VideoWhen Neiman Marcus became the focus of a leveraged buyout by two private-equity funds last year, it also became the latest battleground in an escalating war between equity holders and bondholders. As LBOs have become more highly leveraged, investors have found it more difficult to exit via a sale or initial public offering. Instead, they have been taking their returns in the form of dividends. That drain on cash has made companies less financially flexible, which in turn has made bondholders nervous.
They fought back in the Neiman Marcus case by making an unusual demand: in exchange for accepting (under certain circumstances) interest payments in the form of new bonds — a provision known as a payment-in-kind, or PIK — the investors insisted that Neiman not pay out the cash thus conserved to its equity holders.
While the PIK provision provides, as CFO James Skinner notes, "a security blanket in case of financial stress," bondholders didn't want to see shareholders be rewarded at their expense, hence the extraction of the promise that any cash conserved would be retained. "You want to make sure there's enough cash available to pay debt [rather than see it] go out to the equity holders," says Paul Scanlon, a manager of high-yield funds for Putnam Investments, which bought more than $13 million of the bond offering.
Unlike publicly held companies, LBO firms find it especially difficult to resist demands from their shareholders, given the latter's large holdings of both common and preferred shares. But as the Neiman case illustrates, bondholders are growing more aggressive about protecting their interests. For instance, more than half of Hertz's $15 billion LBO last December represents asset-backed securities based on the group's car fleet. "When markets get tighter, covenants get tight, and interest rates go higher," says Scanlon.
Overall, LBO activity soared in 2005 — topping $120 billion at the end of the third quarter, according to Morgan Stanley — and so did the leverage levels on private-equity deals, a fact not lost on bondholders. "LBO activity has firmly established its place atop the list of bondholder concerns," wrote the authors of a Morgan Stanley report last November. Given the increasingly aggressive terms of the deals, they added, "all we need is Michael Douglas to squeeze back into his bespoke suit, his Gucci loafers, and release Wall Street II, and we'll know the end of the LBO boom can't be far behind."
A different sort of sequel is more likely: should the economy go south and cash-strapped LBO companies stumble, a new spate of legal battles, a hallmark of the late 1980s, when several highly leveraged private-equity firms collapsed, may erupt, albeit with a twist. Back then, bondholders and other unsecured creditors had to prove that managers were engaged in fraudulent conveyance, and proving fraud is "a hard wire to trip," observes William Bratton, a law professor at Georgetown University.
Today, bondholders may be able to sue on different grounds: fiduciary liability. That possibility was first glimpsed in 1991, when the Delaware Court of Chancery, which has great influence over corporate law, posited the idea of fiduciary duties to unsecured creditors. By that time, the '80s LBO wave had subsided. But as a result of that decision and others that cited it as precedent, Bratton warns, bondholders are likely to be much more aggressive in court during the next round of LBO failures.
The Zone of Insolvency
It isn't yet clear just how much the legal climate surrounding such insolvencies has changed since the last LBO boom. But the Delaware court's decision in 1991 in a case involving the Dutch subsidiary of French bank Credit Lyonnais is widely considered a legal landmark.
In that case, a Delaware chancery court judge stated for the first time that creditors were owed fiduciary duties within the "zone" or "vicinity" of insolvency (see "Debating Creditors' Rights" at the end of this article). Legal experts vigorously debate the merits of this view of fiduciary liability and its meaning for cases going forward. But many fear that empowering creditors could ultimately hamper the ability of directors and officers to run companies — and even, perhaps, subject LBO managers to claims for damages if their companies go bankrupt.
Complicating the issue, insolvency is ill-defined for legal purposes. Courts have accepted two traditional definitions: a balance-sheet definition, in which liabilities exceed assets; and an equity or cash-flow standard, where a company is unable to meet its obligations as they come due. But a company may be insolvent under one definition but not another, and there is no standard as to which test courts apply. They can even apply both, says Bratton.
Worse, two accountants employing the same definition may come to different conclusions. As a 2003 white paper by law firm Dorsey & Whitney LLP put it, "It is difficult for a corporation to know whether a court would find it to be insolvent, or 'in the zone' of insolvency." While third-party advisers often supply courts with solvency opinions, these don't always carry much weight.
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