of the Board of Directors of the Company then in office;

(3) the adoption of a plan relating to the liquidation or dissolution of the Company; or

(4) the merger or consolidation of the Company with or into another Person or the merger of another Person with or into the Company, or the sale of all or substantially all the assets of the Company (determined on a consolidated basis) to another Person other than (i) a transaction in which the survivor or transferee is a Person that is controlled by the Permitted Holders or (ii) a transaction following which (A) in the case of a merger or consolidation transaction, holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the surviving Person in such merger or consolidation transaction immediately after such transaction and (B) in the case of a sale of assets transaction, each transferee becomes an obligor in respect of the Notes and either (i) each transferee becomes a Subsidiary of the transferor of such assets or (ii) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the transferee.

Notwithstanding the foregoing, a transaction will not be deemed to involve a Change of Control if (1) the Company becomes a direct or indirect wholly-owned subsidiary (the “Sub Entity”) of a holding company and (2) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of such holding company; provided that, upon the consummation of any such transaction, “Change of Control” shall thereafter include any Change of Control of any direct or indirect parent of the Sub Entity.

Look at the differences from the 8K to the actual indenture language. Specifically look at the clause "other than Permitted Holders" - let's dive back into the indenture and find the definition of "Permitted Holders:"

“Permitted Holders” means Barry Diller, Liberty Media Corporation and their respective affiliates and any group (as such term is used in Section 13(d) and 14(d) of the Exchange Act) with respect to which any such persons collectively exercise a majority of the voting power.

So even if the company gets taken over, but Barry Diller or Liberty Media are the "buying party" the change of control put would not be triggered. All else being equal, if Barry Diller or Liberty Media wanted to lever up Expedia in an LBO, bond holders would see their relative credit metrics weaken dramatically and consequently spreads would widen.

Sometimes in these cases bond holders are protected by negative pledge covenants as well as incurrence covenants. But given how structures and indentures have progressively gotten weaker over the past 18 months, bond holders have little protection when the permitted holders carve out allows for a credit negative LBO or MBO. Read those indentures to make sure you and your investors are protected as I expect to see many more LBOs in the coming months.