Feature INVESTORS DEMAND PROTECTED DEALS

Feature

INVESTORS DEMAND PROTECTED DEALS

Australian investors are demanding increased use of covenant protection in the wake of the private equity takeover of SLM Corporation (Sallie Mae), which gave the lie to the belief that financials would be safe from LBO activity.

BY LAURENCE DAVISON

W ith the Sallie Mae takeover threatening to reduce the US student loans agency's rating to sub-investment grade, credit analysts and investors agree that covenant protection is now high on the agenda. "Bond documentation and covenants in Australia are quite weak compared with Europe and the US, and issuers could now be looking at offering protection in the case of M&A activity in their future deals," says ANZ Investment Bank's Sydney-based senior credit analyst, Bradley Bugg. "It is possible that every issue will be required to have protection in the wake of Sallie Mae as investors have realised that even financials are now in play," he adds. Greg Stock, portfolio manager and credit analyst at Perpetual Investments in Sydney, explains: "The financial sector has traditionally not had many private equity LBOs, and as such Sallie Mae was largely unanticipated by the market. The news highlighted the increased risk of LBOs to sectors not usually targeted by private equity, and particularly to companies which have any form of assets that can be securitised." The use of debt to finance private equity acquisitions is the cause of most concern. Bugg says: "Private equity raises the problem of moving credits from single-A to double-B in one fell swoop. Takeovers have always been a rating threat, but not to the high single-digit notches extent of some leveraged deals."

The mood among credit investors is clearly in favour of protected deals, with some saying they are already staying out of issues that do not offer it. "We have told potential issuers not to come to market without covenant protection and from speaking to other investors I expect a trend towards more of it," says Andrew Morgan, senior portfolio manager at Brisbane's Queensland Investment Corporation (QIC).

There is also a degree of willingness to pay for protection if necessary. Lakshman Anantakrishnan, portfolio manager, credit at BT Financial Group in Sydney, says: "We would be prepared to pay, and investors in all likelihood would have to give up basis points to have a protected deal. It depends on the name, the industry and the sector. But what we have seen this year is there are very few ? if any ? sectors that are immune to LBOs."

HARDER IN PRACTICE

However, the emergence of covenants on Kangaroo issues may not prove straightforward. Says Malcolm Alley, Sydney-based credit analyst at Aberdeen Asset Management: "The investment market has been quite lax in the past in terms of demanding with a unified voice. The market is not very proactive in that respect."

On the borrower side, Greg Hammond, partner at Mallesons Stephen Jaques in Sydney, says his conversations with Kangaroo issuers suggest they will be "very resistant" to

"Most Kangaroo issuers tap Australia as their third or fourth capital-raising market,without having offered change of control protection in any of the others.That makes it easier for them to resist investor demands in Australia."ANDREW BOOTH FREEHILLS

24|KANGANEWS JUNE 2007

granting additional protection. He does add, however, that

"Sallie Mae was largely unanticipated by the market.The news highlighted

some Australian domestic issuers are beginning to add clauses to their bonds,

the increased risk of LBOs to sectors not usually targeted by private equity."

generally offering a

GREG STOCK PERPETUAL INVESTMENTS

put option in the event

of a change of control and a significant ? three or more notch been talked about for some time, but it could prove

? credit downgrade (see box below).

problematic in practice ? there has not been any for

However, Kangaroo issuers should not be expected to

Kangaroos in the past and certainly nothing like a change of

follow suit. Andrew Booth, partner at Freehills in Melbourne, control clause. Covenants are becoming more prominent in

says he is "not seeing the same pressure" from Kangaroo

Europe, although again there is still little change of control

investors to add covenant protection, for two reasons. The

protection."

first is the predominance of agencies and financials, many of

Investors should also be wary of placing absolute faith in

which can justifiably claim to be almost immune to LBOs, in any change of control clauses they receive, according to

the Kangaroo space.

Jenkins. He says some clauses in the US have failed to be

Secondly, Booth explains: "Most Kangaroo issuers tap

triggered because the ratings downgrade caused by a

Australia as their third or fourth capital-raising market, without prospective LBO has come before the takeover completes,

having offered change of control protection in any of the

failing the precise conditions of the clause and leaving

others. That makes it easier for them to resist investor

investors unprotected during the interim period. "From the

demands in Australia as they tend to transfer the substantive investor's perspective, any put option in a change of control

terms of programmes like their EMTN largely intact."

clause should ideally be triggered by a ratings downgrade

Paul Jenkins, Sydney-based partner at Blake Dawson

which has resulted from the issuer's notice of an upcoming

Waldron, agrees: "Kangaroo issuers currently have the upper change in control, not merely from the legal change in control

hand in negotiations. Given the largely benign credit

itself," he comments.

conditions and cash available for investment in the Australian

Sydney-based Allens Arthur Robinson (AAR) partner,

market at present, relevant issuers are unlikely to add LBO

David Clifford, also compares the position in Australia with

protective provisions that they don't offer in the US and

that in Europe, where he says there is a "long and ongoing

European markets."

fight" to add change of control provisions to bonds.

Phil Bayley, director, capital markets Pacific at Standard & Australian investors, he adds, have also been exploring this for

Poor's (S&P) in Melbourne, agrees that protection may not be some time "as they have become more focused on due

immediately forthcoming. He says: "Covenant protection has diligence as well as credit ratings".

COVENANT PROTECTION IN THE DOMESTIC MARKET

WHILE KANGAROO ISSUERS APPEAR TO BE RESISTANT TO THE INTRODUCTION OF CHANGE OF CONTROL CLAUSES TO THEIR BONDS, THERE ARE SIGNS THAT AUSTRALIAN BORROWERS, ESPECIALLY CORPORATES, ARE BOWING TO INVESTOR PRESSURE ON COVENANT PROTECTION.

