Dire Straits Opportunity: Debt Buyback

Dato 20 mar. 2020
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Introduction

COVID-19 will affect corporate earnings significantly and lead to credit downgrades, covenant breaches and eventually credit defaults. Navigating in these dire straits may pose an opportunity for borrowers to buy back debt at a price well below par value and take advantage of the decline in trading prices on corporate debt.


Borrowers and their owners, including private equity sponsors, should consider some of the options set out in this newsletter and capitalize on the catastrophic scenarios unfolding in Europe and the United States.


Debt to be bought could be bank debt (term loans and revolving facilities) or bonds. We will refer to a debt buyback also in cases where the debt is bought by a fully aligned affiliate of the borrower, although this is technically not a “buyback” since the debt is not eliminated.

 

Initial Considerations

Benefits

The benefits of a debt buyback are: (i) an improvement in earnings and (ii) an improvement in cash flow, in both cases by a reduction of interest bearing items; (iii) less risk by improving the leverage ratio; and (iv) removal of financial (and increasingly tighter) covenants and improved credit rating potentially leading to lower interest rate for other indebtedness.

 

Liquidity

A borrower considering a debt buyback must undertake a forecast of its liquidity before the borrower voluntarily completes a debt buyback. It is essential for the borrower to have enough liquidity, and the borrower’s completion of a debt buyback should only be made if there is sufficient liquidity for operations, including in a prolonged downside scenario as we may see in relation to COVID-19.

 

If a borrower is liquidity-constrained, it may be worth considering whether a parent company, an affiliate company or a private equity sponsor could instead purchase outstanding debt. The debt could then be converted into equity achieving the same result.


Covenants

It is paramount for the borrower, a private equity sponsor or a lender prior to completion of a debt buyback that such debt buyback can be completed without a breach of any financial covenant, which may be implicated in other credit agreements.

 

Provisions

Credit Agreements

Voluntarily prepayment clauses would normally permit repayment at par value and would not give the borrower the benefits it could get from a real or perceived increase in default risk for its borrowings. Negotiating a deal for repayment below par value with the initial lenders is likely difficult since the initial lenders would not want to take a haircut outside of a work-out situation.


The best scenario for taking advantage of the downturn is for the borrower to do a buyback of a loan or loan participation at a low market price.


Generally, most credit agreements in the Nordic region would not restrict a debt buyback in the covenants. Share buybacks, dividends and other equity distributions are likely restricted, but debt buybacks will not be captured. Loans repurchased by the borrower are typically deemed cancelled, as a matter of law, upon acquisition thereof and a below par transaction is therefore beneficial to the non-selling lenders as well. Borrowers contemplating a debt buyback must, however, review the “Changes to Parties” clause governing transfers by the lenders to make sure that a debt buyback is indeed permitted. In particular, if the buyback is to be completed by an affiliate to the borrower, the loan will not be cancelled, and the affiliate may have to satisfy certain requirements to become a new lender.


Although there is no public market for credit trading in the Nordic region, credits trade OTC, and in periods of downturn, some banks may find it attractive to reduce loan assets as funding becomes ever more difficult and expensive.  


In the United States and sophisticated European deals, generally, the borrower is only permitted to repurchase term loans (and not revolving loans) on a non-pro rata basis through Dutch auction procedures or open market purchases. Usually borrower repurchases are not capped. Additionally, some credit agreements also prohibit the use of proceeds of revolver borrowings to acquire debt.


Corporate Bonds

Most bond terms in the Nordic region include a call option at a make whole amount for a period after issuance and after that period at a fixed call premium of 103-105 % declining towards 100 % as maturity approaches.


The requirement to redeem bonds above par at early redemption is an extra incentive to take advantage of a market opportunity to buyback bonds. Open market purchases of bonds are, generally, permitted expressly for the issuer and the issuer group. Some provisions require the bonds to be cancelled and others permit cancellation or keeping at issuer’s discretion.


In the United States, notes indentures generally do not restrict the repurchase of notes issued thereunder by the issuer, affiliated lenders or affiliated institutional lenders. Notes owned by such persons, however, are typically disregarded and deemed not to be outstanding for voting purposes. Moreover, purchased notes are generally not automatically cancelled.

 

 

If you have any questions or would like additional information regarding any of the above, please feel free to contact Partner Henning Aasmul-Olsen (hao@mwblaw.dk) or Junior Associate Andreas Egeblad Arendt (aar@mwblaw.dk).

 

The above does not constitute legal counselling and Moalem Weitemeyer Bendtsen does not warrant the accuracy of the information. With the above text, Moalem Weitemeyer Bendtsen has not assumes responsibility of any kind as a consequence of any reader’s use of the above as a basis for decision or considerations.