A private-equity buyout of an American roofing company earned a dubious distinction this week: it offered “some of the worst covenants” ever seen by Covenant Review (CR), an independent credit research firm that specialises in that area.
The company, called SRS Distribution, changed some of the most controversial covenants before the sale last week. But a few of the offending terms still made it into the $380m offering of unsecured high-yield bonds, CR says. The bonds are subordinated to $1.3bn of term loans and a $400m revolving credit facility that will finance SRS's leveraged secondary tertiary buyout by private-equity firm Leonard Green & Partners.
For the uninitiated, covenants are provisions in debt contracts (bonds and loans) meant to protect lenders' interests, by limiting a borrowers' ability to do things like pay dividends, or take on more debt in times of financial trouble.
Protections for lenders and bondholders have been weakening across markets, though the individual agreements vary. SRS's first proposal was an example of this War On Covenants. The initial terms of the bond contract were extraordinarily weak and written with near-arbitrary levels of complexity, said CR analyst Ross Hallock.
“Maybe it was some sort of anchoring game, starting off with something that was so absurd,” he said.
The deal is no longer the worst Hallock has ever seen, after investors pushed back and got the company to remove three of the seven worst covenants, he said.
But four of those problematic provisions remain in the documents in some form, which we will explore below:
1) Risky commitments
One provision that could have a large impact is the company's “designated commitment” covenant, which was buried in an unusual section of the bond prospectus, Hallock says. The covenant is a bit complex, and probably best described with an example:
Let's say Company D has a $100m line of credit with the bank. At the same time, its bond documents say it isn't allowed to borrow money unless it meets certain requirements: for example, it might be required to keep its debt level lower than 5x its ebitda. Today, Company D has $25m of debt and ebitda of $25m, so it can use the $100m credit facility. But if its ebitda falls at all, it would lose the ability to draw credit.
Under a normal version of this covenant, Company D can designate that $100m as a committed credit facility, which means it can use it even if ebitda declines.
SRS's version is not normal, however.
The difference is what happens after company names the credit facility a “designated commitment”. Normally, Company D wouldn't be able to borrow any more after that -- remember the rule that says debt must be less than 5x ebitda? Under that requirement, the $100m facility would still max out its borrowing capacity.
But if it used SRS's version of the covenant, it would be able to exclude the credit line from the entire 5x requirement. That means it would be able to borrow $100m more. Hallock calls this “absurd”, and continues:
The Company could max out capacity under any Ratio test with designated commitments and then subsequently incur future debt that also maxes out capacity under the same test... The Company could even reserve capacity for one designated commitment and then another and then another, ad infinitum. Investors should demand that the proviso... be deleted.
2) Buyouts on buyouts on buyouts -- what's a bondholder to do?
SRS is issuing all of this debt to fund an LBO from Leonard Green. But because this will be its third private-equity owner in a row, the deal should technically be called a “tertiary buyout”. And Hallock said there is a “very unusual, obscure” provision that could bite bondholders if SRS went through a quaternary buyout.
Traditionally, a company's bondholders have some measure of protection in a debt-fueled transaction like an LBO. Specifically, bond covenants usually prevent the company from making debt-funded payments to equity holders without either buying back the bonds, or meeting certain financial preconditions.
In Hallock's interpretation, if a different private-equity firm wanted to buy SRS, the wording of this contract might allow it to raise money for the purchase with debt, and then send that money to Leonard Green without making the usual considerations for bondholders.
From his note, with our emphasis:
Under a typical indenture, if an acquirer incurs debt in order to fund the payment of acquisition consideration to a target’s equity holders, and the target subsequently provides credit support for that debt (either by merging with the acquirer or guaranteeing the debt), then the debt-funded payments to the target’s equity holders should be treated as a Restricted Payment made by the target. If the target is a high yield issuer, then there must either be sufficient capacity under the target’s Restricted Payments covenant or the target’s bonds must be taken out. This customary LBO protection could be undermined entirely be the inclusion of carveout (d) here. The Company might be able to argue that carveout (d) allows any Restricted Payments that would otherwise be deemed to have been made upon a merger with an acquirer. We have never seen a Restricted Payments carveout that tracks the language of this carveout (d), and we see no justification for it here. Investors should demand that carveout (d) be deleted.
3) In-secure debt
SRS apparently still has some loopholes in its bond covenants meant to limit the amount of secured debt it accumulates, Hallock said. Secured debt investors usually want those limits, because their secured status gives them a claim on the company's finite assets in the case of a default or bankruptcy, and the less competition they have for those, the better.
But SRS's bonds simply limit “First Lien Net Leverage”, which means it does not consistently capture debt with a secondary claim (or second lien) on company assets, he said.
And interestingly, that hypothetical quaternary buyout shows up again: the company could “potentially incur unsecured acquisition financing debt” -- debt from a deal -- and then “refinance that debt with secured debt,” he wrote.
4) Six versions of a test
Most junk-rated borrowers' debt contracts include limitations on future borrowing. These might include a “ratio test”, which require companies to show they meet certain standards for key figures in their financials, as measured by a ratio. (Debt to earnings, for example.)
The “standard high yield deal” involves just one test, says Hallock, and that is the “2x coverage ratio”. In short, it says that a company with high-yield bonds outstanding can't take on more debt unless its ebit (earnings before interest and tax) is large enough to cover its interest costs twice over.
In contrast, SRS's bonds include six ratio tests.
Hallock told us that SRS changed some of those six ratios before it closed the bond deal, so we won't get into the weeds by listing the ones originally proposed. But needless to say, we would bet there are some banks that would like to calculate their regulatory metrics this way (six possibilities, all of which they can see ahead of time).