Most recently, Challenger Treasury opted to add a change of control clause to its future bond issues, even within the existing funding programme that did not originally offer protection.

ANZ Investment Bank worked with Challenger on its strategy change. Stuart Raynes, who at the time of the deal was head of frequent borrowers, Australia at ANZ, says Challenger's clause is triggered

if the firm is subject to a change of majority ownership, classified as over 50 per cent, and its credit rating falls below investment grade. Challenger is now rated BBB+ by Standard and Poor's. If the clause is triggered, investors have the option to sell their holdings back to the firm.

It is believed that the addition of the clause boosted investor interest in Challenger's paper, with its most recent issue ? a A$250

million (US$208 million) three-year bond priced on April 23 ? increased in size by A$100 million on the back, ANZ claims, of "strong domestic support".

Challenger's move is understood to be the latest in a line of such decisions, with Mirvac and Fairfax also introducing covenant protection to earlier bond programmes. Paul Jenkins, partner at Blake Dawson Waldron, believes a trend could be developing: "There has been some demand for domestic borrowers to include protective provisions because of the situation in the US where investmentgrade bonds have slipped to junk bond status as a consequence of LBOs. If the LBO wave continues, I would expect change of control protection to become more common in domestic Australian markets over time."

25

Feature

"We have told potential issuers not to come to market without covenant protection and from speaking to other investors I expect a trend towards more of it."

A N D R EW M O RGA N QUEENSLAND INVESTMENT CORPORATION

TIGHT PRICING

BT's Anantakrishnan agrees that market conditions make it a difficult time for investors to demand protected deals. "Covenant protection probably won't become habitual until investors aren't chasing yield and are prepared to stand back from deals. At the end of the day there is so much liquidity in Australian markets and people don't want cash drag in their portfolios affecting performance. So while it's easy to tell bankers you want covenant protection, unless you are going to stand behind that and not invest in deals that don't have it, the situation isn't going to change."

Aberdeen's Alley also claims the market is so competitively priced at present that if covenant protection made spreads even tighter it would be "difficult" to make a commitment to paying for it.

When the private equity consortium headed by JC Flowers and Friedman Fleischer had its US$25 billion bid for Sallie Mae accepted on April 15, all three rating agencies put the US student loan corporation on negative credit watch, with Moody's saying Sallie Mae is in danger of falling from its A2 rating to sub-investment grade. Sallie Mae's Kangaroo bonds, of which there are A$1.6 billion (US$1.33 billion) outstanding, blew out to 500 basis points over swap in the wake of the takeover announcement, according to some bankers.

By contrast, the recent conventionally-structured merger proposal from Barclays to ABN AMRO has not had anything like the same impact. S&P reaffirmed its AA rating for Barclays, having previously said the proposed merger could have a negative impact, while the same agency placed ABN's AA- rating on credit watch "with positive implication". Moody's confirmed its Aa1 Barclays and Aa2 ABN ratings.

A rival bid for ABN, from Royal Bank of Scotland, Banco Santander and Fortis, has also had little initial impact on credit ratings despite the widely-held assumption that, if successful, the bidders will break up the ABN group. These kinds of bids are also a concern for investors as there will inevitably be a knock-on effect on credit quality as the breakup strategy emerges.

Nonetheless, it is the potential for large downgrades caused by private equity buyouts that causes greatest concern. "It is very evident in the current private equity-fuelled market that credit ratings do not always reflect event risk," claims Michael Bush, head of fixed income research at nabCapital in Sydney.

This issue may be systemic, however, with S&P's Bayley commenting: "It is very difficult for rating agencies to act on rumours, and I don't think the market would want us to ? that would inevitably create tremendous ratings volatility. What we can do is try to assess the probability of an announced bid being successful and the impact of that, or indeed the impact of a failed bid, as even these have a good chance of having some credit implications."

Bush agrees it is "unrealistic" to expect a firm's potential as a takeover target to be included in its credit rating. And there is a consensus that investors need to be aware of the probability of leveraged M&A activity when buying bonds, especially longer-dated or subordinated debt.

M O R E P R I VAT E EQ U I T Y D E A L S C O M I N G

W hile analysts also say some financials remain unlikely LBO targets due to regulatory protection, Bayley concludes: "It would be very unwise to say Sallie Mae is a one-off event. Although there may not be a whole raft of LBOs of financials, it would be wise to assume that there will be more to follow."

Although market participants agree that the range of potential private equity targets is now wider than ever, there is still confidence that likely LBO subjects can to some extent be identified among their peers. In the financial sector, most highly-rated institutions operate under greater regulatory oversight than Sallie Mae, which market participants identify as a significant barrier to takeover. According to ANZ's Bugg, the most vulnerable financials at present are financing institutions like Sallie Mae which have the potential to have their funding leveraged.

BT's Anantakrishnan says a useful tool is peer group comparison ? asking whether a financial institution has competitors which operate a similar business with a lower credit rating. "If there are," he explains, "the higher-rated company may be a likely target for an LBO ? if you have the same margin business but can do it at a lower rating, an LBO sponsor can come in and leverage exposure to that margin."

This creates a paradox, explained by nabCapital's Bush: "The same financials that make institutions investment grade can be the things that also make them attractive takeover targets. So we are now seeing some single-A and triple-B rated institutions with greater event risk than double-B rated firms." ?

26|KANGANEWS JUNE 2007

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download