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Out from Under

Deeply discounted corporate debt may tempt companies to buy it back or exchange it, but such deals are far from easy.
Vincent Ryan, CFO Magazine
February 1, 2009

Last fall, as the CEOs of the Big Three automakers were preparing to journey to Washington, D.C., in search of a bailout, auto supplier Metaldyne Corp. pulled off a minor miracle. The $1.7 billion company wiped out a crippling debt load by buying back its bonds at less than 30 cents on the dollar, clearing $300 million in debt and $40 million in annual interest expenses. The transaction staved off bankruptcy.

"While it entailed a lot of 18-hour days," recalls Metaldyne CFO Terry Iwasaki, "we had support early on from customers, and we were able to get the financial sponsors and the debtholders on the same page."

The Metaldyne deal stands out because many of the Plymouth, Michigan-based company's customers themselves were barely hanging on, and other, higher-profile attempts to deleverage and take advantage of the large discounts in the corporate bond market had faltered. Indeed, debt buybacks, exchanges, or any attempt to provide creditors with a recovery of less than par by pushing out maturities or subordinating existing investors to new ones is meeting resistance in the current market.

"It's not compelling for an investor to voluntarily convert to a less secure instrument that may pay better or not, without any confidence that the reorganized entity will survive," says Jeffrey Manning, managing director at Trenwith Securities LLP. "Why should they do it voluntarily when they have the benefit of a court process to protect their rights?"

Given the difficulties in issuing new debt, many companies may find themselves in Metaldyne's position: laboring to conserve cash and restructure existing debt more favorably. This year, a large amount of bond and bank loan maturities are hanging over nonfinancial companies in the Americas — $233 billion worth, estimates Moody's Investors Service. To make matters worse, 10 percent of all rated, nonfinancial companies in the Americas face liquidity shortfalls.

Given that many bondholders have rejected offers from big-name issuers, CFOs may be wondering if wading into these waters — trying to restructure the balance sheet outside of bankruptcy — is worth it. The answer, say the experts: it depends.

Distressed-debt exchanges have become one popular approach. In this transaction, a company trades debt for debt, usually forcing creditors to take less than par, a lower interest rate, a longer maturity, a more junior ranking, or all of the above. In 2008, 20 percent of all bond defaults occurred due to companies offering debt exchanges to bondholders, up from 10 to 15 percent historically, Moody's says. (The credit-rating agencies consider such an exchange a de facto default.)

When credit markets are calmer, managing liabilities using debt exchanges is straightforward. In March 2007, Minneapolis-based Xcel Energy, a $10 billion utility, cut a $600 million bond maturity in half. "We wanted to take out some of the refinancing risk and spread out our liabilities," says Xcel CFO Ben Fowke. "Our motto is, 'Get on top of risk before risk gets on top of us.'"

Xcel had to pay a slight premium to investors and throw some cash into the deal to lure participants. And, most important, bondholders didn't take a haircut. The alternative was tortuous and risky: a combination of prefunding the large debt maturity, forward hedging, and "managing a negative arbitrage on a large cash balance," Fowke says.

What's Rational?
Now would seem like a good time for such deals, with bond and loan prices in the secondary markets exceedingly low — 60 to 70 cents on the dollar, and even cheaper for some issuers.

 "The rational man would conclude that distressed-debt exchanges are an intelligent thing because they may prevent the need for going into a bankruptcy process and losing control of the enterprise," says Trenwith's Manning.

But in many cases, he adds, the rational man would be wrong, for two reasons. First, a wide variety of investors with conflicting agendas may hold the paper, adding friction to the deal. The trustee of a collateralized debt obligation, for example, often does not have the ability to negotiate a debt or redeem a bond for anything less than par. Other investors may be holding the debt in the hopes of owning the company after the equity gets wiped out. On the other hand, "if you can fit every one of your debtholders into a conference room," Manning says, "an exchange is more likely to work."

Second, investors are likely to be skeptical about the state of the company's finances. Bondholders are going to think long and hard before entering any deal, says Christopher Meyer, a partner at Squire, Sanders & Dempsey. An analysis of the company's financial situation is central to the decision. Creditors may be convinced the company is headed into a bankruptcy, where they have more rights and remedies. (The only thing many debt exchanges accomplish is delaying a Chapter 11 filing by a few months.) Or they may believe the company can shoulder more debt than it admits. "The debtholders have to be persuaded that such a transaction is necessary for the company's survival," Meyer says.

There are many ways for CFOs to compel investors to tender their bonds, however. In a distressed exchange, a company could issue new instruments with interest rates that increase over time, giving bondholders more income and the company the incentive to retire the debt early; financial sponsors could promise to kick in more equity ahead of the exchange or buyback, giving a vote of confidence; or, if the existing debt is "covenant lite," a new instrument that affords creditors some protection if the issuer's finances worsen could prove attractive, Meyer says.


And then there are the more forceful methods at a CFO's disposal. Harrah's Entertainment's debt exchange last December stated that holders of old notes who didn't tender their debt would be subordinate to the new, second-priority notes in a bankruptcy.

In this market, though, the best bait is cash, as Metaldyne discovered. "Many of our individual investors needed the liquidity," says CFO Iwasaki. "There weren't a lot of buyers of auto debt at the time." Metaldyne did a lot of other things right. Asahi Tec, Metaldyne's parent company, provided an equity injection in conjunction with RJH International, its largest shareholder, for example. Prior to the buyback offer, Metaldyne also withheld an interest payment to bondholders, proving the severity of the situation. And, in the actual buyback agreement, Metaldyne retained the right to file for a prepackaged bankruptcy if less than 67 percent of the bonds were tendered. The filing would have forced recalcitrant debtholders to take the deal. That provision was key, Iwasaki says, and most investors wanted it.

"We have a competitive group," she says. "They didn't want to sell their bonds just to find out that the other guy didn't tender."

It would be a mistake to think that Metaldyne held investors' feet to the fire, however. Iwasaki left it among the bondholders to negotiate what the payout would be among holders of subordinated and senior debt, for example. And when bondholders balked at signing a lockup agreement, committing them to the tender offer before it was announced, Iwasaki backed off.

One element of buying back debt that is not negotiable is the tax bill. If a company buys back a loan or bond at a discount, the Internal Revenue Service considers that a cancellation of debt, which is taxable income, says John O'Neill, U.S. leader of bankruptcy and restructuring tax for Ernst & Young. Were a third party — such as a special-purpose subsidiary — to purchase the debt, the income would still be taxable. However, if a company is in bankruptcy, debt-forgiveness income is not taxable. If insolvent — defined by the IRS as the fair-market value of a company's assets being less than its liabilities — the income is excluded only to the extent of the insolvency, O'Neill says.

Loan Rangers
Despite being taxable and more complex than bond deals, buying back loans at a discount is another restructuring option for CFOs. In fourth-quarter 2008, $4.9 billion of leveraged-loan assets were for sale, according to Standard & Poor's, and the average loan bid was 71 cents. "It might not be a bad move," says Thomas Bonney, founder of CMF Associates, of buying back corporate loans. "The bank and its investors may just need to get out, because they have pressure somewhere else in their organization." In this economy, buying back a loan might also be the best use of excess cash, Bonney says.

Still, loan purchases are decidedly tricky. In the loan market, more so than with bonds, lenders have always assumed they will get paid back at par. Credit agreements don't allow borrowers to buy bank debt at below par without approval from a majority of lenders. Although generally banks and asset managers like deleveraging stories, they are finding many current offers distasteful. "Ultimately, it comes down to the form and substance of the amendments, which run from plain vanilla to aggressive," says Seth Katzenstein, an alternative-asset manager at GSC Group.

Buybacks that fail usually contain provisions that force banks to take all the pain, Katzenstein says. Some companies try to buy loans at steep discounts and demand that the purchase count toward the "free cash flow sweep" provision, which requires the company to pay a certain portion of year-end excess cash flow to lenders. Other companies try to buy operating-level debt at the holding-company level, which does not deleverage the operating company's balance sheet.

Preemptive Strike
With debt markets so dislocated, finance chiefs are better off weighing the option to buy or exchange debt sooner rather than later. Since bonds are pricing in default rates that may be 10 to 20 percent higher than the actual number of companies expected to fail in 2009, some issues are probably oversold, experts say.

In its fiscal fourth quarter, Morgan Stanley bought $12.3 billion of bonds at a discount, in what CFO Colm Kelleher calls a "debt defense." Kelleher says that letting the debt continue to trade at distressed levels "would have sent a very bad signal." Morgan Stanley also recorded a $2.1 billion gain from the open market transactions. Similarly, last December, Glencore, a Swiss commodities trader, announced plans to buy some of its bonds after the spread on its credit default swap spreads soared. The intention: to assure investors of the firm's creditworthiness.

Although buying back debt may not in itself signal "all's well," as a share buyback does, "if there's buying in the market, it will tend to increase the price of the debt," says Meyer of Squire Sanders.

A company's bond price could be a mountain too heavy to move, however. Unless a dramatic turnabout occurs, few corporate bonds will fetch higher prices this year. Debt restructurings, on the other hand, will be rampant. "We're in the third inning of a nine-inning game," says CMF's Bonney. "There's a lot more of this to come in 2009."


Vincent Ryan is a senior editor at CFO.




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